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Why Spain’s now threatening to drag down Europe

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Just when we thought the euro crisis had subsided for a bit, Spain is bursting back up as a trouble spot. On Wednesday, Prime Minister Mariano Rajoy said the country is “facing an economic situation of extreme difficulty.” Spain is struggling to borrow money and can’t hit its deficit targets.

Alvaro Barrientos/AP

Well when you put it that way. . ..

Why is Spain in so much trouble? The country is still mired in what the Financial Times’ Gavyn Davies calls “the austerity trap.” Last year, the country was supposed to whittle its budget deficit down from 9.3 percent of GDP to around 6 percent. Spain whiffed on that goal by a lot — its final deficit ended up being about 8.5 percent of GDP. In part that’s because economic growth was so poor, and in part it’s because regional governments were hesitant to cut spending sharply enough to hit the targets. (Madrid has only limited control over the provinces in this regard.)

So this time around, Spain’s Conservative government is promising an even stricter austerity plan, vowing to reduce the deficit from 8.5 percent of GDP down to 5.3 percent by the end of the year. Yet this sort of sharp budget-cutting could kneecap Spain’s growth even further. Keep in mind that the country’s unemployment rate already sits at a staggering 23 percent. A deeper contraction could, in turn, cause Spain’s housing and banking sectors to deteriorate further. So it’s not surprising that financial markets are nervous about lending Spain more money: The country’s borrowing costs have soared, with 10-year yields now at 5.75 percent, the highest level in 2012.

“It is very hard to see how all of these problems can be addressed by the single instrument of fiscal tightening,” writes Davies. He cites recent research from the IMF and Goldman Sachs suggesting that austerity can make a country’s debt woes worse, not better, in the short term. While Spain still needs to rein in its deficits, Davies says, there’s a long checklist of other things that need to be done: Everything from higher inflation to looser monetary policy from Europe’s central bank to significant labor deregulation. (That latter task is easier mentioned than done: In March, Rajoy’s government enacted a measure that makes it easier for Spanish companies to lay people off and cut wages. Labor unions responded by staging a massive general strike.)

If none of these reforms take place, then a Spanish crisis could prove hard to contain. In theory, if Spain’s having trouble borrowing money from the private sector, the European Financial Stability Facility is supposed to be able to step in and help out. But last week, European officials only pledged to boost the size of the bailout fund by about $250 billion. “A medium sized Spanish crisis,” notes Davies, “involving both the sovereign and the banking sector, would comfortably absorb most of that.”

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