Let’s give one cheer for Europe’s announcement of a rescue for Spain’s banks. In some ways it is very good news that leaders of the eurozone have agreed to pump as much as 100 billion euros (about $125 billion) into the Spanish government’s fund for bank rescues. At the most basic level, this is money that Spain needs and will be able to borrow from its neighbors at low cost rather than expensively from the financial markets. As important, it begins to break the links between the governments of troubled eurozone countries and their often equally troubled banks by moving, very modestly, towards a so-called “banking union” to supplement the monetary union. In Greece, Ireland, Spain, and elsewhere, fiscal problems of the national governments have harmed the banks and troubles at the banks have harmed their governments, in a vicious circle. Interposing the strength of the eurozone as whole is important.
The political and psychological benefits of the agreement are also important. This substantial act of solidarity may help restore confidence that the eurozone leaders will do what needs to be done in a time of crisis. Further, it sends a signal to the Greek voters that they should not count on being able to coerce the rest of the eurozone into completely rewriting the current bailout agreement by making explicit and implicit threats to bring down the rest of the monetary union through financial contagion. (Changes should be made in the agreement, but they will not be nearly as extensive as the more radical Greek voices demand, nor should they be.) There is now probably at least a modestly greater chance that the more reasonable parties will win in the June 17 elections in Greece, avoiding the worst risks of a showdown between that country and the rest of Europe.
All that said, the weekend’s agreement in principle on Spain retains a great capacity to disappoint, as other eurozone crisis responses have, depending on the details. First, it would be a much stronger signal if the funds were being channeled directly into the Spanish banks, rather than being lent to what is effectively an arm of the Spanish government, thereby increasing its debt burden. Second, we do not know which eurozone-level entity will be lending the money, the European Financial Stability Fund or the European Stability Mechanism. This matters significantly, for technical reasons that are too complicated for a blog posting, but which carry political and economic consequences. Third, we do not know what conditions will be placed on the loans, in terms of their maturity, interest rate, and requirements for policy action. The early word is that there will be few additional policy constraints, but this may be a matter of semantics, since Spain has already committed to a great number of actions as part of the new requirements for coordination among European countries. It may be harder for them to alter these commitments now that they are taking large amounts of European funding.
Depending on the answers to these and other questions, it is quite possible that financial markets will end up dismissing this as yet another half-hearted or misguided rescue effort, once today’s relief rally passes. (European stocks opened up a couple of percent, confirming the positive aspects of the deal, but not showing the euphoria that might have resulted from a true breakthrough.) In the worst case, it will stoke market fears that a full-blown bailout for the Spanish state will be the next stage of the eurozone crisis. If so, Spain will effectively lose access to the bond markets and will need a much larger amount from its eurozone partners, as direct financing of its debts.
One disadvantage of infusing European money into Spain is that markets are convinced that the official funding will have a higher priority of repayment if Spain is ever pushed to the point where it repays less than the full amount it promised. Private sectors holders of Greek debt ended up suffering 80% losses in part because so much of Greece’s debt was from official sources, which have not yet taken a haircut, although this seems inevitable eventually. Thus, the issue of seniority can translate to losses for investors, who therefore may perceive greater risk in Spanish bonds, should things take a turn for the worse again. Investors have to balance the decreased probability of a Spanish default against a higher loss if a default does occur. On the whole, this calculation looks like good news at the moment, but that could change if other factors push Spain towards default.
All in all, it’s definitely good that the eurozone leaders managed to take a positive step on Spain and on a potential banking union. Further, failing to do something this weekend would have been very bad. However, this is far from the major political breakthrough that is still likely to be needed before the crisis is over.