Failing Austerity in Europe: The Case of Spain

In spite – or rather because – of a series of austerity packages and a constitutional “debt brake”, the exercise of squaring the circle is going to collapse in Spain. In the environment of a contracting economy (latest forecast -1.7 %), monthly new unemployment records (February: 23.6 %, youth unemployment 50.5 %) and a deepening social crisis, the Spanish government produced the harshest consolidation package in Spanish history. Spain will again become a European role model for fiscal policy – but this time for the failure of European austerity.

Why Spanish Austerity will fail

There are several factors leading to this austerity failure. Obviously, the most important one is the global economic crisis in combination with the bursting domestic housing bubble. The domestic factor has impeded a fast recovery like in Germany and is the main reason for the unemployment rate more than tripling in just three years. Contracting employment has caused huge revenue losses and rising social spending. Together with relatively large stimulus measures, the result was a worsening of the annual fiscal balance from nearly +2 % of GDP in 2007 to a record of -11.2 % in 2009.

Another factor is politics: the economic policy of the socialist government at the end of 2009 consisted of stimulus, automatic stabilisers, optimism and a moderate mid-term consolidation plan to meet European requirements (improvement of the structural deficit of 3.75 % of GDP by 2012). Counteractive measures to reverse the sharp drop in the tax-to-GDP ratio from 37.1 to 30.7 % of GDP in 2009, which was mainly due to the bursting housing-bubble, were however missing.

This strategy failed in spring 2010 as the interest rate on Spanish bonds shot up after Greece’s inability to finance its debt in financial markets. The outlook for the Spanish economy itself deterioated and the Eurozone leaders’ unwillingness to provide significant help made matters even worse. European fiscal targets for Spain were tightened (structural deficit to shrink by 6 % of GDP by 2013, which means on average 1 ½ % each year) after the Spanish government announced the first harsh austerity programme – despite the ongoing recession in 2010. “Front-loading” became the fashionable term of that time. In 2010 the deficit targets were broadly reached but at high social costs. The austerity programme therefore laid the foundation for a series of victories for the conservative party at all levels of government over the following 1 ½ years.

Austerity causes a Dangerous Downward Spiral

Big fiscal problems arose in 2011, as the deficit reached 8.5% of GDP instead of 6%. In contrast to the mainstream story, the excess deficit was neither caused by the old socialist national government nor a significant lack of policy implementation. It was the unexpected increase of unemployment (2011: 21.7 instead of the forecasted 19.8 %) and the large deficits on the – predominantly conservative-governed  - regional level (almost two thirds of the deviations were counted in the Comunidades Autónomas). On the regional level there were, however, also large consolidation packages (for example a significant reduction of public jobs), but they were just not large enough to meet the exorbitant targets during an ongoing economic crisis.

But whatever the detailed reasons for the 2011 deviations are, what counts is that the significantly higher starting level makes it much more difficult to reach the agreed deficit target for 2012. Furthermore, the economic outlook has worsened considerably: Instead of the predicted growth of 1.7% at the time the European targets were determined, the latest forecasts indicate that the economy will shrink roughly by that amount. Combining these two setbacks, the only conclusion is that the old deficit projections (in June 2010 it was 5.3 % of GDP, later on it shrank to 4.4%) are no longer viable. Even if the “supporting measure” of a radical cutback of labour standards increased employment (which I do not believe), it would not work.

The Collapse of European Economic Governance

The European institutions have reacted by ignoring reality as well as their own decisions. Even though the target was a structural consolidation of 6 % of GDP by 2013, the ministers of finance now still just look at old deficit projections without any cyclical correction. They could argue that Spain actually sticks to every single rule of the new Economic Governance (even though it is likely that it will not in 2013). They could postpone the target date to reach the 3 % annual deficit threshold on the basis of an ongoing recession. But they don’t. They continue to stick to the second stupidest fiscal policy rule (after the 60% threshold for the debt-to-GDP-ratio). The only concession so far has been the shift to the old deficit path of June 2010. A small group of hardliners – including in the country where I live – has tried to oppose even this compromise.

The argument: This is the only way that leads to credibility. But how credible is the negation of reality? How credible is sticking to the deficit projection for 2012 and forgetting about the structural deficit, when your major governance reform is exactly focusing on the latter? How credible is ignoring the recession, a deepening social crisis and a youth unemployment rate of more than 50%? This is only understandable if you want to abandon or prevent a balanced economic policy mix. Or, to put it in the words of the Spanish minister of finance, if your economic policy agenda consist only of the following priorities: “Primero el déficit, segundo el déficit y tercero el déficit”.

As there are more ideological similarities than disagreements between the European and the national level, the Spanish government sticks to the targets. The second austerity package, passed within the first 100 days of the new national government, has a volume of 27.3 billion euros (2.5 % of GDP). Ministries have to cut their spending by 17% on average, with a focus on public investment, active labour market policy and R&D. Although the unemployment rate is expected to surge to 24.3% this year (around 600,000 people), the spending on unemployment benefits is supposed to shrink, indicating measures against unemployment are also to be cut. One should also keep in mind that the Comunidades Autónomas have to slash their deficits by a further 1.4 % of GDP, so the 27.3 billion euros are just the most visible part of the overall consolidation effort.

Austerity will Fail

It is very likely that these measures will harm employment and the economy even further. It seems that the government has not taken into account the multiplier effect of its measures, which should be significant: for Spain, IMF staff estimates indicate a 0.6% fall of GDP for 1% of GDP fiscal consolidation. If this is the case, further revenue shortfalls and higher social spending must be expected, leading to an annual deficit well above the envisaged 5.3% (if the estimates are right, the GDP effect should lead to a reduction of around 0.7% of GDP if the initial consolidation package was 1% of GDP).

Besides the economic consequences, Europeans should also start to think about the social consequences (unemployment, poverty rates, distributional effects, rising number of evictions, increasing desperation associated e.g. with a doubling of suicides, and so on). However, so far European reactions have been quite the opposite. For example the German member of the ECB board suggested the consolidation measures should be approved by emergency laws so that the parliamentary process will not delay their implementation. It is becoming more and more doubtful how this European economic policy can restore confidence or overcome the systemic crisis of the Eurozone if it is deepening the imbalances and disintegration processes. It does not even recognise the cross-country effects of policy measures (for example the worsening conditions for Portugal if the recession in Spain is deepened).

Anyway, it seems as if the strategy of “austerity forever” will continue for a while in Europe. And as the Spanish government wants to become a role model for crisis resolution and the European pressure will increase. The most probable next step is that we will see a third consolidation package in Spain this year. After all, it will again be now or never to save the credible way out of the crises…