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You should care about Spain’s 7 percent bond yields. Really.

at 11:10 AM ET, 06/14/2012

Click over to any business or financial site today and you’ll see horrified headlines. Spanish bond yields hit 7 percent! Italy’s are rising too! Europe is doomed! So why is 7 percent such a scary number?


The horror, the horror. (ANDREA COMAS - REUTERS)
Let’s recall the basic situation: The Spanish government needs to borrow money to fund its day-to-day operations. To do so, it sells (among other things) 10-year bonds. In return for cash from investors, the Spanish government promises to pay a fixed rate of interest — say, 5 percent — every year for 10 years. At the end of that period, the investors get all of their original cash back. When investors are nervous that the government might not repay in full, they demand higher interest rates as a sweetener.

That’s happening right now. Investors are skeptical about Spain’s ability to repay, especially after the Spanish government said it could borrow up to $125 billion to shore up its banks and Moody’s downgraded Spain’s debt. So investors are now demanding 7 percent interest rates from Spain. A very big, very fat sweetener.

In the old days — before Spain joined the euro — this wouldn’t have been a huge worry. In fact, Spanish bond yields were often much higher than that. But back then, Spain printed its own money, and inflation was typically quite high. If the country’s borrowing costs soared, it wasn’t a crisis because inflation ate away at most of Spain’s debts.

Nowadays, however, Spain is on the euro. It can’t print its own money. Inflation is at a low 2 percent. So when bond yields rise to 7 percent, Spain effectively has to generate a 5 percent return on the cash it borrows. When the economy is growing fast, that’s simple enough — more growth means more tax revenue, which means more money available to repay lenders. But Spain’s economy isn’t growing. It’s in recession. Unemployment is at 25 percent. And Spain is carrying out large austerity measures that, many experts think, will keep hobbling its economy.

Essentially, then, there’s scant hope that Spain will be able to repay its debts in full. The fact that it has to pay so much to borrow money means its debts will keep getting bigger and bigger and bigger. Which means it might not matter if Spain’s borrowing costs are at 7 percent or 77 percent. All of those levels appear to be “unsustainable.” At a certain point, no one’s going to want to lend Spain any more money. The government will then either need a direct bailout from the rest of Europe — that’s what happened to Greece, Portugal, and Ireland when their borrowing costs soared too high — or else it will have to leave the euro altogether. The latter might mean global economic calamity.

Are there other ways to save Spain? Perhaps. As Fed Watch’s Tim Duy explains, one possibility is that the European Central Bank, which can print euros, could step in and lend Spain money — at low rates that Spain can realistically repay. Spanish Prime Minster Mariano Rajoy prefers this option. This sort of central bank action would technically count as a “bailout,” and the ECB is reluctant to do it because it would remove some of the market pressure on Spain to curb its deficits. But, as Duy notes, it’s not clear that Spain can bring down its debt load with more austerity. That hasn’t been working so far. (Reuters’ Julien Toyer explains the difficulty Spain faces in curbing its deficit right now.)

Another option is for Europe to find a way to shore up Spain’s banks. Remember, the Spanish government just announced a plan to lend up to $125 billion to its rickety banking system, which is why everyone is now so nervous about the Spanish government’s ability to repay its debts. In response, French President Francois Hollande has suggested that the euro zone band its resources together, “stress test” all of Europe’s banks, and essentially pour money into any institutions that are in dire straits. The hope is that this would restore confidence in the banking system — and, by extension, restore confidence in the Spanish government.

But with all these proposals, Germany is still opposed. For now, German Chancellor Angela Merkel doesn’t sound terribly sympathetic to Spain’s 7 percent bond yield problem. So, we’re back where we started, in panic mode.

 
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