This paper looks at the planned austerity measures in Spain, the rationale for the spending cuts and tax increases, likely outcomes for future debt-to-GDP ratios, and the probable results of alternative policies.
It is widely believed that Spain got into trouble because of the over-expansion of government spending. However, during the economic expansion from 2000-2007, the gross debt-to-GDP ratio declined sharply, from 59.3 to 36.2 percent of GDP. In 2009, interest payments on Spain’s debt were just 1.8 percent of GDP, a modest interest burden. Net debt had declined to 26.5 percent of GDP in 2007.
Net debt is a better measure of the country’s debt burden than gross debt, because interest that is paid on debt held by the government accrues to the government, and therefore does not represent a burden on government finances. In this paper we will use both figures, because the gross debt figures are most commonly cited in the press.
The cause of Spain’s current debt problems, as well as its unemployment and weak recovery, was thus not an over-expansion of government but the collapse of private demand. The country had built up a large housing bubble that began to collapse in 2007, at the same time that the economy was hit with external shocks from the world recession. Between 2000 and 2006, construction increased from 7.5 percent of GDP to a peak of 10.8 percent. Since the collapse, housing starts have fallen by more than 87 percent from their peak.
Spain also suffered from the collapse of an enormous stock market bubble: the stock market peaked at 125 percent of GDP in November 2007 and dropped to 54 percent of GDP a year later. The wealth effect of this huge drop in stock values would be expected to be very large, in the range of a 1.3-1.75 percent fall-off in GDP.
Unemployment has risen from 8.5 percent to over 20 percent, and is projected to be at 15.5 percent at the end of 2013.
For an alternative to current pro-cyclical policies, we consider two versions of a continued fiscal stimulus, amounting to 3.9 percent of GDP over the next two years, as compared to the baseline scenario.
In the first alternative, the European Central Bank (ECB) buys debt equal to 4 percent of GDP annually over two years. This would be done with an agreement to refund the interest payments on the debt to the Spanish government.
Although the ECB and European authorities — which currently includes the IMF for these decisions — would be unlikely to carry out this policy, it is important to illustrate because it shows that there is a simple, feasible alternative to present policies that does not lead to an unsustainable debt burden. In this case, the net debt-to-GDP ratio increases to just 60.5 percent of GDP in 2020, as compared to 64.3 percent of GDP in the baseline scenario based on the government’s projections.
The feasibility of such an approach must be emphasized. The U.S. Federal Reserve has added more than one trillion dollars to its balance sheet — thus more than doubling it — since the U.S. recession began. There has been no threat to inflation resulting from this money creation. The Bank of Japan has financed trillions of dollars of debt since the 1990s by creating money, with the result that there is a more than 100 percentage point (of GDP) difference between the government’s gross and net debt; and yet inflation has been extremely low in Japan over the past 20 years and sometimes negative. Consumer price inflation in Europe is currently at about one percent.
In the second alternative, the continued stimulus is the same size but is financed through regular borrowing, rather than money creation by the ECB as described above. In this scenario the net debt is significantly higher, increasing to 68.3 percent of GDP by 2020. It is worth noting, however, that this is just four percentage points higher than the government’s baseline scenario.
The government currently plans budget cuts and tax increases, which it projects will stabilize the gross debt-to-GDP ratio at 69 percent of GDP by 2013 (net debt at 62.4 percent). However, there are many historical examples in which growth turned out to be seriously overestimated when pro-cyclical policies were implemented. For example, Ireland began reducing its fiscal deficit at the end of 2008. At the time, the IMF projected 1 percent growth for 2009; the actual result was negative 10 percent.
Furthermore, if the planned pro-cyclical policies result in slower growth or push the economy back into recession, this could cause the interest rate on new debt for Spain to rise. In this paper we look at three scenarios that incorporate a lower growth projection, with interest rates of 6, 7, and 8 percent on Spain’s debt. In these scenarios, Spain’s gross debt-to-GDP ratio rises to 85.5, 90.6, and 96.1 percent of GDP, respectively, by 2020. Net debt rises to 76.6, 81.7, and 87.2 percent of GDP, respectively.
Thus, there are plausible scenarios under which the planned pro-cyclical policies can lead to much higher debt levels than would result from the continuation of a moderate fiscal stimulus. Even from the point of view of avoiding unsustainable debt accumulation, the risk of a prolonged stagnation — combined with higher interest rates — may be much greater than the risks associated with counter-cyclical fiscal policy at present. And the alternative, feasible counter-cyclical policies would avoid much of the social and economic costs of lost output and prolonged high unemployment that Spain currently faces.