What is surprising is the magnitude of the miss. Estimates from early November indicated that the 2011 deficit could approach 6.6% of GDP; the actual figure announced by the new government of Mr. Rajoy is a whopping 8% of GDP (1).
This announcement is a serious blow to the credibility of the Spanish government at a time when it can ill afford it. The Spanish Treasury has to roll-over approximately €56 billion in maturing debt between now and April. (2) The announcement cannot make investors very happy.
It is unlikely that Angela Merkel is very happy either. The German Chancellor has been praising Spain as a model of deficit reduction: “Spain has really done its homework and I think it is on the right track” (3). She reinforced this message after the Partido Popular swept the November elections and the then President-elect Mariano Rajoy made a special call to confer with the Mrs. Merkel on his plans for dealing with the crisis in Spain. Now she is faced with the possibility that the country has been either fudging the books or else the central Treasury is unable to deliver on its promises due to regional profligacy. Neither answer is particularly comforting.
“Lies, Damned Lies and Statistics”
There is probably some truth to both claims.
No one would accuse Spain of cooking their books in the same horrifyingly wanton manner as Greece did for decades. The National Institute of Statistics (INE) is a very reliable, independent and thoroughly professional body for measuring and reporting the statistics of the government and the country at large. But as Mark Twain said, “there are lies, damned lies and then there ares statistics”.
The Spanish government at all levels has made it a habit since the beginning of the crisis to delay payment for services to private contractors. As of August 2011, it was estimated that municipal and regional governments owed over €50 billion in unpaid contracts to 3.2 million companies, the equivalent of 5% of GDP. The central government was also renegotiating €26 billion in contracts at the same time. What’s more, the average time to repayment of these debts was 140 days for the central government, 155 days for the regional governments, and a whopping 238 days for the municipalities.(4)
While these liabilities are certainly recognized by the governments in question, they don’t actually count as deficit until they are paid out and become expenses. Thus it becomes relatively easy for the governments to massage the deficit figures by delaying payments here, or accelerating payments there. Mostly the former.
Divide et impera
Spain also suffers from its curious – some say shoddy – form of decentralized government. The central government collects all revenues and transfers a portion of these back to the regions. Bu the center accounts for only 50% of spending and less than 50% of public sector employment. The rest is “devolved” to the local governments.
But there is no link between means and ends. Transfers back to the regions are based on politics, not economics. How much each region gets back has more to do with the shifting balance of power between regional parties and their support or lack of it for the policies Madrid wants to promote than on the actual wealth generated by the region. Catalunya has been a net loser from these transfers, paying in more than it receives back, while traditionally poorer regions like Andalucía and Extremadura have been net beneficiaries.
No one denies the the benefits of and need for transfer payments from wealthy developed regions to poor underdeveloped regions, but sound economics makes for incendiary nationalist politics. It also makes fiscal discipline difficult. Edward Hugh, a Barcelona based economist, writes that the central government is withholding payments to Catalunya of €759 million for contracted services and investments. While this is only 0.4% of GDP, and a small percentage of Spain’s overall deficit, it is a significantly larger proportion of Catalunya’s deficit. (5)
Reducing the central government’s deficit total at the expense of the regional governments may be smart politics – especially if the culprits happen to be run by national parties (Catalunya) or the PSOE (Andalucia), but it is hardly likely to fool foreign investors for long. It also contributes to the sense of uncertainty towards Spanish debt – something Mr. Rajoy’s government should be avoiding at all costs.
Mr. Rajoy’s government was not slow to respond. Along with the announcement of the higher than expected deficit came the new government’s solution: tax increases, on top of the previously announced spending cuts.
The government will raise both individual income taxes (IRPF) and property taxes (IBI), in direct contradiction of the PP’s electoral pledge to not raise taxes.(6) That promise lasted barely 6 weeks after the elections, which must make Spanish senior citizens wonder how long the PP plans to keep its promise to them to not cut pensions.
In fact, the measures are an indirect pensions cut, since the 1% increase in actual pension payments will be cancelled out by the tax increases. The Social Security Administration estimates that approximately half of Spain’s 5.2 million pensioners will lose purchasing power in 2012 due to these measures. (7)
The new finance minister, Cristóbal Montoro, has not discarded the possibility of also raising the value added tax from its current level of 18%. Recall that then MP Mariano Rajoy excoriated the Zapatero government when they announced an increase in the VAT rate from 16% to 18%, citing it as a “job killing measure”.
On the rocks
What is clear is that Mr. Rajoy and his new government have decided to take the politically expedient route of taxing the Spanish middle class, rather than tackling the far more difficult task of reforming Spain’s flawed internal governance model. With the elections won, Mr. Rajoy has little enough to fear from the electorate he is squeezing and memories of broken electoral promises are notoriously short in democracies.
But the price Spain will have to pay to sooth markets and Mrs. Merkel may be steeper than many can stomach. Spain is already in recession (8) – the economy contracted in the 4th quarter and experienced zero growth in the 3rd. Tax increases will only serve to further contract aggregate demand and deepen the recession. It will take years, if not decades, for the middle class to recover the level of prosperity it enjoyed in 2007.
And the long-term cost of the spending cuts and tax increases may be to reduce, not enhance, Spanish competitiveness. Contrary to the PP’s promise to boost spending in productivity enhancing R&D, these investments have been targeted to the tune of €600 million. Leading scientists and researchers warn of a brain drain from Spain as well as a dearth of students studying sciences due to the lack of jobs in these fields. (9)
Full disclosure: As an American residing in Spain, I am subject to any increases in the IRPF, IVA and IBI.
(2) Bloomberg, 25 November 2011
(4) http://ecodiario.eleconomista.es/politica/noticias/3306126/08/11/El-drama-de-las-cuentas-publicas-suman-ya-50000-millones-de-euros-en-impagos.html (in Spanish)