Spain's Game of Chicken

Here's a pro tip: You can't bail anyone out if you don't have any money.

This isn't exactly breaking news, but it is a problem for Spain. Their government is running out of money, and so are their banks. This is normally the time to go to Germany for a sovereign bailout. But Spain has understandably resisted. They're terrified of fully surrendering fiscal sovereignty like Greece, Ireland, and Portugal. An even deeper depression would beckon.

So, instead, we get a game of chicken.

Let's step back a minute. Spain has a trio of problems. First, it has a frightening unemployment problem that's created a deficit crisis, due to its housing bust. Second, its banks have a bad loan problem, again due to its housing bust. And third, it has a capital flight problem. Depositors are moving their money out of Spanish banks into German banks -- some €100 billion or so in the first quarter of 2012 alone -- due to fears that Spain might devalue and abandon the common currency.

The chart below from the Institute of Empirical Research at the University of Osnabrück (via FT Alphaville) basically shows how much each euro zone member owes or is owed by the ECB. It's a good proxy for how much capital flight there's been from each euro zone country. Spain (purple) is the worst, just edging out Italy.


Spain's banks are dead. Their assets and deposit bases are both evaporating. But the government can't afford to bail them out.

Here's how the game of chicken works. Germany wants Spain to formally accept a bailout package. It would be just on the edge of affordable for Germany right now, but it would give Germany control of Spain's budget. Not so surprisingly, this doesn't sound like a good deal to Spain. So instead, Spain has more or less asked the ECB to print some money and give it to their banks. There is precedent for this: It's basically what the ECB has done with some Greek and Irish banks -- although that was after those countries had already accepted bailout programs. The ECB doesn't want to do this as a substitute for an outright bailout, so it has said no. Hence, the standoff.

Spain has another problem. They don't have much leverage. They can threaten to blow up the euro, but it's not that credible a threat. Even if Spain defaulted on all of its debt, it would still have a budget deficit of 6 percent of GDP. It would have to cut spending or raise taxes by roughly that much -- or print the difference. In other words, a disaster. At best, Spain can hope to wrest a few concessions from Germany before accepting a bailout -- like giving it more time to cut its deficit.

Italy should be paying attention. Like Spain, their banks are in trouble. But unlike Spain, Italy has a primary surplus -- that is, its budget minus its interest payments is in the black. A euro zone exit would still be a disaster, but it would be a manageable disaster. As crazy as it sounds, ex-Prime Minister Silvio Berlusconi is right: Italy should consider chucking the common currency if the ECB doesn't start printing money.

Things couldn't get much more upside-down now in Europe.