Spain gave us Warning Signs

The year is 2006 and Spain is riding high. The economy has been experiencing incredible growth

since the turn of the millennium with per capita output having more than doubled in just six short

years. German economists are predicting in as little as five years Spain will overtake them in

per capita income and Spain will become a central power in Europe. Certain regions of the country

were achieving full employment and the government passed laws to make working conditions very comfortable

and rewarding. The boom was fueled by a belief in the continued growth of the beautiful country and

everybody wanted in on it. The Eurozone opened up international investment in a shared currency

and the best way to own a bit of the Spanish success story was to own a bit of Spain. Buying a

beach house in Marbella or a studio in Madrid was not a luxury, it was a savvy investment that could

also be used to enjoy some time in the sun. Real estate agents were doing so much business that

they became local celebrities and tradespeople were in such high demand to build enough houses

to keep up it wasn't unusual to see a plumber driving a Bentley. This all became a self-fulfilling

prophecy because as money poured into the country and people took on debt to get more exposure to

the Spanish real estate market there was more need for construction which made GDP figures look great

which in turn made the country look like a great investment. Of course it wasn't and the economic

shocks of the GFC and the Eurozone crisis put a swift end to the debt fuel party and now almost

two decades later the economy is still poorer than it was back in 2007. Unemployment remains high

especially amongst the youth, broader economic activity has stagnated, the country still struggles

with debt and perhaps worst of all this slowdown didn't even make the housing market that started

this whole mess cheaper for average people. Spain is genuinely one of the scariest economies in the

world because while it's easy to look back at this speculative exuberance for the early 2000s

and conclude with the benefit of hindsight that it was inevitably destined for failure the country

in many ways had a less over leveraged economy back then than a lot of major nations do today.

If Spain is a cautionary tale it's probably worth asking if we've really learned anything from it.

So what drove the rapid growth of the Spanish economy? What really caused it to all come crashing

down? Why has it stayed down for so long? And finally are there major economies in the world

today that are really in more compromised positions than Spain in 2007? As we reflect on

Spain's economic roller coaster from booming growth to sudden downturns it reminds us of

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today. There are a lot of economic roller coasters in Spanish economic history. From their overuse of

gold during colonization to their exclusion from the US Marshall plan revival to early liberalization

policies there's plenty to discuss when it comes to Spain and its financial history. But to get to

the bottom of the country's present crisis it would be best to start off with its apparent success

story kicking off in the 1990s. At the time the country had a higher unemployment rate that wouldn't

budge. The Spanish government started making moves to secure a potentially more profitable seat at

the progressively globalized table and they felt the best way to do this was to join the European

Economic Community or EEC. This seat planted in 1986 was initially underwhelming as Spain's GDP

per capita remained about 72% of the average EEC member. However after the enduring a global

recession in the early 90s the government successfully managed to curb inflation and

managed to budget enough to start a steady decline in unemployment by the middle of the decade.

Almost in tandem with these changes the EEC was integrated into the first pillar of the newly

formed European Union in 1993 prompting Spain to be one of the first nations to adopt the Euro in

1999. As is often the case with most massive geopolitical decisions like changing a nation's

currency and joining a global aggregate this came with a number of costs and benefits.

When an economy remains independent from outside arbitration there's a bit of flexibility that

comes along with it, primarily total monetary sovereignty. If the currency needs to be devalued

to boost exports and shrink trade deficits having a government capable of doing so on its own can

expedite the process before things get out of hand. If they need to control interest rates to

handle inflation, debts or unemployment they maintain that control within the country itself.

Of course on the other hand there are plenty of pros to come along with a more integrated

economic model especially among countries sharing the same continent. For starters sharing a currency

like the Euro makes trade with neighbours a lot easier by simplifying price comparisons as well

as helping individual businesses and their consumers find the best prices. Plus in most cases a shared

currency is a stronger currency especially compared to the previous Spanish Preseta which was not

notorious for its stability. With a huge network of countries keeping a currency relevant paying

for imports becomes a lot easier and most importantly credit becomes much cheaper which

depending on how it's handled can easily join the list of cons.

