Spain can survive its crisis – if its euro partners play their part

http://www.guardian.co.uk/commentisfree/2012/apr/01/luis-garicano-spain-recession

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When Willem Buiter, Citigroup's chief economist, stated that Spain is at greater risk of default than ever before, the internet blogs and comment sections of Spanish newspapers immediately filled up with dark conspiracy theories.

"The Anglo-Saxons have it in for Spain," offered one. "They are jealous; they could never accept Spain's astonishing economic performance in the last 25 years," ran another.

For was Citibank not itself rescued by US taxpayers, while no large Spanish bank has needed help? Did the UK not need to save RBS and Lloyds at large cost, as UK Financial Investments has acknowledged? Did the UK and US not suffer from a worse form of the same illness as Spain, namely a massive credit-fuelled housing bubble that left behind a chronically over-indebted private sector?

The answers, of course, are yes, yes and yes. You cannot fault Spaniards for believing these conspiracy theories. And yet there is at least one pretty solid economic reason why Spain's trouble is much, much worse than what the UK and the US are suffering: the euro.

While the UK and the US can borrow in their own currencies, Spain must borrow in euros. And as Paul de Grauwe – coincidentally the inheritor of Buiter's old chair at the LSE (more conspiracy theory fodder?) – has put it, the euro has converted developed countries such as Spain and Italy into developing ones, exposed to periodic sudden stops.

If the UK cannot face its obligations, it can choose to partially monetise them, causing a depreciation of the pound and an increase in competitiveness that helps to bring back growth. If Spain faces the same problem, it must raise interest rates to keep lenders on board, which kills growth and makes the lack of confidence worse, putting in motion a brutal vicious circle.

The lack of monetary autonomy thus means Spain has also little budgetary leeway. Faced with an economy that is falling into a black hole, Spain has no choice but to make things worse by accepting European mandates to reduce the deficit to 3% in 2013 from 8.5% in 2011. Compare this to the official (OBR) UK forecast which, in spite of higher growth in the UK, still calls for 5.9% deficit in 2013-14, down from 8.3% in 2011-12.

Hence the brutal budget presented last Friday by Spain's conservative Popular party government, which aims for reductions in spending, between the central government and the regions, of ¤55bn, or 5.5% of GDP in 2012, with the aim of achieving (after accounting for further revenue losses) the 5.3% target for the end of the year and the 3% in 2013.

Can Spain avoid going into a Greek-style tailspin? Maybe. Doing so requires dealing with three interrelated problems: an extremely high unemployment rate, a financial system loaded with assets of dubious value and a worrying lack of fiscal discipline among regional governments.

In the meantime, whether the public will be able and willing to put up with the prescribed European medicine is a question that would be better addressed by a psychiatrist than an economist. Spain is in the midst of one of the worst moments of a 50-month-long recession. Even before the last round of budget cuts, the IMF was predicting a 1.7% fall in GDP. It is possible that the brutal fiscal consolidation that is being asked from it, conceived under more benign circumstances, might stop Spain's reform momentum without any actual gain.

The new Spanish government has passed three structural reforms laws in its first months in office to deal with these three problems. First, a labour market reform, which aims to reduce real wages after large real wage increases took place in the midst of the worst employment crisis. The reform makes both the collective bargaining system and the contracting framework more flexible.

To deal with the financial crisis while minimising the appeal to taxpayer funds, the new government has opted for a package that includes €50bn additional provision for loan losses and widespread write-offs on the real estate portfolio. The aim is, first, to increase the transparency of the banks' books and increase confidence in the system. Second, to force the insolvent institutions to put themselves up for sale. Thus the reform encourages further mergers through a range of new carrots and sticks.

Finally, to deal with the wayward regions, the government has presented a financial stability law. The draft is modelled on the new EU fiscal compact, and gives the central government ample supervision powers as well as the ability to impose steep fines on those regions that overspend. Unfortunately, the draft falls short because it does not set up an independent fiscal policy council.

For Spain to succeed, all three of these measures must be successful. Salaries must adjust so that the loss of competitiveness of the post-euro period is reverted. The financial system must recognise losses and move on, hopefully with the biggest and most solvent institutions taking over the weaker ones. Finally, the regions must recognise that they cannot keep spending the money they do not have and expect to be bailed out by the state.

Clearly, Spain cannot possibly do all of this alone. If the rest of the euro countries keep insisting on treating this problem as a morality play, in which some wayward southerners must be reined in, the tailspin will only become worse. Thus the question Spain poses now to its European partners is the same one that Monti has been asking on behalf of Italy: "If we do our part, will you do yours?"

Doing its part means Europe must correct its course and exit the mutual suicide pact in which it has embarked, which requires that all countries simultaneously consolidate their budgets. It also means Europe must stand ready to help with the reforms of the old "cajas" (savings banks) in its financial sector, which may require more funds than Spain has now available.

Spain must be told in no uncertain terms that the reforms should continue. Yet, at the same time, Spain should not be forced into the downward spiral that is destroying Greece. Spain can reform itself, but it requires the support of its European partners to do so. There is a limit to how much pain its people will be able to endure.

Luis Garicano is professor of economics and strategy, London School of Economics and editor of nadaesgratis.es, a popular blog on the Spanish economy