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A World of Trouble if the Spanish Banking Crisis Spreads

Until flaws in the euro are addressed, the crisis is likely to simmer on.

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Spain's banks are in a world of trouble, as you've undoubtedly heard. They are strained by loans made over the course of a a building boom that went bust in 2008, two recessions in the last three years, and the highest unemployment rate among developed nations. Misguided austerity policies have only made things worse. Everybody is biting their fingernails, trying to figure out if the bailout Brussels recently concocted will work. Stocks are reacting in an up and down roller-coaster ride. Depositors are taking their money out of banks in the most vulnerable countries. The biggest fear is that if the bailout fails, the contagion will spread even further into Europe's core and eventually to the shores of the US itself.

That fear is justified.

The 100 billion euro proposed recapitalization for Spanish banks is not a small number. It would be like a $1.6 trillion capital injection into the U.S. banks if it was projected onto the scale of the U.S. economy. That is greater than everything that was done by the Fed and the Treasury to shore up the capital of U.S. financial institutions during the Great Crisis. Nonetheless, I judge that compared to the size of Spain’s non-financial private debt and the size of its bank run, this is a mere bandaid. And remember, even during the darkest days of the Great Recession of 2008/'09, the U.S. did not have a bank run.

Even though Spain's authorities have trumpeted the fact that the "assistance" (as Madrid's leaders laughingly keep calling their bailout) comes without conditions, it is worth recalling that the Spanish government is in the midst of a huge fiscal retrenchment over the next year. They are trying to take government spending as a percentage of GDP from a deficit to GDP ratio of 8.9 percent in 2011 to under 3 percent in 2013 at a time that GDP is forecast to decline by a further 1.7 percent. That's a bad thing. Econ 101 says that when you take spending power from the economy, a crisis is almost certain to worsen.

Like Ireland, Spain has faced declining real estate values as a result of the housing bust, and these declines are closely connected to banking losses due to things like foreclosure and bad loans. The key difference between Ireland and Spain is that Ireland has now experienced three years of wrenching austerity. In the case of Dublin, there is some degree of confidence that real estate prices have bottomed out. As Yanis Varoufakis notes, at least this gives the Irish some clarity, despite a poor outlook. Not so in Spain:

In Spain, by contrast, the downward dynamic of real estate prices is nowhere near a resting point. Some say that real estate has another 40% to lose before it reaches equilibrium. Which means that the banks’ black holes may be much larger than it seems.

What Spain teaches us is that the crisis of the euro is spreading into Europe's largest economies. Last month, the Spanish Prime Minister was denying there was a bank crisis in his country. The Greeks said much the same thing over a year ago. Likewise, the Irish authorities promised an end to that country's problems -- before they sold their people down the river to the austerity hawks now running economic policy in Brussels, particularly the Germans. The Germans, you see, didn't want to force losses on private unsecured bank bond holders, which included German pension and insurance funds.

So today we have yet anther leader, Spanish Prime Minister Rajoy, who is telling his country that the crisis is "resolved" and the euro's credibility restored. It's like a broken record. Given the response of the markets, these assurances are clearly running a bit thin.

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