March 26, 2012 Finanical Times
Just when you thought it was safe to go outside, it turns out that another storm is gathering on the eurozone horizon.
Spain was always on the “one to watch” list. It now finds itself in that most awkward of positions: the financial equivalent of a vicious circle. The interest rate on its sovereign debt is rising, the economy is stalling and the government is fast losing the enthusiasm to deliver the austerity demanded by Brussels. The process then repeats itself.
Reflecting both the economy’s descent into recession and the significant Budget deficit overshoot last year, the Popular government led by Mariano Rajoy informed Brussels earlier this year that it was aiming for a budget deficit this year of 5.8 per cent of gross domestic product, significantly higher than the 4.4 per cent agreed earlier. An almighty row then broke out – one that essentially focused on the degree to which Spain is able to enjoy fiscal sovereignty – which led to a compromise deficit target of 5.3 per cent.
Even if that number is achieved, and with 17 autonomous regional governments in Spain all happily spending away, there is no guarantee that it will be, the thorny matter of reducing the deficit further to 3 per cent of GDP in 2013 remains.
For an economy shrinking rapidly, deficit reduction on this scale is not easy. Whatever one thinks about Greece’s initial fiscal problems, for example, they were made far worse as a result of subsequent economic collapse. In the autumn of 2010, the International Monetary Fund thought Greece would shrink by a rather modest 2.6 per cent in 2011. We now know the economy last year fell about 7 per cent. The Greek fiscal position was bad not only because of a lack of effort but also because the economic problems were far stronger tan expected.
Major deficit reduction in the wake of economic collapse is near enough impossible, particularly when the population starts to protest. Spain is preparing for a general strike on March 29. Yet the more Spain resists deficit reduction, the greater will be the suspicion that the authorities are merely dragging their feet. Perhaps, for example, they’re hoping for further help from the European Central Bank’s long term refinancing operations to push Spanish yields back down, thereby saving the day for the government, for its banks (now up to their gills in Spanish government debt thanks to the carry trades generated by the first two LTROs) and for the single currency, without the need for excessively painful austerity.
Here, then, is the problem. Have Spanish yields risen because investors no longer believe the country is either willing or capable of delivering the necessary austerity? Or have they risen because investors think the eurozone’s creditor nations, and their acolytes at the European Commission, are just running out of patience? Either argument could be used to explain the rise in yields yet there’s a world of difference between deliberate slippage on behalf of the Spanish and a loss of confidence on behalf of their eurozone partners.
Olli Rehn, the EU commissioner for economic and monetary affairs, has made his views known. He’d like more fiscal pain in Spain. “Because there was perception Spain was relaxing its fiscal targets for this year, there has been already a market reaction of several dozen basis points on yields of Spanish bonds,” he said. The fault, according to him, lies solely with Spain and it is up to the Spanish to convince investors that they can bring their fiscal plans back on track.
This has become a familiar lament. Yet it does not deal properly with the interaction between growth shortfalls and the cost of borrowing within the eurozone. In the old days, weak growth was synonymous with low interest rates. In the topsy-turvy world of the eurozone, weak growth is now more often associated with high interest rates. Austerity, by delivering even weaker growth, leads to even higher interest rates.
The only way to get around this problem is to recognise the symbiotic relationship between creditors and debtors. In the eurozone, that means a fiscal union, not the constant bullying of debtors by creditors.