Spain’s misfortune

Martin Wolf argues, in this blog post, that Spain could not have prevented the real estate bubble and the subsequent crisis of its banks. Spain was a well governed economy, fiscally prudent and with a conservative bank regulator. If he is correct, and I think he is, the fundamental problem is not the eruozone, but the free flow of capital. 

“What else could the Spanish authorities have done?

Well, they could have tried to curb bank lending directly, via rapidly falling loan-to-value ratios or direct curbs on lending. There are two reasons for wondering whether this would have worked. First, it would have been desperately unpopular in Spain. People like the property developer I met, not to mention the construction workers and many other interests, would have been ferociously angry if the authorities had tried to curb lending. It takes a very tough set of regulators do so. Often, too, the latter cannot imagine how badly things will turn out. Second, the lending might then have come directly from foreigners rather than via Spanish institutions. Would the Spanish authorities have been able to prevent such inflows under European Union rules? I believe not.

Alternatively, they could have tried to make their banks more robust. But they did in fact try to do so, with their famous policy of dynamic provisioning. It was controversial at the time, though a good idea. The problem, as we can now see, is that it was nothing like enough. Banks needed far more capital than they had to survive a crisis of this magnitude.

Spain did not run irresponsible fiscal policies, as Germans believe, and the fiscal compact would not have saved it from crisis. It did have a huge property boom associated with financial excesses and illusionary prosperity. But that boom was, in sizeable measure, also financed from abroad, via capital inflows, as the history of current account deficit shows…”

“…this is more misfortune than misdeed…”

Would having a national currency have prevented the bubble? I do not see how. However, it would indeed make it a bit easier to get out of the crisis after it happened, mainly because Spain would have a lender of last resort for its banks (and its state).

So, to put it bluntly: in a regime of free capital flows, there is no way to prevent bubbles; we need either to change that regime, or to create much stronger mopping-up mechanisms. There are good reasons to argue against capital controls (protectionism, rent-seeking etc), as there are good reasons against a pan-European lender of last resort (moral hazard). But there are even better reasons to install at least one of the two.



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