Why Spain Will Seek Help—and Why the ECB Retains Its Leverage

After a couple of good weeks for the euro area, the inevitable question has arisen over whether the gains can be sustained, or if another cycle “one-step forward, two-steps back” is in the offing. On the positive side have been actions to shore up finances by the European Central Bank, a favorable German Constitutional Court ruling, and a vote for the euro in the Netherlands. But risk is ever present in the euro area. Overcoming political obstacles to implanting fiscal sustainability and structural reform in Europe’s troubled countries—and transferring sovereignty to Brussels across the region—will require “crisis pressure” on recalcitrant politicians. Recent positive market “relief rallies” and declines in peripheral bond rates could breed complacency and sow the seeds of future market instability. This precarious situation will persist until the euro area restores its elusive and evanescent market confidence. Only then will short-term policy setbacks no longer result in bond market convulsions.

How close is the euro area to restoring its credibility? Spain now poses a crucial test. It is eligible to take advantage of the ECB’s new program of sovereign debt purchases—known as outright monetary transactions (OMT)—and also the central bank’s potentially unlimited secondary market purchases, not to mention the possibility of market assistance from the European Financial Stability Facility and the European Stabilization Mechanism (EFSF/ESM). But such actions are subject to “strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) program.” At last an adequate firewall is there for a big member state. In theory, its mere availability should be enough to restore calm in euro area bond markets. With the bazooka now there for all to see, the chance of using it should decline.

Spanish bond yields have indeed declined following the initial encouraging words from the ECB president, Mario Draghi, in London in late July. But this market reaction probably cannot be sustained without an actual Spanish application for assistance. Investors want to see euro area policymakers put their money where their mouths are before recommitting to Spain. Distasteful as it might be politically, Prime Minister Mariano Rajoy will therefore have no choice but to approach the EFSF/ESM, sooner rather than later.

Make no mistake, it will not be an easy political task. Requests for outside financial assistance have provoked brutal voter hostility. Incumbent governments in Greece, Ireland, and Portugal were decimated in elections after they sought aid, and Rajoy faces regional elections in Galicia and the Basque country on October 21. No wonder he continues to dither.

Yet his concerns may be overwrought. The Basque country and Galicia are small autonomous regions, where Rajoy’s Peoples Party (PP) has not been strong in the Basque region, so it is not obvious what the party has to lose. The PP may lose control of the Galician government, but the effect of such a loss seems limited. Rajoy’s government has already tried to kick the political can down the road until after a regional election, however, when it postponed publication of its new austerity budget until after the voting in AndalucĂ­a in late March. The trick didn’t work then. The PP failed to win a majority.

The downside of seeking help may be overstated as well. Going to the ESM will not be the watershed it was for Greece, Ireland, and Portugal, when they approached the Troika (the European Union, the ECB, and the International Monetary Fund) earlier in the crisis. After all, Spain has already applied for and been granted a bank bailout of up to €100 billion from the euro area in return for far reaching reforms of the Spanish banking sector. Approaching the ESM would be a similar step.

In the end, Rajoy’s most realistic path to re-election in late 2015 is to take the painful decisions as soon as possible, and trust the economy to begin to recover beforehand.

Financially, the Spanish government does not have much time. It faces about €32 billion in bond redemptions in October and perhaps €75 billion to €80 billion in total financing needs for the rest of 2012. This schedule will likely force his hand.

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