The euro boat springs serious leaks

The escalation of the Spanish and Italian risk premiums (Spain's hit a high of 407 basis points on Wednesday before stabilizing at 380) has placed both countries in a situation of emergency. The political alarm set off by the financial markets' scourging led to consultations between Prime Minister Zapatero and the opposition parties to consider possible responses to the deterioration of Spanish solvency and to dispel fears about a possible bailout of Spain, which Brussels denied. The markets' chastisement of the Spanish and Italian debt endangers the survival of the euro zone, which is practically without a roof, as it does not yet possess the political mechanisms necessary to control speculation against the national debt.

The diagnosis is there, but the EU has yet to resolve the underlying problem of the Greek crisis, or to offer an image of centralized economic control. Meanwhile, Spain and Italy are still trapped in the quagmire that results from a drastic plan of fiscal adjustment: the deeper the cutbacks, the sharper the drop in growth expectations. Investors consider that without growth, there can be only slender return on financing received. So the cost of financing increases, which in turn further restricts the already shrunken economic activity. And so on, until bailout is inevitable.

August is going to be hard on Spain and Italy. The investors are unimpressed by the early elections, these being a marginal factor compared with the low growth rate (barely 0.7 percent), the stagnation of the world economy (obvious in the case of the US) and the fumbled political handling of the crisis in the EU. Germany and the European Central Bank (ECB) have yet to specify in detail the financial reform resulting from the last EU summit, while Europe slips toward irreversible crisis. If Italy and Spain have to resort to a bailout, it will be a disaster for the single currency.

The government's room for action is narrow. If the risk premium does not descend, the growing cost of servicing the debt will devour any margin for public political action. Recovery is already hard with a debt differential greater than 100 basis points, but at 400 it is impossible to climb out of stagnation and significantly reduce unemployment. An orthodox response (suggested by the IMF) would be to show to the EU and the markets an additional budget cut, around 2 percent of GDP. But such a move would have effects on growth equivalent to the strangling effect produced by soaring financial costs, pushing recovery further forward into the future.

In a statement the prime minister's office notes that this new pinch has been influenced by the doubts about the US, and by the month of August itself, when the markets are more volatile. True; but it is also true that urgent reforms, such as that of the labor market and that of the Spanish financial system, are moving too sluggishly. New formulas need to be sought, such as decisive and immediate action by the ECB (massive purchase of Spanish and Italian debt), and the constitution of a European debt to substitute the various national debts.