There’s nothing especially new about the present dispute between Catalonia and Spain’s national political leadership. Arguably most of the key arguments date back at least to the 1970s and the end of the Franco era, while the seeds of the present dispute are to be found in the country’s written constitution which was finally put together in 1978, when the threat of military interference in political life was still a real and present danger. Indeed the one thing that both sides of the argument seem to agree on is that the regional system of comunidades autónomas which was established back then doesn’t really work. Equally, after so many years of constant wrangling, most citizens on both sides of the fence are now heartily sick of the situation. According to the latest polls, a majority of Catalan voters would now like to leave Spain, and looking at many of the opinions to be found in the Spanish press, a lot of Spaniards wouldn’t be that upset to see them go.

So where’s the problem? Divorce by mutual consent would seem to be the ideal solution. The rub is we are not back in the dark and distant days of the 1970s, instead we are in the midst of the worst global economic and financial crisis since the 1930s. Not only that, European monetary union – the euro – is now the epicentre of the storm. To make matters worse, Spain has one of the most troubled economies in the European Union, and EU leaders’ efforts to make the single currency work now increasingly depend on finding solutions for the country’s problems, in particular those associated with the large volume of government debt which has been accumulated.

So while in calmer times some sort of dissolution or “annulment” of the marriage by mutual consent would not necessarily be extraordinarily problematic, under present circumstances breaking up would not only be “hard to do”, unless it were carefully managed it could easily turn from being simply a high-risk operation to one that – through that contagion process which is so feared in Greece – actually provoked the very disintegration of the euro itself.

Hence the situation has more general interest for the current evolution of the euro area than the simple desire of one of Spain’s regions to seek independence. It has more significance, since it is impossible to understand outside the context in which it occurs, which is one of an institutionally deficient euro area trying to move towards full political integration, with one part of the currency area bogged down in what can only be termed a huge slump, while the other part lectures them on how deepening austerity is the only way they can bring their economies back to life.

Austerity under the microscope

This is not the place to go into this whole argument, but it is becoming increasingly accepted that austerity alone (or austerity plus structural reforms) won’t work fast enough to turn the ship around before it gets caught up in the rapids, and that some measure of “burden sharing” (and not just loans) across the whole euro area is going to be needed. The trouble is that moves towards the structures which could help provide this burden sharing (banking union, fiscal union, Eurobonds) are painfully slow. Which brings us to Catalonia.

The frustrations currently being felt in Catalonia stem from the situation of being one of Spain’s richer regions and having to bear what is perceived as being more than a fair share of the cost of the failure by Europe’s leaders to resolve the euro crisis. Catalonia is a net contributor to the Spanish fiscal system, and wants to make, at least, a smaller net contribution. The situation has been brought to a head by the fact that the region’s income-to-debt ratio has risen to the extent that government bonds are ranked at junk status by ratings agency Standard & Poor’s. Shut as it is out of the markets, Catalonia has been forced to ask for a financial rescue from the central government, a rescue most Catalans consider to be ridiculous given they feel they are only asking for some of their own money back.

Catalonia’s economy has collapsed along with that of the rest of Spain, but the debate becomes a particularly poignant one given the growing feeling of desperation in the face of the inability of Spanish governments of varying political complexions to take the steps necessary to move the country forward. This frustration is now coupled with the growing awareness that more and more austerity is not the formula needed to restore the region to economic growth. As former Catalan President Jordi Pujol put it in an interview with the FT’s David Gardner, “Europe without solidarity would not be possible, but at the same time an excess of solidarity would make Europe impossible.”

He was reiterating here the view of German Foreign Minister Guido Weterwelle, to the effect that German pockets are not bottomless. What Mr Pujol was suggesting is that Catalan ones aren’t either. Naturally, behind the Catalan independence drive there are also many identitarian issues, issues which are not easily soluble and which are making for a highly combustible environment inside Spain. But underlying the independence debate there lies a much deeper question. If Europe is moving towards a deeper banking, fiscal and political union, but moving far too slowly, why should an unfair share of the burden fall on the richer areas of the countries in the greatest difficulty? Why should more of the burden not be shared more equally and more quickly? This is not a uniquely Catalan problem, since similar issues are arising in Belgium (Flanders) and Italy (the Veneto among others). Europe is a continent of nations, and the euro crisis is opening up the fracture lines.

