For Whom the Bell Tolls: Is Spain Too Big to Fail? Are We?

The following was in the New York Times on the day before Thanksgiving, 2010. It describes with stark clarity the vicious debt whirlpool that Spain is in the grips of. I wonder what Paul Krugman would say about this. I suppose that, someday, the United States could find itself in the grips of the same whirlpool. There comes a time in a nation’s history, when its debt gets too high, that bond purchasers simply conclude that it’s a bad risk:

[T]he yield spread between Spanish 10-year government bonds and those of Germany continued to widen on Wednesday — to as high as 2.59 percentage points, the biggest gap since the introduction of the euro. Spreads typically widen when investors perceive greater risk of not being repaid. The problem for Spain is one of “self-fulfilling expectations,” said Jordi Galí, director of the Center for Research in International Economics at Barcelona’s Pompeu Fabra university. “If investors expect Spain to have trouble refinancing its debt, now or somewhere down the road, then Spain will have trouble,” he added. “This is only aggravated by the fact that the reluctance of investors to purchase the country’s public debt leads to an increase in the interest rate it has to pay and thus in the budget deficit and the amount of debt it has to issue.”

And when you reach such a point with a skeptical bond market, what do you do then?

Well, you put on a happy face. In other words, you start lying:

The looming question is whether Spanish banks are really as healthy as the government and the banks say they are.

Could you say, with a straight face, that your country’s banks are healthy if they had $78 billion dollars in exposure to Portuguese debt? Spanish banks are in the unenviable position of being Portugal’s leading creditor, which looks itself to be next in line, after Ireland, for a bailout:

Spanish banks could suffer if Portugal’s financial problems worsen. Spain is not only Portugal’s biggest trade partner, it is also its biggest creditor, with Spanish banks holding $78 billion of Portuguese debt, according to the Bank for International Settlements. “Spain’s banks already have enough problems, but the exposure to Portugal could just turn into the wild cart which upturns the whole apple cart,” said Edward Hugh, an independent economist based in Barcelona. Ireland’s near collapse has revived concerns about Spanish banks, resulting in a plunge in their stock prices this week. Spain’s vulnerability would rise, warned Ralph Solveen, an economist covering Spain at Germany’s Commerzbank, should the government veer away from its deficit-cutting objectives or Spanish banks show further signs of fragility.

Isn’t it interesting that, in the above quote, deficit-cutting policy is good? Why is it good in Spain right now, but bad here in the United States (at least according to Paul Krugman)?

Hmm.

And, as we go forward, what’s the bottom line for the ripple effect of a Spanish bailout (should one occur)? Well, it appears that Spain is considered too big to fail, but it’s an open question whether the rest of Europe can afford to actually bail the country out (without stalling the economies of the whole continent). Here’s the New York Times again:

[A]ny bailout of Spain — with an economy twice the size of the other three [Greece, Ireland, and Portugal] combined — could severely stress the ability of Europe’s stronger countries to help the financially weaker ones, and spell deep trouble for the euro, Europe’s common currency. Even though Spain, like Ireland, has adopted an austerity plan to help it avoid the need for a bailout, it still could need aid if its banking system proves frailer than the government thinks it is, as was the case in Ireland. This troubling possibility has unnerved lenders, with Spain’s borrowing costs rising even though Madrid has cut its deficit and the country’s banks maintain they have sufficient strength to absorb their bad real estate loans. “Europe can afford the collapse of Ireland, even perhaps that of Portugal, but not that of Spain, so Spain’s ultimate line of defense is in fact this knowledge that it’s too big to fail and that it represents a systemic risk for the euro,” said Pablo Vázquez, an economist at the Fundación de Estudios de Economía Aplicada, a research institute here.

What makes those of us living in the United States think that our debt levels will continue to be considered tolerable to bond markets if Spain upends? And if a bailout of Spain stalls the whole of Europe, why wouldn’t it stall our rickety recovery as well? Do we imagine ourselves to be the global economy’s King Claudius (from Shakespeare’s Hamlet ), bearing free souls, and that what happens over there “touches us not”?

“No man is an island,” famously wrote John Donne. No nation is, either. And one of Donne’s other famous lines (from the same sonnet) may prove to be for us as well, and not just for Europe:

Ask not for whom the bell tolls. It tolls for thee.