The Spanish Dilemma

A year and half ago, Krugman wrote in a NYT editorial that Spain's problem is the euro. What went wrong? This is his (perfectly right) explanation : " Spain experienced a huge property bubble, accompanied by a huge rise in private-sector debt. (...) Spain fell into recession when that bubble burst, and has experienced a surge in unemployment. (...) Spain has seen its budget deficit balloon thanks to plunging revenues and recession-related costs. (...) Spain is on the edge of a debt crisis. The U.S. government is having no trouble financing its deficit, with interest rates on long-term federal debt under 3 percent. Spain, by contrast, has seen its borrowing cost shoot up in recent weeks, reflecting growing fears of a possible future default. (...) At the end of 2007 Spain’s public debt, as a share of the economy, was only about half as high as Germany’s, and even now its banks are in nowhere near as bad shape as Ireland’s.

But problems were developing under the surface. During the boom, prices and wages rose more rapidly in Spain than in the rest of Europe, helping to feed a large trade deficit. And when the bubble burst, Spanish industry was left with costs that made it uncompetitive with other nations". (...) "What all this means for Spain is very poor economic prospects over the next few years".

Spain is now the fourth country to be bailed out by the European Stability Fund, after Greece, Ireland and Portugal. It seems that the assistance (up to 100 billion euros) will be limited to the banks instead of the sovereign debt. This was largely predictable given the continuing attacks of financial markets since last year. Is it really the euro's fault, as Krugman argues or are there any good options to pursue?

Would Spain have been better off if it had never adopted the euro? Interest rates would have been higher and the fiscal situation would have been much worse. EU funds flowed to Spain to finance large infrastructure programmes and stimulated private sector investment. The housing bubble is not directly related to the euro, but is due to speculation, excessive risks born by banks and poor regulation and supervision by public authorities. Now tax payers will have to pay the bill on top of the savage austerity measures already taken, particularly on wage and social spending cuts.

The intervention from the European Stability Fund will provide relief to the Spanish banks but will probably not put an end to speculation. Banks have among their assets billions in State bonds, which will lose in value and if yields remain at current levels, banks will suffer considerable losses. It would have been preferable that the ECB intervenes directly to purchase public debt, avoiding asset depreciation but this not allowed by the Treaties. In that situation, banks will remain vulnerable to speculative attacks as long as the ECB does not intervene as a lender of last resort. The strong opposition of Germany to any reform of the ECB - which has been very active in alleviating the effects of the crisis- could lead eventually to the destruction of the eurozone. There are legitimate concerns of 'moral hazard' but if no bold actions are taken immediately, the crisis may end up in a much more dangerous recession. Big plans for a closer political Union and eurobonds are not for the next ten years but should be realized now together with a credible strategy at the EU level to promote growth and jobs through investment programmes, not with haircuts or other suffering. This is the Spanish dilemma, which depends on decisions to be taken by the European Union for its survival.