Alright so how did this all play a role in what kicked off the Spanish bubble and how did this

country grow on paper to the point of convincing almost everyone it was on its way to becoming the

new Eurozone superpower. According to most economists the dramatic shift was first initiated

in 1998 just a year before adopting the Euro. Banking on an immigration increase that started

the same year Spain became very interested in the housing market more than it already was.

With a wave of new people ready to gain citizenship the focus on constructing comfortable living

spaces began to rise. This was seen as a positive development for the Spanish government because

construction is a labour intensive occupation. One that could keep citizens employed for long

periods of time and given the troubling history of Spanish unemployment it makes sense why Spain

began to theorise that this could be a long term solution to the stubborn unemployment rates faced

in the 20th century. At the peak of the construction boom one can find historical references of

blue collar tradesmen driving luxury cars because their work was so in demand and the fuel on the

fire of this boom was the Euro. Of course this is where the cheap credit comes in. With low interest

rates provided by Spanish banks along with the Euro acting as a prime catalyst for transactions and

low risk foreign exchange fluctuations the property market became a wellspring for those

hoping to turn a profit. The interest in building houses was already favoured by Spain but the

introduction of the Euro made development much faster and easier than ever before.

It also didn't hurt in the eyes of both foreign and domestic investors that the Spanish government

favoured tax breaks in the real estate sector. These policies decreased the user cost of ownership

and made the country an incredibly attractive investment opportunity. There was non-taxation

on imputed rents, the basically untaxed capital gains, the mortgage interest payment deduction

and what truly set Spain apart from the other players at the time payments on the principle

were also deductible from personal income tax. All of this with the economic growth model prioritising

construction caused Spanish borrowing in the real estate market to reach jaw-dropping heights.

So why didn't the Spanish central government see the writing on the wall and why didn't the rest

of the global investors buying into this give it a second thought? After all debt was climbing

dramatically and in hindsight economic indicators were screaming trouble. Well first it's important

to understand that people now look at this from a post-crisis lens. It's kind of like how most

experts saw Bernie Madoff as the Wizard of Wall Street only now coming out to say that everyone

should have been wiser. That said there are other major elements that hid the growing bubble,

one being the unique way the Spanish government and its economy function. The official theory is

fiscal decentralisation, the process of shifting the responsibilities of revenue collection and

expenditure execution from the central to sub-national authorities. What this means is

that the Spanish central government played little to no role in the borrowing process like other

countries in the EU. In fact as far as the world was concerned at the time Spain's debt was

incredibly low because most economic figures only look at the central government and take no

account of provincial government branches. In an effort to guarantee the autonomy of the regions

that made up the country the Spanish government set up a constitution promoting administrative

division activated in the late 1970s. The nation is made up of 17 autonomous regions including the

archipelago of the Canary Islands and the Atlantic Ocean and the archipelago of the

Balyric Islands and the Mediterranean Sea as well as two autonomous cities in northern Africa.

Of course it was clear that construction firms, investors and regular people that just wanted

to buy a home were doing all the borrowing but what wasn't clear was who exactly was doing the

lending. This is where the whole issue of regional autonomy comes in. For a country like Spain a lot

of tax collection, health costs and educational funding is not operated by a central authority

but rather it's respective autonomous regions. Moreover before the 2008 crisis there were approximately

45 different regional savings banks known as Cajas scattered across the country. Most of

them went all in on real estate with high hopes of making it big. This disconnect is one of many

that allowed Spain to actually report a budget surplus when things were running smoothly and for

a time the world just didn't notice. Again with EU membership there was also reduced legal barriers

to investment coming from other European countries so it wasn't long before investments from wealthy

countries like Germany, the UK and France began to pour in. This chain reaction fueled an aggressive

building boom which made the country's economy look great which in turn made investors even more

excited about the economy's growth which made them invest more money which made the country's

economy look even better. At its peak more than 12.5% of the Spanish workforce was involved in

construction. Spain alone managed to create more than half of the new jobs in the European Union

creating more houses than Germany, France and the UK combined. Credit began to explode and

house prices soared by 71% in just five short years between 2003 and 2008 and here's where

things get really interesting. Spain did in a small way anticipate the possibility of a fallout.

