The Pain in Spain ... And What It Means for Europe and BeyondPublished: March 17, 2010 in Knowledge@Wharton
Spain's rapid decline from one of Western Europe's fastest-growing economies to one of its most troubled has left many looking for blame. How could the country, a poster child for the benefits of European economic and monetary integration, suddenly find itself lumped together with smaller, more sickly economies like Greece, Portugal and Ireland?
Because of its size, Spain's success in reversing its fiscal deterioration is critical for the future of the euro, the European Union and, ultimately, the global economy. "The unfolding of Greece's fiscal imbalances and Dubai's episode represented a first sign of how quickly investors can become risk-averse," analysts from JPMorgan wrote in a research report. If Spain fails to execute a credible plan to cut its budget deficit, the worries over sovereign solvency will spread quickly beyond the small, peripheral countries currently making the most headlines, experts warn. A Spanish default could herald the breakup of the euro and a rise in retaliatory protectionism around the world.
The thought that Spain could default on its debt and require a bailout from fellow EU members -- a course of action Greece is currently considering -- is not going over well in Madrid. In February, Infrastructure Minister José Blanco blamed an "international conspiracy" to damage Spain via "apocalyptic editorials in foreign media." Indeed, around the same time, daily newspaper El País reported that the country's intelligence service was investigating the motives for "speculative attacks" on Spain's economy in the English-language press.
Although it is politically expedient to blame shadowy outside interests for a country's domestic troubles, newspaper columnists and bond vigilantes are marginal actors in Spain's financial drama. According to Franklin Allen, a finance and economics professor at Wharton, the bursting of an enormous construction bubble is to blame for the "desperate problem" Spain now finds itself in.
Bolstered by development funds and low interest rates following its membership into the EU and the arrival of the euro, a building boom over recent years created a dangerously unbalanced economy, with construction accounting for more than 15% of Spanish GDP at its peak. When the global recession dented demand for the holiday homes and investment properties that fuelled the boom, Spain was left with a large economic hole to fill. This is the "heart of the problem," Allen says.
Mauro F. Guillén, professor of international management at Wharton, agrees that the construction bubble is at the center of Spain's current problems, which built up "during the last six or seven years." The bubble goes well beyond housing and commercial real estate to include all sorts of infrastructure, "roads and bridges and railway tracks. All that became a very important part of the economy, to the point that about 45% of all new construction -- not just residential construction but any kind of construction -- in all of Europe was taking place in Spain, when the Spanish economy is maybe 15% of Europe." Construction is highly labor intensive," Guillén adds. When it slows down, "then you have a lot of people out of [work]." (See accompanying video interview with Guillén on this page.)
Spain's GDP shrank by 3.6% in 2009. Another contraction is expected in 2010, in contrast to forecasts for growth in most other large developed countries. Unemployment currently stands at 20%, double the rate of two years ago. The strength of a recovery in 2011 and beyond relies on a raft of policy measures introduced to reduce the yawning budget deficit -- 11.4% of GDP in 2009 -- that is causing so much concern about Spain's creditworthiness. As a condition of membership in the eurozone, the country must reduce its deficit to 3% of GDP by 2013. Although it was running a budget surplus as recently as 2007, reversing the recent slide won't be quick or easy, according to Wharton faculty and others.
Government officials' prickly response to critics of their economic management stems from the fact that, in many ways, Spain avoided the traps other countries fell into during the global financial crisis. Thanks to a conservative supervisory regime, the country's banks were not meaningfully exposed to the toxic securities that felled their counterparts. Spain's level of government debt as a percentage of GDP is also well below the eurozone's average. But no matter how well the government managed its own finances and kept tight reins on banks before the financial crisis, Spain's enormous private-sector debt overhang makes markets justifiably nervous. According to an analysis by consultants at McKinsey, the sum of Spanish government, corporate and household debt relative to the size of the overall economy surpasses all developed countries except the U.K. and Japan. Correcting the imbalance has grave implications for the public purse.
For that reason, observers worry about Spain's ability to service its debts. Bailouts of Greece and Portugal, if necessary, would be "not inconsequential but manageable," according to Witold Henisz, a professor of management at Wharton. The EU-led rescues would probably knock tenths of percentage points off of European growth, he adds. It's a different story with Spain.
