In post-modern Spain, where everything (including the term “financial crisis”) is relative, politics will be far more important than economics in determining whether the country avoids a Greek-style debt default.

 

European governments are hoping that a massive new €750 billion ($1 trillion) bailout fund will contain the sovereign debt crisis that started with Greece and now threatens to destabilize the euro currency. But the rescue package, which is on top of a separate €110 billion package to rescue Greece from bankruptcy, essentially transfers the burden of debt from one European country to another and does little to prevent profligate countries from reaccumulating unsustainable debt.

Not surprisingly, speculation is rife (here, here and here) that the new bailout plan is a short-term palliative, one that simply puts off a final day of reckoning. Indeed, many economists believe it’s only a matter of time before Europe’s debt contagion spreads across southern Europe and infects Portugal and Spain.

A debt crisis in Spain would make the problems in Greece look tame by comparison. At €1.3 trillion, the Spanish economy is more than four times the size of Greece’s. Spain is also the fourth-largest economy in the 16-nation euro zone, the eighth-largest in the OECD and the tenth-largest in the world. Many analysts believe Spain is simply too big to be bailed out, and that a Spanish default would almost certainly lead to the breakup of the euro zone.

Economists are divided over the question of whether Spain is dancing on the edge of the abyss, and Spanish politicians insist that Spain is not Greece. Spanish Prime Minister José Luis Rodríguez Zapatero, for example, recently dismissed speculation that the country would need a bailout as “complete madness.”

But the one thing that everyone does agree upon is that the Spanish economy, which is grappling with the fallout from the meltdown of its housing sector, a sharp drop in domestic consumption, a spike in unemployment, and a steep drop in tax revenues, is in deep trouble, and will remain so for many years to come.

Spain is mired in its worst recession in 60 years, and the Bank of Spain projects that GDP will shrink 0.3 percent this year, after falling nearly 4 percent in 2009. Spain’s jobless rate is stuck at 20 percent, almost twice the EU average. Meanwhile, Spain’s benchmark IBEX stock index is the euro zone’s worst performer this year after Greece.

Meanwhile, Spain’s debt to GDP ratio is expected to climb from 53.2 percent last year to 64.9 percent this year and 72.5 percent next year. But investors are particularly concerned about Spain’s gaping budget deficit, which at 11.3 percent of GDP is the third-largest in the euro zone, and which may exceed that of Greece this year, according to the European Commission.

In this context, the extra yield that investors demand to hold Spanish 10-year debt rather than German bunds, Europe’s benchmark securities, has surged to its highest level since the single currency was introduced 11 years ago. That spread, or difference, represents the extra interest cushion that investors demand to hold the Spanish bonds, which are perceived to be more risky.

Standard & Poor’s, the credit ratings agency, believes Spain is caught in a Catch-22 situation. If the government cuts public spending at the level needed to reduce the deficit, it will drag down economic growth and make it more difficult for Spain to emerge from recession. But if the government fails to reduce spending, the chances increase that Spain will default on its debts.  

After pondering Spain’s no-win situation, Standard & Poor’s on April 28 downgraded the country’s credit rating by one notch to AA from AA+, with a negative outlook. “Our conclusion is that challenging medium-term economic conditions will further pressure Spain’s public finances, and additional measures are likely to be needed to underpin the government’s fiscal consolidation strategy and planned program of structural reforms,” Standard & Poor’s said. “The negative outlook reflects the possibility of [another] downgrade if Spain’s fiscal position underperforms to a greater extent than we currently anticipate.”

The Spanish government currently has three main options for dealing with the looming debt crisis. The first option is for the government to do nothing, which would lead to certain debt default, sooner rather than later. The second option is for the government to take decisive but politically costly action to slash public spending in order to bring the deficit under control. The third option is for Spain to withdraw from the euro zone, which would permit a fiscal devaluation that would increase Spain’s competitiveness and allow the economy to grow.

Pressure has been building for Zapatero to pursue the second option. But critics say his government seems perfectly happy sticking with the first option. Barring a swift course correction, however, the third option may become the only one left for Spain.

Both supporters and critics of Zapatero have become frustrated by his now legendary reluctance to grasp the seriousness of the crisis facing his country. A disciple of postmodernism, he often uses rhetorical gymnastics to escape from reality. A full two years into the current crisis, for example, Zapatero asserted that the idea that Spain was actually in trouble was “opinionable.” In any case, he said, “pessimism does not create jobs.” He was finally badgered into verbalizing the word “crisis” in a late-night television interview, after a journalist read him the word’s dictionary definition.

Since then, Zapatero has worked assiduously to pin the blame for Spain’s economic problems on outside forces, going so far as to order Spain’s national intelligence agency to investigate an alleged ‘Anglo-Saxon’ conspiracy.

Under pressure from Germany and elsewhere to bolster confidence in Spanish bonds, Zapatero recently announced an emergency austerity plan designed to cut state spending. He has pledged to reduce the deficit to within the EU limit of 3 percent of GDP by 2013, from 11.3 percent today.

But the prospect of draconian cuts in government spending will not sit well with most Spanish voters, who view cradle-to-grave social benefits as inalienable rights. As a result, most observers doubt that Zapatero, whose 2008 campaign promises alone added up to more than two percent of Spain’s GDP, will cut government spending by enough to reduce the deficit in any meaningful way, especially since 2012 is an election year.

In recent weeks, there have been rumblings of discontent, and a small but growing number of voices are calling for Zapatero to be replaced. But short of a mutiny within the ranks of his Socialist Party, Zapatero is likely to serve out the remaining two years of his term. If he does, it raises the chances that Spain will, in fact, become the next Greece.

 

Soeren Kern is Senior Fellow for Transatlantic Relations at the Madrid-based Grupo de Estudios Estratégicos / Strategic Studies Group