The Stability and Growth Pact (SGP) is a good tool to stop sovereign European nations from becoming too indebted. Traditionally, Southern European countries were fiscally irresponsible, and Central European countries tried and tame that behaviour with the SGP.

Low interest rates resulted as a positive consequence: even though German rates were low due to the European Central Bank decreasing the Main Refinancing Rate (as a result of its control of inflation), spreads of PIGS countries with respect to the German benchmark also posted historical lows due to the newly engineered fiscal austerity.

However, we are facing what could represent the limits of the SGP: the Law of Unexpected Consequences. Or in other words: there can be too much of a good thing.

Currently we are experiencing the beginning of a double whammy: on one hand, monetary policy is starting to become contractionary. The European Central Bank is phasing out its extraordinary liquidity measures, and it will become to hike its Main Refinancing Rate beginning 2011. On the other hand, the SGP forces European countries to comply with a 3% deficit by 2013 by restricting their fiscal policy.

As a consequence, one can expect that these two contractionary forces will result in negative effects on the countries that are farther away from the constraints defined by the SGP.

One could ask, then, if the limits of the SGP could become too dangerous. To give an answer to this question, one would need to have good forecasting tools for GDP, and we do not have any. For example, the Spanish government expected, in 2008, that the Spanish economy would grow at around 3.5% in 2009. Instead, it ended up growing at -3.6% … more than a 7% error!

But we could check if current actions are leading towards reasonable outcomes. I want to present a piece of evidence showing than it could be that the SGP is forcing European countries to take on wrong and dangerous actions, just for the sake of complying with the SGP but devoid of a meaningful economic sense.

From the charts shown above, one can see that even though it is common for the Spanish Treasury to issue mainly long term bonds to finance Spanish public debts, in 2009 the Treasury issued mostly short term bonds for this task. Why was that? Why did the Spanish Treasury diverged from standard practice, both at the international level, and its own reasonable tradition of the past?

The reason is the interest rate curve was massively steep: short term bonds were yielding less than 1%, and long term bonds were at around 4%. As such, under the strong constraints of the SGP, one reasonable action was to switch from long term bonds to short term bonds, and save around 3% of financing costs.

However, this action leads to increased liquidity risk: the Spanish Treasury has to refinance the debt not in 10 or 30 years, but in one year. And if there are stresses in the world financial markets, this may become a game over for the country. In my opinion, it is better to control liquidity risk than to save one or two points of deficit.

To sum up: even though the SGP may be a reasonable measure under normal circumstances, it may be that it is becoming too stressful for Southern European countries suffering from both restrictive monetary and fiscal policies.

The Treaty of Versailles is another example of a highly constrained measure that even though it made sense originally, it created a worse problem than the one supposed to be solving.

Spain is one of the PIGS countries: Southern European economies that have been under severe stress during the current financial crisis. However, Spain is overcoming this difficult phase with healthy public figures: the spread of its sovereign debt with respect to the German reference is at about 70 bp, which is at the low end of the range for the PIGS, especially Greece, with a spread above 300 bp.

One of the main reasons for this good behaviour is Spanish fiscal orthodoxy during the last decade: public debt over GDP has been well below the European average. Even now, with a 2009 deficit of 11.4%, most expectations for the next few years give an estimation of public debt at around 80% of GDP, near the average of the expectations for European countries.

However, there are constantly rumours and comments that Spain’s economic situation is worrisome, both for itself and for the future of the European common project. One reason is the sheer size of the Spanish economy: its GDP is more than four times Greek GDP. A financial crisis in Spain, with a default on its sovereign debt would be less manageable than an equivalent outcome for Greece. Additionally, the openness of the Spanish economy, with a big chunk of its debt held by other Europeans countries, could lead to unexpected cascade effects in European countries apparently better insulated from the financial crisis.

Nevertheless, the main argument of this post is a different one: Spain’s main problem is not public debt, but private debt, both for families and companies.

To support my argument, I want to show the following charts regarding public debt and private debt, both for families and companies:

Spain, as it has been described above, has a low level of public debt, even though its late increases are worrisome. For example, it is still well below the levels of France and Germany, and much below Italy. In fact, one could consider this growth of public debt as a convergence towards the European average, and as such, not excessively problematic.

The biggest issue for Spanish indebtedness is within families and, especially, companies. Corporate debt is the highest for all the considered countries in the study, and for families, debt is only below the American one, and in line with the British one. However, corporate debt in America is quite low, which leads to the conclusion that total private debt sustainability is more an issue in Spain and the UK than anywhere else.

France and Germany show a remarkable European convergence trend: their debt paths are almost parallel, both for corporate and public debt. The main difference is for family debt, which shows a convergence, much weaker than in the other cases, but a convergence nevertheless. Probably, the reason is a demographic one.

Finally, Japan shows the terrible consequences of allowing a financial crisis to extend indefinitely in time, while keeping “undead” those “zombie banks” that should have economically defaulted: while private debt has plunged, public debt has exploded, unable to force companies and families to increase its demand of credit.

The Stability and Growth Pact forces all European countries to be below a 3% public deficit in 2013. As a consequence, the Spanish government has put in place a government program to reach this target. It is not clear at all that this objective will be accomplished (the plan has not many details on how the spending cuts will be allocated, and the growth expectations for the Spanish economy are too optimistic for most analysts). However, one could estimate which would be the economic contraction due to this fiscal retrenching. Some analysts, assuming standard fiscal multipliers, have argued that the impact for the following years could be a whopping 16.5% for GDP.

To sum up, Spain is under the following structural forces for the following years:

- Contractionary monetary policy: the European Central Bank is phasing out its extraordinary liquidity measures (”enhanced credit support”) during this year. Analysts and markets consider the marginal refinancing rate will start an upward move from its current 1% at the end of 2010 or the beginning of 2011 at the latest. Let me stress almost all Spanish mortgages are variable rate, which leads to much stronger responses to the Spanish economy from the monetary policy side. The reduction from 4.25% to the current 1% has been a huge stimulus for the Spanish economy. My personal calculations tell me the impact of monetary policy has been more than three times stronger than all fiscal policy measures together.

- Contractionary fiscal policy: as we have discussed above, Spain is bounded, by the Stability and Growth Pact, to implement contractionary fiscal measures which will probably lead to an overall contraction in GDP in the double digit camp. Economically, this does not make much sense: the public sector has still room to become more indebted (we have argued before the overall level of public debt in Spain was still relatively low), especially when it is the private sector the one that is too indebted.

- Banking system: past Spanish governments boasted that Spain had “the most resilient banking system in the world.” However, this attitude has led to the resistance to implement reforms that have been deployed in most European countries during this crisis. This has induced to the build up of more and more imbalances for Spanish Banks and Savings Banks. This will be the subject matter of following posts in this blog. Suffice to say that the Spanish banking system is in a weak position, and the flow of private credit is already with negative rates.

To sum up: even though it is true that the Spanish public sector is still in relatively good condition, with contained spreads, the main issue for the Spanish economy is its private debt, unlike other PIGS countries.

The main task for the Spanish economy is then to become more competitive: once fiscal and monetary policy cannot become expansionary anymore, growth has to be generated internally. Reforming the job market will be an essential part on this task. More on this subject, in the next posts in this blog.

The following months and years will be key to find out if Spain will be able to refinance and finally pay out the huge amount of private debt that has been assumed due to the massive construction bubble of the past decade.