Cuts will ruin growth prospects, experts warn Rajoy

That the first interview given by new Economy Minister Luis de Guindos should be to the Financial Times rather than to a domestic newspaper, says much about the turbulent times in which we live. So does the fact that Prime Minister Mariano Rajoy's Cabinet announced savage spending cuts to the tune of 15 billion euros, after barely a week in office, with more on the way. What's more, nobody is denying charges that this approach will do nothing to create jobs.

Hardly the best start for a new government, however much its hands may be tied by the current recession. It is a high-stakes approach both for the government and the country; as economists the world over are warning, cutting back spending risks deepening the crisis further, particularly if consumers stop buying and exporters find the world's markets are closed.

"The experiences of the past year throughout Europe show that cutbacks simply deepen recessions. It is a dream to hope that tax hikes will have any impact, particularly given current levels of personal debt, unemployment, and the situation in the rest of Europe. The worst of all this is that these policies will make it impossible to meet the unrealistic objectives of reducing the deficit, as the data for 2011 show," says Jorge Uxó, a lecturer in economics at the University of Castilla-La Mancha.

The incoming government has justified its first measures - nine billion euros in cuts, withsix billion to be raised by tax hikes - citing the "unexpected" failure to reduce the deficit down tosix percent in 2011. Instead, it stands ateight percent. We are now seeing the result of the spending cuts on growth: tax rates are down due to the economic slowdown.

"These measures, along with those that will be announced in the budget in March, will further contract the economy, at least in the short term," says the Carlos III University's Flores de Lemus Institute. Funcas, a think-tank and research body funded by the country's savings banks, has been highly pessimistic in its economic forecasts, predicting that the deficit would fall short at 7.5 percent. Its most recent survey predicted a contraction in GDP of 0.5 percent for this year, with unemployment hitting 23 percent. It now looks as though that view may be an optimistic one.

In his interview with the FT, Luis de Guindos says that the government wanted to send out a clear signal to the markets that it was serious about tackling the deficit. The paper pressed him on the dangers of deepening the recession further, to which De Guindos responded by promising "an aggressive agenda of structural reforms" to stimulate growth in the medium term. But time and again, he came back to the need to placate the international markets and thereby reduce the cost of borrowing.

The yield on Spain's benchmark 10-year bonds closed out 2011 at just over five percent, lower than Italy'sseven percent, a rate that is widely considered to be unsustainable in the long-run. However, in the first few days of the new year the Spanish yield has risen past 5.5 percent amid dismal economic growth forecasts.

"It's a perverse approach," says Santiago Carbó, a professor of economic analysis at the University of Granada. "But the cuts seem unavoidable because that is what the rest of Europe has agreed to do."

Carbó says the markets want to see "a balanced fiscal policy." He believes that the government is mistaken in not trying to balance growth with managing the deficit, "but the rest of Europe, led by Germany, is not interested."

For the foreseeable future, the focus on reducing the deficit will deepen the recession. And this will impact negatively on tax revenue, despite tax hikes. At the same time, it is difficult to assess how successful the government will be in garnering more taxes.

Jesús Fernández Villaverde, a lecturer in economics at the University of Pennsylvania, says that the deepening recession will mean around a third of tax revenue will be lost. But he says that Spain now has little choice but to press ahead, otherwise it risks losing credibility in the eyes of Germany and the international markets. He believes Rajoy should have renegotiated the deficit reduction with Brussels, as the Socialist Party had suggested. If the goal this year, reducing it fromsix percent to 4.4 percent, was ambitious, reaching that figure from a starting point ofeight percent of GDP will be impossible. De Guindos has hinted as such already.

The new government has justified its cuts by citing the need to reign in the deficit. But half of the budget overspending is the responsibility of the regions, which failed to keep their spending in line in 2012. Having already been hard hit by the collapse of the property market, regional governments are now unable even to increase tax rates, the central government already haven beaten them to it.

It's going to be a tough year for the regions, which are already largely unable to borrow on the international markets. Furthermore, this year they will have to return somefive billion euros to the central government for overpayments in 2008 and 2009. The PP's regional leaders are already calling on Rajoy for a breathing space.

Like the central government, the only recourse open to the regional administrations to reduce spending is to cut spending. That will mean less money for health, education and public services, which are the main employment sectors.

"Catalonia, which tends to set the agenda in terms of regional government, has taken tough measures in education and health," says Josep Oliver, a professor at the University of Barcelona. He says that the impact is not just economic: "In Catalonia there is a much more heightened sense of crisis among ordinary people than there is in the rest of Spain."

Aside from freezing salaries and cutting spending at all levels of government, this government, like its predecessor, will be reducing investment in R&D, something that Carbó describes as "incomprehensible."

The government's decision to hike taxes, while surprising few, is a political gamble, given that it will hit middle-class families hardest.

"Raising income tax makes no sense. Spain's income and company tax rates are relatively high, while its VAT is relatively low. We should have raised VAT before income tax," says Juan Rubio-Ramírez, who also criticizes the government's decision to give tax breaks to home buyers.

"Focusing on reducing the budget deficit will not get us out of the current crisis," says Fernández-Villaverde. "The only way out of this mess is to implement deep-rooted structural reforms, something that the government says is also necessary, but has so far yet to detail."

For the moment, the new government is staking everything on trying to bring down the cost of borrowing, an approach that is winning it the support of the European Union, which for the moment, seems to be exercising the biggest influence over its policies.