Spain Could Spoil Global Economic Recovery

As the year ends, there are small signs that the economy is mending. But one country could change that: Spain. Economists and European leaders are worried that debt problems in Spain could have major implications for the entire global financial system.

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So there are at least some signs that the U.S. economy is mending. But an ocean away, one country is causing great concern: Spain. Economists and European leaders are entering 2011 deeply worried that Spain's debt problems could have major implications for the entire global financial system.

Chana Joffe-Walt, with our Planet Money Team, takes a look at how the illness might spread.

CHANA JOFFE-WALT: To deliver a disaster scenario roadmap, I give you Santiago Carbo Valverde. Carbo is an economist with the University of Grenada, here to offer the worst case scenario - a scenario in which Spanish banks drown in bad loans. They become so sick, the losses so great, that the Spanish government and Europe cannot save them.

Carbo actually happened to be walking through this hypothetical future on his iPad in a Madrid hotel lobby when I met him, just staring at the screen, shaking his head.

Professor SANTIAGO CARBO VALVERDE (Department of Economics, University of Grenada): The entire crisis now is down to this problem: Banking. The markets are not lending any money to Spanish banks.

(Soundbite of laughter)

JOFFE-WALT: Now I should warn you, that Carbo chuckles like that a lot, but the longer we talked, I realized his laugh should not be interpreted as lighthearted. No, when Carbo laughs, it's actually a sign that he's telling you something he thinks is very grave, such as...

Mr. VALVERDE: Problems in the banks in one country are causing contagion to other banks in other countries.

JOFFE-WALT: Here's how that works. Spain is big, twice as big as the economies of Ireland, Greece, and Portugal combined. Investors of the world are worried that Spanish banks might not be able to pay them back. The banks funded a huge real estate bubble in Spain that has now collapsed.

So investors are beginning to think maybe I shouldn't be lending them money. And if investors of the world start worrying that you can't pay back your debt, you can't pay back your debt. And this, this is where we get to the iPad. Carbo is staring at data from the Bank for International Settlements that reports how much various banks and governments lend to each other. And Carbo says, smiling, despite the gravity of his words, imagine Spanish banks fail.

Mr. VALVERDE: The Spanish government and the Spanish banks owe to French banks $162 billion; to German banks, $182 billion; to Ireland, there is a bank that has lent us $25 billion; Italy $25 billion, too; United States, $46 - $47 million, sorry, $47 million.

JOFFE-WALT: In other words, if you're on that list in the worst case disaster scenario, you lose big. OK. So that's bad for the guys who are on that list who lent money to Spain, but imagine you haven't lent money to Spain, but you have to Germany. And when I say you, this could actually be you, your retirement fund.

OK, so you've lent money to Germany, generally considered very safe. Now that Spain is in trouble, you're going to stop lending money to Germany, because who knows if they'll be able to pay you back now that they probably got stiffed by Spain. So now everyone's worried about Germany, which is bad for all the countries that have lent money to Germany.

Mr. VALVERDE: Germany owes $255 to France, $255 billion; $254 billion to Italy; $146 to Japan; $150 to the Netherlands; $150 to the U.S.

JOFFE-WALT: So this is the spreadsheet that tells you that Spain can take down the world.

Mr. VALVERDE: Well, in the worst case scenario, I would say that. Yeah, that's the information that makes everybody worry.

JOFFE-WALT: Investors stop lending to Spain, which makes everyone worried about Germany, which makes everyone worried about France, Italy, Japan, and the U.S., and all that happens in a matter of days in a panic. Spain basically becomes the next Lehman Brothers, lending stops.

Now I should say that Carbo and many others do not necessarily believe this will happen. Europe could expand the size of its stabilization fund, get together enough money to save Spain. Spain's economy could turn around, unemployment could improve, losses at Spanish banks could be less dramatic in 2011.

The problem right now, though, is everyone knows that the Spanish banks are sitting on bad real estate loans. What is unclear, is how bad, how many, and that confusion, that's the thing that is the most dangerous.

Chana Joffe-Walt, NPR News.

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