New Spanish Government to Throw Long Bomb, and Bomb the Economy

What Exactly are They Thinking (or Drinking)?

With its election on Sunday Spain will have completed the series of the change of governments in European countries under stress and needing support or a bailout from the IMF and European community.  Previously Ireland, Portugal, Greece and Italy have thrown out the governments responsible for their current economic condition, and with the elevation of Mariano Rajoy to power in Spain this will complete the process.

Mr. Rajoy is head of the Popular Party, a center-right group.  The popularity of the party has been rising  Mr. Rajoy and his party has won a majority of legislative seats and will take control of Spain.  The Socialist government that has tried to fix Spain’s growing deficit and debt problem will be history, perhaps for a long time.

Normally a change in government when new policies are needed is a good thing.  Spain is reeling under market pressures which are driving up the cost of borrowing to unsustainable levels.

At a bond auction on Thursday, the Spanish Treasury was forced to promise nearly 7 per cent in annual interest to borrow euros for 10 years. That level, about 5 percentage points above what Germany pays, previously triggered the rescues of Greece, Ireland and Portugal by the European Union and the International Monetary Fund.

Any new government is not wedded to the past and does not need to try to pursue policies which are wrong but which are intended to avoid criticism that the prior policies were incorrect.  However reports are that Mr. Rojoy will institute a drastic and immediate and severe cut in Spanish government spending to try to reduce the budget deficit.

José Ignacio Torreblanca, senior fellow of the European Council on Foreign Relations, the think-tank, says Mr Rajoy will execute a manoeuvre known in American football as a “Hail Mary”; essentially a last-minute long shot whose success in this case might convince Germany and the bond markets that Spain could avoid financial catastrophe. It would involve drastic cuts in public spending – perhaps as much as €30bn – so that Spain can fulfil its promise to cut its budget deficit to 4.4 per cent of gross domestic product next year, from a targeted 6 per cent of GDP this year that could reach 7 per cent or more by the time the numbers are in.

Will this work?  Economic analysis says no.  The Spanish economy is already in terrible shape, unemployment is near 20% and youth unemployment is much higher.  A “Hail Mary” like the one described will be similar to taking a very sick patient out of the hospital, cutting off treatment and hoping the shock will bring him or her back to health.

As to the reaction of the markets, the expectations are already in place for this policy, and as noted above Spanish debt yields are rising, not falling.  The market knows that contracting an economy does not result in a stronger economy, it results in an economy that is contracting.