Spain's Austerity Dilemma

Spain says deficit bigger than expected, hikes taxes

Spain's new government said on Friday that this year's budget deficit would be much larger than expected and announced a slew of surprise tax hikes and wage freezes that could drag the country back to the centre of the euro zone debt crisis.


In its first decrees since sweeping to victory in November, the centre-right government said the public deficit for 2011 would come in at 8 percent of gross domestic product, well above an official target of 6 percent.


It announced initial public spending cuts of 8.9 billion euros ($11.5 billion) and tax hikes aimed at bringing in an additional 6 billion euros a year to tackle the shortfall. "This is just the beginning ... We're facing an extraordinary and unexpected situation, forcing us to take extraordinary and unexpected measures," Deputy Prime Minister Soraya Saenz de Santamaria said.


Spain has been under market scrutiny over its ability to control its public finances, and Madrid has seen risk premiums soar to record highs on contagion fears as the euro zone debt crisis spread.


Ten days ago the Treasury said the central government budget deficit was on course to meet a full-year target of 4.8 percent of GDP, which analysts said would push Spain's overall public deficit above its 6 percent target for the year.


But the scale of the overshoot took some economists by surprise and led them to forecast a deeper recession, ending the year on a downbeat note for the euro zone as a whole.


My view:


Spain, like much of southern Europe, is struggling with high unemployment and budget deficits.


It continues to outspend its tax revenues of approximately $500 billion by $120 to 150 billion per year.  So though spending cuts and tax hikes are proposed, they do little to address a severe structural deficit.


The Spanish government spends $1260 for every $1000 of tax revenue - that is 26% more than revenues.


This harsh reality is made worse by an unemployment rate over 21%.  


So one in five Spaniards of working age is unemployed, and the government has overspent its budget by 26% in 2011, despite the austerity measures implemented so far.


The bond market will catch on to this unworkable situation sooner or later, but for now the debt will continue to grow by unsustainable rates which will ultimately end in default.


We can expect to see Spanish bond yields rise, harsher austerity measures imposed in an attempt to reduce expenditures by $100 billion to match tax revenues, and likely an exit from the Euro within the next couple of years as expenditures are not cut enough to satisfy the bond market while interest rates on government debts rise to excessive levels.


Note that Spanish debt to GDP is "only" 68% in 2011 - a low number if you believe the likes of Paul Krugman.