When he was elected in December, Spanish prime minister Mariano Rajoy and his new centre-right government inherited a mess. Spain was no Greece or Portugal, but its jobless rate, already the highest in Europe, was trending up, its yawning budget deficit was proving remarkably stubborn and its economy was sinking.
The Greek experiment apparently was not lost on him. Greece had utterly failed to combine growth with austerity. As the German-inspired cutbacks became more severe, Greece's economy had sunk ever deeper into recession. The prime minister feared that Spain's recession would also deepen if his government hacked away at the deficit with impunity.
On Friday, Mr. Rajoy revealed his decision: Spain would breach its 2012 budget-deficit targets in defiance of the European Union's new deficit regime.
Spain now expects a deficit equivalent to 5.8 per cent of gross domestic product this year, down from a hefty 8.5 per cent in 2011 but well above the previous target of 4.4 per cent that it had promised.
It was a courageous move that is bound to have political repercussions in Brussels. Mr. Rajoy's budget decision came within hours of Spain's endorsement of new EU fiscal treaty that is designed to ensure that member countries keep a tight lid on deficits and national debt loads. "This is a sovereign decision that Spain has taken," he told the media.
In order to soften the shock, Mr. Rajoy assured that Spain remained committed to achieving a 2012 budget deficit of 3 per cent, a figure that would put the country in compliance with the new deficit rules. But given the deterioration in the Spanish economy, there's a good -- and rising -- chance the country will blow that figure too.
While investors have been focused on Greece and Italy, the Spanish economy has been quietly falling apart. The latest jobless figures are grim. The national unemployment rate is almost 23 per cent; the youth unemployment rate is 50 per cent. Debt is rising relentlessly, though, at about 68 per cent of GDP, is still within the comfort zone, giving it some flexibility (average euro zone debt is just above 80 per cent of GDP). The latest business and services sentiment indicators, released Monday, are down.
The Spanish economy is expected to shrink by 1.7 per cent this year. After Mr. Rajoy announced his decision to breach the deficit targets, yields on Spanish bonds rose above those of Italy for the first time in seven months.
Given the deterioration in the economy, the prime minister did the right thing. Greece and Portugal have proved that you can't restore growth by slashing spending and raising taxes with alacrity. To meet the original deficit target for 2012, Spain would have had to launch a new austerity program worth about €25-billion on top of the €15-billion package unveiled in December.
His defiance raises two questions.
The first is whether the fatter deficit will translate into higher bond yields. Trading at a yield of about 5 per cent, Spanish bonds are high, but not at crisis levels. They could rise. The European Central Bank can take a lot of credit for the bonds' relatively low yields. Last week the ECB flooded the European banking system with cheap loans, some of which were used to buy sovereign debt. What happens when the banks stop buying the debt?
The second is the EC's response. Having just secured the fiscal treaty, the EU (read: Germany) is no mood to see it so quickly ignored. Indeed, the EU has not approved Mr. Rajoy's new deficit target. After the EU summit closed on Friday, the EU leaders, in a statement, said: "Member states under market pressure should meet agreed budgetary targets and stand ready to pursue further consolidation measures as needed."
Sounds like Spain and the EU are gearing up for a battle. If Spain wins, watch other countries take inspiration and give up on their deficit targets too.