The comparative political economy of the sovereign debt crisis in Italy and Spain

Lucia Quaglia (University of York)1

Sebastián Royo (Suffolk University)

Abstract

This paper sets out to explain why Spain experienced a fully-fledged sovereign debt crisis

and had to resort to euroarea financial assistance, whereas Italy did not. It dissects the

sovereign debt crisis into a banking crisis and a balance of payment crisis, arguing that banks

business model and distinctive features of national banking systems in Italy and Spain have

considerable analytical leverage in explaining the different playing out of the crisis in the two

countries. External factors, first and foremost, the idiosyncratic behavior of financial markets

and the delayed response of the EU, worsened the crisis. Bond markets spread contagion

effects, which irresolute EU intervention did not prevent.

1 Lucia Quaglia wishes to acknowledged financial support from the European Research Council (204398 FINGOVEU) and the British Academy (SG 120191). This paper was written while she was visiting fellow at the Max Planck Institute, the European University Institute and Hanse Wissenschaftskolleg. All errors and omissions are ours.

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1. Introduction

The sovereign debt crisis in Europe dealt a major blow to the international economy. The

periphery of Europe was particularly badly hit by this crisis: Greece was the first victim,

followed by Ireland, Portugal, Spain and Italy. Despite the fact that all these countries – often

collectively referred to with the unflattering acronym of PIIGS (Portugal, Italy, Ireland,

Greece and Spain) - were hit by the sovereign debt crisis, there are important differences

concerning the causes, the dynamics and the outcome of the crisis across countries.

This paper sets out to explain why Spain experienced a fully-fledged sovereign debt crisis

and had to resort to Euro-area financial assistance, whereas Italy did not. This is puzzling for

three reasons, which explain why these countries have been chosen for a structure focused

comparison. First, at the onset of the banking crisis in the 2007, Spain had a surplus in its

budget and its public debt was much lower than in Italy, whose public debt exceeded 100%

of GDP. Hence, Italy seemed to be a more likely candidate for a sovereign debt crisis than

Spain, which was on sound fiscal footing (see Table 1).

Second, in the academic literature, Italy and Spain are often ‘lumped’ together in the same

variety of ‘Southern European’ capitalism, which admittedly, is a residual category for

countries that cannot fit into liberal market economy and coordinated market economy

models. Consequently, one could have expected similar causes and outcomes of the crisis in

the two countries. Finally, in much of the popular press and policy-makers discourse

(especially in so-called ‘creditor countries’, such as Germany) the sovereign debt crisis is

often ascribed to the inability of ‘fiscally lax’ Southern European countries to adjust to

Economic and Monetary Union (EMU) and to sort out their fiscal imbalances in the boom

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years. Yet, as this paper shows, this was the case in Italy but not in Spain, where the main

cause of the crisis laid in a specific part of the banking sector.

Methodologically, the paper engages in a structured focused comparison of the playing out of

the sovereign debt crisis in Italy and Spain. It dissects the sovereign debt crisis into a banking

crisis and balance of payment crisis. Spain experienced a banking crisis: the bailing out of

banks substantially increased the public deficit and debt. By contrast, Italian banks, with one

exception, did not experience significant losses. Spain also experienced an unconventional

balance of payment crisis: when capital flew out of the country, euro-area assistance was

called upon to rescue ailing banks. Spain had a much higher net foreign debt than Italy: a

large part of that debt was private and generated by Spanish banks. Italy suffered from

chronic fiscal imbalances: it had lived with a high level of public debt (mostly domestically

held) for decades, but posted primary surpluses. However, the low growth rate in Italy

challenged the sustainability of the debt.

The paper investigates the domestic causes of the crisis, without ruling out the role of

external factors, first and foremost, the idiosyncratic behavior of financial markets and the

delayed response of the EU in worsening it. It is argued that banks business models and

distinctive features of national banking systems in Italy and Spain have considerable

analytical leverage in explaining the different playing out of the sovereign crisis in these two

countries.

By focusing on banks’ role in the playing out of the crisis, the paper contributes to three

distinct but interconnected bodies of literature in political economy. First, the research

pioneered by Hardie and Howarth (2013; see also Hardie et al. 2013; Deeg 2013) that focuses

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on banks activities in order to explain the evolution of national financial systems. Second, the

literature on domestic political economy institutions and economic policies, in particular the

role of these institutions in mediating the effects of external (macro-level) factors. Third, it

contributes to the literature on sovereign debt crisis, which so far has mostly focused on

developing countries. It questions the explanatory power of the literature on varieties of

capitalism with reference to the sovereign debt crisis.

The paper is organised as follows. Section 2 briefly reviews the literature on the macro and

meso level explanations of the crisis. Sections 3 and 4 examine the anatomy of the banking

crisis and the balance of payment crisis in Italy and Spain, pointing out the role played by

banks in fuelling these crises in Spain but not Italy. Section 5 discusses the impact of external

factors, in particular bonds markets; and euroarea interventions in the unfolding of the crisis.

