The pain with SpainSpain‘s rapid decline from one of Western

Europe‘s fastest growing economy to one of its most troubled has left many looking for blame. How could the country, once a poster child for the benefi ts of European eco-nomic and monetary integration, suddenly fi nd itself lumped together with smaller, see-mingly more sickly economies like Greece, Por-tugal and Ireland. Because of its size, Spain’s success in reversing its fi scal deterioration is critical for the future of the euro, the Euro-pean Union and, ultimately, the global economy. If Spain fails to execute a credible plan to cut its budget defi cit, the worries over sovereign solvency will spread quickly beyond the small, peripheral countries cur-rently making the most headlines. A Spanish default could herald the breakup of the euro and a rise of retaliatory protectionism around the world.

The thought that Spain could default on its debt and require a bailout from fellow EU members is not going over well in Madrid. In-frastructure Minister José Blanco blamed “an international conspiracy “to damage Spain via “apocalyptic editorials in foreign media “. Indeed, the daily newspaper El Pais reported that the country intelligence service was investi-gating the motives for “speculative attacks “on Spain‘s economy in the English-language press.

Although it is expedient to blame shadowy outside interest for a country‘s domestic trou-bles, newspaper columnists and bond vigilantes are marginal actors in Spain fi nancial drama. The bursting of an enormous construction bubble is to blame for the “very diffi cult problems“ Spain now fi nds itself in.

The reasons of the Spanish crisisBolstered by development funds and low

interest rates following its membership into the EU and the arrival of the euro, a building boom over recent years created a dangerously unbalanced economy, with construction ac-counting for more than 16 % of Spanish GDP at its peak. When the global recession dented demand for the holiday’s homes and invest-ment properties that fueled the boom, Spain was left with a large economic hole to fi ll. The bubble goes well beyond housing and com-mercial real estate to include all sort of infra-structure: roads, bridges and railways tracks. All that became a very important part of the economy, to the point that about 45 % of all new construction in whole Europe was taking place in Spain, even though the Spanish economy is around 15 % of Europe. The con-struction sector accounts for more than 16 % of Spain’s economic output, roughly twice the average of euro zone countries. The residen-tial real estate bubble saw real estate prices

rise 201 % from 1995 to 2007. Moreover Spain’s productivity gains in recent years are almost nonexistent. Spain has created more jobs than the rest of the eurozone between 2004 and 20085, but too many of them are low quality.

Spain‘s GDP shrank by 3.6 % in 2009. Another contraction is expected in 2010, in con-trast to forecast for growth in most large Euro-pean countries. Unemployment currently stands at 21 %, more than double the rate of two years ago. The strength of a recovery in 2011 and beyond relies on a raft of policy measures in-troduced to reduce the yawning budget defi cit – 11.4 % of GDP in 2009 – that is causing so much concern about Spain‘s creditworthiness . Spain debt burden, forecasted to be 66.3 % of GDP compared to 36.2 % of 2007 GDP, is less troubling than its peripheral euro zone peers. As a condition of membership in the eurozone, the country must reduce its defi cit to 3 % of GDP by 2013. Although it was running a budget surplus as recently as 2007, reversing the recent slide won’t be quick or easy.

Another problem for Spain is that it has an unprecented combination of structural pro-blems stemming from a very rapid decline in fertility and increase in life expectancy, both of which tend towards a situation of rapid

Dominique Strauss-Kahn, International Monetary Fund Managing Director listens to Robert B. Zoellick, World Bank Group President

population ageing. One consequence of the fertility decline is that there is often now in-suffi cient qualifi ed domestic labor supply to meet the growth needs of these societies, needs which are only reinforced by the weight of the pension’s liabilities which are now im-minently pending. The impact of this has been a considerable migration infl ow which unfortunately is largely unskilled: it was used in the construction industry which has now collapsed.

An additional problem mentioned by eco-nomist Edward Hugh is the relative unreliability of Spain statistics concerning unemployment, the current account and growth. According to Dr. Hugh, “ Spain’s reporting agencies are quick to point out any item in the data which shows the Spanish economy in a positive light , while they have the frustrating custom of passing over in silence any inconvenience“. Dr. Hugh warned that “Spain will face a long period of stagnation or slow growth – oppo-site to the optimistic forecasts of the Socialist government and contrary to other developed economies, the Spanish one will be one of the very few that will continue contracting in 2010 and is likely to record negative growth in 2011”.

