A sombre budget lesson from Spain

Spain's economy is teetering on collapse, and its journey shows how strict controls on central banks and budget deficits – advocated by some US conservatives – can wreck an economy.

Unlike Italy and Greece, Spain did not unravel because Madrid borrowed to finance a welfare state it could not afford.

Like the United States in the 2000s, Spain had a real estate boom caused by efforts to encourage home ownership and Northern Europeans seeking vacations and second homes in its warm climate. Much was financed by private foreign investments in Spanish bonds and banks. Tourism and construction boomed, growth was stronger and unemployment lower than most of Europe. Private debt soared but Spain's government enjoyed budget surpluses.

As in the United States, when the real estate bubble burst, banks could not attract deposits or sell securities backed by loans to maintain liquidity, and faced insolvency.

In 2008, the Federal Reserve began lending US banks hundreds of billions of dollars against loans and securities backed by mortgages, business and auto loans, and credit card debt. Essentially, the Fed ran the printing presses to bail out US banks. Critics like Congressman Ron Paul predicted a burst of inflation would follow and advocated tighter control on the Fed, or even abolishing it and returning to the gold standard.

The great inflation never came. Any first-year graduate student in economics knows, full employment is required for more money to create with certainty additional inflation. What additional inflation the United States endured was instigated by commodity prices driven higher by growth in China.

Spain was operating under the kind of regime advocated by Fed critics. Using the euro, the Bank of Spain could not print money to bail out banks.

Instead, the national government borrowed in bond markets to lend to banks. Its budget swung from a 1.9 per cent of GDP surplus in 2007 to an 11.2 per cent deficit in 2009. And Madrid was in no position to borrow further to finance the kind of aggressive stimulus spending Barack Obama pursued to soften the recession.

Although Spain's accumulated debt to GDP ratio was more modest than troubled Italy or even Germany, the United Kingdom, France, bond investors and European Union governments insisted Spain slash government spending quickly – take the austerity pill – to get its deficit down quickly.

Madrid got its budget gap down to 8.5 per cent of GDP in 2011, and the targets are 5.3 and 3 per cent for 2012 and 2013.

In the United States, thanks to Fed actions and stimulus spending, the economy is growing, albeit modestly, and unemployment has retreated to 8.2 per cent.

In Spain, with consumer spending weighed down by debt and public spending slashed, growth is near zero, unemployment is 22.8 per cent, and young professionals are leaving for Brazil and other countries with better prospects. Private investment is stagnant, and the long-term prognosis is for gradual implosion.

Spain is implementing structural reforms to free up labour markets, but those are hardly enough in the face of slash and burn fiscal policies that are gutting education and public investments in a nation that sorely needs to bring educational attainment and infrastructure in line with more prosperous European rivals.

More recently, the European Central Bank has been lending aggressively to Spanish and other European banks but it lacks the regulatory clout fully empowered national central banks would enjoy to force commercial bank restructuring and recapitalisation – its loans are band-aids in a rapidly deteriorating situation throughout Europe.

In Spain, the government is cutting spending too quickly – even though prior to the crisis outlay was not excessive in the manner of France, Italy and Greece – and consequently, its economy can't grow. Much capital is idle and will rust from disuse, and Spain's economic muscle atrophies.

American conservatives who would require balanced budgets at times of full employment, and permit only modest deficits during recessions, and their more extreme brethren who would gut Fed powers or return the gold standard, have a marvelous demonstration project in Spain.

During the Great Depression, US unemployment peaked at 24.9 per cent. My bet is Spain will break that record soon. Its leaders should invite Congressman Paul and his followers to a grand ball to note the occasion.

Peter Morici is a professor at the Smith School of Business, University of Maryland School, and former Chief Economist at the US International Trade Commission.