A Crisis in Full Flight

MUNICH – For a while, it looked as if the European Central Bank’s €1 trillion credit program to pump liquidity into Europe’s banking system had calmed global financial markets. But now interest rates for Italian and Spanish government bonds are on the rise again, closing in on about 6%.

Of course, this may not be the breaking point beyond which the debt burden becomes unsustainable. After all, interest rates in Southern Europe were well above 10% in the decade before the euro was introduced. Even Germany at that time had to pay bondholders more than 6%. Nevertheless, the markets are clearly signaling growing doubt about whether Spain and Italy will be willing to bear their debt burden.

The main problem is Spain, where private and public-sector foreign debt is larger than that of Greece, Portugal, Ireland, and Italy combined, and, as in Greece, is in the neighborhood of 100% of GDP (93% to be precise). A quarter of the labor force and half of Spain’s youth are unemployed, reflecting the country’s loss of competitiveness in the wake of the real-estate bubble inflated by cheap euro credit in the pre-crisis period. The current-account deficit remains at 3.5% of GDP, despite the recession-induced decline in imports, while economic contraction will cause Spain to miss its budget-deficit target again.

Moreover, Spain’s debt with the ECB’s TARGET settlement system rose by €55 billion ($72 billion) between February and March, because capital outflows of that amount had to be compensated. Since July 2011, Spain’s TARGET debt has grown by €199 billion. Capital is in full flight, more than offsetting the inflows from 2008-2010. The cumulative total since the beginning of the first crisis year (2008) means that Spain has financed its entire current-account deficit via the printing press.