Eurozone: Debt through the Lens of Political Choice (Spain)

Last week, Spain introduced an additional €40bn austerity policy in face continuing recession, unemployment, and violent separatist cries of the Catalonia and Basque region. One should not forget, however, that Spain’s public debt, which hovers at around 70% of GDP, is actually lower than Germany’s. In fact, Spain was able to run a budget surplus between 2005 and 2007, and its gross debt-to-GDP ratio even declined from 59.3% of GDP in 2000 to 36.2% in 2007. What prompted a sudden jump in government debt? To better understand the crisis in Spain, we need to examine the source of Spanish public debt.

Spain’s public debt has private origins. A housing bubble supported the Spanish economy, bringing about wealth effects that were too good to be true. The global meltdown in 2007 generated a massive blow on the Spanish construction industry, which had once contributed to one tenth of the nation’s GDP. The fall of the construction industry and household default on mortgage payments drove banks to the tip of the cliff—it was after this event that the Spanish government added large chunks of debt to its balance sheet. This outcome is not surprising, since the government borrowed great sums to inject credit into its banks on the brink of collapse. Moreover, as the economy fell into recession, its tax revenue declines all the while spending rises in the form of unemployment benefits. The housing sector’s collapse, by generating the twin problems of failing banks and unemployment, greatly aggravated the government’s debt situation. The housing bubble preceded the massive rise of public debt in Spain.

Then what caused the rise in mortgages and house construction? One definite factor is the low interest rates guaranteed by entry into the euro zone. The other—and often neglected—is the Spanish government’s policy of growth based on house ownership, which dates back to the Franco dictatorship following the Spanish Civil War. The surge in public debt was a consequence of the housing bubble, but housing bubble was in great part brought about and sustained by the government itself.

Democracy was installed when Franco died, but the González government did not throw its predecessor’s policies out the window; the housing boom served as a valuable recovery tool for the recession that overlapped the dictator’s death. A sustained increase in housing prices stimulated the economy by promoting consumption, and the González regime was less pressured to develop the industrial sector where Spain was becoming less competitive to stimulate growth. Rising property values also supplemented an under-funded pension system as a guarantee of income in old age. It was in the interest of the González government to make sure housing supply remained on the rise. The long list of pro-housing bills is the best witness: the 1998 Land Act, or the “build anywhere” law, for instance, made it easier to obtain building permits; tax relief programs and successive reforms of the mortgage market made home-buying more affordable; large investments in transportation infrastructure generated new residential areas with market value; a lax environmental policy also posed less obstacles to urbanization. These policies brought about a growth rate of nearly 4 percent every year from 1995, and the Spanish ‘dynamism’ was often an object of admiration.

The highly decentralized nature of the Spanish administration also played its part. Spain is composed of seventeen Autonomous Communities, and each community has the authority to administer a large portion of public finds and interpret laws in its own way. As regional governments competed for higher growth levels, they often re-zoned Greenfield sites for urban development to benefit from greater tax revenues; for similar reasons, they were also prone to advertise to private investors the benefits of investing in housing, an asset whose price rose at an average of 12 percent per year.

The housing stock increased by 220 percent during 1997 and 2007, and the global meltdown generated a massive blow in the construction industry that once contributed to one tenth of GDP in 2007. Indebtedness in Spain rose to 84% of GDP. Even excluding the sum Spaniards owe to each other, Spanish households, firms, governments owe almost €1 trillion to foreigners. We thus see that although Mediterranean economies share similar problems of excessive public debt, public debt is not always tied to profligacy and party patronage.

The happy ending for Spain will not come from the success of austerity measures, but from a sustainable growth model. This is something that bare austerity cannot address. Slashing public debt certainly helps the government save money on interest rates, but the Spanish economy needs more: it needs to find a way to rebuild its economic foundations. But how to do both? I am not so sure. The Economist nicely explains this difficulty: “scrapping thousands of bureaucratic rules will not just make the economy more efficient but also recast the relations between government and citizen. However unambiguous the economic reform, the politics is always almost hard.”