Spanish downgrade signals weakness of eurozone governance

The latest big casualty of the ever-escalating eurozone crisis revealed itself this week to be Spain. The fourth largest of the eurozone economies, Spain’s troubles show another facet of the crisis, not caused not by the careless governments allowing irresponsible deficits, but by a housing bubble fuelled by the borrowing of ordinary Spaniards.

Until the beginning of the 2008 financial crisis, the Spanish government meticulously balanced their budget with neither debt nor surplus year after year. Upon Spanish accession to the Euro in 1999, the Spanish government was careful to resist the cheaper borrowing opportunities facilitated by the lower interest rates dictated by the single currency.Whilst other traditionally high inflation countries, like Portugal, Italy and Greece, financed their spending through cheap debt, Spain maintained its fiscal discipline. In contrast to the Greek chapter of the crisis, the central Spanish government seems relatively blameless. Any increases in government debt have been attributed to regional projects, overseen by the local authorities or “autonomous communities” financing local regional airports, arts centres and other costly projects in isolation from examining the local demand and national interests.

Neither could lower borrowing costs be resisted by many Spanish citizens, given easier access to cheaper credit and mortgages. Overtime the low, centrally determined interest rate fuelled a housing bubble, as banks lent to the construction sector and citizens. Between 2004 and 2008, house prices in Spain increased by over 40 percent until eventually the financial crisis hit, with prices falling by 25 percent since then. The subsequent collapse of the construction sector left the banks heavily indebted as the financial crisis hit. Similarly, the gradual fall in house prices has reduced the value of assets that can be repossessed by banks in the event of default by ordinary consumers. Add to this the large number of rapidly depreciating Spanish government bonds held by the banks, and the magnitude of their dilemma becomes clear.

It is widely doubted that the Spanish government could raise the capital to finance such a bailout, estimated by Fitch to be around €60-100bn. Despite the relatively low level of government debt held, the falling prices of bonds and domestic economic conditions would make such a task very difficult indeed. Spain’s domestic unemployment rate has nearly trebled over the last four years, reaching 24.3 percent, resulting in the highest rate in the eurozone surpassing even Greece, and doubling the eurozone average. Over half of under 25s are currently unemployed. Recent admission that Spain’s economy has once more tipped into recession has left many believing such figures are set to worsen, further increasing budget obligations. Though the eurozone governance framework gives no role for the European Central Bank to act as lender of last resort and give out bailouts, the crisis has necessitated a rethink of the rules. With Greece struggling to raise required funds, especially since having their ratings slashed three points to simply one above junk bond status, a payout from the EU looks to be the only option. Opinions remain divided as to how such a transfer should be allocated, with many countries willing to change the rules to accommodate the Spanish banks’ request and transfer straight to them, whilst others, such as Germany, believe the EU should deal exclusively with government assistance, as has always been the case.

If the previous events in the Eurozone crisis have showed us anything, it is the importance of a united response to such threats. With the hazard of contagion looming large, it is not an option to allow the Spanish banks to fail – the economic governance framework that made the eurozone so prosperous before the crisis has shown itself to be lacking in hard times, and changing such rules may be the best solution. Spain’s troubles have shown that it is not only indiscipline in government budgetary control that has led to problems in the Eurozone, but the availability of lower cost credit to ordinary consumers – the centrally set interest rate that covers such a diverse and large collection of independent sovereign states. The eurozone is looking shakier than ever, with Spanish bailout calls simply one of many examples of the weakness of its governance.