Peter Jones: Spain waves goodbye to prosperity

YOU HAVE to feel sorry for the Spanish. Since casting off decades of Franco's dictatorship in 1975, they have democratised, modernised, and generally worked extremely hard to create what looked until recently an enviable country. But what to many in Scotland looked highly desirable - the decentralised political system and especially the tax autonomy enjoyed by the Basque country - now looks a severe handicap to Spanish attempts to right its struggling economy.

Over the weekend, the European Central Bank's decision to buy the bonds of the Spanish and Italian governments brought those countries back from the brink of having to default on their debts. It remains to be seen whether the move is enough to prevent the need to extend the bail-out loans given to Greece, Ireland, and Portugal to Spain and Italy. But for the moment a breathing space has been bought.

That this should have happened to Spain is all the more astonishing given that in 2007 it looked like a model economy. Spain had a balanced budget (unlike the deficit financing of most of Europe including the UK) and its total public debt, as a percentage of GDP, was only about half as large as that of Germany and less than half the size of Britain's national debt.

The big banks were sound and survived the financial crisis well enough for Banco Santander to become a vital rescuer of troubled British mortgage banks such as the Alliance and Leicester. Big companies, such as Iberdrola, purchaser of ScottishPower, were, and still are, major players on the European corporate stage.

On some pre-crisis forecasts, Spanish GDP per head, a measure of the wealth being produced by the average citizen, was set to surpass that of Germany's by the end of next year.

What went wrong was the recession that followed the financial crisis. Fuelled by cheap interest rates following adoption of the euro, and other Europeans' lust for a summer bolthole, the construction industry boomed. At its peak, it employed 14 per cent of the workforce (in Scotland, building employs about 6 per cent).

The recession, as in Ireland, brought building to a halt which has been a major factor in Spanish unemployment rising to just over 20 per cent. Government tax revenues, a high proportion of which came out of property also took a hit, throwing Spanish public finances into the red.

And yet, for all the crisis headlines surrounding Spain, it doesn't look to be in all that bad shape. The general government deficit, or excess of spending over income, hit 11.1 per cent of GDP in 2009-10, but was reduced to 9.2 per cent of GDP in 2009-10. Total national debt is about 63 per cent of GDP, which ain't good but is not as bad as the UK.

So why do the financial markets think that Spain might struggle to pay back its debts? As in America, much of the answer has to do with politics.

In May, elections took place in 8,000 Spanish municipalities and in 13 of the 17 autonomous communities or devolved regional governments. The Socialist party, which runs the Spanish central government, lost a lot of power to the opposition right-wing Popular Party which now runs 11 regional governments.

It opposes the austerity budgets which Socialist prime minister Rodriguez Zapatero has been doggedly pursuing. Many regional governments, which control about a third of general government spending, have been increasing, rather than reducing, their deficits mainly because they control education and health which, as in Scotland, have budgets which voters don't like being cut.

Except for the party labels being rather different, this mirrors the stances taken by the UK and Scottish governments. But the big and important difference is that the regional governments can, unlike the Scottish government, borrow to balance their budgets.

Mr Zapatero has being trying to persuade the regions to curb their spending. They are very reluctant to do so, and it is this tension which is adding to financial market doubts that Madrid really is in control of the deficit. In June, Moody's, a big credit rating agency, said: "In the absence of credible commitments by the regions to take the steps needed to achieve sustainable improvements in their fiscal positions, we believe the central government will find it very hard to achieve its overall fiscal targets."

This, Moody's said, is liable to lead not just to a downgrading of the region's credit ratings, but also on the central government's rating. This, in effect, is what the markets have been doing to Spanish government debt by raising the interest charged on Spanish bonds, leading to the weekend action taken by the ECB.

Moreover, the markets have evidence that the regions are bucking Madrid's spending cuts. Catalonia this year set a budget which envisaged a deficit twice as large as the 1.3 per cent being urged by Mr Zapatero. The new government in Castille La Mancha said it found that the previous year's deficit was not the 1.7 per cent claimed by the defeated regional administration, but more than 4 per cent thanks to various hidden unpaid bills.

The regional savings banks ("cajas") are also a big problem. Their constitutions, where regional politicians sit on their boards, makes them political tools which were used to expand lending to construction and property.As a result, they now have a pile of dud property on their books, causing huge losses and resulting in forced mergers and the occasional bail-out.

At political behest, these banks also took big shareholdings in local companies, ostensibly to help finance their expansion but also to prevent them from being taken over at, perhaps, a cost in jobs, but also to maintain political influence. Quite apart from creating cronyism, it skews the operation of companies towards a focus on maintaining operations, jobs and tax revenues in the regional rather than operating where they can get the best returns. This also prevents takeovers which would help re-structure the Spanish economy and make it more efficient.

There are hard lessons in this for Scotland. At the very least, at makes obvious the reasons why the UK Treasury is extremely reluctant to concede significant borrowing powers to Scotland.

And for those voices who like to see more Scottish banks, it exemplifies the downside of having too much political control over such banks. Small but powerful regional government does not always lead to better government.