April 17, 2012
Spanish sovereign bond yields are rising again. It seems that the ECB’s long term refinancing operation has not bought as much time as was hoped. But what are the markets worried about? Is it the backsliding by Spain’s government over its fiscal deficit targets? Or is it in fact austerity itself? Market sentiment is never a simple matter, but it would be wrong to assume that fiscal hawks are driving this bus. What markets want, above all else, is growth – the rising tide that lifts all boats. And growth, or the lack of it, is still the biggest challenge facing Europe.  

Spain does have serious, fundamental problems with its economy and public finances. But Spain is not Greece. It did not cook its books to qualify for Euro accession. It ran prudent fiscal policies up until the crisis hit (indeed, until the financial crisis it had lower budget deficits and outstanding public debts than Germany). It has a professional, competent political class. And it has a large, diversified economy that produces goods and services that people elsewhere in the world might actually want to purchase. In short, the pain in Spain cannot be characterized as a morality play in which sinners who falsify their books, evade paying taxes, and retire at 50 get what they deserve.  

The Eurozone is not being brought low because of ‘profligate’ borrowers or ‘lazy’ and ‘corrupt’ southerners. Rather it is Europe’s debilitating internal imbalances and its lack of compensating fiscal and monetary institutions that are the source of its troubles. In the run up to the crisis, capital from core Europe flooded into Spain, leading to asset bubbles and unsustainable investments. Now the problem has reversed – first a sudden stop of capital inflows burst Spain’s real estate bubble, followed by wholesale capital flight by spooked investors. Because its citizens have borrowed in what is effectively a foreign currency, the country cannot use monetary policy to stave off the panic. 

As such, the fact that the Eurozone’s financial crisis has now lapped up against the shores of Spain could mark a decisive turning point in Europe’s crisis management – which has thus far, to put it kindly, been underwhelming. Many of the decisions taken by the troika – the ECB, the European Commission and the IMF – have been driven by a fear of moral hazard. Since Greek politicians could not be trusted, the troika installed itself in Athens and took control of Greek fiscal policy. Likewise in Italy, when the Berlusconi government reneged on its promises of structural reform, it was turfed out of office and replaced with a team of technocrats led by Mario Monti. But Spain is different: its problems are neither self-inflicted nor the result of gross negligence.  

Just as important as what the troika have done, however, is what they have not done. The ECB has not explicitly signed on to be the lender of last resort to sovereign borrowers, for fear that doing so would take the pressure off governments to make difficult fiscal and structural reforms. And no alternatives to austerity – no path to growth that could lead struggling economies out of a debt deflation trap and onto a path of sustainable expansion – have been formulated. The Eurozone’s crisis response could be fairly characterized as all stick and very little carrot.  

So where then is the cause for optimism? Why is this piece headlined ‘How Spain Can Save Europe’ rather than the other way around? Because if Spain requires some assistance from its European partners - and it does - the same can be said of Europe’s survival strategy: it needs help. The EU’s leaders have persistently misdiagnosed and mischaracterized the continent’s financial crisis. In their understandable attempts to pressure Greece and Italy to reform, they have failed to offer appropriate remedies even as the costs of the crisis have grown ever larger.  

Europe cannot continue to kick the can down the road forever. A single minded focus on austerity will not simply fail to improve the Eurozone’s macroeconomic situation, it will destroy public support for the European project. This is not to suggest that there are any easy answers, or that Europe’s politicians don’t face real constraints. But it is beyond time to diagnose the Eurozone’s problems correctly, and start implementing pragmatic programs to boost growth and allow internal imbalances to adjust. 

Again, Spain is not Greece, it did not behave completely irresponsibly. And it is not Greece for another, more important reason: It is too big to fail. Spain is the fourth largest economy in the Eurozone. If Spain goes down, so does the Eurozone. If the Spanish sovereign or major Spanish banks are forced to default, banks and other financial institutions in core Europe will also fail. Since this cannot be allowed to happen, the Spanish government enjoys a not insignificant amount of negotiating leverage.  