After joining the Eurozone Spain central government had a team working around the clock

collaborating with banks to set aside money for potential non-performance loans when things were

profitable. This was very abnormal in the pre-crisis west and the official record indicates that they

set aside about 35 billion euros but here's the problem it wasn't nearly enough to save the country

from what was to come not even close. So what were the key issues here? What really caused it all to

come crashing down? Well to start like any good relationship communication is key and that's

an area where Spain was sorely lacking. Immigration was one of the primary initial motors for housing

development and a reason to put many to work on construction projects as quickly as possible.

It turns out that Spain overshot their estimates for exactly how many homes were needed and that's

a bit of an understatement. Putting it into perspective by 2006 the country had constructed

more than 800,000 homes or the house about 200,000 families. To add to this chaos some participants

in the Spanish housing bubble didn't even go through the trouble of changing regulations to

suit their needs they just lied. In a paper published by two professors Jose Maria Rea and

Jose Garcia Maltova the two studied the nature of the Spanish mortgage system to understand house

prices. They did this by looking at the loan to value ratio or LTV. This ratio is computed using

the value between the mortgage which is given and the value of the house. Seems simple enough but

there was a problem. The disconnect became more elaborate because this value was determined by

outside speculators, appraisal companies. Their job was to provide pricing for the homes according

to a set of characteristics and that's how it works according to the study. The Bank of Spain

is estimated that an LTV equal or lower than 80% is a good mortgage because of the fact that 20%

of the value of the house is already been paid. However the closer an LTV is to 100% the riskier

the mortgage is and the higher the probability of not paying back the debt. If the bank was facing

a mortgage with an LTV higher than 80% it was unlikely that the Bank of Spain would accept it.

This is where Rea and Maltova made a gut wrenching discovery. Banks actually managed to give mortgages

that were not following banking policy and here's how they managed to do this over and over again.

If a financial worker noticed that a family had an LTV closer to or equal to 100% they would just

call up the appraisal company and change the price of the house giving the home a lower LTV.

According to these investigators the appraisal company raised the price of the house so the

bank could give them the mortgage, the buyer could happily enjoy his or her new home and the

Spanish bank was none the wiser. Of course this was possibly the most dangerous involuntary risk a

regional bank or car park could make giving mortgages to clients that had no security with

high price real estate manipulated by appraisers and financial institutions frankly too hungry to

consider the consequences and amongst 80% of Spain's population as homeowners this all felt

like a dream come true that is until the bubble finally burst. With poor data and incentivized

deception everything finally came crashing down in the blink of an eye. By the time everything

in the housing market imploded Spanish real estate debt equaled almost 50% of the country's GDP.

Thousands of families were unable to pay their massive debts and since the homes were well into

negative equity banks had no way to recoup their losses. The once seemingly bountiful flow of credit

dried up almost immediately leaving speculative developers which were ubiquitous at the time to

devolve into a large mass of non-performing loans. Needless to say that 35 billion euro nest egg

didn't do too much. Now again this is all easy to see as a bit ridiculous with the benefit of

hindsight but there are a lot of countries in the world today in arguably worse positions who have

also fallen to the trap of assuming it can't happen to them. For example my own home of Australia

now has a higher level of household debt to GDP than Spain did right before its generational crash

accounting for 116.6% of the country's nominal GDP in March 2023 compared with Spain's all-time

high of what now looks like a rather modest 85%. The increase in the Australian household debt to

income ratio has been more pronounced than in most other countries rising from the bottom half of

the distribution across advanced economies in the late 1980s to the top quartile by 2018.

