06 March 2012

Martin Wolf: The pain in Spain will test the euro

The treaty reflects the view that the crisis was due to fiscal indiscipline and that the solution is more discipline. This is far from the whole truth. Rigorous application of such a misleading idea is dangerous.

Such concerns may now seem remote. The longer-term refinancing operations of the European Central Bank have relieved pressure both on banks and financial markets, including the markets for sovereign debt. Yet the crisis has not passed. To varying degrees, the vulnerable countries are in lasting difficulties. Would these fiscal disciplines have saved the eurozone from its wave of crises? Will they pull afflicted countries out of these crises now? The answer to both questions is: no.

Right now, a row is brewing between the European institutions and the newly-elected Spanish government of Mariano Rajoy. The latter has stated that his government is going to target a fiscal deficit of 5.8 per cent of GDP, down from the 8.5 per cent achieved in 2011, but well above the 4.4 per cent it agreed with the Commission. The latter will huff. But it cannot compel a sovereign government to do what it wants. Spain’s partners can refuse help. But that might redound on themselves.

Spain’s fiscal difficulties are a consequence of the crisis, not a cause. The country experienced huge rises in private debt after 1990, particularly among non-financial corporations (see chart). The overhang of residential construction also rules out substantial household borrowing. Given this, a sharp reduction in government borrowing is most unlikely to be offset by more private borrowing and spending. The result is more likely to be a far deeper recession, along with little progress in reducing actual fiscal deficits. At worst, a vicious downward spiral may occur. Instead of forcing Spain into rapid fiscal retrenchment, it would be far more sensible to give the country the time it needs to let the bold reform of its labour markets work through. This is going to take a number of years.

Yet if the eurozone is to be willing to provide the time needed for such adjustments to occur, the surplus countries need to be aware of their own role. Without doubt, the parallel emergence of current-account surpluses and deficits, the flow of cross-border finance and the folly of cross-border lenders played huge roles in causing today’s crisis.

So, yes, the ECB has bought the eurozone some time. But little yet suggests that a way has been found towards the necessary rebalancing of the eurozone economy and, above all, towards achieving the desired mix of reform, adjustment and a swift return to growth. The chosen way looks instead to go via years of one-sided adjustment and painful austerity. Will that work? I very much doubt it. At best, we can expect many bumps along that road.

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