Just when we thought the European debt crisis was behind us, at least for a while, it is back center-stage and frightening the markets. Not yet frightening them as much as it should…but give it time.

As Greece slips from the front pages, the much larger problem of Spain takes the limelight. Spain Prime Minister Mariano Rajoy’s PP party failed to win a majority in the recent regional elections for Andalusia, according to the Telegraph.

Ruling from a minority position will severely hamper the already tough challenge the PP party faces in Andalusia to implement austerity measures demanded of the whole country by the rest of the EU. Where Andalusia has led other provinces will likely follow as a national strike this Thursday underlines widespread opposition to further austerity as the economy gradually implodes.

Yields on Spanish debt have started to rise again, as investors fear either Spain’s unwillingness to implement the required cuts or a leaking of support by Spain’s EU partners, or both. So far, rates are “only” at about 5.4 percent, up from 4.9 percent at the beginning of the month, but anywhere over 5 percent is painfully high and much depends on the market’s confidence that debt reduction will be delivered.

Following a significant deficit overshoot last year, Mariano Rajoy informed Brussels earlier this year that it was aiming for a budget deficit this year of 5.8 percent of gross domestic product, significantly higher than the 4.4 percent agreed earlier. Following intense public and behind-the-scenes “discussions,” Spain and the EU agreed on a revised target of 5.4 percent for this year, but kept the 3 percent target for next year.

The market’s fear is Spain will not deliver. Indeed, to achieve a significant budget reduction in the face of a contracting economy is a major challenge, even with the population behind you. On top of this, the suspicion is growing that Spain’s position is even worse than it seems as projection falls short of reality.

Continued from Part One.

In the autumn of 2010, the International Monetary Fund thought Greece would shrink by a rather modest 2.6 percent in 2011. We now know the economy last year fell about 7 percent. The Greek fiscal position was bad not only because of a lack of effort, but also because the economic problems were far stronger than expected; the fear is that with 25%+ unemployment and a severe economic squeeze just starting, Spain will contract more than expected. Major deficit reduction in the wake of economic collapse is near enough impossible, the FT suggests, yet the more Spain resists deficit reduction, the greater the eventual scale of the problem will be.

An article in the Independent postulates a third cause for concern among investors, which unfortunately runs counter to the previous positions; namely that austerity, demanded by the EU, is driving the Spanish economy further into the mire and making the need for a rescue (which the EU might not be able to afford) all the more likely.

The problem is Spain cannot address both fears. They either implement austerity measures to satisfy conventional wisdom and their EU paymasters, or they try to reduce debt via growth, which essentially involves stimulating the economy – almost impossible to do while simultaneously reducing government spending and trying to balance the books.

As with Greece, Germany is claiming that the existing facilities are sufficient, but it may be, just as with Greece, that the market has other ideas and that in order to avert a run on Spanish debt, eventually the richer northern states will have to stump up a bailout for Spain as they did for Greece.

The scale of the problem, however, is on a whole different magnitude with Spain.

Image source: dw-world.com