Paul Vallely: Spain – too big to fail, not too big to bail

A run on the banks has, in effect, started in Spain and Greece

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Spain's national football team's players have been told that they are not to use Twitter for the next few weeks. The assumption is that this is about Euro 2012. But it could be another desperate attempt by the Spanish authorities to avoid inflaming the financial markets. Alvaro Arbeloa on austerity might prove too provocative.

Spain is in its worst financial crisis for a century. The gallows-humour gagsters who brought you Grexit or Grout as terms for a possible disorderly exit by Greece from the euro have two more bits of japery on offer. "Spanic" is meant to encompass the markets' alarm over Spain's twin financial and economic crises. More portentously, "Squit" vulgarly raises the prospect of Spain quitting the euro too.

Why should we care? For two reasons. A Spanish exit would send ripples round the global economy that might build to a tsunami by the time they crashed upon our shores. And the process Madrid is currently undergoing – slashing fiercely to reduce a budget deficit amid a gathering recession – has lessons for Britain at a time when George Osborne, for all his Budget volte-faces, continues to insist there is no alternative to his Plan A.

Almost €€100bn has been pulled out of Spanish banks in the first three months of this year – about a 10th of the country's GDP. Two-thirds of it went in March alone, as Spanish citizens and foreigners rushed to find safer places for their money. This capital flight can only have accelerated since, as Spain has resisted pressure to seek international assistance for the parlously debt-stricken banks that provoked the latest crisis in the eurozone's fourth biggest economy.

The Spanish government has just had to find €19 bn to bail out Bankia, the nation's third biggest lender. Its story is all too familiar. Banks which the IMF pronounced "highly competitive, well-capitalised and profitable" before the 2008 crash – and which "would be able to absorb losses from large adverse shocks without systemic distress" – are now on the brink of collapse.

Echoing the US sub-prime mortgages debacle, Bankia made risky loans to low-income immigrants, and built the biggest portfolio of property loans in Spain. It was the same old combination of over-leveraged debt, poor regulatory supervision and a property bubble that burst. Reckless property developers took any loan on offer and arrogant bankers obliged. The man at the top, the infelicitously named Rodrigo Rato, left the sinking Bankia ship last month, just before it was nationalised. All this against an economic policy background uncannily similar to that of coalition Britain. A budget deficit, which reached 8.9 per cent of GDP last year, is being brought down as fast as possible. The aim is to win the confidence of the markets and cut borrowing costs.

But as in Italy, Ireland and Portugal, severe austerity measures seem only to deepen recession. Spain is in a downward spin. With fewer taxes coming in there is less money to pay the bills. Tight bank credit has deepened the slump. Cuts are killing the economy, even more so than in the UK. Spain now has the highest rate of unemployment in the eurozone: 24.3 per cent. Among young people it is an unimaginable 51 per cent. The OECD forecasts the economy will shrink 1.6 per cent more this year. Yet the conservative government in Spain, as here, persists in believing that cuts can bring the economy back to growth.

Instead, the cost of borrowing is up. On Friday, investors demanded interest of 6.6 per cent to lend to the Spanish government. Italy, the world's eighth biggest economy, was not far behind at 6 per cent. Both are perilously near the 7 per cent at which Greece, Ireland and Portugal had to seek European bailouts.

Spain should now focus less on austerity and more on cleaning up its banks. Its poor public finances are a symptom, not the cause, of its economic woes. Private rather than government debt is its banks' problem. Spain wants European cash injected directly into its banks by the European Stability Mechanism; Germany wants the money to go via the Spanish government, so it assumes responsibility for the debt. But the Germans must know that, ultimately, if the euro is to work, there must be a centralised eurozone bank regulator. Fiscal union is the inexorable logic of a single currency. That is why Britain is better off outside it.

In the short term, Spain is too big to fail and but not too big to bail. The alternative – a chaotic series of exits from the euro by Greece, Spain and then Italy – would have consequences too unpredictable to countenance by anyone but Silvio Berlusconi, who last week called for Italy to quit unless the European Central Bank agreed to pump cash into the Italian economy and guarantee its government's debts.

The danger is that none of this will happen through the negotiated decisions of politicians, but through the hysteria of a market stampede. A run on the banks has, effectively, already begun in Spain and in Greece, where the country's power regulator has called an emergency meeting next week to avert a collapse of electricity and gas supplies over unpaid bills. In two weeks Greece goes to the polls in what will virtually be a vote on whether or not to stay in the euro. The outcome is too close to call. The danger is that the markets will make the decision before the voters can.