Spain Faces Potentially Irreversible Economic Problem

Spain’s recently-elected Prime Minister, Mariano Rajoy, faces a potentially unsolvable economic dilemma.

When the euro was first conceived in the 1990s, Germany insisted on a “stability pact” to ensure that governments inside the eurozone would keep their finances in order. When Spain joined the euro in 1999, the Spanish government then proceeded to run a balanced budget on average – that is to say, its borrowing was zero – every year until the eve of the 2008 financial crisis.

And as Spain’s economy grew rapidly, its debt ratio fell to a mere 36% of GDP by 2007. Germany’s, by contrast, continued to rise. While the Spanish government resisted the lure of cheap loans, most ordinary Spaniards did not. The country experienced a long boom, underpinned by a housing bubble, as Spanish households took on bigger and bigger mortgages. During the boom years, Spaniards earned more and spent more.

That helped to flatter the government’s finances. More economic activity means more tax revenues. But it also helped push Spanish wages up to uncompetitive levels. Now Spain is bust. The economy, which grew 3.7% per year on average from the euro’s foundation until the end of 2007, has since shrunk at an annual rate of 1%.

So, although the Spanish government still has relatively little existing debts, it is now having to borrow like crazy to fill the gap left by the jump in unemployment benefits and collapse in tax revenues during the downturn. And the government may also have to throw a lot more money at its banks, which are looking very exposed to the housing collapse thanks to all the mortgages they have lent.

Source: BBC News

Image: The Washington Post