Hugo Dixon

One knee-jerk reaction to Italy’s shock election was to worry about contagion to Spain. As Rome’s bond yields shot up last Tuesday, Madrid’s were dragged up in sympathy. These are the two troubled big beasts of the euro zone periphery and an explosion in either of them could destroy the single currency.

But Spain, where I spent part of last week, probably won’t catch Italian flu. True, the risk of Madrid being thrown off its reform path has risen since Italy’s inconclusive election. But Prime Minister Mariano Rajoy doesn’t have to face the voters for nearly three years. What’s more, the Italian vote may make euro zone policymakers less keen on austerity and so give Spain a better chance of returning to growth.

Indeed, investors have already started having second thoughts. By Friday, Madrid’s 10-year bond yield had fallen back to 5.1 percent from 5.4 percent on Tuesday. The spread between Spanish and Italian yields has shrunk to 0.3 percentage points. There’s even a chance that Madrid could enjoy lower borrowing costs than Rome in the coming weeks if Italy’s political paralysis shows no sign of resolution.

There is, of course, no cause for Schadenfreude in Madrid. The same factors that led to a stunning breakthrough in the Italian elections for the populist Beppe Grillo could eventually play out in Spain, albeit in a different way. Spain’s traditional ruling parties – Rajoy’s centre-right People’s Party and the Socialists – are discredited by a mixture of recession, 26 percent unemployment and corruption allegations. They each enjoy support of around 25 percent in the opinion polls, while the electorate’s trust in politicians has continued to plummet.

Spain doesn’t have a Grillo. But it does have radical left and centrist parties, each with roughly 15 percent support, as well as strong nationalist movements in Catalonia and the Basque Country. Unless there is an economic turnaround, nobody will have a majority in Spain’s next parliament and the country could be hard to govern.

The art of politics is about squaring circles. In the euro crisis, this means pushing ahead with painful but necessary reforms while hanging onto power.

In Spain, where I spent part of last week, these circles are getting harder to square. Mariano Rajoy isn’t at any immediate risk of losing power. His 10-month old government has also taken important steps to reform the economy – cleaning up banks, liberalising the labour market and reining in government spending.

But the recession is deepening, the prime minister is a poor communicator and his political capital has plummeted. Madrid will also find it harder than thought to access help from its euro zone partners.

At a dinner in Madrid earlier this month, the main complaint about Mariano Rajoy was that the new prime minister was treating the electorate like children. Many of the guests, supporters of Rajoy’s Popular Party (PP), understood that Spain had to cut its fiscal deficit and restore its competitiveness. But they didn’t like the fact that the prime minister hadn’t been frank about his plans.

In advance of last November’s general election, Rajoy said he wouldn’t raise taxes, make it cheaper to fire people or cut the welfare state. But he has now done the first two. After this week’s election in Andalusia, Spain’s largest region, he is expected to do the last.

Rajoy’s camp doesn’t see any problem in failing to be upfront. It would have been foolish to talk too much about austerity in the general election campaign as that might have frightened the voters. For the same reason, it would be foolish to tell them about reforming the welfare state in advance of the Andalusia election.

When confidence in a regime’s permanence is shaken, it can collapse rapidly. The fear or hope of change alters people’s behavior in ways which make that change more likely. This applies to both political regimes such as Hosni Mubarak’s Egypt and economic regimes such as the euro.

Fear that the single currency may break up now risks becoming a self-fulfilling prophecy. Banks and investors are beginning to act as if the single currency might fall apart. Politicians and the European Central Bank need to restore belief that the single currency is here to stay. Otherwise, it could unravel pretty fast.

Until a few weeks ago, the idea that the euro wouldn’t survive the current debt crisis was a fringe view. Since the euro summit on Oct. 26-27, it has become a mainstream scenario. So much so that last week risk premiums on the bonds of even triple-A rated countries such as France and Austria rose to record levels, while Spain became the latest country to be sucked into the danger zone.