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Just when you thought it was safe to go outside, it turns out that another storm is gathering on the eurozone horizon.

Spain was always on the “one to watch” list. It now finds itself in a vicious circle. The interest rate on its public debt is rising, the economy is stalling and the government is fast losing the enthusiasm to deliver the austerity demanded by Brussels. The process then repeats itself.

Reflecting both the economy’s descent into recession and the significant budget deficit overshoot last year, the government led by Mariano Rajoy recently told Brussels that it was aiming for a budget deficit this year of 5.8 per cent of gross domestic product, rather than the 4.4 per cent agreed earlier. An almighty row then broke out. A compromise target of 5.3 per cent was eventually set.

Even if that is achieved – and with 17 autonomous regional governments in Spain all happily spending away, there is no guarantee – the thorny matter of reducing the deficit further to 3 per cent of GDP in 2013 remains.

For an economy shrinking rapidly, deficit reduction on this scale is not easy. Whatever one thinks about Greece’s initial fiscal problems, they were exacerbated by the subsequent economic collapse. In the autumn of 2010, the International Monetary Fund thought Greece would shrink by 2.6 per cent in 2011. We now know that the economy last year contracted by about 7 per cent. The Greek fiscal position was bad not only because of a lack of effort but also because the economic problems were far bigger than expected.

Major deficit reduction in the wake of economic collapse is near impossible, particularly when the population starts to protest. Spain is preparing for a general strike on March 29. Yet the more it resists deficit reduction, the greater will be the suspicion that the authorities are merely dragging their feet. Perhaps they are hoping for further help from the European Central Bank’s longer-term refinancing operations to push Spanish yields back down. This would save the day for the government, for its banks (now up to their gills in Spanish government debt thanks to the carry trades generated by the first two LTROs) and for the single currency, all without the need for more painful austerity.

Here, then, is the problem. Have Spanish yields risen because investors no longer believe the country is either willing or capable of delivering the austerity? Or is it because investors think the eurozone’s creditor nations – and their acolytes at the European Commission – are running out of patience? Either argument could be used to explain the rise in yields, yet there is a world of difference between deliberate slippage by the Spanish and a loss of confidence among their eurozone partners.

Olli Rehn, the EU commissioner for economic and monetary affairs, has made his views known. “Because there was a perception Spain was relaxing its fiscal targets for this year, there has been already a market reaction of several dozen basis points on yields of Spanish bonds,” he said. It is up to Spain, he argues, to convince investors it can bring its fiscal plans back on track.

This has become a familiar lament. Yet it does not deal properly with the interaction between growth shortfalls and the cost of borrowing within the eurozone. In the old days, weak growth was synonymous with low interest rates. In the topsy-turvy world of the eurozone, weak growth is now more often associated with high interest rates. Austerity, by delivering even weaker growth, leads to even higher interest rates.

The only way to get around this problem is to recognise the symbiotic relationship between creditors and debtors. In the eurozone, this means a fiscal union, not the constant bullying of debtors by creditors.

Creating a fiscal union will not be easy. As it stands, the fiscal compact does not do the trick: it is a rules-based system for a world where rules too often have to be broken in response to unexpected economic outcomes. A fiscal union also has to address the difficult political issues that result from large income losses. How, for example, should the interests of creditors and debtors be balanced if the creditors lent to the debtors at hopelessly low interest rates in the first place?

Monetary unions fail when they lack the proper fiscal and political foundations. They succeed when their citizens recognise they’re all in it together. As the crisis spreads, the need for a bold political solution has become increasingly urgent.

The writer is HSBC Group’s chief economist and head of economics and asset allocation research

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