Just when you thought the world economy might be improving, along comes Spain. It's Europe's next economic domino, struggling to cope with big budget deficits, massive unemployment and an angry public. Will it fail - and, if so, with what consequences?
As it happens, the $80 trillion world economy splits roughly 50-50 between advanced countries (the United States, Europe, Japan and a few others) and developing countries (China, India, most of Asia, Africa and Latin America). Since the financial crisis, the advanced economies have struggled. In 2012, they will grow a meager 1.4 percent, forecasts the International Monetary Fund. Much of Europe is in recession; the United States (up 2.1 percent) and Japan (2 percent) grow slightly.
Although developing countries have done much better, their economies are now slowing, too. The reason: Rapid growth raised inflation. In China, inflation went from 3.3 percent in 2010 to 5.4 percent in 2011. India's inflation peaked at 12 percent. So central banks in these and other countries (their Federal Reserves) boosted interest rates to dampen price increases.
If Spain's crisis deepens Europe's recession, it could tip the entire world economy into a stubborn slump. The ramifications would be enormous, including: reduced odds of Barack Obama's reelection, assuming a weaker U.S. recovery; less political cohesion and more social unrest in Europe (even now, the European Union's unemployment rate is 10.2 percent); and growing pressures in many countries for economic nationalism and protectionism.
Spain is suffering a hangover from what economist Desmond Lachman of the American Enterprise Institute calls "the mother of all housing booms."
Just so. At the peak in 2006, "Spain started nearly 800,000 homes - more than Germany, France, Italy and the United Kingdom combined," noted a 2009 IMF report. Construction workers represented one in eight jobs (the U.S. figure at the height of the American real estate bubble was one in 18). Even after correcting for normal inflation, Spain's home prices more than doubled from 1995 to 2006.
One cause was a prolonged period of low interest rates coinciding with the introduction of the euro in 1999, says economist Jacob Funk Kirkegaard of the Peterson Institute. Another was that many property and construction loans were funneled through Spanish savings banks, cajas, "that were controlled by local and regional governments that had an interest in economic development," says Jeffrey Anderson of the Institute of International Finance, an industry think tank.
The bubble's collapse crippled the economy, left cajas with large losses and vastly expanded government deficits. Unemployment is almost 24 percent; among those under 25, it's 50 percent. Tax revenue has dropped sharply. In 2011, the budget deficit was 8.5 percent of the economy (gross domestic product). For 2012, the IMF projects a deficit of 6 percent of GDP compared with a target of 5.3 percent.
Spain's predicament is agonizing. To borrow at reasonable interest rates requires convincing financial markets that huge deficits are being reduced. But cutting spending and raising taxes risk deepening the slump, widening the deficit and fostering more street protests. The dilemma is plain: Austerity may produce more austerity, while the absence of austerity may produce a crisis of confidence. In addition, Spain's banks need more capital. Who will provide that?
Previously, Greece, Portugal and Ireland succumbed to similar predicaments. After interest rates soared on their bonds, they had to be rescued by loans from other European countries, the European Central Bank and the IMF. The trouble is that Spain's economy is twice as big as Greece's, Ireland's and Portugal's combined. And financially precarious Italy has an economy that's 50 percent larger than Spain's. Is there enough money to bail out these countries?
In truth, no one has a neat solution to end Europe's financial nightmare. Maybe Spain and Italy will escape calamity. Or perhaps more last-minute loans will buy time until the rest of the world economy revives and pulls Europe from the abyss.
Or perhaps not.
The weaker Europe becomes, the more it may drag down the rest of the world through three channels: damaged confidence and investment, fewer imports, and less credit to businesses and households. Remember: Europe is about one-fifth of the world economy, roughly equal with the United States. The 27 members of the European Union are the world's largest importer (excluding exports to each other), just ahead of the United States. And European banks operate globally.
The foreboding is undisguised. "For the last six months, the world economy has been on . . . a roller coaster," Olivier Blanchard, the IMF's chief economist, said last week. "One has the feeling that, at any moment, things could well get very bad again."
