Spanish Prime Minister Mariano Rajoy has tried to reduce his country's budget deficit, which last year reached 8.9 percent of gross domestic product (GDP), since he took office in 2011. The task has not been easy, and Madrid has asked the European Commission for softer deficit targets for 2012 and 2013. The commission granted Madrid a softer target in March and acknowledged in May that more concessions are under discussion.
Spain's 17 regions, or autonomous communities, account for more than half of overall public spending in Spain. They have become a central arena in Madrid's deficit reduction efforts. On May 18 the government admitted that Spain's deficit for 2011 was not 8.5 percent — as announced in February — but 8.9 percent. This is the third time this year that Madrid corrected upward the country's deficit. According to Spain's Ministry of Economy, this correction had to be made because the regions' deficit is higher than originally thought. To give it an extra tool for pressuring the regions, the Rajoy government pushed a Budget Stability Law through parliament that allows the central government to take over the budgets of regions that fail to meet deficit and debt targets set by Madrid. The provision required each region to present planned spending cuts on May 17 reducing their budget deficits to 1.5 percent of their GDP. These cuts would come on top of two central government decrees passed earlier in May enacting a countrywide reduction of 10 billion euros ($12.7 billion) in education and health spending.
The Spanish communities strongly opposed the Budget Stability Law, accusing Madrid of breaching the constitutionally established balance between central and regional government powers. Asturias took the lead in opposing the measure. Spanish Economy Minister Cristobal Montoro expressed his concerns over the fiscal situation in Asturias, saying May 12 that the government was considering intervening in the region. But Asturias maintains it is in compliance, arguing Madrid is waging a campaign of coercion because Asturias is one of the few Spanish regions not ruled by Rajoy's Popular Party. The region has appealed to the European Commission, accusing Madrid of manipulating regional austerity plans for political purposes and infringing on the powers delegated to Asturias under the Spanish Constitution.
Still, Asturias and the other regions recognize they must reduce their deficits even though that will require painful cuts in health and education spending. Underscoring the severity of the regions' budget problem, Moody's downgraded the credit rating of four regions May 17 due to their inability to reduce their deficits and their high levels of debt. Catalonia, Spain's wealthiest region, was downgraded to junk status.
Though the regions see the need for deficit reduction, they are not prepared to accept Madrid's efforts to centralize power. But if Madrid fails in its first attempt to enforce the Budgetary Stability Law, it will see its credibility seriously undermined. The central government must show the regional governments and international markets that it can control the fiscal crisis in the regions.
The likely solution to this dilemma is a compromise between Madrid and Asturias in which the regional government commits to deficit targets while Madrid abandons threats of intervention. Though this will head off a political crisis between the center and the regions, it does not satisfactorily address the long-term deficit problem. This combined with market pressures on the Spanish banking system will continue to undermine Spain's reputation in international financial markets and keep bond yields high.
Compounding Spain's woes, rumors of a run on Spanish banks emerged after May 17 reports of a run on Greek banks. El Mundo reported that customers of Bankia withdrew more than 1 billion euros in the week after the Spanish bank's partial nationalization this May. While the Spanish government denied these rumors, they show how rapidly instability in one part of Europe can spread to other parts. With Greece in political paralysis and Spain coming under increasing market pressure as it struggles with its deficit, Europe risks having this financial contagion spread to Italy, Portugal, Ireland and Belgium via higher bond yields in the eurozone periphery and a growing lack of confidence in the banking sector.
Editor's note: An earlier version of this analysis misstated Spain's budget deficit. The deficit last year reached 8.9 percent of GDP.