Spain's economic boom gives way to crisis and now austerity
It was all looking so good . . .
It seems a long time ago now but as recently as 2007 Spain was seen as a model economy. The struggle to join the Euro seemed to have really paid off with rapid growth and development catapulting Spain up the ranks of Europe's richest economies, closing the gap with rich northern neighbours like Holland and Germany.
And despite some manic action in the housing market and a trade deficit, it did not look like an economy built on sand. The government budget was under control with a budget surplus and a debt ratio of 40%, one of the lowest in the rich world. Unemployment and inflation numbers both looked pretty respectable and Spanish companies like Zara, Santander and Ferrovial seemed to be flying the flag for Spanish business.
The Euro was not a blessing. For Spain it was a curse in disguise
But things have gone down hill a long way since 2007 and a lot of the apparent progress Spain had made within the Euro area has shown to be a mirage. In fact the Euro stored up a lot of the problems that are now hitting Spain so hard:
1. The Euro bought lower interest rates which stoked up the housing market and created a consumer and credit-led boom that proved unsustainable
2. Normally such booms are cut short by a balance of payments crisis or inflation taking off and the government raising interest rates. Being within the Euro area none of this happened for Spain and the boom was allowed to go on and on making the eventual bust worse.
3. The economy got distorted by the boom: lots of people working in construction, estate agencies, finance. Jobs based on easy money not solid economic success. Export industries and competitiveness withered.
4. The government at a national and local level got fat on the tax money coming in from stamp duty, rising levels of pay and VAT receipts from the consumer boom. They spent accordingly thus adding to the boom and potential for bust.
The hangover . . .
The crash came when credit worldwide dried up in 2007 and 2008 and mortgage finance first tightened up and then practically disappeared. Everything went into reverse very quickly as the housing market soured and unemployment rose. Some people blame the credit crunch in the US for spreading to Spain but in truth that was just the final nail in the coffin of a classic boom that was already showing signs of running out of steam in 2006.
As the crisis has unfolded its main features have been:
- unemployment climbing remorselessly to 20%
- government finances deteriorating badly, going from surplus in 2007 to a deficit of around 10% of GDP now
- housing market depression with few signs of recovery (article 10 Reasons Why Spanish Property Prices Will Stay Depressed)
- the economy shrank at annual rate of about 4% from the middle of 2008 to the beginning of this year when it grew but only slightly (0.1%).
There is a very good blog called Spain Economy Watch which details what's going on with the crisis.
None of this is good but it would have been a lot worse but for government and central bank action. The government pumped in money during 2009 in particular cutting taxes and spending money on public works. They also propped up the banks, some mortgage holders and the car industry, with a scrappage scheme (if you want to learn about this read the Advoco Spanish Scrappage Scheme guide here). The European Central Bank helped by keeping interest rates at rock bottom and making lots of easy loans available to the banks, many of which would have gone bust otherwise. But did all this just delay the inevitable?
Why Spain's economic crisis isn't over - the surface reason
This article is being written in May 2010. Why is the economic crisis back in the news? Why all the gloom and doom pronouncements from commentators and emergency statements from politicians? Isn't this the year of recovery?
The widely accepted reason for the current round of economic crisis talk (and actions which we will come to) is the Greek debt crisis. Without going into the full story of Greece's fiscal crisis (the BBC website has a good explanation here - Greece's Economic Woes) it is clear that their problems have spread to Spain. The delicate little recovery of 0.1% in Spanish growth could be wiped out as follows:
- After Portugal the markets believe Spain is the next most likely country after Greece to default on its government debt. This makes them wary of lending to Spain (buying Spanish government bonds) and makes them demand higher interest rates for doing so. This makes the Spanish fiscal deficit even worse as a large part of government spending is interest on its bonds.
- the only way a country can break this downward spiral in confidence is to show the markets it means business in terms of getting the deficit down. That means either raising taxes or cutting spending or preferably both. This could cut consumer spending just as it starts to recover. Also there are signs that the spending cuts could cause strikes and unrest further damaging the economy.
- The Euro itself is coming under pressure because of the number of countries in a Greece-style pickle. There are also fears for Italy and Ireland. If the other richer countries have to bail them out this could cost hundred of billions and send their own budgets into deeper deficit. The rich countries are saying therefore, that any help to Spain must be dependent on strict budget cuts.
- There are fears that by responding to these multiple pressures to tighten up its budget the Spanish economy will slip back into recession as taxes rise and government spending props to the economy are withdrawn.
- All the problems outside of Spain could also impact in other ways by for example reducing demand for its exports, reducing business confidence so private investment falls and by causing losses for its banks who have made loans to for example Portugal.
