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Greece has drawn investors' ire, but it is in Spain where the policy dilemma is most stark.
Today Spain reported that its unemployment rate in Q4 rose to 18.8% from 17.9% in Q3. The consensus was for a rise toward 18.5%, and the unemployment rate has doubled in the past two years.
As seems to be typical in Europe, the unemployment challenge is especially pronounced for young people. In Spain, the unemployment rate for young people is reportedly in excess of 40%.
The monthly time series will be reported next week, the picture is unlikely to change. The slack in the labor market is transmitted to the economy via weak wage growth and an extended downturn. Spain's economy is expected to contract by around 0.5% this year.
Cyclical forces and the 8 billion euro public works program pushed Spain's deficit to around 11.2% of GDP last year, according to the EC. This is almost as large as Greece's. One key difference between the two in this context is that Spain's debt to GDP is considerably lower than Greece, giving it perhaps a greater chance to stabilize its debt/GDP ratios before they become ruinous.
In the face of such sobering news from the labor market today, Spanish officials have felt compelled to indicate that they are considering increasing their efforts to cut the budget deficit quicker. The government is contemplating proposals that will cut another 50 billion euros, or 5% of GDP, by 2013.
This illustrates the dilemma that policy makers face. The economy does not warrant an end to fiscal support yet, and the IMF and EC have argued this point. But the dramatic market response to Greece has been a siren call, seemingly forcing policy makers--not just in Spain, but in Portugal earlier this week and in Poland earlier today, too--to mitigate the wrath of the bond vigilantes.
By appeasing the vigilantes, officials risk aggravating the economic downturn, which offsets some of the fiscal austerity and spurs social tensions. If the vigilantes' concerns are not addressed in a satisfactory fashion, capital will strike, at least partially, and interest rates will rise that will also exacerbate the economic downturn, increase the budget deficit and may lead to political turnover as well.
There seems to be some limit, even if it is not knowable a priori, that policy makers will sacrifice the public weal for the investor class and coupon clippers. The political backlash could then be an opening for nationalism and protectionism.
Disclosure: No positions