Don Quixote Is Alive and Well and Living in Spain

By Desmond Lachman 

Spain is the euro area’s fourth-largest economy. Bad government policy threatens the whole euro project and the global economy.

It was said of the Bourbons that they learnt nothing and that they forgot nothing. The same might be said of the Spanish government, judging from its recent economic policy pronouncements amid widespread social and regional unrest. The government seems to be persisting with the past year’s failed economic policies, which have not only gotten Spain into its current difficult economic straits but that are now also running the real risk of tearing the country apart.


The Spanish economy is in a sorry state. Despite having barely recovered from the great economic recession in 2008-2009, the Spanish economy has again dipped decisively into economic recession, with no end in sight. All indications suggest that the Spanish economy is now likely to contract by around 1.5 percent in 2012.
Leading the economy’s decline has been the bursting of a housing bubble that dwarfed the one in the United States and is causing Spain’s banks to cut back sharply on extending credit to households and corporations. Meanwhile, Spanish unemployment continues to increase at an alarming rate, with 25 percent of the Spanish workforce now unemployed and youth unemployment above 50 percent.

All indications suggest that the Spanish economy is now likely to contract by around 1.5 percent in 2012.

If Spain’s economy is in poor shape, its politics look at least equally troubling. Anti-austerity protests have now become the order of the day, while the popularity of the Conservative Spanish Prime Minister Mariano Rajoy’s government, which barely one year ago was swept into power in a landslide election, continues to plumb new lows.
Worse yet, Spain’s regions have become increasingly restive in their demands for increased autonomy as the country’s more prosperous regions object to being forced to transfer a disproportionately large part of their tax collections to the federal government. The Catalonian government has now plunged the country into a constitutional crisis by calling for an election on November 25 to gauge Catalonian public opinion of possible secession.
At the heart of Spain’s economic difficulties is the pro-cyclical fiscal policy that is being foisted upon the country by its European partners to correct Spain’s troubled public finances. In that context, the European Central Bank (ECB) recently made it clear to the Spanish government that any support that the ECB might provide to Spain through proposed large-scale government bond purchases is contingent upon Spain subscribing to an externally monitored fiscal adjustment program by the European Stability Mechanism and the International Monetary Fund (IMF).
The trouble with fiscal austerity measures taken this past year by Spain is that they are causing the Spanish economy to contract and are worsening the country’s housing market bust and credit crunch. This in turn is complicating Spain’s ability to meet its budget targets, since a weaker economy has substantially eroded Spain’s tax base. It is now likely that Spain’s budget deficit for 2012 will be closer to 7.5 percent of GDP than to the budget deficit target of 6.3 percent of GDP.

Spain’s regions have become increasingly restive in their demands for increased autonomy.

Spain’s poor economic performance over the past year should not have come as a surprise to its government. For it is exactly what was to be expected from implementing severe budget austerity at a time when banks are cutting back on credit, when the housing bust continues unabated, and when the euro straitjacket precludes Spain’s ability to use exchange rate policy as a means to boost export growth.
Undaunted by the deepening economic recession and by rising social and regional tensions, the Spanish government is now doubling down on a bet that failed so miserably this past year. Indeed, in an effort to keep his European partners happy and in the hope that he can avoid having to go cap in hand to the IMF, Prime Minister Rajoy is now proposing budget cuts totaling €40 billion, or close to 4 percent of GDP, for 2013.
Rajoy is mistaken to propose an even more pro-cyclical fiscal policy now than he did last year — amid an even deeper economic recession and worse external economic environment — and to think it will produce a more favorable economic outcome this time around. Sadly, by the time he finds out that this policy approach will only deepen the country’s recession, his government will have lost what little credibility that remains and the country’s social and regional crisis will have come to a full boil. Given that Spain is the euro area’s fourth-largest economy, this has to be a major concern not only for Spain but also for the whole euro project and the global economy.
Desmond Lachman is a resident scholar at the American Enterprise Institute.