April 25, 2007

More euro problems - now Spain

We looked the other day at strains the euro might be about to place on the Irish economy.

Today Open Europe picks up concerns about Spain. “Low interest rates set by the European Central Bank have fuelled a housing boom since Spain swapped the peseta for the euro in 1999, but excess stimulus has now seriously distorted the economy", reports The Telegraph, which also notes Spain’s current account deficit of 9.5% of GDP – a sign of “extreme overheating” – and reports that many economists predict a hard landing for the Spanish economy.

The governor of the Bank of Spain blamed the bubble on the wrong interest rates caused by Spanish euro membership. The Bank estimates that Spanish house prices are 35% overvalued.

Monetary policy is now shifting from being too loose to too tight for Spain, however, just as it is for Ireland. The ECB’s policies, in trying to cater for German demand for higher rates – which have risen seven times to 3.75% since December 2005 - have hit Spain with an "asymmetric effect", since 96% of mortgages are on floating rates. Most loans in Germany are on fixed rates, meaning that Spanish borrowers suffer disproportionately from interest rate rises. The monetary squeeze has been likened to Britain’s ERM debacle in 1992 – except Spain cannot use monetary policy as an escape route.

This huge difference in mortgage loan arrangements between the two countries is just another sign of how far they were from convergence when they joined the euro. It remains the case that most euro economies will have the wrong interest rate for most of the time.

Bernard Connolly, former head of economic research for the European Commission, said that Spain faces a brutal adjustment over the next two years - if it can remain in the euro at all. "Spain is going to face the very direst of economic circumstances: a cycle of recession, deflation and widespread private sector default - a depression in fact."

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