All eyes are on Greece, wondering whether its fractious political system can combine to affect enough austerity on its people to satisfy the European authorities, in exchange for a bailout. The smart money is on a second set of Greek elections in a few weeks’ time. Meanwhile France’s new President, François Hollande, will eyeball Germany’s Dr. Merkel, looking for signs that Europe will begin to put together a growth strategy he can sell to his supporters at home. The markets are taking a hammering as investors sell off their riskier European assets to get out of the way of a possible disorderly exit from the Eurozone by Greece, or a failure by the Spanish authorities to get their banking system back on track quickly.

While everyone worried about Ireland, Greece, Portugal, and to some extent, Italy, the real problems in the Eurozone have been the balance sheets of the very large banks within the core countries of France, Germany, and Spain. Spain’s banking system is huge, and now there are concerns about the solvency of the sector as a whole.

Last week, the Spanish government had to take a €4.5 billion stake in one private bank, Bankia, in addition to nationalizing BFA, a series of savings banks. The Spanish Prime Minister has been out and about re-assuring the markets that there is a plan to rescue the banking system. The markets are not impressed however and have just pushed Spain’s borrowing costs above just 6pc, closer to the threshold where a bailout by the European authorities (and perhaps the Troika) would seem like a good idea.

The parallels with Ireland are striking. Just like us, the Spanish had a credit boom financed mostly with external debt—meaning the balance sheets of their banks are now stuffed with potential bad debts as asset values collapse.  At the end of 2011, construction and real estate exposures in the Spanish banking system totaled €400 billion. To date, the Spanish government has ‘put aside’ about €120 billion to backstop any bank losses. (To give you a sense of scale, the total output of the Irish economy is €160 billion).

Just like us, Spain’s unemployment rate has soared. In March 2006, unemployment was 8.1 pc of the labour force. In March 2012 unemployment is 24.1 pc, Spain’s highest for nearly 20 years. The increase in unemployment will drive defaults in the mortgage market, depress any chance of growth, and may lead to large-scale social unrest and political turmoil. Youth unemployment is a key policy problem: right now more than half of workers under 25 years old are without jobs. There are no funds available to pursue demand expansion policies: Spain’s government is expected to run a budget shortfall of around 6.4 pc its economic output in 2012, missing the EU-imposed target of 5.3 pc. This means unemployment will continue to stay at dangerously high levels.

Spain is not like Ireland in one crucial respect: it is a huge economy, the 4rth largest in the Euro area, and responsible for more than 10pc of total EU output. That means the European authorities have to treat Spain’s case slightly differently than Ireland’s.

Let us say Spain’s banks, and Spain’s government, get shut out of the usual funding markets like Ireland did in 2010. Let us say that Spain applies for a programme of support in the same way Ireland did, but let us say Spain, having learned from Ireland’s example, attempts to restructure its private and public debt, in order to remain in the Eurozone and have some chance of growing its economy.

This means burning bondholders, kicking cans down the road in terms of sovereign debt, and more. None of this will be pretty, and all of it will add markedly to uncertainty about other countries and their prospects for growth, Ireland among them. Spain’s difficulties may mean Ireland, through no fault of its own, cannot re-enter the bond markets next year, and must apply for a second loan facility (or an extension of the one we’ve already got).

One the programme is agreed, the Troika policies we’ve seen in Ireland, of speedy fiscal adjustment, new taxes, lower government spending, banking restructuring, removal of structural impediments to growth like overly restrictive labour laws, and the management of other initiatives, will also apply to Spain. This set of policies will lead Spain into a deflation, and into a low-growth trajectory for the next few years, exactly as it has done in Ireland. The Spanish authorities know this. Ireland’s policy makers would do well to educate their Spanish counterparts on the Irish experience of the Troika.

If Spain were to attempt to burn its bank’s bondholders, it might get a more sympathetic hearing than Brian Lenihan got from Brussels and Frankfurt, but it might not. Don’t forget the Euro area leaders are looking not just at Spain, but also at Italy, Belgium, Portugal, and the rest. They may not allow a Euro area bank to burn its bondholders.

That would leave Spain’s leaders with an unenviable choice: stick with a series of measures so politically unpalatable that they will surely lead to widespread social unrest, or leave the Euro, establish its own currency once again, default on its debts, and try to keep going somehow.

The markets do not see a Spanish default and/or exit as pie in the sky: the cost of insuring Spanish debt has risen markedly in the last two weeks, leading some commentators to argue that Spain has never been so close to default. A Spanish exit and default might well mean the end of the Euro.

The impact of these events on Ireland would be momentous: we would surely be forced into another loan facility until the Spanish crisis had been stabilized, and we would have our friends from the Troika around for much longer than planned.

Published in the Irish Independent.


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