Washington’s Dangerous New Consensus on China
Don’t Start Another Cold War
November 21 Update: As opinion polls predicted, the center-right Popular Party (PP), led by Mariano Rajoy, swept Spain’s parliamentary elections on Sunday. Despite running a deliberately vague campaign that mainly played to the electorate’s desire for change, Rajoy overwhelmingly defeated the socialist candidate, Alfredo Pérez Rubalcaba, winning an absolute majority:186 of the 350 seats in the lower chamber of Parliament. Celebrations, however, are not expected to last. Although they do not officially take office until the end of December, Rajoy and the PP are already under pressure to stabilize the market for Spanish bonds, to appease calls for austerity from Frankfurt and Berlin, to decrease Spain’s soaring unemployment, and, ultimately, to save the country from economic recession and default.
For Europe, it turns out that November is the cruelest month: The debt crisis will claim at least three eurozone governments before it is over. Yet, unlike in Greece, where Prime Minister George Papandreou resigned last week, and in Italy, where Prime Minister Silvio Berlusconi stepped down over the weekend, the political crisis upending Spain is toppling the government in slow motion. Facing dwindling public support, an unemployment rate of more than 20 percent, and the increasing cost of Spanish debt, the country's Socialist Prime Minister José Luis Rodríguez Zapatero threw in the towel last July and called for early elections to be held on November 20, four months ahead of schedule.
By all accounts, the election is expected to be a landslide. The current deputy prime minister of the Spanish Socialist Workers' Party (PSOE), Alfredo Pérez Rubalcaba, will face the seemingly perennial candidate of the conservative Popular Party (PP), Mariano Rajoy. Rajoy has lost twice before, but opinion polls suggest that the PP will win big this weekend, securing an absolute majority, its first in more than a decade. This is a so-called punishment vote against the ruling PSOE for presiding over Spain's decade-long boom and, now, its bust.
Those punished, however, will actually be the Spanish people and, more so, the rest of the eurozone. Madrid faces critical economic problems, and the policies of the new government will only make the situation worse. In fact, due to huge private debt, a less than fully deflated real estate bubble, and astonishingly high unemployment, Spain's financial crisis is as bad, if not worse, than Italy's. So despite the PP's good intentions, implementing severe austerity measures in the name of "fiscal responsibility" and "restoring market confidence" -- as Germany, the European Central Bank (ECB), and global investors are urging -- would sink the Spanish economy and push Europe's experiment with a common currency closer to its end.
This is not the standard prognosis. According to most observers, Spain appears to be on the mend. The country's current debt-to-GDP ratio is only slightly more than 60 percent, the maximum debt threshold established under the Maastricht criteria. Italy's is 118 percent. Moreover, the outgoing Spanish government has worked hard to lower the general deficit from just more than 11 percent of GDP in 2009 to some six percent today. Italy's has been increasing (yet is currently up to only 3.2 percent). And in contrast to Berlusconi's two years of dithering on cuts, the Spanish parliament passed a modest round of austerity measures -- including a decrease in public wages, pension reductions, and an increase of the retirement age from 65 to 67 -- back in 2010. Spanish banks even appear secure, receiving praise from many economists for their overall conservative portfolios and high capital provisions. So from the sovereign debt perspective, Madrid looks pretty good.
The problem, however, is not public debt. The problem is Spain's private debt. Years of historically low interest rates allowed individuals and corporations to borrow too much and invest it poorly. The average level of Spanish household debt tripled in less than a decade, raising the median ratio of indebtedness to income to 130 percent today. Corporate borrowing has soared as well. Its private debt is close to 200 percent of GDP, whereas Italy's and Greece's are around 110 percent. According to a 2010 report from the McKinsey Global Institute, among the 20 most developed countries in the world, Spain has the third-highest level of total debt (government, business, and household), after Japan and the United Kingdom. In total, Spain's debt-to-GDP ratio is 366 percent.
Where exactly did all that money go? Some of it clearly went to good use, producing the eurozone's largest bank, Santander, the world's largest fashion retailer, Inditex, and the global leader in wind energy, Iberdrola. However, much of the money was ill spent on construction and real estate.
