Spain could ruin Europe's Economy

The Pain in Spain

By Robert Samuelson

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 re-election, 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 revenues have 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."