Financial Pain in Spain Falls Mainly on… Spain?

For over a decade we have heard reports of China’s increasing world dominance. Yet while Beijing has amassed a large war chest of savings over the past decade – $2.5 trillion remain under its control – it has been cautious in waiting for a rainy day to put its savings to use.

The times they are a changing. One day prior to his arrival in Madrid for an official visit, Chinese Vice President Li Keqiang announced that China had the utmost confidence that Spain would recover from its economic malaise. And to put China’s money where his mouth is, Li made an open-ended pledge to “help” (read: “bail”) out Spain in the future.

Citing China’s stance as a “responsible investor” with a long-term view of European financial markets, Li assured investors that purchases of Spanish public debt would continue. Moreover, the man who is widely reckoned to become China’s next premier commented on Chinese support for Spain’s austerity measures, and confirmed the conviction that Spain would achieve a swift economic recovery.

While Spain’s austerity measures are admirable, there is still a long way to go. With a deficit of 9.3 percent of GDP for 2010, and 6 percent forecast for this new year, total debt will grow to 62 percent of Spanish GDP by the time this year becomes bygones. That is, it will be 62 percent of GDP as long as GDP does not collapse further than it already has been. While GDP contracted by over 2.5 percent in 2009, and the final tally for 2010 still to come, the future debt load of Spain is more than a little uncertain.

Meanwhile, Spain’s own Socialist Prime Minister Jose Luis Rodriguez Zapatero noted that the Chinese commitment will “play a key role” in financial stabilization. This seems to be a signal that the stabilization that Zapatero is talking about is different than that which China reckons to be “investing” in.

Real stabilization will not come from having a bailout by different words. The Eurozone economy – of which Spain is a not insubstantial part as the fifth largest economy – is in the midst of a deteriorating debt crisis. Continued bailouts are band aid solutions to the wrong problem. When faced with a crisis of insolvency the solution is not continued doses of more debt. What are needed are drastic cuts to expenditures.

Spaniards, or anyone for that matter, should not be fooled into thinking that Beijing’s generosity will solve any problems. If anything a bailout will exacerbate and prolong the pain which has already been assured by the excesses of the past. When you wake up with a hangover, drinking more does little to numb the pain. More alcohol may get rid of the morning shakes, just as this “bailout” may calm market jitters, but at the cost of a more severe eventual withdrawal.

Philipp Bagus, in his new book “The Tragedy of the Euro”, explains lucidly how the European debt crisis emerged. Southern European countries joined a currency union assumed to be unbreakable. Any eventual signs of trouble with any of the weaker countries – the PIIGS of today – would by necessity be attended to by the strong. Incidentally, with reports of Belgium and even France someday requiring external aid, the list of the strong is quickly shrinking. Adding fresh troubled economies to its scope is not helping this situation either. On January 1st Estonia became the 17th country to enter the Eurozone. While Estonia ran a budget deficit of 8 percent of GDP last year it is only a matter of time before the new addition joins the ranks of the needy.

Unfortunately for Spaniards, what commentators are commonly missing (besides the fact that this bailout will breed more painful adjustments down the road) is that the pain of this bailout will fall mainly on Spaniards.

Guaranteeing a bailout will assure the government that they can continue their spending binge for a little while longer. Necessary cutbacks will not be enacted, as they will not be deemed as necessary. While the punch is still flowing, drink up. Without meaningful budget cuts there will be no improvement in an already tenuous fiscal situation. How long can insolvent countries keep getting bailouts to keep them going?

China has deep pockets, enabling it to keep bailing out troubled Europeans for a long run. But we all know what happens in the long run. Surely such a fate for Spain is worse than some short-term pain today.