Spain – the next big problem for the eurozone

Forget Greece, the eurozone's major fault line has always been Spain. And things there could soon be coming to a head. John Stepek explains why, and looks at what might happen next.

It's not often that I feel sympathy for a politician.

But you have to feel for Spain's prime minister, Mariano Rajoy. Three months into his government, and he's facing a general strike from the unions on the one hand, and a potential buyers' strike from investors on the other.

The unions are striking because they're fed up with economic reform that might reduce their power. Investors are threatening to stop buying Spanish government debt because they want even more reform.

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What's a prime minister to do? And more importantly, what does his dilemma mean for you?

Spain more so than Italy has always been the major fault-line in the eurozone.

Sure, Greece causes a lot of noise and commotion. There was always the chance that Greece would throw a hissy fit and pull out of the euro unilaterally. Better-behaved small countries like Portugal and Ireland barely warrant a mention in the papers these days.

Even so, people always knew that in terms of size, Greece by itself didn't matter. It was the knock-on impact that everyone worried about. The big fear was always that the market would say to itself, "If Greece can go bust, maybe it will be someone who matters next time."

So the point of all the bail-out packages wasn't so much to save the smaller countries. It was to prevent fears about the small countries from spreading to the "too big to fail" ones.

For a short while, it seemed as if the European Central Bank's LTRO (Long-Term Refinancing Operation) had done the job on that score. Now it's starting to look as though that was over-optimistic.

Investors are fretting about Spain again. The government's cost of borrowing over ten years has risen by around 0.5 percentage points since the start of this month.

The trouble is, Spain missed its 2011 budget deficit target (in other words, it ended up overspending by even more than expected). As a result, it set itself a softer target for 2012.

Markets don't like to see this sort of target slippage. For now, they don't care so much when it's the US or the UK. Those countries have their own currencies and central banks who are prepared to print as much money as it takes to pay off their creditors.

Europe isn't prepared to do that (although it might be getting closer to doing so). And as private investors in Greek debt have discovered to their cost, there's no guarantee that a eurozone country with problems will make good on its debts. So naturally, investors are warier of European government debt than perhaps they once were.

Spain's big problems debt and unemployment

Spain's big problem is private sector debt, which might end up on the government's balance sheet. Spain had a massive property bubble. The fall-out from that bubble continues. Prices haven't been allowed to fall as far as they really need to. And that means no one can be sure just how much bad debt is still sitting on the banks' books.

As we've been experiencing in the UK for a while, when banks don't know just how bad a state their balance sheets are in, they stop lending. That makes it even harder to dig an economy out of trouble.

Spain also has the usual European problem of overly restrictive labour laws that discourage hiring. This is something the government is trying to tackle. The general strike today is partly about an overhaul of labour rules. A new bill passed in February makes it easier to cut wages, reduces the power of the unions, and could cut the cost of firing staff.

Given that unemployment is standing at 23%, and an incredible 50% among young people, you have to wonder who's left to go on strike. As one Spanish political communications professor tells Bloomberg, the unions "have a lot at stake as Spanish society is very much questioning their role [They] don't represent the unemployed".

This is one of the rarely-appreciated benefits of having a hard currency' like the euro. When it's harder to take the easy way out (allowing your currency to weaken) then sometimes you are forced to take genuinely tough measures to change the way your economy works.

Of course, the trouble is that it takes a strong government to cope with the resulting social upheaval. And if your economy is in such a deep hole that people don't get to see the benefits of reforms, only the pain, then it's even harder to push reform through.

So what happens next?

Spain can't be allowed to go bust. And it won't be. We're going to see the usual back and forth about bail-out funds and arguing between the Germans and the rest of Europe. But the most likely outcome still seems to be some form of European quantitative easing. The ECB has already taken a pretty big step in that direction with the LTRO.

But what does all this mean? The short answer is that the future for Europe holds continued loose monetary policy, and a banking system in many countries that's largely reluctant to lend.

That sounds grim. But one economy will benefit in the short term at least. Europe got into this mess in the first place because ten or so years ago, monetary policy was right for a weak German economy. But it was too loose for the likes of Ireland, Spain and Greece.

Now it's the other way around. A strong Germany could do with higher rates, but the ECB needs to prop up the periphery. So we're seeing talk of a German property bubble German house prices have been rising since 2009, after being moribund for years.

What do booming house prices tend to lead to? Rising consumer spending. German retailers saw like-for-like sales beat their expectations in March, according to this morning's German retail sector data from Markit. We'll be looking at the best way to play the return of the German consumer in a future issue of MoneyWeek magazine.

Meanwhile, in the latest issue of MoneyWeek (out tomorrow - if you would like to become a subscriber, you can subscribe to MoneyWeek magazine), James Ferguson explains why the euro's woes are just one reason why the US dollar is set for a massive rally in the months and even years ahead.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.