Editorial Board

Spain’s Disappearing Economy Demands a Bold New Approach

If you catch yourself feeling a little more optimistic about Europe’s economic prospects now that the cost of government borrowing has eased, take a look at Spain. With an unemployment rate of 26 percent -- about one in three of all jobless people across the euro area -- Spain is entering its fifth year of recession and the pace of contraction is actually accelerating. The country’s austerity-first approach to budget policy is a main reason.

Nobody doubts that Spain needs further economic reform, especially in its notoriously dysfunctional labor market. Its fiscal position is unsustainable, too. Spending cuts and tax increases will be needed to balance the books long term.

Spain, however, stands as the classic example of self-defeating fiscal stringency: Its efforts to curb deficits too much, too soon have squeezed demand to the point that budget targets have been missed and the economy keeps shrinking.

Gross domestic product fell 0.7 percent in the fourth quarter, a bigger drop than the Bank of Spain and most private forecasters had expected. When comparing fourth quarter over fourth quarter, Spain’s GDP fell 1.8 percent in 2012. Domestic demand dropped more abruptly last year than in 2011, mostly because of repeated rounds of budget cutting. Retail sales were 11 percent lower in December 2012 than the year before. Unemployment, in other words, is headed even higher.

Missed Targets

Despite increased taxes, spending cuts and public-sector firings, the government keeps missing its deficit targets. The government says it probably did so again last year, when its deficit goal was 6.3 percent of GDP. For now, though, it stands by its promise to the European Union that the deficit will fall to 4.5 percent of GDP in 2013. With the economy shrinking at its present rate, that isn’t going to happen.

Last week, Olli Rehn, the EU’s economic and monetary affairs commissioner and chief budget enforcer, hinted that Spain’s deficit targets could be eased. An assessment of its fiscal program is scheduled for this month. Some further relaxation is necessary, just as it was last year, but merely accommodating some of the inevitable slippage doesn’t go far enough. What’s needed is a deliberate EU effort to extend collective fiscal support to Spain.

The country is experiencing such intolerable economic stress that its political stability is surely in doubt. The danger of collapse in that sphere just increased significantly: A widening corruption scandal is implicating Mariano Rajoy, the prime minister. The newspaper El Pais is running articles saying that Rajoy received regular payments from an undisclosed party slush fund. Rajoy denies the allegations; inquiries are under way. With Spaniards struggling to get by in a new age of sacrifice, the last thing they want to read is that their leaders may have been living it up with the help of under-the-table funds.

Falling Yields

Government bonds of distressed EU countries have rallied since the European Central Bank pledged to avoid a euro-area crackup last summer. This has aroused fears that the pressure for economic reform will ease.

In the case of Spain, whose 10-year bond yield has fallen from more than 7 percent at the peak to a little over 5 percent, the greater danger is just the opposite. This pause in financial-market stress may convince the government that Spain can avoid seeking a full international bailout and the fiscal relief that would come with it.

Yet fiscal relaxation is exactly what Spain needs. With support from the EU and the International Monetary Fund, Spain should suspend its budget squeeze until its economy shows signs of reviving.

Supply-side reforms can’t happen too soon, but new plans for fiscal consolidation should be delayed. Adopt them now, but execute them only once the country’s crippling rate of unemployment has declined. Far from consenting reluctantly to such a course, the EU and the IMF should be aggressively advocating it.

    To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.

    Before it's here, it's on the Bloomberg Terminal.