While markets are again correctly obsessing over Italy and Spain’s poor economic growth prospects, as reflected in markedly higher government bond yields for those two countries, they seem to have taken their eye off two upcoming political events that could usher in a new and more serious phase of the European debt crisis. The first is the French presidential election, the first round of which was scheduled for last Sunday, and the second round for two weeks later. The second is the Greek parliamentary election on May 6, which could result in the formation of the weakest of Greek governments.
This week, the IMF revised its economic forecasts for Italy and Spain in a manner that will only heighten the market’s deep concern about those two countries’ prospects of restoring long-run fiscal sustainability. In its revised World Economic Outlook, the IMF now expects that the severe budget austerity being undertaken in both of those countries will result in their GDP declining by close to 2 percent in 2012. Worse still, the IMF is predicting that a deepening economic recession in Spain will undermine the Spanish government’s efforts to reduce its budget deficit, which the IMF expects to remain at around 6 percent of GDP in both 2012 and 2013. Similarly, the IMF believes that a weaker Italian economy will prevent that country from stabilizing its public debt-to-GDP ratio, which the IMF now forecasts to rise to 124 percent of GDP by 2013.
The IMF now expects that the severe budget austerity being undertaken in both of those countries will result in their GDP declining by close to 2 percent in 2012.
Against this gloomy economic backdrop for Europe’s third- and fourth-largest economies, the last thing that the European debt crisis now needs is destabilizing political events. Yet that is what is all too likely to occur in both France and Greece within the next few weeks. In France, the Socialist Party’s Francois Hollande is consolidating his commanding lead in the polls against the incumbent Nicolas Sarkozy in an almost certain second round run-off between those two candidates. Meanwhile in Greece, the polls are suggesting that the New Democratic Party and PASOK, which form the current ruling coalition, will be lucky to retain the slenderest of majorities in a newly elected Greek parliament. At the same time, the political parties of the hard Left will garner almost as many votes as their centrist rivals, while the number of political parties represented in the Greek parliament could rise from its present five to nine, as parties on the extreme Right and extreme Left exceed the 3 percent minimum threshold for parliamentary representation.
The significance of a Francois Hollande election in France for the course of the euro crisis should not be underestimated. This is not only because it will put him on a collision course with German Chancellor Angela Merkel due to his insistence that Europe’s economic policies should be more growth-oriented and that the recently agreed European fiscal pact should be reopened. Rather, his insistence on a 75 percent income tax for those in the highest income tax bracket and his declared war on the financial system are unlikely to be well received by the markets. In that context, Hollande might want to recall how savagely markets punished Francois Mitterand in 1981-82 for his unorthodox economic and financial policies.
The Socialist Party’s Francois Hollande's insistence on a 75 percent income tax for those in the highest income tax bracket and his declared war on the financial system are unlikely to be well received by the markets.
Likewise, a weak Greek government will have a significant effect on the debt crisis because it will only reinforce the market’s priors that Greece is simply not capable of delivering on the conditions of the second IMF-EU bailout package so recently agreed upon, especially against the backdrop of a collapsing Greek economy. In particular, markets will correctly be highly skeptical that the new Greek government will be able to deliver the 5.5 percentage points of GDP in budget cuts for 2013 and 2014 that it is supposed to have parliament approve by as soon as June. They will also strongly doubt that Greece can implement the radical and painful structural reforms on which its European partners and the IMF are insisting. And if the Greek government cannot deliver on its promises, it will only be a matter of time before Greece defaults on its official borrowing from the IMF and the ECB, which could provoke a new round of contagion to the rest of the European periphery.
All of this has to be highly disconcerting to the Zioconned Obama administration, which until recently had been hoping, along with the Zioconned European governments, that the strong intervention last December by the European Central Bank through its Long-Term Refinancing Operation had put the European crisis to bed. Instead, economic recessions are deepening across the European periphery and political uncertainty is growing in several important European countries, with serious systemic consequences for the global economy. President Obama is about to find out how long six months can be....