FOUR POSSIBLE SCENARIOS FOR SPAIN

By: Jose M. de Areilza & Jose Ignacio Torreblanca- 26 June 2012 Published on European Council on Foreign Relations Website

Extract

Spain is in the eyes of the euro crisis storm as the most vulnerable country supposedly 'too big to fail'. All of Spain's governments in the first decade of the new millennium benefited from tax returns generated by easy growth based on a property bubble and near full employment, while neglecting productivity, labour relations, wage policies, competitiveness, and investment in research, innovation and development. Instead of pressing on with a profound reform agenda, governments succumbed to the temptation of complacency, and a false sense of security took over. The upshot was a property crisis, trade deficit, a dual labour market, lack of competitiveness between companies, with autonomous , regional and local government spending spiraling out of fiscal and budgetary control, politicised savings banks, and a finance sector exposed to the property sector.

Four possible scenarios for Spain are hereby presented:

Scenario 1: Exit from the Euro

This scenario is widely cosidered as catastrophic as to be deeply unlikely, although this does not mean that it is impossible. A Euro exit could take place if outside intervention were to fail, politically, or economically (the Greek path). It could also take place in the event of the Euro breaking up and reconfiguringn itself with a limited number of (northern) members.

A voluntary exit, however unlikely, might be contemplated if the two main parties reached a consensus on the impossibilty of remaining in the Euro, believing the political, economic and social costs of austerity measures at home were insupportable taken together with scant and insufficient aid from European institutions.

A second (and more worrying) scenario would be a Euro exit that follows the collapse of the two main political parties. It is easy to imagine a turnaround in public opinion that wiped out the government in elections without the opposition being able to benefit commensurately. This could result from the failure of austerity measures, internally through the loss of growth and external through failure to win over market confidence or the solidarity of European governments, added to a failure of the political system to offer the necessary stability to stay on the path of reform.

Indefinite, unqualified support of European policies cannot be taken for granted from the Spanish people. In most recent polls, more than 34% of respondents thought that Spain's membership in the Euro made it more difficult to escape the crisis (only 20% thought it facilitated it). 57.5% said that belonging to the Euro has been negative for Spain, and 33.5% were convinced that Spain would be better off outside the Eurozone.

Scenario 2: Intervention

In this scenario, the Spanish government would go beyond the 'light' bailout package it received on 9 June, requesting a European loan to maintain the lifeline for its banking sector. The government, given negative unemployment, debt and deficit figures, would then show itself to be incapable of restoring confidence in the markets, submitting Spanish debt to prohibitive interest rates and forcing an intervention (Portuguese variant). Likewise, intervention could take place if contagion from a Greek exit spread to the weaker Eurozone countries (Greek variant).

Governing under further intervention would be challenging, with additional cuts and reforms on the table. As in Greece and Portugal, many measures would focus on sensitive parts of the welfare state, such as pensions, education and health, and public administration (reordering of local powers and finance, reduction of the number of civil servants, etc.). These would have a great impact on public opinion, political stability, and the governability of the country, and consequently could move Spain closer to an exit scenario.

Political consequences of such an intervention may include pressure on Prime Minister Rajoy to step down, the inclusion of the main opposition Socialist PSOE in coalition with Rajoy's Popular Party to generate public support, or the formation of a new government headed by a technocrat. Intervention would inevitably lead to an erosion of popular support for the EU, and potentially the rise of eurosceptic parties.

Scenario 3: Muddling Through

In this scenario, Spain carries on much as before. There is neither a Euro exit nor outside intervention, nor are they any big changes in the European arena. Germany and the other countries might adopt a more flexible position, but not one with any substantial changes- no Eurobonds, no easy road to rapid growth. With the fiscal pact and the European Stability Mechanism (ESM) in force, President Hollande secures some stimulus measures through the European Investment Bank (EIB) and/or the mobilisation of untapped structural funds in the EU  budget. However, these would not be channeled through Spain, which would continue with a confidence problem abroad,  a financial sector in a critical condition, public debt approaching 90% of GDP, and reforms (with the unstable, complex Spanish autonomous regional state system as an added difficulty) having no noticeable effect on growth and employment during Prime Minister Rajoy's term of office. In this scenario, the crises would have a knock-on effect, due to external or internal events (Greek exit; high differentials in Portugal; political instability in Italy as Monti's term of office runs its course; another bank rescue in Spain) although the possible exit of Chancellor Angela Merket, and the arrival of the Social Democrats or a grand coalition, including them might offer some relief. In general, Spanish government policy would be reactive and survival driven, lacking the capacity to contribute to the design of common institutions, and with no prospects or plans in the medium term.

This might result in a serious erosion of support for the government at the polls and possibly in the street, with levels of public disaffection and a possibility of minority governments. The ground would be open for the rise of parties able to capitalise on the failure of the PSOE and PP to get Spain out of the crisis. On the other hand, 'muddling through' could lead to the current sacrifices and reforms overcoming the acute crisis, staving off foreign intervention and the collapse of the political system through the concrete support of the ECB and other partners. This would require a very narrow consensus between the two main parties likely to govern, and the adoption of a series of profound reforms, devoted to improving the credibility of Spain in the eyes of its EU partners and the financial markets.

Scenario 4: Steps towards an economic Federation

In this scenario, there would be a turnaround in the handling of the economic crisis. European leaders would recognise the critical need for centralisation within the Eurozone and seize it. This about-turn might stem from sustained and compelling pressure on Chancellor Angela Merkel from leaders of other big countries in difficulties, a political crisis in Italy, or the collapse of the Spanish government and the subsequent need for intervention in Spain, with the resulting threat to stabilise across the entire Eurozone.

This scenario would see the emergence of a powerful dynamic in favor of political negotiation aimed at complementing economic and monetary union with political and fiscal union. This would include European taxes; a European Treasury; a change in the role of the ECB which would allow it to buy sovereign debt; the issuing of Eurobonds; the conversion of the ESM into a European IMF; the setting up of a bank resolution mechanism; and a Europe-wide deposit guarantee fund. Such measures would demand significant constitutional reforms (in Germany, and Spain too), including uncertain national referendums that may result in some current Eurozone countries ending up outside the single currency. The result would the the formation of an economic federation with the objective of a viable single currency (that may allow for the future return of countries that exited).

Conclusion

Spain needs to promote measures making its national interests compatible with those of Europe as a whole. But here Spain finds itself in a difficult situation: The country cannot confront Germany with balance of power policies, or 'coalition of losers', because Spain needs German cooperation. At the same time, however, Spain has to builld a solid union of interests around three deficits: Confidence Deficit, Convergence Deficit and Institutional and Political Deficit. Spain needs to promote measures which are positive for the countyry, and which can also create acceptance and legitimacy at the European Union level. That is why moving quickly forward towards a 'Europe of results' is not enough.

The transference of newpowers to the EU can only be justified by an improvement in governance in democratic terms and the acceptance of a new social contract between Europeans. This would help resolve the tensions and political and economic imbalances which have introduced so much uncertainty into the European project, and, in doing so, would play an important part in relaunching it.