Scotland or Slovenia?

Which brings us to the world of the investor, and how this dispute could affect the market for Spanish government debt in the future, or indeed the trajectory of conversion risk in the euro area.

My feeling is that market participants are not taking all this uncertainty about outcomes seriously enough, and that could prove to be a risky bet. People tend to feel that there is a track record which offers precedents: the confrontation of the Basque leader Juan José Ibarretxe with an earlier Partido Popular government a decade ago, the attempts by Quebec to separate itself from Canada, or even the present agreement between Scotland and the UK to hold a referendum. What all of these situations seem to have in common is a good dose of what the Spanish would call mucho ruido y pocas nueces – or a lot of smoke and very little fire. Many indeed doubt that after all the stage-managed theatricality is over Scotland will eventually vote to separate itself from the UK. One of the reasons for this lack of conviction is that Scotland is not one of Europe’s richer regions, and is even arguably fiscally dependent on England.

But these situations give us little guidance in cases like Catalonia, Flanders or the Veneto, which are evidently richer than many of the neighbours they share a country with. What’s more neither Quebec nor Scotland belong to a currency union that is faced with a life-threatening crisis. Arguably in the case of the euro regions the examples of Latvia, Estonia, Lithuania and Slovenia offer a much better and clearer point of comparison, especially since two of these new European states are themselves now members of the euro area.

The case of the Baltic countries is an interesting one, since these new countries belonged to what was then a disintegrating USSR, a bloc which had a common currency – the rouble. Indeed under the hammer blows of the disintegration crisis, the currency was steadily flexibilised in a way which some (including Citi Chief Economist Willem Buiter) have suggested the eurosystem is being flexibilised (via Emergency Liquidity Assistance and differential collateral rules), until finally it all fell apart.

In another context Slovenia could offer a speedometer, in the sense that the country, which was one of the ex-Yugoslavia’s richer regions, left peacefully following a very swiftly executed referendum process. In the summer of 1990 opinion polls showed a bare majority in favour of independence, by December 23 when the referendum was held 88.5 percent of all voters (94.8 percent of those participating) voted in favour of establishing a sovereign state.

Those who think we could not see such a swift-momentum political process in the crisis-ridden euro area underestimate, in my opinion, the depth of the euro crisis, the gravity of the mess that Spain is now in, and the motivational drive the idea of having their hands on what regional premier Artur Mas calls the “instruments of state” offers a Catalan population who have lost all hope of Spain’s leaders ever dragging their country from the decaying economic state into which it has fallen. King Juan Carlos recently called on Spaniards to fight their way out of the crisis with a smile on their face and a knife between their teeth. On the other hand, legend has it that the Estonians would rather eat dirt than surrender before their crisis, or be perceived as fiscally feckless or non-payers. Do risk-shy investors really want to bet Catalans are any less determined?

Where’s the market consensus, and is it right?

A flavour of just how market analysts are viewing the Catalan situation can be garnered from the contents of two recent research reports, one from UBS’s Matteo Cominetta (ably summarised by CNBC correspondent Liza Jansen here), and the other from JP Morgan’s Alex White and Raphael Brun-Aguerre. Both reports concur that in principal, and in the most ideal of all possible worlds, Catalonia – like any of the EU’s myriad of small countries – would be perfectly viable as a state in the longer term. Neither, however, sees such a state being created any time soon, partly due to the depth of the economic crisis being faced by all parts of Spain, and partly because of the very complex euro area dynamics that would be unleashed, and especially the risk of “new European state” contagion spreading elsewhere.

