Investors are feeling more optimistic about the euro crisis. So are policymakers. That much was evident last week at the World Economic Forum’s annual meeting in Davos. There was much satisfaction over the early performance of the Super Mario Brothers – Mario Draghi, president of the European Central bank, and Mario Monti, Italy’s prime minister. What’s more, a deal may be in the works to build a bigger firewall against contagion, constructed out of commitments from euro zone members and the International Monetary Fund. And it looks like there will be another short-term fix for Greece.
But three bad fairies were lurking at the Davos feast. Spain and France are relatively new problems and Greece is an old one. All three are powerful menaces.
Madrid is staring at a particularly vicious version of the austerity spiral afflicting most of the euro zone. The last government missed its fiscal targets, leaving the country with a budget deficit of 8 percent of GDP in 2011. The programme agreed with the European Union commits Spain to cutting this to 4.4 percent in 2012. Doing so would be hard in good times. Trying to reach this target when GDP is set to shrink by at least 1.5 percent and the unemployment rate is already 23 percent would be nearly suicidal.
Mariano Rajoy’s new conservative government is making a lot of the right noises. It is steeling itself for a long overdue overhaul of the labour market. It is also preparing to clean up its banks’ toxic balance sheets. But requiring it simultaneously to throttle the economy with such a severe squeeze would set it up to fail.
There’s an obvious trade-off: in return for going full steam ahead with the structural reforms, Madrid could be allowed a little longer to get its deficit under control. Such a deal could be applied to other countries too. But it would require Germany’s blessing – and that doesn’t yet appear to be forthcoming.