Why Spain Is Officially Europe's Biggest Crisis

Spain is up next in As The Euro Crisis Turns after it admitted that it can't afford to bail out its banks.


Spain has a problem. It's running out of money.

More precisely, it's running out of euros. It can't print them. It can't borrow them, except at ruinous rates. It's bailout or bust.

But first, a bit of background. Spain was, as Paul Krugman colorfully put it, the Florida of Europe. It had a prodigious housing bubble that has subsequently gone into reverse. But that's where the similarities end. Spain is on its own. Florida isn't. Remember, Florida doesn't pay for its social insurance spending or bank bailouts. The federal government does. Social Security checks keep coming and the FDIC keeps taking over failing banks regardless of the state of Florida's finances. Spain doesn't have that safety net. That's how you get 25 percent overall unemployment and over 50 percent youth unemployment.

The only question is whether Spain will go bankrupt now or later. It's looking much more like the former than the latter due to the spiraling cost of its bank bailouts.

Spain's big banks actually didn't get into too much trouble. It was its small banks -- the so-called cajas savings banks -- that threw fistfuls of euros at dubious real estate deals. And now they've reached the limit of how long they can pretend the problems don't exist.

Bankia is the poster child for these bad banks. It's the unholy progeny of seven troubled cajas thrown together. Not so shockingly, it turns out that it's just as easy to fall together as it is to fall separately. After getting a €4.5 billion capital injection from the government, Bankia recently revised its 2011 earnings down by a modest factor of 100 -- although we should cheer up, because it might be twice as bad. Now, Bankia needs at least another €19 billion to stay afloat.

That's roughly €19 billion more than the Spanish government can come up with right now. Over the weekend, the government admitted that its borrowing costs are too high for it to raise that much money in the bond market. But the government did suggest an eye-popping alternative. They proposed recapitalizing Bankia with €19 billion worth of Spanish bonds, that Bankia could then use as collateral at the ECB for new money. It that sounds suspiciously like asking the ECB to print money to bail out its banks, that's because it is.

This is a fairly frank admission that Spain is insolvent. The ECB has financed nations through the backdoor before -- Greece and Ireland come to mind -- but that's certainly not a club Spain wants to belong to. It's a reminder of how dire things really are in Spain.

There are two broad stories about the ways they are doomed -- though these are hardly the only ways. First, Spain is supposed to trim its budget deficit some 3.6 percent of GDP this year alone. That's an impossible task that will only push Spain further into depression, as their economy falls more than they save. And second, the ongoing collapse of its banking system is starving the private economy of credit. Small and medium-sized businesses can't get loans. It's the same dynamic Ben Bernanke famously observed in the U.S. during the Great Depression: As cajas fold into each other and shrink their balance sheets, they lose the local knowledge they need to make loans to smaller, riskier customers. A credit crunch follows, even if the economy recovers -- which it's not. That's how you get retail sales falling 9.8 percent from the previous year. Neither businesses nor customers have enough money to keep going on. It's a vicious circle down.

Only the government can stop a complete collapse. Except the euro stops the Spanish government from doing so. That leaves Europe to bail Spain out. The ECB isn't likely to go for not-so-stealth money-printing, so that means Germany and France will actually have to put money in their mostly imaginary bailout fund.* It will be enormously expensive.

But the only thing more expensive than bailing out Spain is not bailing out Spain. Of course, the people don't necessarily think about these counterfactual costs, which is why there's a real danger of a TARP-like political backlash once the full costs of the euro become clear.

One way or the other, the slow-motion trainwreck that is the euro crisis looks to be picking up speed. Time to buckle up.
* Update: As expected, the ECB has turned down Spain's request to use government bonds to recapitalize Bankia.