Hugo Dixon

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.

In the long run, the failure to treat the population like adults could cause trouble. But in the short run, the strategy has paid off. The socialist party lost nearly 40 percent of its votes in the general election, not least because it had done a poor job in government. It is now expected to lose control of Andalusia, its last main bastion, according to an opinion poll by Metroscopia.

Rajoy has already used the absence of any serious opposition – even a general strike called for next week doesn’t pose much threat – to push through one batch of reforms. The most important is of the labour market. He has made it cheaper for companies to fire people and largely dismantled the nationwide system of collective bargaining. The net effect will be that wages, which rose rapidly during the early years of the single currency, will fall – so restoring Spain’s competitiveness.

Between end 1998 and end 2009, Spain’s unit labour costs rose 38 percent, compared to 23 percent for the euro zone as a whole. In the past two years, they have come down 4 percent. The latest labour reforms could cut wages another 5 percent this year, according to Fernando Fernandez, economics professor at Madrid’s IE Business School. If the trend continues for another year or so, Spain will no longer be out of kilter with its euro peers.

The other main reform – cleaning up toxic loans from banks’ balance sheets following the country’s real-estate bubble – has had more mixed reviews. The government has told the industry to take provisions and stash away capital to the tune of 50 billion euros. While the number sounds high, the detailed rules mean many banks won’t need to raise capital and some of the rest could have nearly two years to do so. The government itself has been reluctant to put any more of its own money into banks. So it is trying to push weak banks into the arms of stronger ones and fill any capital shortfalls with guarantees from an underfunded deposit insurance scheme rather than with real cash.

The litmus test of whether this financial jiggery-pokery works will be whether banks are able to borrow in the markets and are then willing to support economic recovery by lending to businesses and consumers. There are some positive signs: Santander last week issued 1 billion euros in five-year senior debt. But most of the industry is still relying on handouts from the European Central Bank.

Rajoy’s second blast of reforms will be about putting the public finances onto a sustainable basis. In 2011, the budget deficit hit 8.5 percent of gross domestic product. Spain last week reached a deal with its euro zone partners to cut it to 5.3 percent this year. Although this is not as severe as the 4.4 percent originally pledged, it will still constitute a severe squeeze. What’s more, the government remains committed to bring the deficit down to 3 percent next year.

The prime minister has already given some ideas about what he will do. Income taxes were raised and some spending cut in an emergency budget just before the New Year. Rajoy is also putting in place a straitjacket to control the borrowing of the country’s profligate regional governments. If he wins this week’s Andalusia election, he will be in an even better position to impose his will as the vast majority of the regions will then be under the PP’s control.

But more will be needed. The regions, which are responsible for education and healthcare, will probably be allowed to charge people for part of the cost. And Rajoy will have to cut the number of public-sector employees and increase taxes further in next week’s budget.

Economically, this is logical. The concern is that Rajoy’s failure to be frank with the electorate could increase its cynicism. The people already have little trust in politicians of all stripes. Witness last year’s indignado movement, when hundreds of thousands of protestors took to the streets to complain.

This won’t matter if the economy, which the government expects to shrink 1.7 percent this year, stabilises next year. But what if GDP keeps shrinking, unemployment (now 23 percent) continues rising and the deficit remains stubbornly high? Spain would face renewed bond market jitters and further pressure from its euro partners to cut its deficit. Rajoy would then have to sell another dose of austerity to voters that wouldn’t believe him. Having treated them like kids, they might even throw a tantrum.

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.

The summit itself made two technical decisions which have had damaging, unintended consequences. First, banks underwent a stress test that marked their sovereign bond exposures to market whereas previously regulators maintained the fiction that these positions were risk-free. This meant that lenders suddenly had to start holding capital to back their sovereign debt investments. Not surprisingly, they have become more reluctant to buy bonds. This, in turn, has made it harder for governments to fund themselves.

Second, the summit decided to strong-arm the banks into agreeing to a “voluntary” debt restructuring for Greece. Because the deal is supposedly voluntary, credit default swaps (CDS) – a type of insurance policy that pays out if an entity goes bust – won’t be triggered. This arm-twisting has convinced lenders that CDSs are a useless way of hedging the risk of investing in euro zone government bonds. Without a hedge, many prefer not to hold the bonds at all – again making it harder for states to fund themselves.

After the summit, things went from bad to worse with Greece’s disastrous plan to call a referendum on its latest bailout plan. That idea was withdrawn – but not before Germany and France suggested that Athens might need to be kicked out of the euro unless it came to heel. The snag is that it would be very hard to isolate the Greeks. If one country could leave the single currency, why not two, three or all 17?

As investors thought about the possibility of a euro break-up, they started factoring in currency risk. Under such a scenario, the new Greek drachma would plummet in value; the new Italian lira and Spanish peseta would also take a tumble; even the new French franc would depreciate versus a vibrant new Deutsche Mark. That gave the market another reason to sell pretty much every non-German government bond – again making it harder for those states to fund themselves.

As if this wasn’t bad enough, banks are also suffering from a liquidity squeeze. It’s not just investors who are getting jittery about putting their money in banks; lenders are reluctant to lend to each other because they are not totally sure that their peers will survive.

Banks outside the euro zone are also cutting their lines of credit to those inside the zone. The big four UK banks cut interbank loans by around a quarter in the three months to end September, according to data compiled by the Financial Times. Meanwhile, the United States is about to embark on a new stress tests of its lenders. This will include contingency planning against further disruptions in Europe. It wouldn’t be surprising if this provoked American banks to cut their exposure to their euro counterparts, further exacerbating their funding problems.

These vicious spirals have drowned out the good news on the political front. Italy, Greece and now Spain have new prime ministers, all of whom seem intent on cutting debts and making their economies fitter. But they will struggle to reduce their borrowing costs unless investors can be convinced that the euro is here to stay.

The one thing that probably would restore confidence is if the ECB found some way of supporting governments that were pursuing sensible policies. But the central bank itself and Germany, the euro zone’s main paymaster, have so far resisted this. In part, this is because they think governments won’t have a strong incentive to reform if they are bailed out too easily.

The logic of making countries sweat so that they address problems they have shirked for years, and sometimes decades, is a good one. But the ECB and Germany should remember that carrots are useful incentives, as well as sticks – and, if they don’t provide the carrot soon, the euro may not survive.