Spain's Example Shows Limits of EU Targets

Madrid's Success in Meeting Goals Until '08 Hid Vulnerabilities in an Economy Relying Too Heavily on a Property Boom

MADRID—As euro-zone leaders discuss whether to impose penalties on heavily indebted member countries that break certain fiscal limits, Spain's experience shows why more centralized supervision of governments' budgets is unlikely to address some key economic problems plaguing the currency bloc and undermining investor confidence.

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Analysts say plans to prod member countries to cut their public debt and keep their deficits in line ignore the recent history of nations like Spain—which met those limits before 2008, but had serious economic vulnerabilities brewing underneath, mainly a property bubble.

WSJ's Ilan Brat takes a look at Spain and a lesson it provides in the current European economic crisis...when things seems fiscally strong in the late 1990's, weaknesses in the economy were not noticed. AP Photo/Arturo Rodriguez

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The new plan, advocated by French President Nicolas Sarkozy and German Chancellor Angela Merkel, "is a one-size-policy-response-fits-all type of approach which I think doesn't address some of the problems that some countries are facing," including low internal demand, weak international competitiveness and nearly frozen bank lending, says Jacques Cailloux, chief European economist at Royal Bank of Scotland.

Spain, the euro zone's fourth-largest economy, is a key example. Leading up to the 2008 financial crisis, it was one of few euro-zone countries—Ireland was another one—that complied with the EU's so-called Stability and Growth Pact. Since 1998, Spain's budget deficits came in below the limit of 3% of gross domestic product.

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The country ran surpluses some years. Government debt stayed below 60% of GDP, and climbed above that threshold only last year. It remains well below the euro zone's average. These achievements were helped by the Spanish government's wish to project fiscal responsibility as well as the boom in its property sector.

But Mr. Cailloux says meeting those targets didn't prepare Spain for or fix the problems that had built up in its economy during the housing boom and that became clear after that bubble burst in 2008.

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During the boom years, a wave of cheap credit flowed into Spain, feeding the bubble. Soaring household consumption boosted tax receipts and employment. But labor costs and private household debt also rose quickly even as productivity flat-lined or declined.

Amid its continuing economic slump, Spain needs to regain investor confidence to keep down its borrowing costs. Prime Minister-elect Mariano Rajoy has vowed to support the Sarkozy-Merkel plan. At a meeting Thursday with fellow members of the European Popular Party, Mr. Rajoy said Spain would "impeccably" meet its commitment to cut the budget deficit to 3% of GDP in 2013 from 11.1% in 2009, but also called for more financial firepower to quell Europe's debt crisis.

Meanwhile, households are trimming debt and buying fewer electronic gadgets and cars. Unemployment has hovered above 20% for nearly two years. Youth unemployment is almost 50%.

Spain's economy grew at a 0.7% annual pace in the third quarter, after contracting in 2009 and 2010. Many expect it to turn negative again.

That may spell trouble, says Simon Tilford, chief economist at the London-based Centre for European Reform. Businesses may be unwilling to invest while the outlook for demand continues to be weak, he says. Government austerity may further lower internal demand, which in turn would weigh on tax receipts and government budgets and debt levels as well as GDP.

Spain relied too heavily on its construction sector to spur growth in the early 2000s, and now "they don't really have a growth strategy," he says. "The only real way out is export-led growth, and it's far from clear how they are going to be able to generate that." He said because European countries buy mostly from each other they cannot all boost exports at the same time.

Not everyone agrees that austerity programs amid a weak economy could cause government budget deficits and debt to rise. Willem Buiter, a Citigroup economist, noted in a recent research note that austerity is the only option other than default for highly indebted countries. It should help improve government finances by spurring investor confidence and lowering government expenses, as long as the population goes along with it.

"We have little experience of the peacetime willingness of voters to put up with years of austerity, negative growth and rising unemployment, but that is what we are going to get" unless government creditors decide to lower their debtors' obligations, he wrote.

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