Biting the bullet

Spain's Prime Minister: Mariano Rajoy
By: European People's Party - EPP

“You have the Greek model, or the Irish model. You can either go kicking or screaming, or you can bite the bullet, like people have done in Ireland”. Thus Gayle Allard, an economist from Spain’s IE Business School. Judging by Spain’s latest budget, it seems the centre-right government headed by Mariano Rajoy is firmly determined to follow the Irish model.

On March 30^th the Spanish government announced what was the most austere budget since Franco’s death in 1975. In an attempt to save €27bn this year, public sector salaries will be frozen, ministries will face budget cuts of up to 17%, income tax will rise by 1.9% and electricity and gas bills will rise by 7% and 5%, respectively. Unemployment benefit will be frozen and pensions will be indexed to inflation. As a palliative for consumers, VAT will stay at its current 18%. Following massive protests across Spain, which turned violent in Barcelona, the budget minister Cristobal Montoro was careful to ensure that most of the savings would come from higher corporate taxes, a fiscal amnesty in return for a 10% fee and public sector cuts.

The draconian budget follows negotiations with the European Union last month during which Spain agreed to reduce its deficit from 8.5% to 5.3% of GDP in 2012. This figure was a compromise on Spain’s earlier announcement in March that it would reduce the deficit to 5.8%, a long way from the 4.4% previously agreed with the EU. Blaming the previous Socialist government, the current administration justified this unilateral announcement with its discovery that the country’s finances were more rickety than it had expected.

A lot of commentators have expressed doubts about the feasibility of the budget cuts. One worry is that Spain might fall into a downward spiral of spending cuts, recession, unemployment and falling tax revenues, given that the economy is already in recession and predicted to shrink by 2% this year before any savings are made. Moreover, unemployment already stands at 23%, rising to over 50% for young people. Given that the troublesome regional governments were largely responsible for Spain overshooting its deficit target of 6% last year by 2.5 percentage points, the latest budget is at risk if they fail to cut down on their spending.

On the other hand Spain is anxious to step out of limelight and quash any concerns about it needing a bailout, especially as bond yields rose almost a full percentage point since the start of March. Should Spain prove incapable of reining in its spending and raising revenue, interest rates could well rise to unsustainable levels. Mr Rajoy has a brief window of opportunity to push through his programme as exports in January were 3.9% higher than a year earlier and a weaker recession in Europe ought to buoy the upward trend. Spain’s public debt is also small by European standards, something that ought to give it some respite.

Spain’s budget is thus a gamble between self-perpetuating recession and slow growth. One can only hope that it pays off.