Specter of Spain’s Demise Worries Europe

The solvability of Europe’s fourth economy threatens the entire eurozone.

After bailing out Greece and Ireland and undertaking an unprecedented rescue effort to save the single currency this spring, European leaders now fret over the fate of Spain which, as the bloc’s fourth largest economy, imperils the future of the eurozone as such.

The bailing out of Ireland with €85 billion in loan guarantees from the International Monetary Fund and its fellow European member states has temporarily laid to rest fears that its collapse could trigger debt crises throughout Southern Europe. But Portugal and Spain remained mired in recession and are unlikely to be able to restore balance to their budgets any time soon.

The eurozone would probably survive a financial rescue of Portugal which has only half the population of Ireland and an economy of comparable size — even if European Commission President José Barroso denied pressuring the country to request financial aid from Brussels today. Government spending has been on the rise for several years in the country but business, investment and trade freedoms are high. Portugal’s greatest impediment to growth may be its rigid labor market. Although unemployment hovers around 10 percent, reform of burdensome regulations on hiring and firing workers is unlikely to occur under Socialist Party rule.

The threat of sovereign default in Portugal could well affect neighboring Spain which is both Portugal’s largest trade partner and biggest creditor. Spanish banks hold some $78 billion of Portuguese debt.

A crisis in Spain, which has an economy twice the size of Greece, Ireland and Portugal combined, would severely test Europe’s ability to maintain economic stability and possibly threaten the future of the eurozone as we know it.

Spain has been mired in recession for many months with one out of five workers unemployed and a deficit that peaked at a little over 11 percent last year. The country’s socialist prime minister José Luis Rodríguez Zapatero has been trying to convince markets of Spain’s solvency but as the willingness of private banks to lend and invest remains limited, it is difficult to imagine Spain recovering soon. Zapatero has announced labor law and pension reforms but with trade unions marching against austerity and his own approval rating down to approximately 25 percent, he may not have the political capital anymore to push for necessary spending cuts.

Spain was hit hard by the crisis in 2007 after maintaining seemingly stable growth rates for over a decade. When Zapatero came to power in 2004 he was aware of the need of diversifying Spain’s economy. The preceding years of boom had been driven by a real estate bubble that was bound to burst eventually. The socialist government pledged to invest in renewable energies, bioengineering and infrastructure but six years later, it is still uttering those very promises. Meanwhile, as a result of the recession, Spain’s public finances are in a dismal state.

Following the example of many governments worldwide, Zapatero’s government attempted Keynesian stimulus which, after the meltdown in Greece this April, only added to mounting concern about the sustainability of deficit spending. Since 2008, Madrid hasn’t been able to solve an almost 10 percent gap on its budget. The public debt has since ballooned and Spain’s credit rating is under pressure.

Next year will see Spain’s fiscal strength tested when it is due to repay lenders €192 billion — about a fifth of its total debt. As a result of increased interest it would have to pay for new borrowing, the Spanish government expects to see a rise of 18 percent in the cost of financing its debt.

Unless Spain manages to rein in spending soon and restore investors’ confidence, interest payments on its debt will only continue to grow as a result of its budget woes up to a point where the country can no longer afford to borrow.

In a radio interview Friday the prime minister ruled out the possibility of accepting a European bailout. Instead, if worst comes to worst, his government may have to restructure its debt obligations, inflicting heavy losses on bondholders, many of whom are European banks. German chancellor Angela Merkel, whose taxpayers have very little enthusiasm left to help out other eurozone members in fiscal crisis, has already warned that in future bailouts, investors will have to share in the burden.