Belt tightening in the board room and the living room, deep public budget cuts and anaemic bank lending may be setting Spain up for years of economic stagnation that could eventually force it to seek a bailout.

Under pressure to chop Spain's deficit to the European Union limit and stick to new fiscal rules, Prime Minister Mariano Rajoy has promised to present a budget on Friday that will be very, very austere.

With the economy on the verge of its second recession in three years, soaring unemployment and rising borrowing costs, some economists are predicting a lost decade of growth such as the one experienced by Japan in the 1990s from which it has never fully recovered.

Others, including Italian Prime Minister Mario Monti, say Spain could drag the euro zone back into a deep crisis.

We've signed a suicide pact in Europe by agreeing that we all need to make cuts, said Luis Garicano economist at the London School of Economics and head of Spanish think tank Fedea.

Europe has to recognize that this is a downward spiral that's not helping anyone.

With public debt at almost 70 percent of gross domestic product and one of the highest levels of private debt in the euro zone, Spain has been a focus of investors since Greece first appealed for international help in early 2010.

The economy is more than twice the size of Ireland, Greece and Portugal combined, and is seen as too large for the euro zone to let it fail.

Spanish government borrowing costs have fallen from 14-year highs reached last year but with economic fears resurfacing the risk premium over German bonds has started to rise again.

If the government consistently runs large deficits in the midst of a very deep recession, or possibly both, then it's likely yields will rise, said Ben May of Capital Economics.

There is a risk that eventually Spain will need to seek a bailout to borrow at reasonable rates of interest.

Rajoy's 2012 budget will include at least 35 billion euros of savings through tax hikes, wage reductions and public service cutbacks, in a bid to chop the deficit to the EU's 3 percent limit next year. The 2013 budget will be just as austere.


As in other European economies, domestic demand was one of the cornerstones of growth in the boom years but consumers are no longer seen as the economy's potential saviors.

Celinda Garcia, 55, has run a delicatessen in a middle-class neighborhood of Madrid for 30 years and the four-year economic crisis had not affected her business until the most recent round of reforms and cuts.

I've really noticed a big drop in sales in the last couple of months, she says.

My customers mostly have secure jobs and a good income, but the latest reforms have left everyone worried for their future.

The economic troubles began over four years ago when a decade-long property bubble burst. The economy is expected to shrink 1.7 percent this year.

Housing prices fell 11.2 percent in the fourth quarter of last year and may still have another 30 percent to go. The construction sector has hemorrhaged jobs, putting millions of low-skilled builders out of work.

Unemployment is more than double the European Union average, almost half of young people cannot find a job and poverty levels are rising faster than anywhere else in Europe.


Companies are also struggling. Even the most promising sectors are making cutbacks.

Tourism accounts for around 11 percent of gross domestic product. But listed Spanish tourism group Sol Melia had to sell assets in the fourth quarter to help reduce its debt.

Spanish tourism benefited last year from increased numbers of holiday makers avoiding troubles in northern Africa but even so Sol Melia was reluctant to invest at home.

At this stage, with no significant booking position from early booking markets, we prefer to adopt a 'wait and see' stance, even more so considering the sluggish state of the Spanish feeder market, Chief Executive Gabriel Escarrer said.

Bank lending meanwhile has slowed to a trickle. The financial sector, which has already been through a round of mergers and consolidations, has been told by the new government to reinforce balance sheets with another 50 billion euros.

I don't see any credit growth this year. It won't accelerate with the economic slowdown, a high-ranking financial source said.

The credit drought is hurting large, well-established companies as much as families brave enough to apply for a mortgage to buy their own home.

We're one of Spain's healthiest companies but the banks just don't want to lend, said an executive at a blue-chip company who asked for anonymity.

His group can raise money in the bond markets but that is not an option for smaller firms.


Some economists fear the outlook for the Spanish economy is worryingly similar to Japan's situation in the nineties.

A fiscal austerity drive in 1997 while the private sector was deleveraging at near zero interest rates prompted five quarters of contraction and the Japanese budget deficit ballooned.

The recession will last much longer if the government continues to insist on fiscal consolidation when the Spanish private sector is deleveraging at the same time, Tokyo-based economist at the Nomura Research Institute Richard Koo said.

The government should recognize that Spain is suffering from a very rare disease called balance sheet recession that happens only after the bursting of a nation-wide asset prices bubble financed with debt.

Interest rates in the euro zone are at record lows, but during a balance sheet recession, loose monetary policy will not stimulate new lending as it does during a normal economic downturn, Koo said.

It took Japan 10 years to climb out of this policy mistake. I hate to see Spain going down the same route, he said.

(Additional reporting by Tracy Rucinski and Julien Toyer; editing by Anna Willard)