Spain’s Slump Means Europe Must Rethink Tough-Love Policy
BLOOMBERG EDITOR
Spain is the crucial front in Europe’s battle to contain its economic crisis, and the fight is going badly.
Spain’s economy is in a tailspin. Some forecasters say the unemployment rate, already a punishingly high 24.4 percent, could reach 30 percent. The government’s credit rating has just been downgraded, and its cost of borrowing -- close to 6 percent -- is putting its solvency in question. Investors are watching the country’s banks with mounting concern.
Europe’s leaders cannot blame Madrid. Mariano Rajoy’s center-right government is making progress on reforms aimed at improving the country’s competitiveness and has tried -- to a fault -- to meet the European Union’s austerity demands. The resulting budget cuts are strangling the economy, squeezing the government’s revenue and increasing the likelihood that Spain will need still more austerity to meet the EU’s fiscal targets. The policy has become self-defeating.
The EU must come to the country’s assistance while it can still make a difference. If Europe’s leaders don’t move fast to help rescue Spain’s banks and at least mitigate its economic decline, the crisis will quickly become much harder to contain.
Spain is running out of options to shore up its banking system, laden with problem loans extended during the country’s record-breaking housing bubble. The government has reformed the sector and called for new capital and loan-loss provisions, but analysts increasingly doubt this will be enough.
Bad Assets
Rajoy is now considering a program to protect banks’ capital by getting bad assets off their balance sheets. To do this in a way that strengthens the banks, though, the government will need to put in money -- money it doesn’t have. If it taps funds set aside to guarantee deposits -- an approach that is being debated -- this would only increase financial risk with one hand while reducing it with the other.
Rajoy has also done plenty to reform Spain’s notoriously sclerotic labor market. The government has liberalized the dual- contract system that made many employees impossible to fire and forced all the stress of economic adjustment onto temporary workers. Although only a first step, it’s a radical move that took courage.
Persevering with these and other structural reforms, plus wage restraint, can improve the country’s long-term prospects but can’t provide short-term relief. Such relief can only come from the EU as a whole, partly through easier monetary policy and partly through backloading of the fiscal consolidation. Spain can’t loosen its fiscal policy on its own for fear of spooking investors. So any feasible solution will require some pooling of Europe-wide fiscal policy, with the European Central Bank acting as lender of last resort for distressed sovereigns or the issuance of euro-area bonds jointly backed by all the currency union’s members.
The ECB’s trillion-euro liquidity operation brought temporary relief, but only at the cost of increasing Spain’s financial fragility as its banks used the ECB’s loans to buy more of their government’s subsequently downgraded debt. The more investors understand this frailty, the greater the risk of financial meltdown becomes. Considering that Spain’s economy is far larger than those of Greece, Ireland and Portugal combined, the repercussions would put all of Europe at risk.
On this background, it’s absurd to assert -- as Germany has -- that Spain and other struggling economies can claw their way back to economic stability through fiscal austerity, despite slow or no growth. If Europe’s leaders are betting they’ll have time to act if the situation deteriorates, they’re wrong. The pressure on Spain is no longer productive. It’s undermining a government that is doing all it can. If the gamble fails, things will unravel quickly -- too quickly, maybe, for Plan B to take effect.
The time for Plan B is now.