Why Spain's economic crisis isn't over - the deeper reason
All this is bad enough but again it implies that all Spain's problems are external: this time it's not the US sub-prime crisis that's doing the damage, it's Greece or the European Central Bank or speculators in the government bond market. Without this chaos the recovery would gradually take hold and the fiscal deficit start to fade away. This is a false argument.
Forget scapegoats, this is very much a problem of Spain's making and regardless of what happens abroad, Spain will have to find a solution. The are two things that make it a domestic Spanish problem without anyone to blame or help solve:
1. All the economic distress we are seeing in Spain at the moment is the mirror image of the fun that was had during the boom. Every empty shop, abandoned building site, restaurant or bar for rent, small business closed had its flipside during the go-go years prior to 2007 when the economy over-expanded and everyone was doing well.
If Spain really is a victim of the Euro it was a very willing one. When interest rates were low the country could have done things to dampen down the excesses but instead certain elements within the system made the housing and credit boom even worse. Think of the banks throwing money at people without proper lending criteria, greedy and corrupt town hall officials greenlighting every building project and all the lawyers and estate agents getting in on the act.
2. The Spanish government is not blameless even though that is what some economic commentators are saying (see this NY Times piece by Nobel prize winner Paul Krugman - The Spanish Tragedy) because they went into the crisis with the government finances in surplus, unlike Britain. But the government did nothing to calm the overheating of the boom years or stop people getting reckless mortgages or stop construction firms pillaging the country.
It just took all the tax revenues and continued with wasteful public spending without tackling the serious underlying issues the country has in education, infrastructure, competition and the labour market.
And after the crash happened the government spent even more money (as we have discussed) on makework schemes, subsidies and tax-breaks which quickly turned budget surplus into the horrendous deficits that the markets fear today.
These schemes may have bought time in 2009 but are now coming back to haunt us because of what is about to unfold in 2010 . . .
What it means for us
In short there is every reason to believe that any Spanish recovery will be shortlived or at best very weak, as the government is being forced into an austerity programme.
The problem with governments propping up the economy is that they can't do so indefinitely and, even if they could, they are only able to "rob Peter to pay Paul" (create jobs and growth in part of the economy by taking resources from the rest of it). Spain is now being forced to pull the government supports from the economy and indeed send them into reverse.
To give just one example the Spanish version of the scrappage scheme gave 2.000€ subsidies to new car buyers last year and that supported car sales. Now car dealers have to cope without the subsidy and a VAT rise (IVA goes up from 16% to 18% in July).
The tax rises in the pipeline are discussed below.
Another possible side-effect of the new twist in the crisis is the bankruptcy of some of financial institutions that take our deposits. Already administrators have been called into CajaSur and rumours swirl around other savings banks like Caja de Mediteraneo ("CAM") which is in merger talks with other institutions. Each account holder is protected with €100.000 of deposit insurance.
There is also a strong possibility of a General Strike being called against the austerity measures and against plans to make the labour market more flexible.
A silver lining to the Euro's problems?
The problems of the Euro area generally have led to a weak currency which has caused the pound to recover slightly. If the pound were to leap further this might have a positive impact on the Spanish property market which has it's own special problems even before the austerity measures bite (see Advoco blog post 2010 Spanish Property Market Outlook).
The problem is that the pound has only gone up by 2-3% since the start of the year. The UK has similar problems with a weak economy and an alarming deficit. In some ways the UK has more reasons to cheer, being outside the Euro, but then again Britain went into the recession with a large deficit to begin with and thus a bigger headache now.
Besides a weak economy, the other most visible impact of this latest twist in the crisis is going to be on taxes and government spending.
Highlights of the austerity package
The Spanish government has been forced into two austerity packages this year and there may be more measures to come, all aimed at getting the budget deficit under control.
- the latest plan is to bring the deficit down from 11.2% of GDP in 2009 to 3% by 2013, a very tall order
- in January there were a series of tax measures designed to cut the deficit by €50 billion over four years:
rise in the general rate of IVA from 16% to 18% with effect 1/7/2010.
rise in the "reduced" rate of IVA which applies to things like flights and restaurants from 7% to 8%
a 400€ tax deduction for all taxpayers introduced in 2009 was abolished
tax on investment income and capital gains raised from 18% to 19% for the first 6.000€ and 21% thereafter
rises in duties on petrol, tabacco and alcohol
- in May 2010 the government was forced by the growing market pressures described above to introduce further measures, this time mainly involved with spending cuts:
a freeze on state pensions
a cut in public sector salaries, up to 15% for the top paid but averaging 5% overall
abolition of the "baby check" , a €2.500 payment made to all mothers of new babies
The hope is that around €5 billion will be saved this year and €10 billion next year
The government also intends to raise some money by increasing taxes on "the rich" but details are hazy. One suggestion is that the wealth tax will be introduced for all taxpayers with a €1 million or more in assets.
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