Spain, again

Now that Greece is off the front pages for a few days, we all turn our attention to Spain (Spanish bonds hit by poor auction - FT.com).

Spain's problems are rather different from Greece's, and those differences are now widely understood: Spain had a balanced budget and a small public debt before the crisis, but ran up a crazy amount of private debt, largely backed by a property bubble in a largely saturated housing market. The result is that Spain has a British-style deleveraging recession, which is starting to become a sovereign debt crisis too as investors wonder whether it can sustain high budget deficits in the absence of growth.

The irony of all this is that the markets now that austerity won't work, but insist on it anyway. What do I mean by this? That investors want some kind of guarantee that deficits will be reduced so that the state debt burden will be sustainable, but know perfectly well that retrenchment now will make the recession worse, making everything less sustainable.

So what indebted governments need is a mechanism for convincing the markets that deficit reduction will come, but not yet. This mechanism has to be some kind of credible European-level institution, that can commit to both sovereign solvency and growth. The current German obsession with punitive deficit reduction strategies is the last thing we need, since the alternative - euro exit and default - is in no-one's interests, yet may end up happening anyway because of the impossibility of everyone deleveraging at once.