At the end of 2012 youth unemployment in Spain was at a staggering 56%. This sorry state of affairs for the Spanish economy came after almost four years of negative growth, Spain plunged into recession in 2008 after a litany of crisis – a housing bubble burst, the labour market was highly uncompetitive and their inability to revalue their currency (the Euro) meant their terms of trade would stay in deficit. While the Euro zone as a whole has faced dogged economic turmoil, Spain has a unique set of challenges and there is fierce debate about their hopes of recovery.
The Spanish housing bubble
Contrary to popular belief the Spanish government was relatively restrained in its spending levels prior to 2008. The budget was in surplus and the government’s debt level, 36% of GDP, paled in comparison to Germany’s rate of 65%. It was, instead, reckless spending in the housing sector that started Spain on its downward spiral.
A broad estimate suggests that residential real estate prices rose 200% between 1996 and 2007. This was due in large part to the low interest rates that became available after the launch of the Euro in 1999. Banks, developers and home-buyers all gorged themselves on cheap debt. Inflation skyrocketed and, in text-book fashion, wage pressure grew quickly.
This bubble did what they always do, it burst, and the construction industry was left in tatters. There were widespread bankruptcies and a corresponding tranche of layoffs. The burden on the government was a double whammy: the unemployed headed to the welfare office, while tax revenues plunged.
Spain’s Fragile Labour Market
We can better understand Spain’s unemployment problems by making a comparison with another European economy that is mired in recession and high unemployment, Greece. While Spain and Greece have similarly dire unemployment figures, Greece has suffered the additional blow of an immense drop in output. Greece’s output, by GDP, has dropped by 19% since 2007, while Spain has managed to keep its drop in output to only 4%. The question of why, is a big one.
It seems it has a lot to do with the labour market, “In 2007, almost 13% of jobs in Spain were in construction, compared with roughly 8% in Greece and the euro area.” analysts say. The housing bubble burst and construction activity contracted by 35%. This fatal blow was a huge contributor to Spain’s employment losses, it is estimated that this downturn accounted for 60% of the retrenchments.
Similarly the OECD suggests that 32% of Spanish workers were employed under temporary work contracts. While in Greece only 10% were on temporary contracts. This would have helped growth in the boom years prior to 2008 but as recession hit it made it very easy for firms to lay-off workers.
Stubborn Wage Pressure
If a housing bubble wasn’t bad enough, the country’s sky-rocketing wage levels left the labour market painfully uncompetitive. Imports were cheap but Spain’s exports were expensive for their trading partners. This came at a time when they desperately needed to increase their output. In 2007 their current account deficit was a debilitating 10%. (ie. The country was spending 10% more than it was earning.)
At this stage the classic reaction would have been to devalue the currency. The countries workers would be producing at a lower cost and exports would fuel the return to positive growth. But instead, Spain is stuck with the Euro and its stubborn valuation.
Spanish workers will have to deal with sluggish growth until their competitiveness slowly realigns with the rest of the Euro zone. All the while the government and the private sector will be forced to borrow from foreign banks – debt is vital to reinvigorate growth but the question making everyone nervous is how much should Spain be borrowing? From whom? And, will they be able to pay it back?
Traditionally Spain has borrowed the bulk of its funds from French and the German banks, however, as Spain remains mired in recession there is a building fear that they could make the rash choice to flee the Euro. In this situation the countries debtors would be forced to convert their lendings into the new Spanish currency. This process would involve an aggressive devaluation, leaving the foreign banks with a huge loss.
As such the Spanish government has faced outrageously high costs of borrowing as those lending to them try to mitigate the risks of lending to this unstable economy. This situation was alleviated somewhat in October 2012 when the so-called Troika (European Commission, European Central Bank and IMF) negotiated for a €100Bn “bank recapitalisation” package. At the same time they appealed for a “Precautionary Conditioned Credit Line”. In essence this gives the Spanish central bank access to unlimited yield lowering bond purchases with the condition that they reduce their budget deficits. They stressed that it was not a bailout. Debt got Spain into this mess and it seems they plan to use it get themselves out. It is estimated that the Spanish central bank owes the ECB 285bn Euros, this represents 27% of Spain’s GDP.