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Table 1: Main Economic Indicators 2007-2013

Country Subject Descriptor Units 2007 2008 2009 2010 2011 2012 2013

Italy GDP % change 1.683 -1.156 -5.494 1.804 0.431 -2.292 -0.73

Italy Inflation % change 2.038 3.5 0.764 1.639 2.902 3.014 1.813

Italy Unemployment rate % labor force 6.108 6.783 7.808 8.408 8.425 10.552 11.064

Italy Government structural balance % potential GDP -3.292 -3.476 -3.635 -3.282 -3.406 -0.637 0.586

Italy Government net debt % GDP 86.892 88.781

97.19

4 99.098 99.62 103.073 103.908

Italy Current account balance % GDP -1.242 -2.905 -2.061 -3.551 -3.26 -1.476 -1.36

Spain GDP, constant prices % change 3.479 0.893 -3.742 -0.322 0.417 -1.538 -1.316

Spain Inflation % change 2.844 4.13 -0.238 2.043 3.052 2.44 2.426

Spain Unemployment rate % labor force 8.275 11.3 18 20.075 21.65 24.9 25.1

Spain Government structural balance % potential GDP -1.13 -5.019 -9.021 -7.317 -7.482 -5.389 -3.518

Spain Government net debt % GDP 26.7 30.801 42.49 49.805 57.485 78.626 84.43

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1

Spain Current account balance % GDP -9.995 -9.623 -4.822 -4.521 -3.526 -1.973 -0.148

International Monetary Fund, World Economic Outlook Database, October 2012

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2. State of the art and research design

A sovereign debt crisis occurs when a government defaults on its debt (Reinhart and Rogoff

2009) or is unable to borrow funds on the markets and has to resort to external financial aid

(Hardie 20121), such as the International Monetary Fund (IMF). A ‘banking crisis’ occurs

when ‘a country's financial and banking industry experiences a significant number of defaults

and…as a consequence… a large part of the capital in the banking system is reduced’.2 A

‘balance of payment crisis’ is preceded by persistently high current account deficits and net

capital inflows into a country, followed by massive and sudden outflows of capital from the

country, which triggers the crisis.

The literature in economics has paid considerable attention to the economic factors associated

to sovereign debt crises. One of the most extensive studies of financial crises over two

centuries highlighted a strong causal link between banking crises and sovereign defaults in

developed and developing countries (Reinhart and Rogoff 2009). In their book, Reinhart and

Rogoff reached three conclusions: i) private debt surges fuelled by domestic banking credit

growth are recurring antecedents to banking crises, ii) banking crises often precede or

accompany sovereign debt crises; iii) governments often have “hidden debts”. Another paper

pointed out the link between banking crises and balance of payment crises (the so –called

twin crises) (Kaminsky and Rogoff 1999). Kaminsky and Rogoff found that problems in the

banking sector typically precede a currency crisis - the currency crisis deepens the banking

crisis, activating a vicious spiral; financial liberalization often precedes banking crises. Crises

occur as the economy enters a recession, following a prolonged boom in economic activity

that was fueled by credit, capital inflows, and accompanied by an overvalued currency. These

2 http://www.stlouisfed.org/publications/re/articles/?id=2096 accessed in January 2013

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accounts, written by economists, are somewhat de-voided of politics and one is left to explain

the causes of banking crises and the balance of payment crises in the first place.

In the political economy literature, several complementary explanations have been put

forward for the occurrence of sovereign debt crises, mainly in developing countries. These

explanations can be articulated at the macro-level (international level), meso-level (ie

national level) and micro-level (Germain 2012). At the macro-level, different authors have

pointed out a variety of factors that can fuel sovereign debt crises, namely: the impact capital

liberalization (XXX); the activity of bond markets (Mosley 2003) and financial innovation,

especially financialisation (Hardie 2011); the spread of neo liberal ideas (Major 2012 ); and

the lack of a proper hegemon in the international system (cf Kindleberger 1973), or more

recently in the European Union (Mabbet and Schelke 2013).

While some elements of the crisis can certainly be explained by international systemic

factors, particularly the withdrawal of foreign funds, macro-level factors are basically the

same for all countries, especially within the relatively homogenous regional block of the

euroarea. Hence, they are not very well suited to explain differences in the playing out and

outcome of the sovereign debt crisis across the euroarea. They are background factors that

have fuelled the sovereign debt crisis, but national level factors are better suited to explain

different dynamics and outcomes of the crisis across countries (see Jabko 2012; Haggard and

Mo 2000).

An obvious starting point in order to investigate the importance of national level factors in

the playing out of the sovereign debt crisis is the literature on varieties of capitalism (for

some comprehensive analyses, see Amable 2003, Hancke, Rhodes, and Thatcher 2007; Hall

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and Soskice 2001; Schmidt 2002; for a review, see Jackson and Deeg 2010). This body of

work has examined the main components of varieties of capitalism, namely: industrial

relations institutions; education and training systems; corporate governance and systems of

corporate financing; product markets; social protection systems and welfare states; and public

intervention in the economy. The financial system has also been considered as one of the

components of the variety of capitalism, but the attention has mostly been on the sources of

corporate finance (see Zysman 1983, see also Deeg 2010).

This literature has generally focused on the Anglo-Saxon and continental varieties of

capitalism, characterizing them, respectively as ‘liberal market economies’ and ‘coordinated

market economies’. The Southern European countries have mostly been overlooked or placed

in a residual category of ‘Southern European’ or ‘State- led’ model of capitalism (Schmidt

2002; Della Sala 2004).3 The literature on varieties of capitalism is of limited utility in order

to explain the dynamics and outcome of the sovereign debt crisis in Italy and Spain, as it

would predict similar (not different) outcomes. To be fair this literature was not developed

with a view to explaining sovereign debt crises, but rather to tease out institutional

complementarities that can enhance or hinder the competitiveness of national economic

systems in the world economy.

Two other bodies of literature are useful to investigate domestic factors at the origins of the

crisis. The first is the research pioneered by Hardie and Howarth (2013; see also Hardie et al.