Spain's property bubble has become almost as famous as its sunny beaches. According to the Spanish Ministry of Housing, the country saw real estate prices rise 201 percent from 1985 to 2007, with the vast majority of those gains occurring in the last decade. At the beginning of 2008, the construction industry represented 16 percent of GDP and 12 percent of employment. The building craze and ensuing housing bubble pushed home ownership above 80 percent; it has left more than $820 billion in mortgages outstanding. However, unlike in Ireland and the United States, the Spanish bubble has yet to fully pop. Real estate prices in Madrid and other major cities still remain high: On average, prices have dropped 18 percent since 2007, compared to 40 percent in Ireland and 32 percent in the United States. Defaults on construction loans and mortgages are likely to rise as prices continue to fall. Oversupply is almost guaranteed for years to come, with approximately one million vacant properties (30 percent of the housing supply) spread out across the country. That is not all: More than 90 percent of all Spanish mortgages have variable-interest rates and are pegged to the one-year Euribor money-market rate, which has been on the rise this year. But unlike in the United States, laws in Spain prevent mortgage holders from walking away from their homes if they hold other assets. In Spain, the deleveraging process has only just begun.
Adding insult to injury, Spanish unemployment is even worse. The country has the highest rate in Europe. Currently, it stands at 22 percent, more than twice the EU average. It is increasingly possible that an entire generation of Spaniards could fail to establish itself within the labor force, as almost one in every two young people does not have a job. Even Greece, which has been the poster child for European joblessness, posts better numbers. And Italy recorded a comparatively modest rate of 8.5 percent unemployment last month.
Of course, all three of these problems are actually interconnected and negatively reinforce one another. Increased unemployment leads to both higher public and private debt and greater downward pressure on the housing market; lower home prices mean less construction activity (lower employment) and more defaults; more private defaults threaten the stability of Spain's banking industry, which increases the likelihood of further asset devaluations and of additional capital injections from the government. And the growing number of private-sector defaults will only make the country less competitive as time goes on, further increasing unemployment. It is a downward spiral, and it is accelerating.
Nevertheless, Spain's incoming conservative government, increasingly under pressure from Berlin, believes it has a solution: austerity. Without offering many specifics, Rajoy, should he become prime minister, has promised to cut spending and streamline the state. The goal is to impress the ECB and investors alike by meeting all future deficit targets, including a reduction of the general deficit to only three percent of GDP by 2013. In its recent manifesto, the PP calls for more flexible labor contracts, decreased regulation, and incentives to encourage entrepreneurs to start more businesses. Privatization of public companies and greater limits on collective bargaining are also on the table. Analysts expect coming cuts to be severe; they point to the PP's record on the regional level, where the party currently controls 14 of Spain's 17 autonomous regions. For example, in the regions of Castilla-La Mancha and Extremadura, the PP has already cut spending by 20 percent. With an absolute majority in parliament and little oppositional force from the Spanish trade unions, severe austerity measures are on the way.
Rather than saving the day, this program will spell disaster for Spain. Lower government spending during a downturn will result in slower economic growth; the evidence from Greece builds every day. And slower economic growth will only make all of Spain's problems worse. Fewer public-sector jobs and lower pension and unemployment payments will lead to lower aggregate demand, more job losses, higher social welfare payments, more loan defaults, and eventually, a true banking crisis -- especially among the smaller regional banks. More of Spain's enormous private debt will then have to be transferred to the government's balance sheet. Cutting will send Spain back into recession.
Should that moment come, a European bailout of the Spanish economy is an impossibility. Spain's debt is simply too big, especially given the ECB's other obligations, not to mention its unwillingness so far to step in even as a lender of last resort. Nor can Spain's current private-debt problem be solved by any rescue package from the outside. In fact, it is arguably more difficult to save individual mortgage holders and corporate borrowers than it is to rescue a single government. In this way, Greece and Italy are easy -- sovereign default and devaluation can solve a host of problems all at once.
What is Spain to do? Without sustained economic growth, there is no easy way out. In the end, Spain's massive total debt will have to be either written down or inflated away. Investors, both foreign and domestic, are loathe to do the former, and the German government will do everything it can to prevent the latter. Within the confines of Europe's current monetary system, someone has to lose. In this context of conflicting interests, resurgent national chauvinism will eventually win out. But that means the only endgame is the end of the euro.
(Photo: GonchoA / flickr.)