Maginot Lines and Illusions

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd. Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of "13 Bankers."

Many commentators suggest Spain is now the euro zone's Maginot Line. The argument is clear: Spain, with gross domestic product of more than $1.3 trillion (the eighth largest in the world and fifth largest in Europe) and with large outstanding bank and public debt, is simply too big to fail without causing irreparable harm to the euro-zone financial system. If we dig in here, the reasoning goes, euro-zone market upheavals can be stopped.

In past weeks, though, global market forces circumvented this new Maginot Line without serious resistance, just as Germany did in 1940 with the original. The events that shook equity markets were not just in Spain; they were everywhere in the world.

The cost of protecting against default at India's largest private bank crept up 66 basis points, or 39 percent, from mid-April, and the cost of protecting against major South Korean banks' default rose 50 percent. Oil prices collapsed and emerging markets found their access to credit markets had dried up. The interest rate for lending between banks in American dollars, or Libor, shot up, and investors piled funds into perceived safe havens, driving down the yields of German, French and United States bonds.

This pattern reflects the core problem facing world markets today. Investors have already begun to extrapolate from euro-zone problems, recognizing that the world remains a highly dangerous place. The latent dangers include our overreliance on rapid Asian growth that might falter, the pressure for sharp fiscal tightening in nations with high deficits, and highly leveraged banks that continue to own toxic real estate, weak sovereign debt and other assets. If world financial markets once again decide their risk appetite is low, many unsustainable leveraged institutions and governments are in for a tough ride. Spain's role in this possible calamity is more that of a sideshow than a front line. Spain has a fighting chance for survival without serious economic disruption, but only if the world economy remains at the least benign. To get out of its difficulties, the Spanish government needs to be far more determined than the light approach taken by its Irish and Portuguese counterparts (which face far worse problems).

Spain has a better chance of avoiding sovereign and bank defaults than Greece, which is now in intensive care with a doubtful prognosis despite a permanent resource infusion from the European Central Bank. In this regard the announcements in the last few weeks from Spain were helpful — for example, when the government chose resolution authority over religious authority in taking legal control of a troubled savings bank, CajaSur, from the Catholic Church.

Spain's savings banks, often owned by local authorities, the church and civic groups, are generally a bastion of moral hazard because of the implicit belief that no political leader would let the relevant creditors fail. The CajaSur takeover did not impose losses on creditors, but it did establish that the managers of failed banks can at least lose their jobs.

The highly unpopular budget cuts announced by Prime Minister José Luis Rodríguez Zapatero also demonstrate some resolve — and the fact that the program just passed a legislative hurdle is encouraging. According to optimistic forecasts, Spain's budget deficit will fall to 5.3 percent of G.D.P. next year (although the European Commission still has this projected at 9.8 percent). If Spain can get anywhere near this level, despite 20 percent unemployment, then the financial markets will probably go easy on it. Spain's high unemployment is partly the result of a more liberalized labor market that made it easier to let workers go when their labor contracts expire. This has made Spain one of the worst nations in Europe in terms of employment loss, but it also means jobs could rebound quickly.

So the question is not whether Spain can remain solvent, but rather whether world markets will be patient enough — and risk-tolerant enough — for many other nations to have enough time to make the needed adjustments.

The Achilles’ heel for Spain, and for others in Europe, are the private credit markets. Loose banking regulations and, in some countries, lax fiscal policy during the boom of the last decade have placed serious countries at the mercy of bond markets. We now know the European Central Bank will refinance sovereign debt for a long time, but there are 22 trillion euros of credits provided by the euro-zone banking system largely to the private sector (with total euro-zone G.D.P. around 9 trillion euros, this makes euro-land highly dependent on credit). If the banking system decides it needs to tighten up on risk-taking, some of this credit will be cut off — further slowing growth in the region.

The first and greatest cuts under such a scenario would be for debtors in Portugal, Ireland, Italy, Greece and Spain, which are still lumped together by markets. There are 2 trillion euros of external private credits to Spain, Greece and Portugal alone. Any modest attempt to reduce this amount will set off a new round of lower asset prices, as enterprises and households try to sell what they can in order to repay loans, while banks march in to foreclose on property and cut their exposures.

In the United States, such a credit contraction would be met with the Federal Reserve pouring out liquidity and helping to bail out many creditors. This would not solve the underlying problem — and stores up serious moral-hazard issues for creditors in the future — but it at least provides time for the debtors to make payments. The United States will also remain a safe haven, at least for a while, and that gives a cushion for the government to run budget deficits and avoid fiscal cuts driven by nervous bond markets.

For Europe it is much harder to predict how events will evolve over the same time frame. The recently announced 750 billion euro package actually implies that the troubled nations — definitely Greece and Ireland, probably Portugal and perhaps Spain — must make large fiscal cuts. Bond-market vigilantes reign supreme if their actions force fiscal cuts — and, sadly, this is where the euro-zone periphery finds itself. At the moment Germany and France are the safe havens. Bond yields in France fell sharply in the last two weeks, while Spain's yields rose and would have increased much more were it not for European Central Bank purchases.

But who is really safe in Europe? With France running an 8 percent G.D.P. budget deficit for 2010 and debt at 83.5 percent of G.D.P., should we be confident it is safe while Spain is not (with debt at 65 percent of G.D.P.)? France's 30 years of budget deficits do not bode well for anyone expecting an immediate strong fiscal response. In many ways Spain appears better placed to take tough actions than France.

If investors decide that risk-taking is no longer the right mode, many nations will be in trouble; there may be Maginot Lines, but they are worth nothing. If recent market sentiment signals a coming global downturn rather than continued world growth, investors will soon question whether even the safest havens are safe.

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Catherine Rampell is the economics editor at nytimes.com.

David Leonhardt writes the Economic Scene column, which appears in The Times on Wednesdays.

Sewell Chan writes about economic issues from Washington D.C.

Jack Ewing about European economics and business from Frankfurt.

Marc Lacey is The Times's bureau chief for Mexico, Central America and the Caribbean.

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An accounting of the government’s rescue package.

Three economists explain what worked and what didn't.

A map of unemployment rates across the United States, now through January.

Faces, numbers and stories from behind the downturn.

A series about the surge in consumer debt and the lenders who made it possible.

A series exploring the origins of the financial crisis, from Washington to Wall Street.

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