2013; Deeg 2013) that focuses on banks activities in order to explain the evolution of national

financial systems. Since banks were at the epicenter of the crisis, it is important to understand

what they were doing in the run up to and during the crisis. Furthermore, the literature on 3 Indeed, this literature has been criticized for overlooking of countries that do not fit easily into liberal market economies’ and coordinated market economies’, for neglecting the role of the state and the broader macroeconomic framework. An exception is the work of V. Schmidt (2002) that has brought the state and its macroeconomic institutions ‘back in’ into the analysis of varieties of capitalism.

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domestic political economy institutions and economic policies draws our attention to the role

of domestic factors in mediating the effects of external (macro-level) factors, for example

framing the impact of liberalization (Deeg and Perez 2000), and/or bringing about domestic

economic reforms (Perez 1997, Perez and Westrup 2008).

The dependent variable of this research is the playing out of the sovereign debt crisis in Italy

and Spain. In June 2012, the Spanish government requested euroarea financial assistance,

which was agreed by the Eurogroup meeting in July. It was agreed that financial assistance

from the euroarea member states was to be provided to the bank recapitalisation fund of the

Spanish government, and then channeled to ailing financial institutions in Spain. In

December 2012, the Spanish government formally requested the disbursement of about €39.5

billion of funds.4 By contrast, the Italian government has not requested outside financial

assistance to date, even though, like Spain, it benefited substantially from the purchase by the

European Central Bank of government bonds in the secondary markets in an attempt to

reduce borrowing costs, as discussed below.

This different outcome of the crisis is explained by the fact that Spain experienced a banking

crisis and balance of payment crisis, whereas Italy did not. In Spain (but not in Italy), there

was also a real estate bubble: the banking crisis cannot be understood without reference to the

real estate bubble. In parallel to the banking crisis, Spain experienced a balance of payment

crisis. Spain had a high net foreign debt, fuelled in the bonanza years by capital inflows.

When the banking crisis gained momentum in Spain and capital flew of the country, external

(euroarea) assistance was called upon. Italy escaped the worst of the sovereign debt crisis

mainly because of its relatively low external debt and balance of payments imbalances as

compared to Spain. Italy had lived with a high public debt for decade, but the level of private

4 http://ec.europa.eu/economy_finance/assistance_eu_ms/spain/index_en.htm accessed in March 2013.

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debt was rather low, and the public debt was mostly domestically owned. For example,

Japan’s public debt exceeds 200% of its GDP, but is mostly domestically held and the

country has not been threatened by a sovereign debt crisis.

What explain the banking crisis and the balance of payment crisis that conflated into the

sovereign debt crisis and the request for external financial assistance in Spain but not in Italy?

This paper argues that a key role was played by banks. In other words, banks business model

and the distinctive features of the banking sector in Spain and Italy account for the banking

crisis and the property bubble in Spain and for the absence of a banking crisis and a property

bubble in Italy. Banks also contributed to fostering the external imbalances that caused a

balance of payment crisis in Spain, whereas this was less the case for Italian banks.

3. The (late) banking crisis in Spain but not Italy

Initially, after the collapse of the the subprime market in the US in late 2007 and the

bankruptcy of the US financial firm Lehman brothers in October 2008, Italian and Spain

banks weathered the banking crisis rather well: they did not experience major losses and did

not need state recapitalisation. The limited impact of the banking crisis in Italy and Spain is

explained by the banks business model and balance sheets, which were in turn influenced by

the sound regulatory framework in Italy and Spain (see Barth and Levine 2006). 5 Moreover,

Italian and Spanish banks were relatively sheltered from the most intense forces of global

financial contagion in 2008-9: Italian and Spanish banks did not invest in ‘fancy’ financial

products that later proved to be ‘toxic’. The expansion abroad of Italian and Spanish banks

was mostly in retail business, with ownership of retail subsidiaries and participation in

5 The data produced by Barth and Levine (2006) on capital stringency and bank regulation show the diversity of regulatory practice across countries. Italy and Spain scored high in terms of stringency of regulation.

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banking groups in Central and Eastern Europe, for Italian banks, and Latin America for

Spanish banks.

Nonetheless, in late 2009, major financial problems began for the Spanish saving banks

(cajas), which had to be recapitalised first by the Spanish government and then through

euroarea financial assistance. Italian banks, with the exception of the recent case of the Monte

dei Paschi, did not experience significant losses. The bad performance of Spanish cajas is

explained by bad mortgages and loans to construction companies, which in turn fuelled a

property bubble in Spain. The Bank of Spain had limited supervisory competences on the

cajas, whose management was affected by the interference of local politicians. Italian banks,

less subject to political interference, mainly lent to non financial corporations, especially

small and medium enterprises.

Italy

At the outset of the global financial crisis, in Italy (as in Spain) the majority of banks’ assets

were loans to customers, and a significant part of banks’ assets involved national government

securities, which at that time were considered among the safest possible asset investments

(Pagoulatos and Quaglia 2013, Royo 2013b). Unlike Spanish banks, Italian banks did not fuel

a property bubble: they lent to households far less than either Spanish or Greek banks.

Lending to Non-Financial Corporations (NFCs) was higher in Spain, than in Italy and

Greece, though not really dramatic. However, in Spain the NFC lending included a very large

proportion of property developers, especially for the cajas, as explained below. Data from the

Bank of Italy (2008c) suggest that Italian banks were predominantly lending to NFCs, and

that amongst NFCs, the bulk of the loans went to services and industry, not building (see

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Table 2). Obviously, a property bubble can come also from residential mortgage lending, but

there was no significant rise in consumer lending in the years preceding the crisis.

