IMD International

Where does the "right direction" go?

IMD Professor Arturo Bris reacts to news out of Spain

April 13, 2012

Recently, a German delegation led by the head of the CDU parliamentary group praised the reforms adopted by the Spanish government by publicly stating that "they are heading in the right direction." I wonder, with an economy that sees no sign of recovery, more than 50 percent youth unemployment, and the determination of our new government to cut on spending and investment, where the right direction ends.

Even domestically, the view that is spreading quickly is that the government is not doing enough. After announcing an income tax increase, issuing new laws to reform the financial system, approving a very restrictive government budget and even announcing measures against tax fraud by allowing tax evaders to pay 10 percent of undeclared assets, Europe and the markets are calling for more. As I write this piece, Spanish 10-year bond yields have climbed to 5.85 percent and our risk premium is 408 above German treasuries. Our reliance on financial markets to finance our growth in the past years has become a powerful disciplining device because markets now want to see that we are able to repay our debts.

I do not like where this is going because however I look at it, this vicious circle ends up with an intervention by European authorities as a precondition for an ESM/ESFM financial package. It can happen soon, if financial markets react harshly to whatever Spanish authorities decide in the next days; or it can take months, if Spain complies with market rules and does whatever it takes to prevent our yields from skyrocketing as the Greek and Portuguese yields did in the past. What European officials, financial analysts and even reputed economists at home and abroad are recommending is chemotherapy to a country with a severe lung cancer: it may help us make it to the next day, but it is extremely painful, and the chances of survival are still very small.

We are jeopardizing the future opportunities of one or two generations of Spaniards. What Spain needs is simple: less spending, more investing. There is a lot to do to eliminate duplications and inefficiencies, to reduce the size of the public sector, to spend less in what is really unimportant. But we cannot stop investing in education and roads. We cannot burden the middle class with the totality of this crisis because at the end of the day, it is the middle class that will reactivate the economy. We need creative ideas to reduce spending instead of cookbook recipes which ultimately result in more taxes. Spain's cure is only possible with more fiscal flexibility instead of an irrational focus on very short-term targets.

Let us not forget that financial markets love volatility. We have seen such volatility in the Greek, Irish and Portuguese crises. We have also seen that it is very easy for European officials, and in particular for German ones, to spur and reduce such volatility via public statements. Angela Merkel's suggestion in November 2010 that lenders should bear part of the cost of the European crisis—which was the very first time a European politician refers to haircuts in such a clear way—sent Irish and Spanish borrowing costs up by 74 and 64 bps respectively and cost the PIIGS more than €15 billion in borrowing costs, sending Ireland to the warming hug of a European bailout. By the same token, this crisis will be over if those to whom the market listens make a clear statement that Spain (and Italy) be given an opportunity to grow and create employment.

Otherwise, the earlier we put an end to this turmoil, the better. Do not inflict the patient more useless suffering.

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