With Greece hogging the headlines, it’s important to understand that what it represents is more important than what it is. With maybe 2% of Europe’s GDP, Greece is a small economy and by itself can’t cause any real problems. But it does set a precedent for the bigger implosions that will follow. So the real action will come later in the year when the solution Germany and France devise for Greece is applied to countries like Spain.

Here’s an excerpt from a long Wall Street Journal article that illustrates the size of the euro’s challenges:

The Euro’s Next Battleground: Spain

MADRID—Greece set off the crisis rattling the euro zone. Spain could determine whether the 16-nation currency stands or falls.

The euro zone’s No. 4 economy, Spain has an unemployment rate of 19%, a deflating housing bubble, big debts and a gaping budget deficit. Its gross domestic product contracted 3.6% in 2009 and is expected to shrink again this year, leaving Spain in its deepest and longest recession in a half-century.

At the center of the crisis are millions of Spaniards like Olga Espejo. The 41-year-old lost her administrative job at a laboratory in Madrid, then found a temporary post replacing someone on sick leave—until that job was abolished. Her husband and her sister have also been laid off—all among the one in nine working Spaniards who have lost jobs in the past two years.

Each gets an unemployment check of at least €1,000 a month, or about $1,350, part of a generous social safety net that Madrid says it won’t cut. But Ms. Espejo’s benefit runs out in July and her husband’s in May.

“What prospects do any of us have now?” Ms. Espejo asks.

That question haunts Spain and the entire euro zone as the Continent faces its biggest economic crisis since the common currency launched in 1999. Worries over Greece’s ability to finance its huge debts have spread to other, weaker members of the euro zone, but these same fears are now nipping at Spain’s heels. The problem is that, thanks largely to its membership in the euro, Spain lacks tried-and-true means to heal its economy.

Spain can’t devalue its currency to make its exports more attractive and its sunny beach resorts cheaper because the euro’s value is driven by Germany’s bigger, competitive industrial economy. Madrid can’t slash interest rates or print money to spur borrowing and spending, because those decisions are now made in Frankfurt by the European Central Bank.

Spain could still try to stimulate growth through tax cuts and spending increases. But it has already mounted enormous stimulus spending that swelled its budget deficit to 11.4% of GDP last year, and it would need to sell more bonds to raise fresh cash. Buyers of Spanish government bonds, spooked by the prospect of a Greek default, have already demanded higher interest rates from Madrid.

“Spain is the real test case for the euro,” says Desmond Lachman of the American Enterprise Institute in Washington. “If Spain is in deep trouble, it will be difficult to hold the euro together…and my own view is that Spain is in deep trouble.”

The government rejects talk of crisis. “The fundamentals of our economy are solid,” Elena Salgado, Spain’s economy minister, said in an interview. Ms. Salgado said the country’s big banks are sound, its economic statistics credible and its companies dynamic enough to maintain their share of export markets. She pointed out that Spain was running budget surpluses until the financial crisis struck, and its government debt has grown from a very low base.

Euro-zone heavyweights Germany and France have pledged to support Greece if necessary. But any bailout for Spain—whose $1.6 trillion economy is nearly double those of troubled euro-zone partners Greece, Portugal and Ireland combined—would be far costlier.

A “shock and awe” infusion aimed at renewing faith in Spain’s finances, should it be necessary, would take roughly $270 billion, according to an estimate by BNP Paribas. It estimates similar confidence-restoring moves in Greece, Ireland or Portugal would require $68 billion, $47 billion and $41 billion, respectively.

…The housing bust shows how Spain differs from Greece in the current crisis. Economists say Greece’s troubles stem from its profligate government. Madrid ran budget surpluses for years— but Spain’s private sector went on a debt-fueled spending binge.

Spanish private and public debt rose an average of 14.5% a year from 2000 to 2008, according to McKinsey Global Institute. Total debt peaked at the end of 2008 at $4.9 trillion, or 342% of GDP—a higher percentage than the level in the U.S. and most major economies except Britain and Japan. Six-sevenths of that is owed by the private sector.

McKinsey expects households, indebted companies and real-estate developers to shed debt, a widespread “deleveraging” that is likely to trigger defaults and harm the banking system. Most analysts say Spain’s banking problems are concentrated in the country’s 45 cajas, regional savings banks usually run by local politicians that often went deep into real-estate lending.

Nonperforming loans in Spain’s banks and regional savings institutions are now estimated at 5% of the total, up from 3.2% a year ago. Santiago López Díaz, a bank analyst at Credit Suisse in London, estimates this may underestimate the total by 30% to 40%.

Roughly half of Spain’s estimated 1.3 million unsold houses are now on the books of cajas and banks, which have been slow to sell them because they don’t want to realize losses. Financial institutions “have become the biggest realtors in Spain,” said Fernando Encinar, co-founder of Idealista.com, Spain’s largest property Web site.

Some thoughts:

• It’s pretty obvious that this mess won’t be fixed anytime soon and that in the meantime government borrowing will have to keep rising to offset the deleveraging in the private sector. So Spain, like the U.S., will see sovereign debt rise as a percent of GDP for years to come. That is, IF the global markets continue to lend it money.
• Spain’s borrowing costs are, according to the Journal, less than one percentage point higher than Germany’s. That doesn’t seem like much of a spread between a country (Germany) that’s by all accounts in good shape and another (Spain) that is looking at national bankruptcy.
• The only conclusion is that when the markets look at Spanish debt they see German debt. In other words, they expect Greece to be bailed out via a German guarantee of its debt, and they expect this deal to then be extended to Spain. That’s not unreasonable, given the other options.
• Assuming the PIIGS are all bailed out in the coming year, the question then becomes, what does all this junk debt do to Germany’s balance sheet. The answer won’t be pretty.

Tagged as: Dollar, euro, inflation