Spain's Twin Crises
Spain is special. Every European country these days seems to have its financial crisis. Spain has two.
One crisis stems from the by-now-commonplace mismanagement of the nation’s finances. The other stems from a collapsed real-estate bubble and all the financial strain that can cause. Having bled into each other, these crises have imposed financial burdens on Madrid far beyond anything it can deal with on its own. The strains are so severe, in fact, that not even the committed resources of the entire euro zone are sufficient to handle them, not alongside the other demands of Europe’s so-called periphery. Making matters worse, markets, noting the untenable nature of Spain’s problems, have refused to lend unless Madrid pays impossibly high rates for credit. The only relief available has come from the European Central Bank (ECB). But at base, even that is insufficient. The best the ECB can do is buy Spain time for more fundamental fiscal, financial and economic reform.
The first aspect of Spain’s crisis looks, in its essentials, much like the rest of Europe’s periphery. Madrid has long overcommitted the state’s financial resources so that the nation, despite high rates of taxation, has run ever-larger budget deficits. The red ink flowed even in the best of times. But in the wake of the global recession of 2008–2009, shortfalls in revenues and greater demands for government assistance have widened the budget gap to shocking proportions. Last year, the budget gap averaged €109 billion, an impossible 9.4 percent of the country’s gross domestic product (GDP). The run of deficits has accumulated to an immense debt overhang, verging on 80 percent of GDP. Meanwhile, the understandable reaction among lenders has driven up Madrid’s longer-term borrowing costs to near a 6 percent rate, compared with just over 2 percent, for instance, for Germany. With so much debt outstanding, the rising borrowing rate has pushed debt-service costs up over 10 percent of annual government outlays or almost 3 percent of GDP.
In addition to all these strains, Spain now also faces a second banking crisis connected to the collapse of its real-estate markets. This kind of pressure is surely familiar to all Americans. Much like the United States, earlier in this century Spain enjoyed a housing boom. Though the country avoided subprime, its banks still lent freely—too freely—causing an unsustainable surge in real-estate prices that prompted still more aggressive buying and still more reckless lending. The resulting bubble surely would have burst on its own, but the global recession has hurried the process along.
Now Spanish banks face a huge overhang of bad loans, approaching 10 percent of their total lending, the highest level since the country began collecting statistics in 1962. Depositors, aware of the danger, have begun to withdraw their funds, compounding the banks’ problems and imposing on them a desperate need for new capital just to keep their doors open.
The threat to the Spanish economy cannot be overestimated. Spain, under pressure from the global economic slowdown and its fiscal crisis, was in recession even before the banking crisis broke. Unemployment has reached an astronomical 23 percent of the nation’s workforce. Youth unemployment has risen over 53 percent. Against such a backdrop, Spain dare not allow any bank to fail. The collapse of even a middle-sized financial institution could prompt a general flight of deposits, a proverbial run on the banks. Combined with an intense reluctance among international lenders, even a relatively minor failure could create a cascade of bank failures. To avoid such a catastrophe, the government, understandably, has decided to stand behind the nation’s banks, effectively, if not literally, making their debts its own and so adding them to the government’s already severe fiscal imbalance.
Spain needed outside help with its financial problems even before adding the banks’ bad loans. The euro zone’s Stability Mechanism is simply unable to cover all this debt, especially since other nations in the periphery also need help and fewer member nations have financial resources to spare. The only viable source of immediate help is the ECB. Through its president, Mario Draghi, the central bank has offered its immense financial resources, promising to supplement private lending to Madrid by buying enough Spanish bonds in secondary markets to contain the rise in lending rates. But even this massive and welcome relief cannot meet Madrid’s needs.
Full recovery can only come from a restoration of sufficient confidence among investors, international lenders and depositors to bring down borrowing costs to manageable levels. Spain will only do that when it demonstrates that it can 1) narrow its budget gap and put its public finances on a sustainable path; 2) support economic growth to produce enough real wealth to repay its debts; and 3) show that it has implemented sufficient financial reforms to guard its banking sector against future profligate behavior.