After only three months in office Finance Minister Cristóbal Montoro announced last week the most severe budget cuts Spain has witnessed since the end of Franco’s totalitarian reign. Last month, Mariano Rajoy asked exemptions on the budgetary path set out by the troika to raise the deficit ceiling from 4.4% to 5.8% since the economic situation was “extremely severe”. The Troika granted him a drop of something more than 1% but still demanded an enormous austerity program including budget cuts and tax hikes. The outcome of this programme is a plan to purge the budget with a whopping 27 billion Euros, in the hopes of restoring the confidence of the financial markets. The need to be cautious with extreme measures in Spain is however critical, since it is the fourth largest economy of the Eurozone and is crippled by an unemployment rate of 25%. Nevertheless, this falls on deaf ears within the EU.
The program consists out of several tax increases and should supposedly avoid further pressure on already hard hit middle or low income families. Therefore no pension cuts, reductions in social benefits or an increase in VAT taxes were announced. Corporate taxes, however, will be raised together with closing fiscal loopholes and a fiscal amnesty measure to retrieve hidden money from the underground economy with a one-off tax at the very low rate of 10%. On the budget side, the ministries of the central government have to cut their expenses by 17%, with a severe cut for infrastructure expenses. The regional governments also have to do their share and cut spending, but since they mostly concern education and health, the danger arises of cutting into the heart of society.
As time continues, the devastating effects of the austerity measures resulting from the six-pack for economic governance and the budgetary treaty become apparent. It is baffling to see how European leaders are struck by blindness to the effects of austerity that would supposedly lead to drop in interest rates, and therefore a regained investor confidence. Alas, markets and economies do not work like this. The adage of ‘growsterity’ that is haunting every country in the Eurozone is eroding private consumption and investment, crippling the educational, health and social security system and fuelling youth unemployment, thus eroding the basis on which the European welfare states are built. If the failed recipe of Greece, Ireland and Portugal is continued to be tried on to Spain, the outcome could well mean the rupture of the Eurozone.
It’s private debt, you stupid...!
Often the current crisis in the Eurozone is all too easily described as a problem of fiscal profligacy of the governments of the peripheral countries. In fact this is only true in the case of Greece. Spain for example – oh the irony! – never violated the stability and growth pact. On the brink of the crisis, its debt was downsized to 30% of GDP with a budget surplus of 2%. This is in comparison with a debt of 50% and a budget surplus of 0,7% in Germany. To be honest, Spain’s economy was not an example of sound economic policy, since it was solely based on a property boom and internal consumption with large labour market rigidity. But nevertheless, government spending wasn’t the problem.
Rather the combination of the lack of an integrated European macro-economic and fiscal policy has led Spain to where it stands today. As the Euro was introduced, interest rates dropped dramatically which fuelled a credit boom among the private sector and then resulted in a housing boom. This boom was very difficult to control since monetary policy was set out by the European Central Bank (ECB) in Frankfurt, which had to balance itself between the overheating economies in the periphery and the slacker economies in the northern part without a common fiscal and economic policy. The boom continued and many young Spaniards quit higher education to start working in the well paid construction sector, where companies were happy to attract them since they were very easy to lay off in contrast to their elderly colleagues. This expansionary economy was accompanied by a huge rise in private debt due to inflation and great growth prospects, financed by the account surplus in Germany.
When the banking crisis emerged asset prices plummeted, banks needed huge bailouts and as companies fired construction workers, unemployment rose very quickly. This is nourishing a vicious circle where unemployment causes defaults on private debt, therefore increasing the capital need of banks and reducing the necessary lending for investment project, resulting in a recessionary economy. Government debt exploded and with an economy in distress, financial markets doubted the ability of Spain to repay its debt, resulting in a huge spike in interest rates. By demanding above all huge budget cuts off Spain, Europe is however not addressing the underlying problems of the fourth largest European economy, but is feeding the downward spiral in which an already beaten down population is entrapped.
The fable of internal devaluation
Although it is very clear that structural measures such as a more flexible labour market and service market have to be implemented to ensure a competitive economic recovery, the idea of growth by an internal devaluation is too costly from a societal perspective, too slow to mitigate the market anxiety and too theoretical to have substantial results. The opposite is rather true.
There is very little evidence that a country can emerge out of a currency crisis by internal devaluations. The main cause is nominal wage rigidity, or to put in other words, the unlikelihood that wages can be adjusted downwards. As Ireland is hailed for its austerity measures, a closer look at the figures reveals that it is very difficult to cut in the payroll to make the economy more competitive. This is because private companies are reluctant to lower wages for fear of social unrest and demotivating their employees; instead they fire people or let them work less. The effect is even reported by the Fed in the United States, which on the contrast to their very flexible labour market didn’t know a nominal decline in wages this crisis.
Moreover, even if it would eventually succeed, the time it takes to revitalize the economy on such a premise is just not there. Economies undergoing austerity are hitting their third to fifth year of recession, which automatically increases government debt. Markets are aware of that and are pushing interest rates even higher. Furthermore, the effects on society are neglected. Ireland, Portugal and Greece are incredibly hard hit by this one-sided strategy. People are rapidly impoverished and are emigrating their way out of the crisis. Ireland and Portugal have already lost more than 150,000 nationals each, who have moved abroad in search for a better life. Unemployment still continues to rise and the process of losing a whole generation into this mess has already begun.
Over the few past years, the EU has seen many efforts by the populations of the peripheral countries. It seems therefore unjust that the core countries still wave with moral hazard issues instead of coming across with some measures that would alleviate the unsustainable pressure on the population. The EU has several unused tools to battle the crisis, including loose monetary policy of the ECB, a controlled inflation leap in the northern countries, investment projects in the periphery, Eurobonds and the encouragement of labour mobility within the EU. Just focusing on yet another round of austerity in Spain will drive the whole EU off the cliff and is just insane since : “Insanity is doing the same thing over and over again and expecting different results.”