The Corner

The Pain in Spain

Paul Krugman (yes, yes) makes an important point:

[T]he Spanish story bears no resemblance to the morality tales so popular among European officials, especially in Germany. Spain wasn’t fiscally profligate — on the eve of the crisis it had low debt and a budget surplus. Unfortunately, it also had an enormous housing bubble, a bubble made possible in large part by huge loans from German banks to their Spanish counterparts. When the bubble burst, the Spanish economy was left high and dry; Spain’s fiscal problems are a consequence of its depression, not its cause.

And why did German banks do this? Because the myth of euro-zone economic convergence (talked up by those in charge of the project, incidentally) meant that Spanish risk was fundamentally mispriced. The banks are not the (real) villains of this piece. Responsibility ultimately lies with those who set up this hugely speculative single currency in the first place. And what they and their successors are doing now is blaming Anglo-Saxon speculators for the mess. Again.

Meanwhile over at the FT Wolfgang Münchau is (I suspect) painting too simple a picture when he argues this:

News coverage seems to suggest that the markets are panicking about the deficits themselves. I think this is wrong. The investors I know are worried that austerity may destroy the Spanish economy, and that it will drive Spain either out of the euro or into the arms of the European Stability Mechanism [the bailout fund].

I think that it’s better to say that investors are worried both by the deficit (remember that funding that deficit can be complicated by the operation of the currency union) and by the steps that are being taken to (allegedly) cure it. When it comes to the following, however, Münchau is spot on:

Spain’s  targeted fiscal adjustment amounts to 5.5 per cent of GDP over a period of two years. It is one of the biggest fiscal adjustments ever attempted by a large industrial country. It is perfectly rational for investors to be scared.

European policy makers have a tendency to treat fiscal policy as a simple accounting exercise, omitting any dynamic effects. The Spanish economist Luis Garicano made a calculation, as reported in El País, in which the reduction in the deficit from 8.5 per cent of GDP to 5.3 per cent would require not a €32bn deficit reduction programme (which is what a correction of 3.2 per cent would nominally imply for a country with a GDP of roughly €1tn), but one of between €53bn and €64bn. So to achieve a fiscal correction of 3.2 per cent, you must plan for one almost twice as large.

Spain’s effort at deficit reduction is not just bad economics, it is physically impossible, so something else will have to give. Either Spain will miss the target, or the Spanish government will have to fire so many nurses and teachers that the result will be a political insurrection.

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