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Here We Go Again

The eurozone crisis is alive and well and living in Spain.

Apr 30, 2012, Vol. 17, No. 31 • By ANDREW STUTTAFORD
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Like just about everywhere else, Spain saw a massive construction and real estate boom in the 2000s. This was fueled by low interest rates that reflected conditions in the eurozone’s Franco-German core rather than Spanish reality, as well as the belief, cheer-led by Brussels, that the economies of the currency union’s members were converging when, particularly as compared with Germany, they were doing anything but. 

The bust that followed that boom took down a large chunk of the Spanish economy (unemployment stands at 23 percent, over 50 percent among the under-25s, a disaster exacerbated both by Spain’s sclerotic labor market and the malign impact of apothecary economics). There will be more misery to come. The IMF is forecasting that Spanish GDP will shrink by 1.8 percent in 2012. If Ireland is any precedent, and if the apothecaries have their way (the proposed deficit reduction amounts to a daunting 5.5 percent of GDP over this year and next), Spanish real estate prices could fall by another third. Should that happen, the country’s battered banks are (according to Open Europe, a mildly Euroskeptic think tank) likely to take a hit too large for cash-strapped Spain to cover by itself.

And the knife has further to twist. When the first LTRO was announced, French president Nicolas Sarkozy had a bright idea. Each state could sell its bonds to its newly flush banks. At first glance, such a trade would not only be patriotic, but profitable. The yield on debt issued by the eurozone’s struggling sovereign borrowers would comfortably exceed the bargain rate that the banks were paying to borrow from the ECB. And that’s the “carry trade” that Spain’s banks made. Indeed, in the view of Open Europe, Spanish banks have been the principal (“essentially the only”) buyers of Spanish government debt since December. But these banks are fragile and frighteningly reliant on ECB support (their borrowing from the central bank almost doubled between February and March). What would happen if their vulnerability to Spain’s mounting economic distress, not to speak of their specific exposure to Spain’s real estate nightmare, meant that those banks could no longer keep buying? How would Spain’s bills then be paid? After all, membership in a currency union means that Spain (unlike, say, the U.K.) can no longer print its own way out of a liquidity crunch. As the University of Leuven’s Paul De Grauwe pointed out last year, a “liquidity crisis, if strong enough, [could] force the Spanish government into default.” Indeed it could. Spain has already (and wisely) issued about half the debt it will need for 2012, but the rest?

Wait, there’s more. Spain’s borrowing costs are rising (yields on its 10-year bonds have been testing, and sometimes breaking, the toxic 6 percent barrier), to a level that may not be sustainable. That’s bad enough, but those higher yields also mean that the value of Spanish bonds bought by Spanish banks playing that Sarkozy carry trade will have been falling, with unpleasant implications for their beleaguered balance sheets at exactly the wrong time. If you are looking for a fine example of a vicious circle, this will do nicely.

Optimists will counter that the European Central Bank can again help out. And they are right. As an institution subject to relatively low levels of direct democratic control, it is better placed to ignore the concerns of northern voters than many eurozone institutions. Meanwhile the IMF’s managing director is in full telethon mode. Maybe the IMF/G20 meetings (underway in Washington, D.C., as I write) will see agreements to fund a firewall large enough to reassure. Maybe, maybe, maybe .  .  . 

Outside Spain, Portugal, and the carcass that was Greece, the theoretically praiseworthy reforms launched by the eurozone’s proconsul in Italy, the technocrat prime minister Mario Monti, are beginning to run into serious opposition. The country’s planned move to a balanced budget in 2013 has also been postponed by two years (for now). New spending cuts will add to the economy’s pain. Italy has revised its forecasts for 2012’s decline in GDP from 0.4 percent to 1.2 percent, but that’s a sunny projection when contrasted with the fall of 1.9 percent forecast by the IMF.

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