Message to Germany: Do not waste Spain’s reform efforts

(*) This article was published on 13/11/2014 in

Spain is often presented in Germany as the Musterschüler (the model pupil) of the Eurozone. In a recent interview with a number of European newspapers, Wolfgang Schäuble, the Finance Minister of Germany, summarized this sentiment by describing Spain as “an example for the rest of the world”. These days there is no international conference where German officials are not full of praise for the reform efforts of Spain. International media have bought this story. The Wall Street Journal, for example, has described Spain’s determination to overcome its deepest economic slump since its 1930s Civil War as Europe’s “only real turnaround story in this crisis”.

This recognition is justified. Spain is currently the only large European economy that is growing. This is due to both the decisive action by the ECB and the reform efforts of the country. Spaniards have had to endure a painful internal devaluation process in order to regain competitiveness. Firing and hiring has been eased. Salaries have been cut. Public expenditure has been reduced. Worker and social rights have been curtailed. This has produced public discontent, but it has also helped to cut the current account deficit – which was at a worrying 10% of GDP in 2008 – to an even balance in 2013. Spain has witnessed record export numbers in the past years.

The problem, however, is that these stoic efforts have only produced meager results. Spain’s unemployment levels remain stubbornly high at 24%. The public debt has gone from 36% of GDP in 2008, before the crisis, to 96% today. The net external debt position of Spain remains at roughly 90% of GDP. Spanish firms need to pay on average a 2% interest premium for their new loans compared to their French and German competitors. Some even argue that at the current rate of growth it will take Spain 15 years before it can reduce its unemployment to 2008 levels.

Given these bleak numbers, is there any surprise that the socialist leaders of France, François Hollande, and Italy, Matteo Renzi, have no desire to follow the Spanish example? They must be thinking: “Look at the Spaniards, they have followed the German diktat, they have undertaken titanic efforts, but the rewards have been dismal. We won’t force our people to go through the same pain”. This attitude is understandable but it is also worrying. For if Italy and France do not undertake reforms, their economies will not grow, and if they do not move forward, the whole Eurozone will be stuck in a recessionary spiral.

In order to change this dynamic, the German government should not waste the reform efforts of Spain. On numerous occasions, it has proposed establishing contractual arrangements between the Eurozone member states and the European Commission whereby the former commit to reforms in exchange for targeted financial help. It is about time to apply this logic. If Germany wants to incentivize reforms in Italy and France, it is the time to compensate Spain, and other ‘well-behaved’ countries such as Ireland and Portugal, for their reform efforts.

In other words, Germany has been successful in applying the sticks. Now it is time to hand over the carrots. For this, no new treaty would be needed. The financing of new investment in this crisis-hit countries could be managed and monitored by the European Investment Bank (EIB) or, alternatively, by the European Stability Mechanism (ESM), which could issue project bonds for specific investment targets. In Spain, for example, there is no need for new infrastructure. But there is lack of funding for R&D, start-ups, programs to promote entrepreneurship, the establishment of an efficient dual education system and active labor market policies. All areas where Germany has internationally-recognized excellence upon which the ESM and the EIB can draw on to secure the effective use of the European funds. Under the contractual arrangement, if the money is wasted, the financing should be stopped.

The provision of this targeted programs could become a game-changer in the resolution of the Eurozone crisis. The Spaniards would feel that their efforts have brought them some tangible results. The French and the Italians would see that their future pains will bring certain compensation. Germany would no longer be seen as the bad guy that only wants to impose austerity on everyone else. The dynamic around the future of the Eurozone would change to a more positive outlook. Targeted project bonds could be seen as the first step towards a genuine fiscal union, something absolutely necessary for the Eurozone to survive in the long term.

More importantly, in the short term, this proposal would square Mario Draghi’s three-dimensional circle. It would incentivize structural reforms, it would augment investment at the European level and it would give the ECB a safe pan-European debt instrument to expand further its balance sheet if necessary. 

Miguel Otero-Iglesias is Senior Analyst for European Economy and Emerging Markets at the Elcano Royal Institute | @miotei