In a joint statement, eurozone countries have pledged to take "determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole." If such action amounted to a bailout of Greece or Portugal, the gravity of the situation would immediately bring Spain under intense pressure, considering it is expected to be the next domino to fall. Should it be unable to avoid a rescue, Spain would demand "the same or better terms" as previous aid recipients, Henisz says. Spain is the fourth-largest economy in the eurozone, more than twice as large as Greece and Portugal combined. "When we talk about bailing out [countries] like Spain, the magnitude is pretty daunting," he adds. The effect of such a bailout would knock full percentage points off growth in Europe at a time when economies are in the fragile early stages of recovery.
A Spanish bailout would also usher in a perilous second phase of the global financial crisis, Henisz warns, with large countries -- Italy, for example -- facing default as they became unable to fund budget deficits. The viability of the euro currency would come into question, as the union's stronger members could eventually refuse to prop up weaker members and decide that their destiny would be better served by monetary independence. Spanish officials' lashing out at indistinct foreign culprits is a precursor of what to expect, Henisz says. The risks of a "spiral into protectionist isolationism" would rise. "Political parties that espouse nationalism and xenophobia could get some serious purchase under these conditions."
But whatever the chances of a default in Spain, one thing seems clear -- the country is unlikely to try to solve its current problems by withdrawing from the currency union and returning to the peseta so it can devalue, Guillén says.
For one thing, support for monetary union was highest in Spain, "much higher than in Germany, where a lot of people were reluctant because they already had a strong currency," Guillén says. "So Spain is very pro-European." As a result, the chances of Spain pulling out of the euro are "just unthinkable." But it is also "unthinkable from another point of view, which is that you have a lot of home owners in Spain who have a mortgage. Their mortgages, in 95% of the cases, are variable, [with] adjustable interest rates." Those interest rates are linked to the euro, and if Spain turned away from the euro, then "their mortgage payments would go through the roof.... So there's absolutely no chance that Spain by itself would want to get out of the euro."
Preventing Doomsday Scenarios
The doomsday scenario could be avoided by allowing Greece to default, Allen says. Voters in the EU's stronger countries are loath to support rescues of weaker members, so the talk of a bailout merely "postpones the day of reckoning," he says. It's better for a small eurozone country like Greece to default first so that policy makers "can see how it will play out." Although unwelcome, the experience would steel governments' resolve to push through the short, sharp cuts necessary to bring their finances into line lest they suffer the same fate.
In this respect, Ireland is leading the way, according to Allen. Suffering late last year from the effects of the bursting of a massive property bubble as well as dangerously overextended banks, the Irish government introduced severe austerity measures, including pay cuts of up to 15% for civil servants and reductions in unemployment and welfare benefits. "The effort demanded of every citizen in this budget is substantial, but it is the last big push of this crisis," Irish finance minister Brian Lenihan said when unveiling the measures. He had previously noted that elsewhere in Europe, "you would have riots if you tried to do this."
Spain's recovery plan does not go as far as Ireland's. Indeed, the Spanish government backed down on a proposal to revise the way pensions are calculated when faced with public opposition. Nevertheless, the latest package of tax hikes, spending cuts and phase-outs of stimulus measures adds up to a fiscal adjustment of nearly 10% of GDP, according to Moody's. In a presentation to investors in February, the government noted that it had already made cuts to its budget deficit worth 2.2 percentage points of GDP since the start of the year. For its part, Moody's is "relatively confident" that around 5% of Spain's proposed fiscal adjustment -- or half of the proposed cuts -- will "more or less" be achieved. "This is, in our view, a good start," the agency said.
Some aspects of Spain's policy proposals have been criticized, however. Most notably, the GDP growth projections built into its budget "look plainly optimistic given existing economic imbalances and the anticipated hit to domestic demand from higher taxes and lower spending," according to the Economist Intelligence Unit (EIU), a research firm. The government forecasts GDP growth of 1.8% in 2011; the EIU reckons 0.8% is more realistic.
Selling the public on sacrifices that are "extremely unpopular politically" is one of the biggest challenges Spain faces, notes Henisz. After all, the "best-case scenario is somewhere between five and 10 years of below-trend growth and above-average savings to pay off the debt overhang."
One of the key underlying problems is that all of the growth from the construction boom pushed up wages. "Low productivity growth in Spain relative to its competitors is what is really causing trouble right now," says Guillén. The only way for Spain to remain competitive is for the country "to increase productivity, because it cannot lower prices artificially through the exchange rate."
He adds that Spaniards will "see their standard of living come down as they restructure their economy. They will find a way in which they can compete globally." Over the next few years, there will be "a big readjustment, a big restructuring in Europe, and also in the United States ... as a result of the big changes that are taking place in the global economy."