The challenges confronting Spain stem from the same source as those in Greece: a huge misallocation of resources and loss of competitiveness that began with the adop-tion of the euro. Spain non-tradable sectors – housing, the government and a broad array of market services – had grown far too big. Spain has a debt-to-GDP ratio that is half of Greece and has more time and resources to fi x its problems. However, its large defi cits and the collapse of the post-euro growth model imply that its public debt could, if remedial measures are not taken now, follow an exploding path. Moreover the European monetary policy was to loose for Spain and it reinforced the nega-tive trends especially in the housing sector. Over the last decade, Spain exports have lost share in world markets but have roughly matched the advance of other euro area ex-porters. This perhaps seems adequate at fi rst glance, but is wholly unsatisfactory in reality, given that Spain’s productive capacity surged relative to that of its euro partners due to im-migration and investment growth, and that its import demand expanded correspondingly. In fact, exports as a share of GDP fell by 3 per-

centage points from 2000 to 2008 in Spain, compared to a rise of nearly 14 percentage points in Germany. While Germany grew its current account surplus, Spain‘s plunged into deep defi cit. In this regard, Spain shares the experience of Greece, Ireland and Portugal which also became excessively dependant on domestic demand and non-tradable.

Credit Crunched Government offi cials’ prickly response to

critics of their economic management stems from the fact that, in many ways, Spain avoided the traps other countries fell into during the global fi nancial crisis. Thanks to a conservatory supervisory regime, the country’s banks were not meaningfully exposed to the toxic securi-ties that felled their counterparts. Spain‘s level of government debt as a percentage of GDP is also below the eurozone’s average. But no matter how well the government managed its own fi nances and kept tight reins on banks before the fi nancial crisis, Spain’s enormous private-sector debt overhang makes markets justifi ably nervous. Spanish citizen seem also to be willing to get into debt. Spain ownership is 85 %, far and away the highest rate in the OECD countries. Because of the high level of mortgage debt, the cushion of saving has prac-tically fallen to zero by the end of 2008. Spain has û 7.4 billion in mortgages. If you divide that by the national income, Spanish house-hold are indebted by 130 %. Some 90 % are variable-rate loans, so an interest hike would cause real pain. The sum of government, cor-porate and household debt relative to the size of the overall economy surpasses all developed countries except the UK and Japan. Correc-ting the imbalance will have grave implications for the public purse. Spain is the fourth-largest economy in the eurozone, more than twice as large as Greece and Portugal combined. Should a bailout of Spain be necessary it would knock full percentage points of growth in Europe at a time when economies are in a fragile early stage of recovery. And then there’s infl ation, which remains the “Achilles heel” of the Spanish economy, currently running at an annual rate of 4.1 %, almost twice the eurozone average.

The Mañana SyndromeThe list of things that need repair is ex-

tensive. Spain‘s structural faults were long hidden by the housing bubble and are gla-ringly exposed now that it has burst. From unemployment and low productivity growth

to weakened saving banks and creaky public fi nances, the problems are piling up. With the government unwilling until recently to apply radical surgery, there are fears that Spain will fall further behind its neighbors and risk a lost decade like Portugal or Japan. Unemployment tops most people‘s worries. Faster growth is needed to bring it down. Yet Spain has been in recession for seven quarters; the govern-ment expects GDP to shrink again this year; and the IMF forecasts growth of less than 0.5 % in 2011. The public fi nance must also be fi xed. Last year’s defi cit ballooned to over 11 % of GDP. In our opinion growth will be negative in 2010 and maybe 2011. More tax rises and spending cuts are inevitable if the government is to hit its 3 % defi cit target by 2013. Spain remains the last major economy, the fi fth largest in Europe, still in recession.

The IMF Report On the 24th of May the IMF came out

with its 2010 Article IV Consultation Conclu-ding Statement of the Mission. It is damning. “Spain‘s economy needs far-reaching and comprehensive reforms. The challenges are severe: a dysfunctional labor market, the de-fl ating property bubble, a large fi scal defi cit, heavy private and external indebtedness, anemic productivity growth, weak competi-tiveness, and a banking sector with pockets of weakness. Ambitious fi scal consolidation is underway, recently reinforced and front-loaded. This needs to be complemented with growth-enhancing structural reforms, buil-ding on the progress made on product markets and the housing sector, especially overhau-ling the labor market. A bold pension reform, along the lines proposed by the government, should be quickly adopted. Consolidation and reform of the banking system needs to be accelerated. Such a comprehensive strategy would be helped by broad political and social support, and time is the essence. Although the necessary adjustments are underway and output has stabilized, unemployment has soared as fi rms adjusted employment rather than wages or working hours”. IMF chief Do-minique Strauss-Kahn concedes that the risk of the Greece debt crises could engulf Spain. The Spanish government said it agreed with these fi ndings which were based on a periodic weeklong appraisal by the IMF.