On the liabilities, Italian and Spanish banks had a broad and stable funding base. Funding

from retail customers, more stable than wholesale funding, constituted a large share of the

total liabilities in both countries (Pagoulatos and Quaglia 2013, Royo 2013b). However,

banks in both countries also depended on wholesale inter-bank funding, which some

importance differences. First, Italian banks tended to lend mostly to each other. The average

home bias for Italy was the highest in the euro area’s national banking systems (Manna

2011). At the height of the crisis, banks cut their lending to banks in other countries far more

than their lending to banks in their own country, so the fact that Italian banks lent to each

other suggests that inter-bank borrowing was more stable than in those systems (like Spain)

where inter-bank funding was largely from abroad.

Second, although Italian banks have high levels of wholesale funding, this is relatively longer

term: ninety-three per cent of debt securities issued by Italian banks are over two years in

maturity and none are under one year. For Spanish banks, the figures are seventy-three and

twenty-two per cent respectively. Third, several of the debt securities issued by Italian banks

were sold to their customers, which made this sort of funding less subject to the vagaries of

the financial markets. Italian banks have greater access to retail investors for their bond issues

than elsewhere in Europe (Bank of Italy 2011).

Table 2. Italian banks’ loans distribution by: Customer segment of economic activity

September 2007 October 2008

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TOTAL LOANS (million of euros) 1,453,323 1,500,679

SEGMENT OF ECONOMIC ACTIVITY

General government 56,985 58,357

Financial companies 161,470 168,448

Non-financial companies 775,447 809,079

of which: Industry 259,068 274,649

Building 108,621 110,943

Services 393,365 408,285

Producer households 88,665 89,645

Consumer households 370,809 375,151

Bank of Italy (2008). Summary Report of the Statistical Bulletin 2007-2008, Data on credit,

securities business and interest rates, quarter 4, p.3.

The only Italian bank that experienced serious problems as a consequence of the global

financial crisis was the Monte dei Paschi di Siena, which is the world’s oldest bank. In

February 2013, it was the subject of a major scandal involving losses of 730 millions euros

from (‘toxic’) financial products that had previously been hidden from the supervision of the

Bank of Italy. The transactions took place between 2007 and 2009. The scandal discredited

the bank's former management, which was by and large appointed by local politicians (the

municipality of Siena and the region of Tuscany are mostly governed by the Democratic

party). It exposed the close lies between politicians and banks. It also questioned the

supervisory activity of the Italian central bank, the Bank of Italy, which has extensive

supervisory powers. The supervisory department of the Bank of Italy pointed out that the

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management of the Monte dei Paschi had hidden from the central bank the ‘toxic’

transactions that led to financial losses.

Unlike in Spain, in Italy there was not direct competition between commercial banks and

savings banks, which were subject to the same regulatory framework. The banking reform in

Italy in the late 1990s and early 2000s was instrumental in facilitating the merger of

commercial banks and saving banks, as well as in modernizing the Italian banking system.

Prior to the reform, saving banks in Italy, like the cajas, tended to have close ties with local

communities and local politicians (Deeg 2013), as it was still the case for the Monte dei

Paschi.

Despite the Monte dei Paschi debacle, banking supervision in Italy has been assessed as

systematic and diligent during the crisis and in the years preceding it (IMF 2008). The Bank

of Italy, like the Bank of Spain, discouraged lenders from adopting risky ‘off balance sheet’

accounting methods and from acquiring billions of Euros of repackaged US subprime

mortgages and other toxic assets. Moreover, the Bank of Spain and Bank of Italy were

instrumental in forcing banks to focus on conservative risk management and quality of

capital, limiting their leverage and the debt to equity ratio.

Spain

In Spain, between 2008 and 2010 the financial system was still one of the least affected by

the crisis in Europe. In December 2010 Moody’s ranked the Spanish banking system as the

third strongest of the Eurozone, only behind Finland and France. Spanish banks, like Italian

banks, had a rather traditional business model. As in the case of Italy, in Spain the majority of

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banks’ assets were loans to customers. On the liabilities, Italian and Spanish banks had a

broad and stable funding base, mainly from retail customers (Pagoulatos and Quaglia 2013,

Royo 2013b). However, Spanish banks raised funding on the wholesale market more than

Italian banks, which made the former more vulnerable to the credit crunch (it the freezing of

the interbank market) than the latter. The Bank of Spain had imposed a regulatory framework

that required higher provisioning, which provided cushions to Spanish banks to initially

absorb the losses caused by the outset of the global financial crisis (Royo 2013a).

Nevertheless, the relative success of the Spanish banks proved short lived. The collapse of

the real estate market eventually led to a traditional banking crisis fueled by turbo-charged

lending funded on the interbank-market on the liability side of the Spanish bank’s balance

sheets. However, Spain was rather unique in the fact that the largest banks did not face large

problems. While the cajas were struggling under the weight of bad mortgages and loans to

construction companies, the exposure of ‘Big Three’s’ large private banks to toxic assets

associated with the Spanish real estate sector was a relatively small problem. BBVA and

Santander diversified internationally gaining access to funding and capital that allowed them

to liquidate the toxic property assets at a lower price than their rivals, and with limited

damage to their earnings.

When looking at the performance of the Spanish financial system, it is very important to

distinguish between the large banks and the cajas - unlisted in the stock market, regionally

based, and often politicized savings banks— accounting for half of the financial sector’s

assets. The large banks performed relatively well during the crisis while the cajas suffered

from a somewhat traditional financial crisis. Much of what the cajas were doing was lending

to NFCs in construction, rather than just mortgage lending. Yet, a key element that separates

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this crisis from a traditional one, particularly on the cajas’ side, is their heavy borrowing on

the interbank market (Carballo Cruz 2011). This distinction is unique in comparative terms;

in no other country were small banks uniquely hit and large banks left largely unscathed.

