SPAIN: The keyv battleground in the eurozone crisis this year

It was always likely that Spain would prove to be the key battleground in the eurozone crisis this year, and so it is proving. If the eurozone’s austerity strategy, based mainly on the imposition of fiscal contraction in the peripheral economies, works in Spain, then it will probably work elsewhere. But if it fails in Spain, the long term outlook for the eurozone would seem ominous. The EFSF/ESM “firewall” announced last week was at the low end of market expectations, providing new funding for future crises of only E 420 billion by July 2013, and E 500 billion a year later. A medium sized Spanish crisis, involving both the sovereign and the banking sector, would comfortably absorb most of that, leaving nothing over for the many other potential calls on the eurozone’s bail-out funds. That is why the market was so focused on the Spanish budget announcements on Friday. Last year, Spain missed its target for the budget deficit by around 2.5 per cent of GDP, partly due to shortfalls in GDP growth, and partly to the reluctance of its regional governments to hit their deficit targets. The new Conservative government has not been willing to correct this fully in 2012, but has nevertheless announced a huge fiscal policy tightening of around 4 percentage points of GDP this year. After allowing for a further weakening in GDP, this is intended to reduce the fiscal deficit from 8.5 per cent of GDP last year to 5.3 per cent in 2012, but few observers expect this target to be achieved. Once again, problems with the regions (especially after the Conservatives’ lukewarm endorsement in the recent Andalusia election), and with the deepening recession, make the likely out-turn for the budget deficit at least 6-6.5 per cent of GDP. Here are the key figures: Spain isdiscovering how difficult it will be to escape from its current predicament through fiscal austerity alone. J.P. Morgan now estimates that the fiscal policy tightening will amount to 7.7 per cent of GDP from 2010-12, compared to 5.8 per cent predicted by the IMF last October. But despite this additional tightening, Spain will still probably miss the IMF’s original budget projections for this year by around 1-2 percent of GDP because of the GDP shortfall. In other words, it is chasing its own tail, and is doing so unsuccessfully. This illustrates the danger of viewing the Spanish economic crisis, and the eurozone crisis in general, solely from the point of view of public debt and deficits. As Jay Shambaugh points out in a perceptive paper presented at Brookings last week, the eurozone faces at least three inter-locking crises (insolvent banks, excessive sovereign debt, and inadequate GDP growth), which need to be treated in a holistic way. In Spain’s case, it is easy to add two further crises to this list, involving unfinanceable current account imbalances, and excessive private sector debt ratios, especially in the non financial corporate sector (see Martin Wolf here). It is very hard to see how all of these problems can be addressed by the single instrument of fiscal tightening. In fact, this will make some of the other problems worse. The most obvious of these is the growth shortfall, which is clearly not immune from the fiscal measures. Both the IMF and Goldman Sachs have recently estimated that the fiscal multiplier for a country which cannot either devalue its currency or reduce its short term interest rates as it tightens fiscal policy is in the region of 1-1.5, and Spain’s experience seems to be bearing this out. This will remain a severe problem for some time to come. By the end of this year, Spain will have reduced its primary fiscal deficit to around 3 per cent of GDP. If bond yields average 4.5 per cent in the medium term (compared to 5.3 per cent now), this primary deficit will need to be transformed into a surplus of around 1 per cent of GDP in order to stabilise the public debt ratio at about 80 per cent of GDP. That means that fiscal policy may need to be tightened by a further 4 per cent of GDP after this year, a tightening which could depress cumulative GDP growth by 6 per cent over the period in which it takes place. Note that, even then, Spain would still have a debt ratio some 20 percentage points of GDP above the 60 per cent limit now set by the eurozone. With GDP likely to remain in the doldrums, the adverse feed-back effects on unemployment (already at 23 per cent of the labour force) and house prices (already falling at 11 per cent per annum) could be very large. What would then happen to the solvency of the banking sector, which has recently been addressed, but not fully corrected, by the new government? Would it be possible, with the rise in unemployment beginning to affect prime household earners as well as young people, to force through the government’s ambitious labour market reforms, which have to be the centrepiece any successful growth strategy? I doubt it. None of this means that the government can afford to abandon its fiscal consolidation programme. If it did so, the path to a financial crisis would be a short one indeed. But it does mean that fiscal contraction within Spain is only one of a long list of measures which the eurozone needs to contemplate in order to resolve the crisis on a permanent basis. This list includes slightly higher inflation and easier fiscal policy in Germany (which will probably be needed anyway to hit existing budgetary targets); co-ordinated measures across the eurozone to reduce labour taxes in the deficit economies, while increasing them in the surplus countries; dramatic deregulation, especially in the labour market and the service sector; much lower marginal tax rates; easier monetary policy by the ECB, along with a weaker euro, assuming that overall inflation is within target; and further steps towards fiscal union and eurobonds. If that list of reforms is deemed impossible by Germany, then Spain will remain mired in its austerity trap. And so will the eurozone as a whole.