There are also the same key warning signs of generous tax policies for real estate investing,

banks willing to look the other way to get a deal done, migration and field speculative mania and

a self-assurance that just because we have nice beaches our home should be worth 15 times national

income. Then there's Canada. As of the end of 2023 Canada's household debt to GDP ratio was

estimated to be 104% which is again higher than Spain's ever was. There are also the same

anecdotes in a lot of these modern economies about tradesmen making much more money than

their professional counterparts with more training and real estate agents getting their own TV shows.

Spain's meteoric house price rise in the early 2000s now almost looks relatively conservative

compared to the house price increases experienced in these economies over the past five years and

as nice as it would be to say that things turned out just fine for Spain the reality is that it

is still dealing with the fallout of this crisis almost two decades later. Initially Spain did

what many countries do when they're trying to revive their economy put simply when in doubt

spend it out and spend they did spending more as a percentage of GDP on stimulus than any other

European country. All of this would have probably been front page news for years if it weren't for

another country stealing the spotlight with its own financial failures. Greece. For Greece in 2009

the new government then disclosed that Greece's fiscal deficit was far higher than anyone thought

one market started to lose confidence in Greece's economy and they became the new headline in many

ways burying the cautionary tale of Spain's real estate for nearly two decades. Obviously this

didn't suddenly nullify the Spanish problem for Spain itself just because the world's eyes

looked away from the falling tree doesn't mean the Spanish people weren't still there to hear

the sound of the fall themselves. There are a number of serious challenges the country still

deals with to this very day. While most western nations took a beating at the start of the 2008

housing crisis Spain's system was hit particularly hard and even though they managed to see a few

years of growth their GDP still hasn't recovered from where it was in 2007. When the country was

flying higher in the 90s annual salaries competed with the likes of France, Germany and the UK.

However now it stands far lower than most other developed nations at 29,113 euros on average

an annual income that is about 9 to 11 percent less than what they were experiencing before the

crash. With a steady rise in debt and inflation the average Spaniard is worse off today than they

were two decades ago. With increased international borrowing in the bailout of Spain's banks the

nation was forced to modify the structure of all but two of the aforementioned 45 car cars

referenced earlier making it harder for people to access credit even to this day.

Moreover its ties to the euro or once promising move for the financial stability removes much of

Spain's ability to depreciate exchange rates. This in tandem with lower income saw what economists

refer to as brain drain the emigration of highly trained intelligent people from a particular country

which as it turns out doesn't bode well for a nation requiring problem solvers. The days of

blue collar workers riding in sports cars are also a fading memory as unemployment remains higher

than in most other European nations. As of April 2024 there's been an upward trend in fact the

stats can be somewhat misleading as many of those deemed employed are actually just working small

gigs to make ends meet with no promise of long term career opportunities. Of course it may be too

late for Spain and the country will need to grow back slowly if it's to do it at all but for other

countries there's always an opportunity to change these habits and this is where the message

becomes crystal clear. With these common themes hopping up in other nations it's time for those

to look at what Spain really is at least from an economics perspective. It's more than just a

country with a struggling economy, astronomical youth unemployment, low growth and ironically

high housing costs. It is in every sense of the word a warning. A warning that an economy cannot

solve fiscal problems unilaterally with one sector assuming mass amounts of debt. A warning that

excitement can eclipse rational judgement. A warning that if a housing crash like this can

happen in Spain it can happen feasibly anywhere else. Fast money is exactly that. Fast money and

it can disappear just as quickly or faster than it arrived. Now Spain's neighbour Portugal

experienced a similar set of challenges but they're trying to rebuild their economy in a unique way

that looks like it's working but hasn't been particularly popular