During the boom years, the cajas successfully captured market shares from the banks,

investing heavily in real estate (lending both to consumers and companies). Significant levels

of interbank liabilities were taken on by both the big Spanish banks and the cajas, but in

particular by the cajas in the context of their efforts to expand and strengthen their national

presence, as illustrated most visibly by a rapid growth in the number of employees and

branches. When the economic recession kicked in, they were exposed to the collapse of that

sector and the payment difficulties of mortgage holders. Cajas, highly dependent on

international wholesale financing, were also forced to turn to the government and the ECB

for liquidity when wholesale markets froze.6 Fortunately for the largest Spanish banks, their

geographical diversification helped them to counterbalance their domestic losses.

In the end in Spain the financial system, to be precise the cajas was unable to decouple itself

from the economic cycle and the huge macroeconomic crisis that has besieged the country.

The deteriorating economic conditions had a severe impact on the banks’ balance sheets. The

liquidity problems of Spanish banks problems were reflected in their dependence on the ECB.

Spanish banks increased their ECB borrowings by more than six times since June 2011. In

March 2012, they borrowed a record 316bn euro from the ECB, 28 percent of the euroarea

total, the highest level in absolute terms among euro area banking systems (Royo 2013b).

6 By May 2010, 34 of the 45 cajas were involved in merger and restructuring discussions; it was expected that that would lead to the creation of 11 new cajas.

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In Spain, the distinction between banks and cajas is key to understand the banking crisis that

developed from 2010 onward. Indeed, their performance has been very different. A crucial

reason for this divergence was the difference in their regulatory framework. Cajas are very

peculiar credit institutions because they used to dedicate a significant portion of their

provisions (usually over 20 percent) to social causes, and, prior to the crisis, they have strong

links with the regions in which they operate. They are regulated by both the national

government (in charge of basic norms) and by the autonomous communities governments (in

charge of application and development of the rules established by the central government).

Political institutions (parties and unions) participate in their governing bodies.7 This proved to

be a gaping hole in the regulatory framework, and had devastating consequences.

Since the crisis started, the country adopted five financial reforms in three years, and

implemented three rounds of bank mergers (for more details, see Royo 2013c). Many cajas

were merged and their number dropped from 45 to 9. The Spanish government repeatedly

increased the capital provisions. Those banks unable to meet the new provisioning rules were

able to borrow the additional money in the form of state-backed convertible bonds carrying a

10% interest rate. Furthermore, banks could transfer their riskiest assets to state-guaranteed

asset management companies to help speed the sale of real estate assets the bank holds. Each

bank was forced to create a bad bank into which it will put physical property assets at marked

down valuations, in preparation for potential sales to outside investors.

In May 2012, the Spanish government was forced to nationalize Bankia the country’s largest

real estate lender and the result of the merge of several ailing cajas. This was the largest bank

nationalization in the country’s history and was overseen by the Bank of Spain. The failure of

7 However, it is important to stress that political control was not always detrimental. In the Basque Country, there was strong political control of the cajas, and still the Kutxa channeled most credit towards the business sector (Fisham 2012).

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Bankia validated some concerns about insufficient regulatory oversight and the perception

that banks and the Bank of Spain had played down the risk posed by real estate loans. In

August 2012, a new financial reform was approved in response to the EU financial rescue

package. It created a bad bank that could absorb the toxic assets from the real estate sector,

and had the authority to buy and sell all kind of assets and to issue bonds. The reform

reinforced the role of the Bank of Spain in the creation of the bad bank. It also established a

new process to restructure and liquidate financial institutions and it gave a central role in that

process to the FROB and the Bank of Spain. Finally, the reform reduced the role of the

regional governments in the restructuring and liquidation of cajas and saving cooperatives.

These five reforms in less than three years were largely perceived as ‘too little and too late,’

and failed to sway investors’ confidence in the Spanish financial sector. Both the Socialists

and Conservative governments were reluctant to admit the depth of the liquidity and solvency

problems of many institutions, particularly the cajas, where politics has continued to play a

role throughout the crisis.

4. The balance of payment crisis in Spain, but not Italy

Both Italy and Spain suffered from internal and external imbalances. As Bini Smaghi put it

(2008) ‘external imbalances are the reflection of internal imbalances’. All the periphery

countries hit by the sovereign debt crisis had a persistent current account deficit over the last

decade or so, coupled by significant private capital inflows from 2002 to 2007-9. In

comparison to the other countries, in particular to Spain, which had the largest current

account deficit in the euroarea, Italy had a much smaller current account deficit. It also

experienced very limited capital inflows.

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In the first four countries, large current account imbalances were mainly funded through

portfolio debt securities and banks loans (Commission 2006), not so much by foreign direct

investment, with the exception of Ireland. As Merler and Pisani-Ferry (2012) note ‘Such a

financing structure, biased towards banks’ intermedia-tion, rendered the deficit countries very

exposed to the unwinding of capital inflows…..’. Indeed, when the banking crisis began,

followed by the sovereign debt crisis, the capital inflows of the previous decade were

followed by large capital outflows.

This trend was reflected by the positions of the eurosystem central banks in the TARGET 2 –

the interbank payment system of the Eurosystem. Until 2007, TARGET 2 positions were

close to balance. When the global financial crisis began in 2007 and even more so when the

sovereign debt crisis broke out in 2010, imbalances emerged within TARGET 2, whereby

Germany was the largest creditor and Greece, Spain, Ireland and Portugal were net creditors.

