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Earlier this month, Mariano Rajoy claimed to have made a "sovereign decision" to increase Spain's previously agreed-on 2012 budget-deficit target to 5.8 per cent from 4.4 per cent, thereby making a mockery of the new eurozone fiscal pact that the prime minister had signed minutes earlier. On Monday, eurozone finance ministers hit back, demanding that Madrid accept a new budget-deficit target of 5.3 per cent this year. The Spanish government duly acquiesced.
In fact, this was a politically sensible compromise to defuse what threatened to become a destabilising row. The eurozone can claim that its fiscal pact does indeed have teeth, unlike the old Stability and Growth Pact. The eurozone had already used the new rules to impose tougher budget discipline on Belgium and the Netherlands. Meanwhile, the additional burden on Spain is small: an extra €5 billion ($6.58 billion) of fiscal tightening beyond what Mr Rajoy had proposed but €9 billion less than required under the old plan.
Whether the new target makes economic sense—or is even achievable—is another matter. No one believed the old target was manageable: It had been set on the assumption that last year's deficit would be 6 per cent and growth this year, 2.5 per cent. Instead, last year's deficit was 8.5 per cent, and the Bank of Spain expects the economy to shrink this year by 1.5 per cent. Despite unemployment at 23 per cent, Madrid has already introduced austerity measures worth €15 billion this year, equivalent to 1.4 per cent of GDP. It needs to find a further €23 billion to meet this year's new target. The 2013 deficit target remains at 3 per cent.
But the major concern remains the banking system. Investors are sceptical that overhauls announced in January will write down bank property exposures to levels that will allow the market to clear. This was a true sovereign decision—and Mr Rajoy flunked it.
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