Nothing’s working in Spain, especially not the Spanish. Unemployment has risen to the highest level in the developed world, at 25%. More than half the youth are jobless. The economy is in terrible shape, the government finances a shambles. Banks are failing, and fearful account holders are withdrawing money at an alarming rate.
There is worse to come. It doesn’t require top-notch prognostication to foresee a sovereign bailout in Spain’s near future. But a strange showdown is shaping up between the eurozone’s powers, which cannot and will not extend unconditional aid, and a country ravaged by austerity with little appetite for more. The consequences could reverberate far beyond Spain. “It’s a game of chicken,” says Nicholas Spiro, managing director of Spiro Sovereign Strategy, a London-based consultancy specializing in sovereign credit risk. “We’re in this perverse situation where the markets are becoming as concerned about the willingness to support Spain as they are about Spain’s willingness to request a program.”
A bailout for Spain would likely total about €300 billion. The eurozone’s central bankers, as well as some of the less charitable politicians in the region’s lending countries, say Spain must first request that money from the central bailout funds and agree to stringent conditions in return for support. Spain’s leaders say they cannot abide by any more tough measures and that efforts to repair the country’s finances already qualify it for aid. Spain is willing to accept sovereign assistance, but only if there are no conditions attached. It’s that dispute that is now defining the fight to save the currency. “My colleagues are aware that the battle for the euro will be fought in Spain,” Spanish finance minister Luis de Guindos told a German newspaper recently. “Spain is right now the breakwater for the eurozone.”
Spain’s intransigence is understandable. This summer, Spain’s leadership agreed to impose new taxes and cut spending on unemployment benefits, public sector jobs, wages and more in order to reduce the deficit by €65 billion—roughly 5% of the economy—by 2014. As yet, the restructuring has produced little fiscal or economic progress. “I can’t think of a government that has done more on the reform front, and it has almost nothing to show for it,” Spiro says. The banking system is laden with toxic debt and repossessed property, which Spain is soaking up through a €100-billion bank bailout. Austerity has deepened the recession, stricken the labour market and failed to sufficiently reduce the deficit.
Ultimately, Spain will buckle under the economic pressure and request a bailout. Brinkmanship aside, it has no leverage. The country’s most important economic region, Catalonia, has already asked for a rescue package from the federal government. To make things worse, the outlook for the eurozone as a whole is quickly deteriorating into an “event more akin to the Great Depression of the 1930s than to any business cycle we have seen in our lifetimes,” Carl Weinberg, chief economist at High Frequency Economics, said in a recent note. Such profound region-wide limitations make recovery for any member of the currency bloc all the more remote.
It is the bond market that will likely push Spain into becoming the fifth eurozone state to accept a bailout—after Ireland, Greece, Portugal and Cyprus. As fear for Spain’s economic health flared up in recent months, so did the country’s borrowing costs. European Central Bank president Mario Draghi delivered a much-needed note of optimism when he vowed to do “whatever it takes” to save the currency union. On those words alone, yields on Spanish 10-year government bonds backed down from the 7% threshold at which government finances are generally considered unsustainable. But nothing has fundamentally changed in Spain.
The importance of a Spanish bailout is less about the country than what it might portend for the rest of the eurozone. “It could cause increased concerns about the magnitude of the [region’s] problem,” says Craig Alexander, chief economist at TD Bank. The financial destruction that began in economically inconsequential Greece will have moved on to much bigger game. With GDP of €1.1 trillion—the fourth largest behind Germany, France and Italy—Spain is no peripheral economy, and its bailout would mark a significant escalation of the European debt crisis.
Investors could certainly take a bailout as cause for optimism, particularly in the immediate aftermath of the decision. Or they could panic over which country might be next. “If somebody is next, the next country would be Italy,” Alexander says—a G7 economy and the world’s third-largest issuer of government debt. It’s too big to save. The eurozone does not have the resources to bail out Italy. So the contagion must be stopped at Spain’s borders. A bailout will buy some time, but it will by no means end the crisis.