Spain’s Death Spiral and the Hypocrisy of the Euro
Anyone out there who thinks the euro zone debt crisis is over - and you know who you are - should take a good look at what’s going on in Spain. If Italy represented the biggest threat to the euro in 2011, then Spain will be the big story of 2012. Whatever numbers you look at, Spain is in a death spiral, a self-defeating circle of recession and austerity that is sending one of Europe’s most important members into an economic dark ages. Spain today represents all of the failings of the monetary union, from its misconceived inception to its misguided approach to the debt crisis.
Here’s just a brief summary of the ugly statistics: (1) The government in Madrid expects the economy to shrink by 1.7% in 2012 - its third contraction in four years. (2) Unemployment continues to rise. It is now more than 23%, and youth unemployment is above a staggering 50%. (3) Housing prices are down 22% from their peak, and are likely to continue to drop, perhaps by 20% or more. This puts extreme pressure on the balance sheets of an already shaky banking sector.
Obviously, this is an economy in severe distress. And what is the government’s response? More growth-killing austerity. In late March, it announced its most severe package of tax hikes and budget cuts yet, aiming to reduce the deficit by $36 billion. What gives? Madrid is extremely worried about the state of its national finances. It missed its deficit target in 2011, and, without the latest austerity package, would have done so again in 2012.
However, the austerity drive is failing to achieve what it aims to do: improve Spain’s financial position and rebuild investor confidence. Instead, investors have been spooked by the deterioration of the Spanish economy. Demand for Spanish government bonds was weak in a Wednesday auction. Since the government announced its latest austerity budget, yields on its bonds have risen, a sign that investors see them as riskier. Yields on 10-year bonds jumped over 5.6%, the highest since January. And why is that? Well, by tanking the economy, the austerity measures are making Spain’s financial standing weaker, not stronger. Despite its new austerity budget, Madrid estimates that the government-debt-to-GDP ratio will INCREASE in 2012, to nearly 80% from 68.5% in 2011. Simply put, Spain is moving backwards.
Meanwhile, what the austerity measures will achieve is further damage to Spain’s growth prospects. New taxes and reduced government spending will further inhibit any hopes that Spain’s economy can turn around. Unemployment will go up further, reducing tax revenues and inflicting even more suffering on the Spanish people. Thus the death spiral. By squelching growth, austerity is making it more difficult for Madrid to meet its budget targets and stabilize debt levels. So it introduces more austerity to meet those goals. And that in turn weakens growth further, pushing the targets farther off. And so on. And so on.
This is just the result of simple math. Let’s say, for example, we have a country with a GDP of $100 and government debt of $100. So it has a government-debt-to-GDP ratio of 100%. Now let’s say we want to reduce that ratio to 90%. We can achieve that two ways. We can reduce the amount of debt to $90. But if the economy is shrinking, we’d have to cut even more debt to cut the ratio. Let’s say GDP contracts to $90. That means we’d have to cut debt to $81 to meet our 90% target. Now let’s flip our math around a bit. We can get to our 90% ratio by increasing GDP to about $111, without cutting the amount of debt at all. Growth can fix a nation’s financial position just as well as austerity. Preferably, a country like Spain would stabilize its finances with a mix of both.