Prime Minister Rajoy certainly ruffled some feathers when he returned from signing onto the EU’s Fiscal Compact only to announce that the county wouldn’t meet its deficit targets. Rajoy might have shown bad manners, but he wasn’t wrong on the substance of his decision. If Rajoy can convince (or force) his European allies to provide assistance to Spain without demanding a never-ending austerity regime as the quid pro quo, he could yet save Europe.  

So what are the immediate problems facing Spain? They begin with a large and growing overhang of private sector debt that is approaching 300% of GDP. Like Ireland and the United States, Spain experienced a large real estate bubble. Households racked up large mortgage debts, while developers and construction firms borrowed heavily from Spanish banks. Real estate prices are now off 27% from the peak, but many analysts, like Willem Buiter of Citi, predict that prices have much further to fall, meaning that ever more borrowers will find themselves underwater on their mortgages. To make matters worse, Spain now has the developed world’s highest unemployment rate at 23%, while youth unemployment is, appallingly, over 50%. 

Many Spanish banks have not yet written off the losses on their existing non-performing loans and face further losses as real estate prices keep falling. The precarious state of the Spanish financial sector, particularly the cajas, or savings banks, which often have cozy relationships with regional and municipal governments, is perhaps the elephant in the room (or is it white elephant?) when it comes to rising Spanish sovereign bond yields. 

If too many Spanish banks need to be recapitalized by the Spanish government, the country’s currently manageable stock of sovereign debt could balloon to unsustainable levels. This is the Irish problem redux. When Ireland’s banks collapsed in 2008, the Irish government made the huge mistake of guaranteeing not just depositors, but all unsecured creditors. Because the balance sheets of Irish banks had grown to a multiple of Irish GDP, the ensuing bill was so large that the country was soon forced into an IMF program.  

This is a trap Spain must avoid. Not every Spanish bank is insolvent. But for the ones that are there will be political pressure to save favored regional institutions. Many of Spain’s regional governments have used the local savings banks as tools of their regional economic development strategies. By directing investment to state supported business sectors, they contributed to the misallocation of capital that sank too much money into too many unprofitable real estate and infrastructure projects. Many of these banks could now safely go away without unleashing a systemic financial crisis or hobbling local economies. Losses could then be borne by the people who made bad investments – the shareholders and unsecured creditors, rather than taxpayers.  

In this regard, the ECB’s LTRO has proven to be a mixed blessing. Though the cheap liquidity has been a lifesaver for many solvent but illiquid financial institutions, the lending facility has also provided cover for foreign investors to get out and move their money back to core Europe. Capital flight from Spanish (and other peripheral) banks only worsens Europe’s internal imbalances. Instead of moving towards an ever closer Europe, the continents’ financial institutions are becoming ever more bound to their nationality. 

So how can Spain save Europe (and itself)? One idea that has been floating around for a few months now has been to use the European Stability Mechanism (ESM, the rescue fund set to join the EFSF shortly) to recapitalize solvent Spanish banks. This is a good idea. A targeted use of ESM money would not exhaust the resources of the fund and it would take pressure off Spanish sovereign yields, which would be off the hook for all that contingent capital. 

Finally, the ECB is going to have to restart its Securities Market Program, under which it purchases sovereign debt in the secondary markets. On the one hand, 6% yields on Spanish sovereign debt are unsustainable. On the other, if the Eurozone is going to have any chance of fixing its internal imbalances, the periphery needs easier money and a lower exchange rate to boost its competitiveness. By the same token, higher inflation in Germany and the rest of the core would push up domestic wages and prices.  

The ECB has been loath to rely too much on this program because it fears moral hazard. This time around, the Spanish government should take a strong and public stand against self-defeating austerity measures, and insist that structural reforms are sufficient prerequisite for European support Spain’s labor market is much too rigid. Spain’s adjustment will occur that much faster if employees can be easily fired or forced to take big pay cuts. Young people will then start to enter the labor force and jobs will be created in newly competitive (read, non-real estate related) industries. It won’t be easy, but it does open up a path towards sustainable growth.  And growth is what markets really want. By standing up to the Austerians, Spain really could save Europe.

Ben Carliner is a fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. The original article can be found on Ben Carliner's blog.