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Why a visit to the eurozone doctor won't relieve the pain in Spain
So much for the idea that the euro crisis is over! Last week it resurfaced again – with Spain now first in the firing line. How serious is the Spanish problem?
Although they share some things in common, each vulnerable euro member's plight is slightly different. The Spanish economy did not get where it is today through a great splurge in public spending and borrowing, as happened in Greece. Indeed, in 2007, the Spanish government's budget was in surplus.
Admittedly, last year it was in deficit to the tune of 8pc of GDP. But this was a response to the collapse of the economy, not the cause of it.
What did for Spain was the mother and father of a boom in private spending and borrowing, much of it connected with a bubble in the property market. In this sense, the country that Spain most resembles is Ireland.
At the boom's peak, Spain was running a trade deficit of about 10pc of GDP, financed by overseas borrowing. This money was frittered away on consumption and squandered on useless property projects. The result is that Spain's international liabilities exceed her international assets by about 90pc of GDP, roughly the same as for Greece.
Her heavily indebted private sector – with a debt to GDP ratio of over 300pc – is now trying to deleverage, while the public sector also cuts back savagely.
Having announced a fiscal tightening of €27bn (£22bn), the government has been forced to announce a further dollop of €10bn, making a total of 3.5pc of GDP.
Meanwhile, the rise in costs which the boom unleashed has left Spain uncompetitive against the German core to the tune of 20pc-30pc, thereby inhibiting a revival through the strong growth of net exports.
In these circumstances, austerity threatens to be self-defeating. So far, Spain's economy has been nothing like as weak as Greece's. But the omens are bad, with GDP likely to fall this year and next. Unemployment is already running at over 20pc of the workforce, and more like 50pc among the young.
Deflation, ie. so-called internal devaluation, would worsen the already threatening burden of private sector debt. Both would weaken the asset quality of Spain's banks. In particular, deflation would intensify downward pressure on property prices, which are falling anyway.
In keeping to the current path, Spain is supposedly doing the right thing because she is following Germany. But Germany did not start with Spain's culture of high inflation and did not experience a property boom. Moreover, after the advent of the euro, when Germany successfully kept her costs and prices in check, others in the eurozone did not.
This caused Germany's competitiveness to improve. If Spain now merely keeps her costs and prices rising at the same pace as Germany, she would be running faster just to stay in the same place.
The German economic establishment sees this issue in stark moral terms. "Just do the right thing and it will be all right – as it has been for Germany."
But competitiveness is not the same thing as productivity. It is about the relation of costs and prices in one country against others. It is very difficult to make much impact on it through reform and measures to boost productivity, worthy though these may be.
If a country managed to increase productivity growth by 0.5pc a year it would be a miracle. But, at that rate, to erode a 20pc gap in competitiveness would take 40 years. Meanwhile, for a country as heavily indebted as Spain, cutting domestic wages and prices risks causing a financial catastrophe.
Last week the market breathed a sigh of relief when the ECB suggested that it could buy up Spanish bonds. But this would merely relieve short-term pressures and push the ultimate reckoning further into the future. With each year that passes without an adjustment of costs and prices, and without a revival of demand, the scale of the problem – and of the eventual disaster – continues to increase.
As it is, although the Spanish government's debt to GDP ratio is only about 70pc, compared with Greece's 160pc, the absolute size is much bigger – about €730bn compared with €350bn. You can just about see how the eurozone could ease the burden by providing more official finance but, on its own, this would not solve the problem.
When will the euro-elites stop thinking about financing and start thinking about adjustment? When they do, could they please spell out how they see Spain returning to growth with something like full employment while she stays within the euro.
At the moment, their approach is not to try to refute the eurosceptics' arguments but rather to refuse to listen to them – and then to hope for the best. You – and they – would be better advised to prepare for the worst.
Roger Bootle is managing director of Capital Economics.