Why Spain’s in worse shape than Greece

By Felix Salmon
May 19, 2010
Martin Wolf's latest column:

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Note the circular reasoning in Martin Wolf’s latest column:

Greece is likely to restructure its debt at some point, as John Dizard has argued in the FT. That would not be the worst outcome. Once a country is in the “junk bond” category, no reputation is left.

Or, to put it another way, Greece got downgraded because it is likely to default, and it is likely to default because it got downgraded. This is yet another reason to start ignoring credit ratings.

The main point of Wolf’s column is a very good one:

European orthodoxy is that the crisis is, at root, fiscal. Marco Annunziata of UniCredit summarises it in a recent note: “In hindsight, it seems obvious that the flaw in the eurozone’s institutional setup is both extremely serious and extremely simple: first, a currency union cannot work without sufficient fiscal convergence or integration; second, the eurozone has been unable to create incentives for fiscal discipline.” Mr Annunziata’s chart shows that this view is wrong. Just consider the frequency of breaches of the rules requiring fiscal deficits of less than 3 per cent of gross domestic product. Greece is a bad boy. But Italy, France and Germany had far more breaches than Ireland and Spain. Yet it is the latter that are now in huge fiscal difficulties.

The fiscal rules failed to pick up the risks. This is no surprise. Asset price bubbles and associated financial excesses drove the Irish and Spanish economies. The collapse of the bubble economies then left fiscal ruins behind it.

It was the bubbles, stupid: in retrospect, the creation of the eurozone allowed a once-in-a-generation party.

This, in hindsight, was the biggest weakness of the Maastricht rules, capping debt at 60% of GDP and deficits at 3%. It’s not that the rules were broken: it’s that they were insufficient to prevent the kind of debt-fueled boom which leads inevitably to a fiscal crisis. As Wolf points out, the countries in fiscal trouble, like Spain, aren’t necessarily the ones with the highest sovereign debt ratios: they’re the ones with the highest debt ratios overall, including private debt. (Spain’s public debt is just 56% of GDP; its private debt, however, is 178% of GDP.) And private debt was never included in the Maastricht rules.

In a way, Greece has it easy: a sovereign default and devaluation solves a lot of its problems at a stroke. Spain, on the other hand, has a much tougher task ahead of it, since private-sector defaults won’t make the country any more competitive. And it’s already got unemployment over 20%. Only tough structural reforms have any chance of working, and those will take a long time, and face enormous political opposition. As Andrew Eatwell says:

Having squandered the opportunity to embark on unpopular economic, labour and pension reforms when his popularity ratings were relatively high after the 2008 general election –a period in which he fervently denied that Spain was facing an economic crisis– Zapatero now faces the prospect of tackling those issues while trailing the main opposition centre-right Popular Party in the polls and with a string of potentially tight regional elections around the corner. Necessary but unpopular measures may therefore be put on the backburner or at least kept to a minimum for fear of a voter backlash that could cost the governing Socialist Party dearly in regions such as Catalonia, where the Socialists lead a coalition government and elections are due this autumn. Zapatero also faces a general election in early 2012.

With regional governments accounting for 57 percent of total public spending in Spain, there is a serious risk that national interests and the economy as a whole may find itself subordinated to entrenched regional interests, crowd-pleasing promises and partisan politics.

All of which is different only in degree, not in kind, to what we’re seeing in the US right now.

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