Why the crisis in Spain could take years to fix

Spain is threatening to throw the global economy into turmoil yet again. Earlier Monday, the country’s borrowing costs spiked: Spanish bond yields are back up above 6 percent, perilously close to the level at which Greece, Portugal and Ireland all needed financial bailouts.

The legacy of Spain’s housing bubble could take years to resolve itself. (Angel Navarrete/Bloomberg) Spain’s problems, many analysts say, aren’t primarily about deficits. As economist Paul Krugman points out, Spain was actually handling its budget and debt burden more responsibly than even Germany before the 2007 financial crisis hit. But the euro zone is forcing Spain to act as if its chief problem is deficits, pushing the country into a counterproductive cycle of austerity that’s hurting Spain’s economy and ensuring, as Wolfgang Munchau writes in the Financial Times, that “Spain will miss the target, or the Spanish government will have to fire so many nurses and teachers that the result will be a political insurrection.”

The real roots of Spain’s woes lie elsewhere. The country suffered a massive housing bubble during the run-up to the financial crisis — driven, as Krugman notes, partly by loose lending from German banks. When that bubble finally popped, Spain faced massive layoffs in its construction sector, and unemployment soared to jaw-dropping levels (the current rate is 24 percent). And Spain is still very, very far from recovering from the fallout. As Cinzia Alcidi and Daniel Gros discuss at VoxEU, Spain is still suffering from a “housing overhang” that hasn’t even begun to correct itself:

Investment in construction as share of GDP on the vertical axis, the red line is the average over the period 1970-2000. Source: European Commission services

Basically, construction investment (the blue line in the chart above) needs to sink down below the red line (the long-run average for construction) for long enough to absorb the overbuilding of the 2000s. As Alcidi and Gros note, “If construction were to continue at the still relatively high rate of today, the process of absorption of the bubble would take more than 30 years.”

So if austerity won’t work, what can fix Spain? Alcidi and Gros argue that the country needs to shift more workers away from construction and toward export sectors. But, they note, Spain can start exporting more goods only if its wages fall relative to other countries. And, since the country can’t devalue its own currency, that’s a difficult process. Various restrictions and regulations in Spain’s labor market are also preventing an adjustment.

Krugman, for his part, offers another proposal for Europe as a whole: “The Continent needs more expansionary monetary policies, in the form of a willingness — an announced willingness — on the part of the European Central Bank to accept somewhat higher inflation; it needs more expansionary fiscal policies, in the form of budgets in Germany that offset austerity in Spain and other troubled nations around the Continent’s periphery, rather than reinforcing it. Even with such policies, the peripheral nations would face years of hard times. But at least there would be some hope of recovery.”