Italy became a major net debtor in TARGET 2 in the summer of 2011. As Merler and Pisani-

Ferry explain ‘Once the crisis broke out in the euroarea, sub-stitution of private-capital

inflows by public inflows, especially Eurosystem financing, helped accommodate persistent

current-account deficits…’ 8

Spain

Despite the tendency to lump Spain, Italy, Greece, Portugal and Ireland together and view the

crisis as caused by fiscally irresponsible governments, Spain’s public finances were in robust

shape prior to the European sovereign debt crisis: public debt was only 36.3% of GDP, and

the country had budget surpluses from 2003 through 2007. In Spain, the public deficits and

8 Merler and Pisani-Ferry (2012) estimated that the cumulated net position of the northern euro-area central banks reached €800 billion in December2011, being matched by the southern euro-area central banks' equivalent negative position.

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then the debt soared as a consequence of the crisis, in response to which the government

implemented an €8 billion public-works stimulus. These expenses, combined with the fall in

revenues, the need to recapitalize a large number of Spanish banks (see previous section) and

the deficits run by the regions, blew an enormous hole in the public accounts (see Table 1).

The regions struggled to cut their budget deficits, were shut out of the credit markets, and

were crippled by mountains of debt accumulated during the boom years. Many of these

regions asked the national government for emergency financing, tapping into the 18bn fund

set up by the central government to help regional governments meet their debt repayment

obligations. The regional governments combined debts of 140bn euros, of which 35bn euros

matured in 2012. Hence, Spain’s regional state structure, and with the exception of the

Basque Country and Navarra, the very limited fiscal powers of the regional governments

worsened the state of public finance.

The key problem for Spain, unlike Italy, was not so much the public sector debt in as much as

the private-sector debt, driven by record-low interest rates after the country joined EMU and

fuelled by reckless banks’ investments and loans (see Table 3). These, in turn, fuelled a

property bubble, which Italy, unlike Spain, did not experience. Land prices increased 500

percent in Spain between 1997 and 2007. At the end of 2010, the International Monetary

Fund (IMF) reported that Spain had the largest real estate bubble in the developed world. But

the global financial crisis burst it: because of high unemployment and lower wages caused by

the economic crisis many mortgage holders were unable to repay their debt.

By the end of 2011, land prices, adjusted for inflation, had fallen about 30 percent from the

2007 peak, and home prices were off about 22 percent. House prices fell by 11.2 percent in

21

2011 alone, while in Madrid, prices went down by 29.5 percent. Expectations, however, are

that the entire original house price increases may be reversed, so prices would have to fall

40% from that level.9 The implosion of the real estate market exposed the vulnerability of the

banking sector to that market, which constituted 60 percent of the banking loans (i.e., loans to

families, enterprises in the real estate sector or direct real estate assets), as explained in the

previous section, which pointed out the role of banks and municipalities in fostering the

bubble. In Spain, the decision by the cajas to channel funding disproportionally to the

construction sector (both to construction companies and real estate developers) and toward

private mortgages (their reticence to lend to SMEs outside of the construction and real estate

sectors) was critical to fuel the bubble in that sector (see Serra Ramoneda 2011). Moreover,

restrictive lending to SMEs was one of the reasons that accounts for the poor labor market

performance of the country because it undercut these firms’ efforts to create jobs and

innovate (Fishman 2010, 293–299).

Unlike in Italy, the main fiscal problem in Spain was not the total amount of its public debt,

but rather the fact that it is mostly held abroad. Hence, the country’s problems intensified

when foreign investors became more reluctant to refinance its debt, as reflected from the

increasing yields in the last two years (see Figure 1). This high degree of Spain’s external

indebtedness was partly the consequence of the record current account deficits that Spain

suffered during the first decade of EMU membership. Since joining the final stage of EMU

the current account has been in deficit in Spain. In 2007, it reached the record of almost 10%

of GDP, one of the highest in the euro area. These current account imbalances were funded

through portfolio debt securities and banks loans (Commission 2006). As Merler and Pisani-

Ferry (2012) note banks’ intermediation played a key role in attracting capital inflows and

9 “A complacent Europe must realize that Spain will be next,” in Financial Times, April 11, 2011.

22

channeling them in the construction sector, rendering the Spanish economy vulnerable to the

sudden withdrawal of these funds.

Figure 1. Debt Burden in Selected Advanced Economies (Percent of GDP)

Source IMF Global Financial Stability Assessment 2012.

Italy

In Italy the gross public debt was very high before the crisis. Italy has managed a public debt

above 100 GDP for the last three decades. On the negative side, the Italian government failed

to take advantage of the low interest rates following the entry of the country into EMU in

order to substantially reduce the outstanding public debt (refs needed). On the positive side,

23

Italy has run a primary surplus from 1992 onwards, with the exception of a primary deficit in

2009 and 2010, which were mainly due to a falling growth rate (see Table 1).

The main problem in the Italian case was not so much the high level of public debt, especially

taking into account that the relatively low level of private debt and the fact that the public

debt is mostly held abroad. Italy had lived with a high public debt for decades. However, the

very low growth rate raised serious issues about the sustainability of the public debt (Jones

2011). Italy has been suffering from low economic growth for more than a decade: 0.54 per

cent annual average real GDP growth between 2000 and 2010 versus 1.37 per cent for the

euroarea, whereas economic performance in Spain was significantly better during the decade

prior to the crisis (thanks largely to the state bubble). Since the beginning of the crisis, the

low or negative economic growth and rising unemployment in Italy and Spain worsened the

state of the public finance.

