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Spain is sending Europe a message. Is anyone listening?

September 26, 2012: 12:23 PM ET

Spain's slow motion implosion seems to indicate that things will have to get much worse before eurozone leaders are willing to swallow their pride to make things better.

By Cyrus Sanati

madrid-riotsFORTUNE -- From riots in Madrid to talk of secession in Barcelona, Spain appears to be teetering on the edge of political and economic ruin as the European debt crisis intensifies. While the European Central Bank's revamped bond buying scheme unveiled last month was successful in keeping the eurozone together temporarily, the structural deficiencies inside member states, like Spain, continue to fester, threatening to rot the eurozone from the inside out.

Europe and Spain will continue down this autopista of economic tears until they are both willing to make the tough sacrifices that come with establishing a more coherent political and economic union.

But Spain's slow motion implosion seems to indicate that things will have to get much worse before eurozone leaders are willing to swallow their pride to make things better.

The ECB's bond scheme bought the continent some time to get its act together, but that time seems to be fading much faster than anyone had predicted. Spain's economic troubles are boiling over as its economy stalls, creating civil unrest and exposing old political cleavages threatening the nation's sovereign integrity.

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This has reversed the downward trend in Spanish interest rates, which until Tuesday had been falling since the ECB announced its revamped bond buying scheme last month.  The Spanish 10-year bond jumped 0.26% in early Wednesday morning trading to break 6%, which is the biggest jump in yield for Spanish debt since August. Meanwhile, yesterday, the Spanish treasury was forced to pay investors a higher yield as it issued $5.2 billion in short term debt. The interest rate on three-month bills came in at 1.2%, which was significantly higher than the 0.9% it paid to issue similarly dated debt back in August.

The ECB's unlimited bond buying plan has yet to take off as the various multi-billion dollar bailout schemes, which have already been approved by eurozone members, continue to linger in bureaucratic limbo (the ECB plans on using part of the bailout fund to help pay for its initial bond purchases). The ECB could intervene now, but that would mean it would be increasing the size of its already bloated balance sheet, something Mario Draghi, the head of the ECB, wants to avoid until the bailout fund is drained first.

The bailout fund has already committed around 100 billion euros to Spain to help its crippled network of banks. The deal, agreed to earlier this summer, was extended to Spain initially without any preconditions or budgetary promises. But yesterday, that deal appeared to be in doubt as the finance ministers of Germany, the Netherlands and Finland issued a joint statement that individual nation states should bear the cost of recapitalizing their banking sector first before coming to the bailout trough.

The timing of the announcement is no coincidence. On Thursday, the Spanish government will unveil its 2013 budget while on Friday the independent consulting firm of Oliver Wyman is set to release the final results of the stress test it conducted on Spanish banks. Germany seems to be sending a message that Spain's budget needs to incorporate some serious cuts if it plans on getting its 100 billion euros, despite the original agreement that they would get the money with no preconditions.

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Spain has set up a bailout fund for its 17 provincial governments totaling 18 billion euros, which is less than a third of the projected 60 billion euros needed to recapitalize its banks. If it has to use that money first, then Spain's provinces will see massive holes in their budgets next year. If it issues a lot of new debt, yields will rise to uncomfortably high levels. So coming up with the other 42 billion euros, possibly through further austerity measures, is simply impossible, especially given how poorly the Spanish economy is doing at the moment.

By potentially reneging on the Spanish deal, Germany could damage its credibility with investors who may come to doubt its word when brokering future deals. But this is Germany's way of playing hardball, which for many investors is the only way to get Spain's attention. After all, Spain reported Tuesday that the federal government's budget deficit is up nearly 5% in the first eight months of the year compared to the same time last year. Spain's conservative government promised to cut the nation's budget deficit to 6.3% of GDP this year from 8.9% in 2011. With the budget deficit up, it is clear that Spain will fail to get anywhere close to stabilizing its deficit, let alone reducing it. In that case one can interpret the German pressure as justified as they agreed to let Spain have the money thinking that it was on its way to stabilizing its fiscal regime.

Spain will probably need to make more impressive cuts when it announces its budget if it wants its 100 billion euro. The Spanish government may think it is being bullied about, but it is no stranger to bullying. After all, it has to deal with a similar situation with its own provinces, which are drowning in debt. Yesterday, Andalucía, which has traditionally been one of the poorer provinces in Spain, hinted that it may need a 5 billion euro bailout from the federal government to make ends meet.

The poorer provinces, like Andalucía and others like Extremadura, already receive a disproportionate level of taxes based on their contribution to Spain's overall GDP. That means the richer states like Catalonia, the Balearic Islands and Madrid usually pay more into the system than they get out. While that sounds unfair, it's a normal federal arrangement, something that Europe should look to emulate as it considers forming a closer fiscal union.

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But Spain offers a glimpse of some of the troubles that come with the centralization of fiscal power among disparate states. The leaders of the Spanish province of Catalonia, home to Spain's second city, Barcelona, and second language, Catalan, have threatened to secede from the Spanish federation unless it is given more control over its finances. It believes that the transfer of wealth out of Catalonia was the reason why it is currently running a budget deficit of around 8%.

Spain's conservative leaders, who, unlike their liberal counterparts, are vehemently against granting provinces further autonomy, have criticized Catalonia's leaders, saying that it has basically made a bad situation even worse. They noted that Catalonia cannot legally secede but if it did, Spain would veto its eventual application to the EU as an independent nation "indefinitely." It might not even get that far as the Spanish military, which remains very conservative, has reportedly hinted that they stand ready to invade and occupy Catalonia if it votes to secede from the union. The current Spanish military, after all, descends from the days of the Spanish civil war where General Francisco Franco overthrew the government and set up a dictatorship that would last for 36 years.

But all the talk about secession may just be a bargaining chip. Catalonia, like the rest of Spain's 17 provinces, is totally shut out of the debt markets. That means it needs the federal government to sell bonds on its behalf, which has been difficult lately. Two weeks ago, Catalonia asked the federal government for 5 billion euros from the 18 billion euro provincial bailout fund. It told the federal government that they wanted the money with no preconditions. But the federal government has refused, noting that Catalonia, which has racked up major debts following the property crash in Barcelona, basically needs to cut spending to put its finances on the right track.

While secession may just be a bargaining chip to some, there are real Catalan nationalists that see this as an opportunity to finally win independence from Spain. Last year only 25% of people living in Catalonia would vote for secession, but recent polling out this week show that support has doubled to just over 50%.

Yet the Catalan issue is not only a problem for Spain, it is also a problem for the whole of Europe as it suggests that the eurozone is going to have a very hard time forming a fiscal union. If Catalonians have a problem with redistributing their wealth to a neighboring Spanish state, how would they feel if it is redistributed to, say, Slovenia or Cyprus? And if Spain refuses to fix the structural problems in its economy for a 100 billion euro, what would it take for them to give up their fiscal power to Frankfurt?

For now, Spain is sending a powerful message to the markets that Europe is indeed neither ready nor desperate enough to form a stronger fiscal union. With that the euro could be potentially doomed.

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