On Monday, interest rates on Spain's long-term debt rose above 6 percent, a level not seen since the last flare-up of the euro crisis. On Tuesday, Spain saw its costs of short-term borrowing nearly double from a month ago. Although investors snapped up its debt issues with enthusiasm, they demanded nearly twice the return that they did a month ago. Spain's 12- and 18-month government bonds went for an average yield of 2.6 percent and 3.1 percent respectively, up from 1.4 and 1.7 percent on March 20.
If its borrowing costs keep rising, then Spain will be unable to service its debt – a squeeze that has already forced Ireland, Portugal, and Greece to seek a bailout from the European Union. But Spain isn't Greece, it's far larger. The default of the euro zone's fourth-largest economy would shake confidence in the currency in a way that tiny Greece never could.
"Spain is a much bigger threat to the euro zone itself," says Mark Zandi, chief economist of Moody’s Analytics, an economic research subsidiary of Moody’s Corp. and based in West Chester, Pa. "If Spain goes, then the entire periphery [of the euro zone] will unravel."
So far, Spain appears to be in a stronger position than Greece. It has a more solid competitive economy. It is slightly ahead in its timetable to sell €86 billion ($113 billion) of debt this year. On Thursday, Spain will auction two- and 10-year bonds, a crucial test of investors' confidence.
Another plus: While the EU and European Central Bank (ECB) still appear behind the curve in solving the region's mounting debt problem, they at least have gained more experience dealing with it.
"The leadership has been reacting to and addressing crises in the past two years rather than being ahead of the market, but look at where they are now compared with 2010 when Greece first became a problem," says Hung Tran, deputy managing director of the Institute of International Finance, Inc. (IIF), an association of global commercial banks and other financial institutions, based in Washington, D.C. The euro zone has created firewalls to contain the crisis and signed a fiscal compact that binds nations to budget targets. "Compared with two years ago, we have the tools" to address the crisis.
While Greece's problem is whopping government debt – 160 percent of gross domestic product – Spain's government debt at the end of 2011 stood at only around 70 percent of GDP, which is below US levels and even the euro zone's average. Instead, its main problem is private-sector debt.
The collapse of a housing bubble has pushed the private sector's debt to GDP ratio to a huge 214 percent, 70 percent higher than Greece's. Of the five largest euro nations, it has by far the highest private debt ratio.
Spain's housing prices soared more than 50 percent between 2002 and 2007 in Spain, twice the US gain, according to the International Monetary Fund. Only Iceland, a nation that defaulted early on in the debt crisis, saw a higher increase. Now those housing prices are crashing, pushing hordes of homeowners into insolvency along with the banks that financed their mortgages.
It's the parlous state of these mortgage loans that has markets worried. The total debt exposure of Spanish banks is an estimated €2.4 trillion, or about 230 percent of its GDP. That's a huge burden anytime, but it is especially difficult now when the Spanish economy is contracting. Recession means fewer jobs. Nearly a quarter of Spaniards are already unemployed – the worst unemployment rate in the euro zone – and the more workers that are thrown out of jobs, the harder it will be for them to make their mortgage payments.
When the US faced the initial fallout from the bursting of its housing bubble, the federal government stepped in with a huge stimulus package. Spain's new prime minister, Mariano Rajoy, is doing the opposite. He's pulling government money out of the economy by reining in Spain's deficit spending from 8.5 percent of GDP back to 5.3 percent.
In reality, he has little choice. The EU has demanded austerity before it will step in and help. But it might be demanding too much austerity. If the economy contracts too much, then its banks will be in a worse situation, causing even more jitters among buyers of Spanish debt because the government might be forced to step in and bail out troubled banks.
"Regardless of where you are in the economic cycle. you have to address the issue of lack of growth in the peripheral area," says Mr. Tran of the Institute of International Finance. "Cutting the deficit alone is not sufficient, particularly in the countries suffering from recession."
But that help would have to come from the EU or the ECB, neither of which so far has been willing to commit the type of resources that would be needed. The EU's firewall is not big enough to handle a default the size of Spain. The ECB has so far shown an unwillingness to make new purchases of government debt.
Spain's job is twofold: rein in its deficits and restructure its labor rules to make its workforce more competitive, says Mr. Zandi of Moody's Analytics. "That isn't going to happen without help" from the rest of Europe.
Some analysts are critical of the moves that Europe has made so far. "They're not adopting sound policies that are putting the system back on a sound basis," says Robert Carbaugh, professor of economics at Central Washington University in Ellensburg, Wash., and author of "International Economics" a textbook in its 13th edition. "It's a series of Band-Aids."
But others are more sanguine that Europe's moves to solve the crisis, even if by fits and starts, will pay off. "They have to go through this process. They can't make these changes without the angst of investors – they need the angst to maintain the pressure," Zandi says. "I think they'll figure it out."