I have to be honest with you, before the global financial crisis, I knew very little about Spain. I knew the name of its capital city, and that it was densely populated, and also that it had quite a creative film industry… but that’s about it. Now, from an international macroeconomic perspective, it’s arguably the most important country in the world - and potentially the next domino to fall in the European debt crisis.
Last week saw the country make front page news again with mass demonstrations in the streets. Spaniards are unhappy. The government’s taken the axe to public spending, and the country’s people are crying out in economic pain. The Spanish government has been forced to tighten its belt because the country has run out of money. That in itself would not be a huge problem, but it also follows the demise of Greece’s economy, and the realisation that all of these countries (Greece, Spain, Italy, France and Germany) are all connected by the euro. If one domino falls, it’s very hard for the rest not to fall also.
Despite having stayed in the euro and continued on as a going concern, make no mistake, Greece has gone bust. The Troika (IMF, ECB, European Commission) is keeping it on life support, but that’s all that’s keeping it alive. Greece is the first domino and it has fallen. Fortunately, Greece is not that large (from an economic perspective) - roughly the size of Victoria. So its potential knock-on effect may not be as powerful as another, bigger country. Spain, on the other hand, is the euro zone’s fourth largest economy. If it fell over, Italy, France and Germany would almost certainly follow.
The European Central Bank knows this, so the president, Mario Draghi, announced a few weeks back that the ECB was going to provide a back-stop (or a circuit breaker) for this threat that more dominos would fall. It announced it would buy up the debt of any struggling euro zone country to keep it afloat. Its only caveat was that the country asking for the bond market assistance would first need to formally request a bailout, which would involve drawing money down from that bloody big sovereign fund called the European Stability Mechanism. That all seems fine, right? The problem, as Spain sees it, is that there’s no such thing as a free lunch. That bailout money comes with a lot of strings attached.
For a start, Spain would effectively be under administration. That would not only be humiliating for the country’s leader, Mariano Rajoy, but it would mean handing over more budget controls to a third party. Mr Rajoy faces an unenviable choice: force budget cuts of his own (making him more unpopular) and hope it’s enough to earn some bailout money; or formally request a bailout with the further austerity measures that are likely to come with that (and become even more unpopular). One path (requesting a bailout) is arguably more financially secure than the other option, but neither are comfortable decisions. At this point it’s unclear as to exactly which path the country will go down in the longer term.
Spaniards took to the streets in protest as recently as last Thursday. That was after the government handed down its budget. Mariano Rajoy didn’t mess around. He found 40 billion euros in savings. As part of the cuts, each government department will scale back operations by as much as 9 per cent. The government has frozen public sector pay for another year and the retirement age has been extended out. Some Spainiards have not received a pay packet since the middle of 2011. They’ve gone back to living with their parents or have accepted a one income family lifestyle. Unemployment has climbed to around 25 per cent and the economy is still contracting. More and more Spaniards are moving into poverty. With an economic backdrop like that, Mariano Rajoy is betting that it would be worse under official administration so is going it alone (formulating his own austerity package) for the time being.
It’s not just his constituents that Mariano Rajoy has to battle though. The financial markets are arguably an even more formidable force. Sure protesting in the streets can make a government feel uncomfortable (if not unpopular), but the market can send a country bankrupt. The market was already doing this before the ECB stepped in with its unlimited bond purchasing policy announcement. Ten year government bond yields climbed to around 7 per cent (unsustainably high). Now, the situation is more dramatic. Despite the ECB making that announcement, the ten year bond yields have continued to climb. Now you could argue shorter term bond yields (the yields the ECB is more concerned about) are a more important measure and have stabilised, but as it stands any upwards pressure on the cost of debt (wherever that falls on the yield curve) is still politically unpalatable. Analysts will argue it’s not fair to make any comparisons because the ECB hasn’t yet even been given the opportunity to make good on its word, but I would argue even the threat of coming into the bond market should scare the bond vigilantes sufficiently to give countries like Spain some breathing room to sort out its finances.
The fact is that Spain is in serious financial distress. Its banking system has already received a bailout from its European neighbours. After the latest report on its financial system (just last Friday), it’s been determined that it’ll need another 52 billion euros to stay functional. The government is also making the country weaker in a time it needs to be stronger. That strength could come in the form of a rescue, or bailout, but at the moment that’s creating considerable social and political unrest. Put simply, the country’s in crisis. As in all crises, something will need to change, or the system will collapse. At this point, it’s unclear as to what will eventuate.
The big question, for my mind, is who will determine how this crisis evolves? Will it be the bond market, forcing the ECB into more drastic and unsustainable policy measures by driving down bond prices? Or will it be the Spaniards, Germans and Italians who have been thrown into poverty by the economic crisis, thereby creating a social and political nightmare?
One thing you can be sure of is that more dominos are likely to fall.
David Taylor
