Saturday, February 1, 2014

Catalonia, The EU, And The Spanish Suicide Bomber

The European Union has a number of very important tasks – facilitating trade and keeping peace in Europe being among the most important. Whether the European Union is the reason why European countries haven’t engaged in warfare against one another since the end of the Second World War is an interesting question (if you want my view, click here). But, that’s a discussion for another time: What is important is that the EU is supposed to keep peace between European nations, and right now, it’s not doing a good job.

If the title didn’t give it away already; yes, I am talking about Catalonia.

The way I see it, there are two interesting questions we need to ask: What should the EU do, and why hasn’t it done anything so far? This article will primarily focus on the second question.

To understand why the European Union hasn’t done anything to stop Spain, there are a couple of things we need to understand:

First, the Eurozone is very frail. While from a stock market point of view last year was great, growth & unemployment numbers are still dismal. Debt levels are have continued and will continue to rise, and if one country were to declare default, few people doubt that it would cause a ripple effect that would bring a new recession to Europe and quite possibly the world. This is especially true if a large country were to default; such as Spain.

Secondly, we need to understand that Spain is governed by a neo-fascist party which doesn’t have much respect for democracy or fair play in general.

Thirdly and finally, this neo-fascist government appears to be willing to do just about anything to keep any region in Spain from becoming independent.

What does this mean then in practice? It means that Spain can threaten to default if the EU were to openly support Catalan independence. This threat would be credible because 1) debt levels in Spain are very high and 2) the Spanish government hardly considers such a threat to be unethical or unfair towards the other European countries (in a fascist worldview, whether an act is ethically right or not is determined simply based on whether or not the act will help achieve the goals of the fascist state).

But wouldn’t this hurt Spain? The answer is, of course, yes. Defaults always hurt the country that is defaulting (ask anyone from Argentina). But they also hurt the surrounding region (ask anyone from any of Argentina’s neighbor countries). In the case of Europe, our economies are so intertwined that a Spanish default could definitely cause a continent-wide recession. Basically; we have a lot to lose from a Spanish default. They have a lot to lose too, but the EU certainly has enough to lose that it would want to avoid such a scenario from occurring at almost any price.

In essence, Spain is acting like a suicide bomber: Do as he says or he’ll blow himself up. Sure, he’ll die if he pulls the trigger, but you’ll be going down with him. He knows you don’t want that to happen, which is why he can get you to do what he wants. In the case of Spain, what he wants is to be left alone to oppress the Catalan people.

But how can Spain make a credible threat, given that they have so much to lose? To understand this, we need to understand Catalonia’s role in the Spanish economy. Catalonia is pulling more than its own weight; contributing about 9 bn euro more tax revenue than it receives. Without Catalonia, Spain will be economically weakened and will be forced to raise taxes in the remaining regions to make up for the shortfall. These tax hikes (or spending cuts) would be in addition to the ones they have already been forced to introduce since the beginning of the Eurozone crisis (when Spain’s fiscal deficit blew up). Exactly how much the transition would cost the Spanish economy is hard to determine, but figures around 50 billion euro have been quoted. Needless to say, an independent Catalonia would be a tough blow to Spain.

The Spanish government may well have informed the EU of this and told the EU officials that rather than shouldering the costs, they will opt for default. Every economist agrees that government default can be a good idea under certain circumstances – a default simply means that the government must henceforth live within its means (not spend any more than it takes in) as no-one will be willing to lend them any money for a long time. But if a country’s debt repayments get too large, then it may be worth it as a default would also eliminate said repayments. If Spain can convince the EU that they will consider default a better option to borrowing the amount of money (or raise taxes/cut spending) that they will need if Catalonia secedes, then they’ve effectively guaranteed that the EU will stay on the sidelines.

If you think this is unrealistic; consider that this strategy has already been used. Back in the summer of 2011, Ireland managed to convince the EU to lower the interest rate on the bailout it had received. How did Ireland do this, seeing as how the country didn’t really have anything of value to offer in return? While we may never know exactly what was said during the negotiations, most likely what happened is that the Irish government said “Look, our debt repayments are too large – we’d rather default and start over with a clean sheet than continue like this. Either you lower the interest rate, or else…”

This situation leaves the EU impotent in dealing with Spain. If Spain were to use military force against Catalonia, what can the EU do? Any form of economic sanction or fines would simply push Spain towards default; a scenario nobody wants.

There is a larger point to be made here: Because of the debt crisis in the Eurozone, there are now a lot of countries whom the EU dare not touch lest they default. Had it not been for the debt crisis, any threat from Spain to default would have lacked credibility and been ignored. In fact, had it not been for the Eurozone, a Spanish default would never have had any negative consequences anywhere other than Spain & possibly the countries neighboring Spain (tough luck, France & Portugal!) – but because of the way the Eurozone is set up, all the countries’ economies are tied together and a default would therefore hurt everyone and possibly lead to defaults in other countries as well (Greece being the most likely example). Talk about creating bad incentives when countries with bad fiscal discipline can get away with things countries with good fiscal discipline could never dream of getting away with.

Worse, the EU can’t even discuss the issue – the last thing they want to do is to remind investors and business owners that Spain may split up later this year; that kind of economic uncertainty would be bad for growth in the entire region.

Then what is the solution? First of all, Spain needs to remove all the uncertainty by agreeing to a referendum. Everybody knows what the outcome of that referendum will be, and so once Spain has given its permission for a referendum to be held, everyone will know that Europe is getting another state. However, there is no reason why this state would have to be created immediately – as long as Spain agrees that Catalonia should be allowed to secede, the timeline can always be negotiated. Catalonia needs time to set up all the necessary institutions (such as an army and a treasury), and Spain and the Spanish economy could also use some extra time to make the transition smoother.

It is still quite likely that Spain will need some economic support from the EU to get through the transition. The sooner Spain accepts that Catalonia will secede, the sooner it can begin negotiations with the EU (and other institutions such as the IMF) over the terms of such a bailout package – in fact, the EU should reach out to Spain immediately to discuss this as Spain appears unlikely to make the first move; the Spanish government still being in denial about the inevitability of Catalonian independence.

Of course, in the long run Spain will have to learn to stand on its own feet; one reason why an independent Catalonia may actually be good for Spain in the long run is because the rest of the country will have to learn how to provide for itself without free-riding: Sort of similar to a lazy 20-year old who gets kicked out of the house by his parents and has to learn how to earn a living. Sure, it will be tough at first, but eventually (millions of parents & children can testify to this) they will mature – because they are forced to. Once Spain accepts that Catalonia really is leaving, they can begin to work on the economic reforms (not merely spending cuts and/or tax hikes – Spain will need actual policy reforms if past mistakes are not to be repeated) that will be necessary for it to survive economically after Catalonia’s secession. In fact, Catalonia’s separation may be what is necessary to motivate Spain to introduce economic reforms that they should introduce anyway.

There are other issues that I would like to discuss, but this article is already quite long so I’m going to stop here and return to them in the future. Thank you for reading.

John Gustavsson

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