Are the markets panicking because Spain may fail to hit its deficit targets, or are they panicking at the thought that Spain may succeed? That, to me at least, is the key question facing eurozone policy makers. The ultimate outcome of the eurozone crisis will depend to a large extent on how that question is answered.
News coverage seems to suggest that the markets are panicking about the deficits themselves. I think this is wrong. The investors I know are worried that austerity may destroy the Spanish economy, and that it will drive Spain either out of the euro or into the arms of the European Stability Mechanism.
The orthodox view, held in Berlin, Brussels and in most national capitals (including, unfortunately, Madrid), is that you can never have too much austerity. Credibility is what matters. When you miss the target, you must overcompensate to hit it next time. The target is the goal – the only goal.
This view does not square with the experience of the eurozone crisis, notably in Greece. It does not square with what we know from economic theory, or from economic history. And it does not square with the simple though unscientific observation that the periodic episodes of market panic about Spain have always tended to follow an austerity announcement. One such episode came with the discussion that led to the recently introduced draft budget, which included a deficit correction of 3.2 per cent of gross domestic product for 2012. When Mariano Rajoy, Spain’s prime minister, began to outline the deficit cuts for 2013 last week, the markets panicked again and drove Spanish 10-year yields back to 6 per cent. The targeted fiscal adjustment amounts to 5.5 per cent of GDP over a period of two years. It is one of the biggest fiscal adjustments ever attempted by a large industrial country. It is perfectly rational for investors to be scared.
European policy makers have a tendency to treat fiscal policy as a simple accounting exercise, omitting any dynamic effects. The Spanish economist Luis Garicano made a calculation, as reported in El País, in which the reduction in the deficit from 8.5 per cent of GDP to 5.3 per cent would require not a €32bn deficit reduction programme (which is what a correction of 3.2 per cent would nominally imply for a country with a GDP of roughly €1tn), but one of between €53bn and €64bn. So to achieve a fiscal correction of 3.2 per cent, you must plan for one almost twice as large.
Spain’s effort at deficit reduction is not just bad economics, it is physically impossible, so something else will have to give. Either Spain will miss the target, or the Spanish government will have to fire so many nurses and teachers that the result will be a political insurrection.
The wider eurozone crisis was caused by financial flows from banks in the core countries, which financed bubbles in the periphery, except in Greece. Spain may also have a dysfunctional labour market and fixing it may still be highly desirable. If this is a good moment to do it politically, then so be it. But we should not fall for the illusion that structural reforms are going to make a big difference. Austerity and reform are not the magic combination policy makers believe them to be.
Fixing the Spanish crisis will have to start with the banks – and this is a task the private sector is not willing, and the government not able, to perform. The only halfway benign solution I can see would involve a European rescue programme for Spain that focuses specifically on the recapitalisation and downsizing of the financial sector. Spain would also need to undershoot the eurozone’s average inflation rate over many years to redress some of the lost price competitiveness. At the same time, the country needs to go easy on austerity.
That combination of policies might just work, though it would still be difficult. What is not going to work is a combination of deflation, austerity and private sector deleveraging, all at the same time, for a decade.
But it will be tried – of that there can be little doubt. The EU will resist an ESM programme for as long as possible. The eurozone finance ministers fear that any such programme might reopen the debate about the size of the ESM, a debate they want to avoid at all costs. But as the recession gets worse, and Spanish unemployment rises towards 30 per cent, the pressure for Spain to turn to the ESM will grow. It will happen eventually. And even when that happens, it will not end the crisis in Spain. For that a eurozone-wide bank resolution system would also be necessary.
I can see only two outcomes for Spain. The crisis will end either in a catastrophic Spanish withdrawal from the eurozone, or in a variant of a fiscal union that includes a joint eurozone backstop to the financial sector. If the Spanish government pursues the strategy it has announced to the bitter end, the first outcome will become vastly more probable.