Table 3. Indebtedness and Leverage in Selected Advanced

Economies

(Percent of WEO projections for 2012)

Euro

Area

Ital

y

Spai

n

General Government Debt

Gross 90 123 79

Net 70 102 67

Primary balance -0.5 3 -3.6

Household Debt

Gross 70 51 89

24

Net -123

-

171 -72

Nonfinancial Corporate Debt

Gross 138 112 196

Debt divided by equity (percent) 106 139 149

Financial Institution

Gross debt 142 97 109

Leverage of domestic banks 23 19 20

Bank claims on public sector n.a. 32 26

External Liabilities

Gross 191 142 221

Net 14 23 93

Government debt held abroad 25 49 28

Source. IMF Global Financial Stability

Assessment 2012

Unlike Spain, Italy had a limited degree of external indebtedness and did not experience the

high level of capital inflows that Spain had. This was the consequence of the relatively small

current account deficits that Italy suffered during the first decade of EMU membership and

the high saving rate in the country. Far more export-led than all other Southerners, Italy had a

lower current account deficit (see Table 1). Unlike Spain, Italy has the second-largest

manufacturing and industrial base in Europe, after Germany, and is one of the biggest export-

oriented economies in the euro zone. ‘Made in Italy’ is still a valuable brand the over the

world. Moreover, Italian banks did not perform the intermediating function that Spanish

banks had by channeling capital inflows into a property bubble.

25

Both Spain and Italy suffered from a loss of competitiveness since joining EMU, hence once

they gave up the possibility of devaluing their currency. Between the introduction of the euro

and 2008, unit labor costs in the manufacturing sector, the strongest indicator of the

economy’s competitiveness, increased substantially in Italy and Spain (see Figure 2). During

that period, the countries’ productivity increased marginally. According to the World

Economic Forum’s annual 2012 competitiveness ranking ‘one of the shared features of the

current situation in all these [Southern European] economies is their persistent lack of

competitiveness….Over all, low levels of productivity and competitiveness do not warrant

the salaries that workers in Southern Europe enjoy and have led to unsustainable imbalances,

follow by high and rising unemployment’.

Figure 2

Source: OECD.

26

5. Macro level factors: Bond markets and euroarea assistance

There are two types of external factors that are important in the playing out of the sovereign

debt crisis in Italy and Spain: the reactions of the bond markets as manifested by the spread

between Italian and Spanish bonds yields and German ones, and external financial assistance.

In Spain, there was no IMF financial assistance. euroarea financial assistance has taken three

forms in Spain: provision by the Eurosystem of liquidity to the banking sector through

TARGET 2 (see Section 3); ECB purchases of sovereign bonds under the SMP and euroarea

assistance programmes. Both in the case of Italy and Spain these external factors were mostly

a function of the domestic development in the two countries, rather than being causes of the

sovereign debt crisis. Bond markets contributed to the contagion effect that hit Spain and

especially Italy. Delayed and ad hoc euroarea financial assistance also contributed to this.

When the sovereign debt crisis broke out in Greece in 2009-2010, Italy and Spain were

initially unaffected, as suggested by the ten years spreads on government bonds for Italy and

Spain versus the German bunds (see Table 4). Spain began to face serious problem in the

bond market in the second half of 2010 because of rising concerns about the crisis in the

financial sector, the continuing decline of the real estate sector, and the impact of the

economic recession. The Socialist led government overestimated the capitalization of Spanish

companies, the resilience of the Spanish financial system, the strength of the counter cyclical

dynamic provision system; and the openness and competitiveness of the Spanish economy.

At the same time, the attempt to force restructuring through mergers backfired, as proven by

the Bankia fiasco (a savings and loan that had to be nationalized in the Spring of 2012): the

governments failed to recognize that merging weak banks does not create a strong one.

27

Italy began to face serious problem in the bond market in the summer of 2011: the spread

between Italian ten-year bonds and their German counterparts widened; Italian sovereign debt

yields moved above those charged to Spain; and rating agencies downgraded the

creditworthiness of the Italian government and consequently of Italian banks. [Beside the

economic crisis, Italy was also facing a political crisis, with several scandals (including sex

with an underage woman) involving the then Prime Minister Silvio Berlusconi. There was

also an open conflict within the government between the Prime Minister and the Treasury

Minister Giulio Tremonti, which weakened the government coalition. The deterioration of the

fiscal situation and the inability of the centre-right government of Silvio Berlusconi to put

together a convincing adjustment package, together with strong diplomatic pressure from

abroad, led to the government resignation and the nomination of the ‘technocratic’

government headed by Mario Monti in November 2011 (Jones 2011).

Spain also underwent a change of government, though not to a technocratic one. The Partido

Popular government, which came to power at the end of 2011, sought to convince the market

of the government’s commitment to austerity and structural reforms, but without positive

results. They tried to execute a ‘hail Mary’ in the form of deep cuts and structural reforms,

but this ‘shock and awe’ strategy did not work. If anything, the PP government policies in the

first half of 2012 were also mired in parochialism, often showing more concern about

political interests than doing the right thing.

