Why I worry more about Spain than about Greece

By: Wolfgang Münchau

After a decade of not always constructive ambiguity, the European Union now has a bailout rule. It goes as follows: A bailout shall be granted to any country that subsequently complies with a brutal adjustment programme, dictated by the EU. I suspect that Greece, being the first country in trouble, being small and sufficiently scared, will comply with all the conditions. Maybe Greece will not need a bailout. I still suspect that it might. But in any case, we have established a new principle. Whereas previously nobody was really sure what would happen in such a case, we now know that there are specific cases in which a bailout is likely.

But that leaves still plenty of scope for ambiguity. For example, what would happen if the country did not, or could not, comply with the conditions? Greece will almost certainly not be that country, but Spain just might.

Spain’s problem is not fiscal profligacy. Its debt-to-gross domestic product ratio – still below 50 per cent - is relatively mild compared to even Germany’s or France’s. But it is going to rise fast as the country remains mired in a growth trap out of which I cannot see a realistic way out – economically and politically. Spain is a country that should never have adopted the euro so early on – even though the country easily qualified on all the convergence criteria. The problem with Spain is that the significant reduction in interest rates that came with monetary union implied a huge housing bubble, which no financial regulation could have counteracted. Spanish banking regulation may not have been perfect, but it was better than most. So we cannot blame the banks, as we did in the US. Membership of the euro area gave rise to a domestic mortgage lending boom and massive foreign capital inflows, both of which triggered one of the biggest construction bubbles ever witnessed in the EU. What’s more, hardly any Spanish economist noticed that the situation was unsustainable. They were all caught by the Spanish miracle story, just as German economists believed in 1990 that unification would turn Germany into a strong economy. It did, but with a delay of some 15 years.

Spain’s burst bubble is a shock of at least the same magnitude, probably worse, because it occurs in a different global economic climate. Spain could switch to an export-led model, but then others are doing the same – so the scope is much reduced. In any case, such a strategy would require significant labour market reforms, and downward wage flexibility, which the Spanish government is not contemplating for political reasons. But even if the Spanish government were to implement the entire reform agenda of the Organisation of Economic Co-operation and Development (OECD), it might still not suffice to escape from the trap. A decade or more of deflation beckons – that is deflation relative to Germany, which is close enough to deflation itself. It is easily possible that the trajectory of the Spanish economy might mirror-image that of Japan after its own extreme housing bubble burst in the early 1990s. Japan ended up with two decades of mild deflation, very low growth rates, and a debt-to-GDP ratio of close to 200 per cent. Like Spain, Japan used to be fiscally prudent before.

Now what would happen if our new bailout-rule meets a Spanish crisis, say in five years time? The then-president of the eurogroup of finance ministers and the European Commission would, by instinct, demand greater consolidation efforts. They would ask the Spanish government to increase taxes, and to cut the wages of public sector employees. They would demand an increase in the pension age from whatever level it will be then by another two or three years. They would demand a total liberalisation of the labour market, the introduction of hire and fire, and a law to give employers the ability to renegotiate labour contracts.

I would bet that whoever will be Spanish prime minister then will respond with a rude finger sign, walk out of the meeting, travel home, and declare with pride that Spain would not accept such an extreme loss of sovereignty. Better to perish than to be subjected to a hostile foreign rule. The next day he would declare a moratorium on the country’s debt. What then?

Germany may be reluctant to bail out Greece for all sorts of reasons. But Germany will do it. But Germany cannot conceivably bail out Spain. Germany and France together cannot bail out Spain. Spain is too large. And Spain is guaranteed not to be nearly so compliant as Greece. In every scenario, there is always the possibility of an accident. There is now in the case of Greece. But should Spain ever get into trouble, I can hardly see how an accident can be avoided. Furthermore, Spain is very likely to get into trouble.

This is why the EU and the euro area in particular need to be prepared. The new bailout rule is fine for now, fine for Greece, but it will not stand up to a larger shock. We should not repeat the mistake of the stability pact, which was revised in 2005 only to fail again in 2009. If our bailout rule fails, the survival of the euro area itself will be at risk.

The author is associate editor of the Financial Times, and president of Eurointelligence ASBL.

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