To follow the circle of funds we see that it is in fact the German central bank, the Bundesbank, that has been propping up the ECB’s profligate lending. Remembering of course that it was the German bank’s initial hesitation to lend to Spain that pushed up their borrowing costs forcing the Bundesbank to step-in to hold-off the need for a full-scale bail-out.
So, we now have a situation where the ECB is easing monetary pressure on Spain but at the same time its other lenders are becoming nervous. The ECB doesn’t have unlimited funds. The loans are backed by Spanish government debt and this is in short supply. But even more invasive is the fact that the ECB have made it clear that they intend to be repaid in full and their contract demands they be paid-back ahead of any other creditors.
It was hoped that this access to funds would be a turning point but it is clear that it has its own risks. Which leads us to one of the most hotly debated issues, the requirement for the Spanish government to implement far-reaching austerity measures.
Austerity – the Big Bad Wolf
“Our top priority is to clean up public accounts,” Spain’s Deputy Prime Minister Soraya Saenz de Santamaria said of the governments adopting extreme austerity measures. This follows the agreement by the Prime Minister, Mariano Rajoy, that the Spanish deficit would be reduced from 8.5% to 5.3%.
In its simplest form Austerity measures involve “deficit-cutting through a reduction in public services and benefits.” This narrow aim of reducing government debt hopes to make the economy more resilient in the long-term and eventually lead to positive growth. But will it work?
For many the answer is no. Economists suggest budget cuts and tax hikes won’t help the deficit situation while the country is mired in recession. Stimulus is what’s needed as without economic activity the country’s citizens will never be able pay enough taxes to help their governments pay-off their debt.
If this all seems like economic pain with no gain then you’re not the only one. The Economist magazine suggests it’s little more than a crisis solution, “The aim is to demonstrate a willingness to suffer great enough to convince Germany you’re worth sharing risks with. So far the Spanish are game. But a quarter of Spanish workers are unemployed, a number that has risen 4 percentage points over the past year. One wonders how much more they’ll stand.” The reality appears distasteful enough to have incited large-scale protests across Spain demanding that these austerity measures be axed.
The IMF and Gross Forecasting Errors
The IMF is no stranger to enforcing unpopular economic measures on struggling governments and Spain’s austerity measures were no different. Things got even uglier with the dispiriting announcement that the IMF made major forecasting errors in the impacts that austerity measures would have on economies like Spain’s.
The IMF chief Olivier Blanchard released a paper that suggested the organisation was too optimistic about the capacity of Spain’s economy to absorb savage cuts in government spending, “Forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation.”
The culprit was multipliers, this is a sticky economic concept that tries to model the increase in aggregate demand that comes from an increase in spending. The modern multiplier effect, as propounded by John Maynard Keynes, tries to explain how an incremental increase in spending will increase demand well beyond its initial injection, consider the way government investment creates jobs and the way those employees go on to spend more money on rent and food, the growth continues to ‘multiply’.
In the case of Spain and austerity, this effect was obviously in reverse with the pain of the measures being multiplied, Blanchard suggests that, “fiscal multipliers were substantially higher than implicitly assumed by forecasters.” The IMF forecast that a decrease in government spending would contract economic activity by 0.5% when in reality the effect was a 1.5% contraction. This 1% forecasting error has made it even harder for the IMF to sell their austerity prescriptions.
Blanchard was quick to add that he was not criticising her employer, “This working paper should not be reported as representing the views of the IMF…Working papers describe research in progress by the author(s) and are published to elicit comments and to further debate.”
In a shallow retort Blanchard added that, “Some commentators interpreted our earlier [findings] as implying that fiscal consolidation should be avoided altogether. This does not follow from our analysis. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy.”
This suggests that economies like Spain need to find other ways to balance the impacts of fiscal tightening. It’s a tough pill to swallow for an economy that has faced negative growth for four years.
Is there any light at the end of the tunnel?
As hopeless as all this sounds there is some minor consolation in the fact that many leading economic pundits had actually forecast that the situation would be far worse. Paul Krugman didn’t mince words in his analysis, “Things could fall apart with stunning speed, in a matter of months, not years. And the costs — both economic and, arguably even more important, political — could be huge.” That was May 2012 but by the beginning of 2013 the Union is still in tact. Analysis suggests that the unknown quantity, the element that many economists underestimated so grossly, was the sheer political determination of European policy makers to hold the Euro-zone together.