Table 5: Ten Years Government Spreads for Italy and Spain (2009-2012)

Bonds-Ten Years Government Spreads (September 30th, 2009)

Bid Yield Spread Vs. Bund

28

Italy 4.03 +0.79

Spain 3.83 +0/59

Bonds-Ten Years Government Spreads (September 30th, 2010)

Bid Yield Spread Vs. Bund

Italy 3.86 +1.58

Spain 4.13 +1.85

Bonds-Ten Years Government Spreads (September 30th, 2011)

Bid Yield Spread Vs. Bund

Italy 5.55 +3.66

Spain 5.13 +3.24

Bonds-Ten Years Government Spreads (September 28th, 2012)

Bid Yield Spread Vs. Bund

Italy 5.17 +3.71

Spain 5.97 +4.51

Bonds-Ten Years Government Spreads (November 23rd, 2012)

Bid Yield Spread Vs. Bund

Italy 4.76 +3.32

Spain 5.62 +4.19

Source: Thomson-Reuters

29

In December 2011, the ECB launched a program of Long Term Refinancing Operations

(LTRO), issuing loans at the interest rate one per cent for a period of three years to European

banks, accepting government bonds, mortgage securities and other commercial papers in the

portfolio of the banks as collaterals. At the same time, the ECB changed its rules on

collaterals, accepting lower quality collaterals in return for its loans. Under this program, the

ECB loaned €489 billion to 523 banks, mainly in Greece, Ireland, Italy and Spain. Indeed,

Italian and Spanish banks took about sixty per cent of all the net new loans from the ECB,

with Spain's overstretched banks taking marginally more than Italy's. 10 The banks used these

funds to buy government bonds, effectively easing the debt crisis. In February 2012, the ECB

held a second three year auction of €529 billion to 800 European banks. Although the ECB

program did not target specifically Italy, the country benefited through a temporary reduction

of its borrowing costs. The ECB lent to euro area banks, which in turn lend to euro area

governments, and then used the government debt they bought as collateral for yet more loans

from the ECB.

Market instability in the euroarea and the unsustainable borrowing costs for countries such as

Spain and Italy led to ECB’s decision, announced on 6 September 2012, to purchase euroarea

countries’ short-term bonds in the secondary markets, as part of the new program dubbed

Outright Monetary Transactions (OMT). However, government from the beneficiaries

countries were required to apply for aid from the euroarea rescue funds and to comply with

conditions in exchange for the support. In the fall and early winter of 2012, Spain was

considering whether to apply for this aid. The Spanish government, facing regional elections

in the Basque Country, Galicia, and Catalonia, was keen to avoid the humiliation of

requesting another bailout and having European authorities dictate the conditions of a rescue.

10://www.bbc.co.uk/news/business-18058270

30

The Italian government has repeatedly ruled out the possibility of requesting EU financial

assistance, pointing out that the economic situation of Italy was different from that of the

countries that had requested EU financial assistance. The Italian authorities often highlighted

the ‘permanent risk of contagion’, portraying Italy as a bystander in the crisis, and argued that

‘the strengthening the euro zone is of collective interest’ (New York Times, 11 June 2012). At

the EU level, in June 2012, together with the Spanish government, the Italian government

called for and obtained the creation of an ‘anti-spread shield’, that is a mechanism to stabilize

markets and to fix a ceiling for interest rates of so-called ‘virtuous’ countries (Sole 24 Ore, 5

July 2012). The Italian Prime Minister made it clear; however, that Italy would not use the

measure for the moment.

Conclusion

Despite the fact that Italy and Spain are often considered as belonging to the ‘Mediterranean’

variety of capitalism, there are important differences in the way in which the crisis played out

in these two countries. This is because a coherent variety of Mediterranean capitalism is

missing and certain domestic political economy institutions – namely, banks - that are key in

order to explain the outcome of the sovereign debt crisis are overlooked by the literature on

varieties of capitalism.

This analysis highlights the important role that banks had in the playing out of the crisis.

Banks in Spain (to be precise, the cajas) turbo charged a property bubble. The implosion of

this bubble in Spain, together with the dependence on wholesale market liabilities, and the

depth of the economic crisis got the Spanish cajas into trouble, triggering a rather ‘traditional’

banking crisis. The Spanish government did not have the fund to recapitalize these banks and

31

had to resort to EU funds. Hence, the sovereign debt crisis in Spain was triggered by the

banking crisis, worsened by a balance of payment crisis, which was caused by a high net

foreign debt and sudden capital outflows. In both countries the accumulated loss of

competitiveness worsened the current account deficit, which was however much larger in

Spain than in Italy. Unlike Italy or Greece, at the outset of the crisis Spain had a strong fiscal

position, hence the financial crisis in Spain originated from private sector overindebtedness

(as in Ireland). The soaring public deficit and debt were largely a result of the banking crisis.

By contrast, Italian banks did not fuel property bubble and did not experience significant

losses during the global financial crisis. It was the high level of debt (which increased, though

not substantially, during the crisis) and the low level of growth that raised concern about the

debt sustainability. Unlike in Spain, Italian banks were not instrumental in fostering

significant capital inflows, making the country less vulnerable to a balance of payment crisis

as a consequence of sudden capital outflows. All this explain why Spain had a fully-fledged

sovereign debt crisis, resorting to EU financial aid, whereas Italy did not.

The Italian and Spanish experiences show the importance of domestic political economy

institutions, to be precise of banks business models and regulatory/supervisory framework in

the development of the two crises that conflated into the sovereign debt crisis. The collusion

between local politicians and the management of the cajas proved to be a toxic mix for the

Spanish banking system. Moreover, the cajas partly managed to escape regulation and

supervision of the Banco de Espana. The Spanish commercial banks remained sound and

profitable, and so did Italian banks. The main ‘toxic’ product in the portfolio of Italian banks

are currently Italian public bonds.

32

33

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