The concern about Spain prompted U.S. President Barack Obama to call Spanish Prime

Minister Jose Luis Zapatero on the 12th of May to stress the importance for Spain to take resolute action as part of Europe‘s effort to strengthen its economy and build market confi dence.

Deeper reforms to Spain’s economy looked unlikely until the IMF report. What is needed is a deep reform of a rigid labor market that makes employees too costly to fi re but condemns a third of workers to un-stable, unprotected temporary jobs. Yet the government has repeatedly delayed pension and labor reforms. Mr. Zapatero’s great goal was to conserve social peace. That means keeping trade unions happy, even if reforms and growth have to wait. Some detect a whiff of cowardice. Mr. Zapatero‘s deter-mination to avoid general strikes is proof that he may never take a diffi cult decision. Moreover because broad agreements on public spending cuts lack details, they also lacked urgency. A recent austerity deal with regional governments for over a third of Spain’s public spending required more than two months of haggling. Spain is already raising value-added tax, with the top rate going from 16 % to 18 % in July. Mr. Za-patero says this will fi nance the unemployed benefi ts to half a million people. Yet higher taxes will also dampen consumer spending, sending growth lower still.

The CajasSome Cajas de ahorros (Saving Banks) are

heavily exposed to construction and housing loans. According to the Bank of Spain, one third of the 45 Cajas need to disappear through absorption by others. A 99 û billion rescue fund is available since the beginning of 2010, but it produced only limited consolida-tion so far. Local politicians who have a big say in their Cajas, do not want to lose power. The system cannot improve as long as doomed entities are being kept alive.

The managers of Spain Cajas could hardly have picked a worse time to restructure their institutions. The politicians and local power-brokers who wield most infl uence over the Cajas have resisted for months the pleas and threats of the Bank of Spain. It was only after the CajaSur, a struggling saving bank control-led by the Roman Catholic Church in Cordoba, was seized on the 24th of June by the Central Bank that spurred into action much of the other Cajas. Since then, there has been a fl urry of announcements about full mergers or plans to create forms of a “Systema Institional de Protectio” ( SIP), a kind of “soft merger” in which lenders pool some central functions but retain their regional brands and identi-ties. Cajas must fi nalize these deals before June the 3rd if they want access to state aid through loans from the FOBR even though the

various groupings have already put in requests for funds totaling about 10 billion euro. The Cajas are also suffering now from low inter-est rates on their property loans. This reduced their margins, as well as the competition for customer deposits from better capitalized listed banks like Santander and BBVA. More-over the guarantees of the Cajas are land and properties: Caja Mediterraneo, which is planning a SIP arrangement with CajaSsur, Caja Extremadura and Caja Cantabria, an-nounced on the 30th of May that it is offering discounts of up to 70 % on more than 1.000 buildings for sale. As a result of repossessions and debt-for-property swaps with developers, banks and Cajas are now among the biggest real estate owners in Spain.

Within months the number of Cajas in Spain is likely to fall the original 45. The con-solidation of the Cajas is going at full speed and there are more than 25 Cajas in this period of restructuring. Bankers in the private sector also believe the number of Cajas will settle at about 20. They will fi re people, they will cut offi ces and they will have more effi -cient units. The use of SIP’s – a route chosen by Caja Madrid for its proposed tie-up with fi ve smaller Caja – is controversial because it is seen as an escape route for regional barons reluctant to impose painful cuts or lose their power of patronage by accepting full merger.

President Barack Obama and President Jose Luis Zapatero - 13 October 2009

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But pressure to rationalize properly remains intense. Nevertheless, offi cials and bankers insist that the Spanish fi nancial system is more robust than many foreign investors believe. Cajas have set aside 400 % more provisions than required. Despite these efforts, Spanish saving banks will face a diffi cult few months. If the “Mañana” approach had not been so important, Spain would probably not have needed to face this imperious necessity.

The Spanish Austerity Program and changes to the labor laws

The austerity plan decided on the 30th of May by Spain has as main objective, namely the reduction of Spain defi cit. In the plan the salaries will be reduced on average by 5% from June 2010, they will be frozen in 2011. The high salaries of government employees will be the most affected. The pension in-crease will be frozen in 2011 and maybe later. Support for the birth of 2.500 Euros, which was introduced in 2007, will be deleted. On the other hand the public investment will be reduced by 6 billion Euros by 2011 and the allocation to regions and municipalities will be reduced to 1.2 billion Euros.

