Every time the leaders of the beleaguered euro zone come together to make a decision aimed at quelling its debt crisis, the boost in confidence for the common currency’s future becomes shorter-lived. The latest step — a European Union–backed bailout of Spain’s weakened banks of up to 100 billion euros ($125 billion), announced on Saturday — was, as usual, hailed as another landmark toward ensuring the survival of the 17-nation monetary union.
E.U. Commissioner Olli Rehn called the bailout “a very clear signal to the market, to the public that the euro area is ready to take decisive action in order to calm down market turbulence.” But the decision barely registered on the sentiment meter. By Monday afternoon, the yields on Spanish bonds — a measure of how risky investors perceive them to be — were again on the rise. By Tuesday, they were spiking toward 7%, the level at which other euro-zone countries were forced to seek a rescue, putting more pressure on the government in Madrid.
What went wrong? The usual charge — that Europe’s leaders responded too feebly — can’t necessarily be leveled this time. The promised funds for Spain’s banks exceed some estimates of what the sector might actually require in new capital. In a recent report, the International Monetary Fund, which called the Spanish banking crisis “unprecedented in its modern history,” estimated that the banks will require some $46 billion in fresh capital. But the problem starts with how the bailout will be implemented. Rather than inject money from the euro zone’s bailout fund directly into Spanish banks, the E.U. rescue will take the form of loans funneled through Spain’s government bank-repair vehicle, called the Fund for Orderly Bank Restructuring, or Frob, which will then use that financing to recapitalize the banks. That means the Spanish government will ultimately be on the hook for paying the bailout loans back.
And that’s exactly what investors have been worried about — that Spain’s government will in the end bear the burden of fixing the banks, worsening its own financial position. The bank bailout will only further increase the government’s debt, heightening concerns among investors about the health of the country’s finances, and making them more reluctant to hold Spanish government debt. That, in turn, will make it harder for Spain to finance itself at affordable interest rates. In other words, the bank bailout may only make another bailout of the Spanish government more likely. This shift of private-sector banking problem to public-sector debt problem is what landed Ireland in a bailout situation. Add in Spain’s incredibly weak economic position — the country is still in recession — and Spain looks that much more vulnerable. Here’s what research firm Capital Economics had to say:
The poor economic outlook will also maintain concerns that Spain will at some point require a Government bail-out, too. Although Spain’s public debt to GDP ratio is relatively low at around 70%, the banking package will raise it by around 10%. Meanwhile, weak economic growth will continue to hamper efforts to bring the deficit down. Against this background, Spain’s fiscal position may soon look rather less favourable relative to the other bail-out recipients … Overall, then, the banking support package may help to insulate Spain from the problems elsewhere in the eurozone, at least for a while. But we suspect that Spain will still need substantial further support.
The other problem is that the proposed bank bailout hasn’t alleviated concerns about the course of the Spanish economy overall. Yes, the banks need to get fixed if the economy is to grow again. Healthy banks would improve confidence in the economy and get lending going again. That, however, can’t happen in a vacuum. Simply tossing bailout money at Spain’s banks isn’t sufficient to turn around the Spanish economy. The country’s other difficulties are not being addressed. The bank bailout, in other words, has to be part of a greater program.
That program should include further structural reform within Spain to break down the many barriers to growth. For example, more labor-market liberalization is crucial if Madrid is to reduce the country’s staggering 24% unemployment rate. The euro zone must do more than provide bailout money, as well. There is talk of forming an E.U.-wide banking union, with some sort of regional oversight of European banks. That would help tackle the debt crisis, but it is still not sufficient to repair the euro zone’s weakest economies. What Spain really needs from the rest of Europe is a plan to spur continent-wide growth. But despite the revolt against austerity, marked by the election of François Hollande to the French presidency and the rise of radical parties in the Greek parliamentary elections in May, no significant steps have been taken to alter that misguided approach to the debt crisis.
The bottom line is that Spain has to break out of its death spiral before it can restore confidence in its economy and government, no matter how much bailout money might be tossed at it. As long as the Spanish economy continues to be mired in joblessness and recession, pressure on the banks will persist. In a contracting economy, bankruptcies will likely only increase, while property prices will fall further, widening the hole in the banks’ balance sheets. The fact is, we don’t know where the bottom for Spain is.
Worse still, the intensifying crisis in Spain is just one piece of bad news for the euro. Fears remain that new elections in Greece on Sunday will usher into office a government opposed to the terms of its E.U. bailout, possibly forcing the country out of the monetary union. And in Italy, Prime Minister Mario Monti’s honeymoon has come to an end. His much-needed labor reform has stalled in Parliament, even though his original proposals got watered down, and his approval ratings are starting to slip as the economy contracts. As a result, Italy’s borrowing costs, which dove after Monti’s arrival in November, are back on the rise as well.
There are scary times for the euro, times that demand a broader, more comprehensive approach to reform and renewal. Until the leaders of Europe come to realize that — and do something about it — the euro will remain under threat.