The worst nightmares are the ones you cannot wake up from. Just ask Spain. A year ago the cost of Spanish government borrowing soared as euro contagion spread from Greece, Ireland and Portugal. Panic seemed to subside with central-bank intervention and the promise of a new reforming government in Madrid. Since then Spain has, broadly, been as good as its word and Mariano Rajoy’s government has cut budgets, freed its labour market, played its part in countless “make-or-break” summits in Brussels and secured up to €100 billion ($121 billion) to prop up its banks. Yet despite all its efforts and pain, Spain cannot shake off that sense of doom. On July 25th the yield on ten-year bonds touched a euro-era record of 7.75%. Two-year bonds have climbed above 7%: investors fear that Spain must soon ask for a bail-out—or default.
Spain’s nightmare is a symptom of what is wrong with the entire euro zone. As the months drag on, the crisis is deepening. Europe’s leaders have asked the world to trust that they will do what it takes to save the euro. They have also pleaded for more time to sort out the mess. Their task is indeed immense, but as they disappear to their chateaux and beach villas, trust is draining away and time is not their friend.
The bull and the horns
Spain’s situation today is all the more shocking because only this month it had announced €65 billion of tax rises and spending cuts and won the funds for its bank rescue. This was meant to persuade investors that the whole euro zone is serious about keeping Spain. Yet the message was obliterated by news that the government now expects the recession to last into 2013 and, worse, that it will have to find the money to bail out regions which have suddenly confessed to being broke.
The prognosis for Spain is bleak (see article). The economy is in recession, the public sector is cutting spending and the private sector is reluctant to invest. This lack of domestic demand almost guarantees that Mr Rajoy will fail to meet the target to reduce the deficit. If that happens, Spain will be asked to impose yet more austerity. That will undermine his popularity, which has already fallen steeply since he was elected. Spain’s resolve will be further damaged by rows over budget cuts between Madrid and regional politicians, who control 40% of public spending—and who, even if they are from Mr Rajoy’s party, jealously guard their autonomy. Political uncertainty will feed back into the economy, which will only deteriorate more. And the vicious circle continues.
Spain cannot escape from this trap by itself. The government has admitted it does not have money to spare, and lenders are starting to doubt its solvency. A rescue of sorts can be cobbled together, with bond yields held down by some combination of the European Central Bank (ECB) and various rescue funds (even if the main one is still subject to a German constitutional court, whose judges are scandalously slow).
But that would only buy time. Perhaps not very much. Bail out Spain and immediately investors will rightly worry about Italy and whether the rescue funds are big enough. There are technical complications: new money from the rescue funds might count as senior debt, potentially leaving other creditors worse off. And political ones: the ECB cannot sustain huge intervention if Germany, its main shareholder, objects. Saving Spain will remain a short-term fix unless the euro zone genuinely unites around a plan that is economically sufficient and politically feasible.
Unite or die
Ultimately, as we have argued, a solution requires the currency’s members to draw on their combined strength by mutualising some debt and standing behind their big banks. But alongside greater federalism, Europe also needs to do something about growth. Moderating austerity programmes is a priority (Spain shows how self-defeating they can be), but so is pursuing the structural reforms to set entrepreneurs free. Since 1975 the countries now in the euro zone have given birth to just one company currently among the world’s 500 biggest (ironically it is from Spain: Inditex); by contrast California alone has created 26. Get rid of the mad rules that keep European business puny, and it could yet surprise everyone (see article).
That blueprint—greater federalism, a bail-out and pro-growth policies—would work, but it would take time. Even if the governments could today agree on what to do, haggling over the details, holding referendums and amending constitutions could easily take three years. The delay in even starting that process is only making a difficult task harder.
The trouble is that the 17 members of the euro zone, let alone their 333m citizens, cannot agree on who must sacrifice what to allow this new Europe to emerge. Germany, which this week was warned of a possible debt downgrade, is fearful that it is already being asked to pay too much. The Dutch and the Finns are also getting cross. France differs from Germany on what changes are needed in the way the EU is run (see Charlemagne). As for the debtors, in Greece voters are drifting from the centre to the political extremes. In Italy Mario Monti is the best prime minister in decades, but he is unelected, increasingly unpopular, and ever less able to see through the reforms his country needs. Instead, Silvio Berlusconi is contemplating a comeback—and he is outshone by an (intentional) comedian, who commands a fifth of the vote in polls.
The euro zone is stagnating (and dragging Britain down with it—see article). The crisis is engendering a combination of public-sector austerity and private-sector uncertainty. Investors hold back because they perceive some risk of a huge loss. Consumers save for the next rainy day. For as long as the catastrophic collapse of the euro zone remains a real possibility, it is hard to see that changing.
Perhaps the politicians will be shocked into action, by a euro-zone bank run, a chaotic Greek exit, or flight from Italian government debt. But Europe’s leaders will find it increasingly hard to drag their people along with them. This is the deeper lesson of Spain’s nightmare: delay is worsening the odds of the euro surviving.
The Economist, 27/07/2012