The lost decade facing Spain

During his visit to Paraguay two weeks ago, to attend the Iberian-American Summit, Prime Minister José Luis Rodríguez Zapatero was told by his Latin American colleagues about their countries' emergence from the lost decades of being trapped in a vicious cycle of fiscal adjustment and asphyxiating debt. Their words must have sounded like a prophecy for Spain.

During the last two weeks, with no sign of a solution emerging from Brussels, confidence in the euro zone has hit a new low. Each day brings ever-more dire warnings: "We are facing the risk of a decade of low growth and high unemployment," said Christine Lagarde, the head of the International Monetary Fund (IMF).

The huge amount of debt accumulated by the world's leading economies was already pointing to a slow and delicate recovery. The idea was for governments and central banks to take action by pumping money into the financial system. But the international markets remain unimpressed, and are pushing up borrowing rates. Europe's economies lack cash, without which its businesses cannot operate. Meanwhile, the recession bites deeper.

"Several countries are on the road to a lost decade. No European institution is yet in a position to do anything about the mounting debt," says Keiichiro Kobayashi, a researcher at the Rieti Institute.

The ongoing euro-zone crisis has delivered another blow to Spain's hopes of recovery. In 2009, the IMF predicted that the country wouldn't get on the path to growth until 2014. That forecast is beginning to look optimistic. "It is taking a long time to digest the combination of the collapse of the property market and private debt," says Santiago Lago, professor of economics at the University of Vigo.

Pablo Bustelo, a researcher at the Elcano think tank, is more optimistic about Spain's chances, but says that Italy is definitely headed for a decade of zero growth. "That is the only country in the euro zone that will be looking at annual growth of less than 1.5 percent," he says. He believes Spain will reach growth levels of around 2 percent between 2013 and 2016.

Japan's experience offers some idea of what Spain might be headed for: its main problem, deflation, which hit savings hard and increased debt at the same time. As we are seeing in Spain, the banks virtually stopped lending. But unemployment in Japan, even during the worst years, never came close to Spanish levels, which are now above 21 percent. In Japan, joblessness rose from 3 percent to a high of 5.5 percent. Italy is currently at around 9 percent, up from 6 percent before the crisis. Even at the height of the boom, in early 2007, it never fell below 8 percent.

"Unemployment will continue around the 20-percent level until at least 2014 unless things change radically in Europe," says Lago. The Spanish economy faced a similar situation in the early 1990s, when it was closing down industries and cutting public spending following a crisis sparked by the fall in the value of the peseta. Unemployment rose to today's levels. But the situation cannot be properly compared. In the 1980s, with an economy that was coming to terms with competition from the EU, unemployment never fell below 16 percent. In the first years of this decade, now part of the euro zone, unemployment stayed at around 11 percent. It was only the brief construction boom that took it down to 8 percent.

The IMF says that unemployment will not fall below 16 percent until 2016, and will likely prompt a rethink on how to finance the welfare state, along with pensions and public sector employment.

Even when the economy does get going again, "there is no guarantee that enough new jobs will be created," says Javier Andrés, a professor of economics at the University of Valencia. Andrés points to the competition posed by emerging economies and Spain's skills shortage as restricting job creation.

He is critical of the reaction of Spanish companies to the current crisis: layoffs and longer working hours. "This is not the approach that advanced economies should be taking," he says. "We have to rethink employment, which may mean job sharing."

"Labor reform must be the priority of the new government," says Javier Díaz-Gómez, a lecturer in economics at the IESE business school. Early on in the crisis, Díaz Gómez warned that the government may have jumped the gun by increasing VAT. "That was before the Greek crisis. We have to continue cutting spending or leave the euro," he says.

Bustelo believes that by increasing VAT, Spain has repeated the mistake made by the Japanese in 1997. "We may have gone for austerity too soon," he says.

"We need to temper fiscal policy," adds Lago, who is skeptical of the impact of the government's labor reforms.

Kobayashi says that Spain needs to learn the lessons of Japan. "The government should have used huge amounts of taxpayers' money to clear the banks' books: a once-and-for-all measure. This would have encouraged the banks to start lending again."

At this stage in the euro zone crisis, he says that the only solution is for Germany and the European Central Bank to take a much more active role, something that he doesn't believe will happen. "The euro zone is designed for gradual monetary convergence. But there is no way that the German electorate would tolerate that," says Díaz-Gimenez.