These measures are tremendously un-popular in Spain and there has not been any agreement settled with the unions. They do not want to cooperate. In fact a general labor strike is planned on June 8, which is something very rare in Spain. If by the end of June there is no agreement with them, the government will pass in Parliament a law imposing these measures. The tripartite (go-vernment, unions, and employers) has not yet tackled the relaxing of the laws in the hiring and laying off of employees because the unions resist changes to their social rights. The government is trying to complete the labor-law overhaul before it seeks passage of its 2011 budget. The Bank of Spain views the new government package positively, calling it “important“ but considers it “pre-mature“ to see what effect they will have on the economy. Nevertheless the bank believes that the economy is heading toward “an improvement “adding that the prospect of reducing the defi cit to 3% of GDP by 2013 has been “substantially reinforced “. Never-theless the spending plans which aim to cut defi cit from 11.2 % in 2009 to 6 % of GDP in 2011 will be the biggest two year reduc-tion in at least 3 years.

The poor showing of Spain’s foreign policy as President of the European Union

Before taking up the rotating presidency of the EU’s Council of Ministers in January 2010, Spain had certain ambitions for the EU’s foreign policy and was determined to pursue them despite the Lisbon treaty which hands most responsibilities in the fi eld to the EU’s foreign policy chief . With every month that has passed, however, Spain ambitions have dwindled. A summit in Barcelona on the 7th of June was supposed to breathe new life into the Union for the Mediterranean. Until late last year, the Union for the Mediterranean was all but paralyzed by the Israeli-Arab confl ict prompting Spain – the seat of its permanent secretariat – to try to relaunch the process.

Alas the summit has now been postponed to November 2010. Some suggested that the cancellation was prompted by a lack of inte-rest among the 40-odd leaders.

The other set-piece summit that the Spanish wanted to hold in June is hardly faring better. On the 2nd of June, the coun-tries of the Balkans were to meet their EU counterparts in Sarajevo in order to “reaf-fi rm the EU’s commitment towards the Eu-ropean perspective of the region “according to Spain. This summit has been downgraded to a “high-level meeting“ diminished by a set-up whereby attendees no longer speak as offi cial representatives of their government. Spain incidentally is the most infl uential of the fi ve EU member states that do not recognize

Francisco de Goya, Los Caprichos,El sueño de la razón produce monstruous, 1796-97

Kosovo’s independence. A diplomat from the region compared the timid Spanish approach to the many problems in the Balkans with that of Turkey, which has stepped up its mediation and achieved concrete results.

The list of Spain’s foreign-policy disappoint-ments go on. US President Obama cancelled an EU-US summit scheduled to be held in Madrid in May because the agenda was too thin. A summit with Latin America and the Caribbean

in Madrid on 16-19 May yielded little of sub-stance. Spain bid to normalize relations with Cuba appears to have failed. The ambition to put Croatia fi rmly on course to complete talks on EU membership before the end of the year, described by Spain’s foreign minister as being “at the heat of the Presidency“ is off track. Turkey membership talks – another Spanish priority – are painfully slow, and Spain will be lucky if Turkey manages to open one policy package of the four Spain wanted.

The fi rst half of 2010 was always going to be diffi cult for the EU’s foreign policy. The Lisbon Treaty was never to work its magic in-stantly and the creation of the European Ex-ternal Action Service was always going to take time. Nevertheless Spain had ambitions to assert the EU’s presence on the world stage. It has failed to realize them as it failed to re-cognize earlier in the year that its economy was going to face a wall of bricks.

ConclusionsHow bad things get depends largely on

how long Spain’s unemployment rate hovers near 20 %. The Bank of Spain is fi xated on the need to reform the labor market. Selling the public on sacrifi ces that are extremely unpo-pular politically is one of the biggest challeng-es Spain faces. In the best case scenario Spain economy will be between fi ve to 10 years of below-trend growth and average saving to pay off the debt overhang. One of the key un-derlying problems is that all the growth from the construction boom pushed up wages. Low productivity in Spain relative to its competitors is what is causing trouble right now. The only way for Spain to remain competitive is for the country to increase productivity because it cannot lower prices artifi cially through the ex-change rate. Spanish people like in the case of Greece will see their standard of living come down as they restructure their economy. Another major problem related to lost pro-ductivity is Spain rapidly growing trade defi cit which has reached a staggering 10 % of the country GDP by the summer of 2008, due to the recession. Spain needs to undertake now the necessary adjustments concerning wages and prices, and facilitate the reallocations of resources from the commercial and construc-tion sector to the export sector. It is crucial to make now appropriate choices: policies that boost productivity and skills reduce the need for adjustments in nominal wages and facili-tate the reallocation of labor.

Michel ClerinEconomist - University of Chicago

Francisco de Goya, Burial of the Sardine, 1812-14

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