The decisive test of the euro area’s plans for economic recovery was never Greece but Spain, and the European Union shows every sign of failing it.
The Spanish government’s new austerity plan hasn’t won investors’ confidence, and this creates a threat not just to Spain but to the whole EU. Europe’s governments need to change course before it’s too late.
An auction of Spanish bonds on Wednesday was the first verdict on Spain’s new budget. It didn’t go well. Demand was poor and prices fell. The country’s borrowing costs rose with 10 year bond yields in the secondary market hitting 5.7 percent, the highest since the beginning of the year. The premium over German government bonds increased to nearly four percentage points, the highest since November.
The problem is not that Spain’s new austerity plan is too timid. Just the opposite: Under EU orders, Spain is promising what might be the tightest fiscal squeeze that it or any other European economy has ever faced. The new plan calls for the budget deficit to fall from 8.5 percent of gross domestic product to 5.3 percent this year. Since the economy is already shrinking, this requires a discretionary fiscal tightening of roughly 4 percent of GDP -- with the unemployment rate already standing at about 23 percent.
Spain overshot its previous too-demanding fiscal targets, and is being told to make up lost ground. It missed its budget goal because regional governments, over which Madrid has limited control, failed to do their part, while economic growth came in lower than expected. This is all too likely to happen again. Excessive austerity stamps on growth, which causes public borrowing to rise despite the government’s efforts. The government’s new plans are simply not credible: The more it succeeds in cutting public spending, the worse the outlook for growth and hence for public debt.
Spain’s overall unemployment rate is terrible enough, but the youth unemployment rate is an amazing 50 percent. Recession isn’t the only cause. The country’s labor market, divided by Franco-era rules between an absurdly protected sector for long-term employees and a lightly regulated sector for those on temporary contracts, has long been seen as one of the most dysfunctional in the developed world. The government’s efforts to reform it are necessary and long overdue -- but it’s hard to win support for reforms that will cause further labor-market disruption at a time like this. The new center-right government, in office barely three months, is facing strikes and just lost a regional election it expected to win. As well as losing the confidence of the markets, it may already be losing the confidence of voters.
The Greek economy is tiny, but Spain’s is the fourth largest in the euro area. If it goes down it will take the EU’s still-puny defenses against such an eventuality down with it. The European Central Bank’s long-term liquidity operations, which have let banks borrow roughly 1 trillion euros on easy terms, have lately helped to stabilize financial conditions, but Spain’s worsening predicament shows this was a false dawn.
Spain cannot work through this crisis without more help from its EU partners. In their own larger interests they should allow a milder path of fiscal consolidation, and support Spanish growth along that path. That means steps to buoy EU-wide growth, including easier fiscal policy in Germany and easier monetary policy from the ECB. It means outright temporary fiscal transfers to Spain. Above all it means announcing that the ECB will act as lender of last resort to distressed euro-area governments.
Spain is being drawn into a vicious circle of economic, fiscal and political collapse. Even now, this is an avoidable danger, so long as the EU is willing to act. But if it stands aside too long and lets Spain fall into the trap, containing the damage will make dealing with Greece look like child’s play.
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