Beyond this basic agreement in principle, however, there are important differences between the two reports. Cominetta thinks Catalonia won’t leave because it can’t. The title – ‘Can Catalonia leave? Hardly’ – is suggestive in this sense, since he draws attention to the legal constraints presented by the Spanish constitution and the threats of direct rule from Madrid which are being rattled in the background should the Catalan parliament vote to proceed with a consultation deemed by the Spanish government to be illegal.

The JP Morgan analysts are not convinced that a simple “no” to a vote will work, and adopt what could be considered to be a more positive and constructive approach, suggesting Catalonia won’t ultimately leave Spain because it won’t want to. They argue “more autonomy is the most likely outcome,” using arguments similar to those found in a recent Bloomberg editorial entitled “To Keep Catalonia In, Spain Should Allow a Vote to Secede”.

The kernel of the argument here is that faced with the debt insolvency cliff, Spain’s leaders will offer concessions to the Catalans (or be pushed by the Troika into doing so) and that these concessions would be sufficient to persuade Catalan swing voters to change sides.

In this sense, the JP Morgan view is more sophisticated and more reasonable than the UBS one. Telling people they can’t leave because they can’t have a vote on whether they want to is an argument which comes with a definite “sell by” date in the context of modern democratic societies. Not to mention the fact that it is only inciting people to want to vote “yes”. Contemporary political theory recognises that there is such a thing as a “legitimation problem”, and that you really can’t hold people somewhere for any length of time against their will just because you have a constitution in your hand which says you can.

So offering Catalans a good deal more autonomy – the asymmetric federalism that former Catalan premier Pascual Maragall advocated, for example – would seem to be an ideal solution, at least as a transitional stage. But is it possible?

In order to decide on this, people need to think about just where Spain is at this moment in its history, what the medium term future for the country and its economy looks like, and ask themselves just how easy it would be for the country’s political leadership to “sell” such a deal to a Spanish population who would need to be asked to make even more sacrifices to allow the Catalans to enjoy more of their fiscal surplus.

A great deal of controversy now surrounds what actually took place on that day in late September when the prime minister and Catalan premier got together to discuss Catalonia’s request to negotiate a new fiscal agreement. But through the mist, one phrase rings true, at least to me. Immediately after the meeting, Catalonia’s premier Mas said that Mariano Rajoy had informed him that whatever the rights and wrongs of the situation he simply had “no margin” within which to negotiate a separate fiscal agreement for Catalonia. Assuming this to be a fair summary of the conversation, it would be the first clear and absolutely undeniable statement I have heard the Spanish prime minister make since he took office at the end of last year.

He has no margin, since if Spain already can’t comply with its deficit objectives even with the Catalan contribution, then how could it hope to do so without it? Also, since Europe’s leaders are insisting on implementing a serious programme to rein in Spanish regional spending, how would Rajoy ever justify to his voters tightening their belts, while loosening those of the Catalans?

In fact, if the Spanish Constitution were to be changed to enable greater autonomy for Catalonia, this would involve a vote of not only the Catalan electorate, but of the entire Spanish one, since it would be a change which would involve the whole of Spain. And there is “autonomy weariness” in Spain, with many now seeing that the Catalans will never be satisfied short of full independence, so “what’s the use”?

So no, for these and many other reasons I don’t think we will see “more autonomy”, and it seems to me a head-on confrontation is about to be served.

Catalonia: a new state in the euro?

However, looking at such short term political dynamics, the ins and outs of any longer term divorce issue are complex. Who, for example, would end up with responsibility for Spain’s massive debt burden in the event of separation? According to Matteo Cominetta, the Kingdom of Spain would have responsibility for all the debt in circulation with its name on it as issuer, unless it were willing to recognise the new state (and hence negotiate a division). So in the event of non-recognition, what sort of bailout would Spain need, and would the EU be willing to provide it if Spain didn’t want to recognise its new neighbour? Would an independent Catalonia be inside or outside the EU and the euro? All this is at present unclear. The legal issues are tricky, but I think it should be remembered here that the ECB’s initial legal report on euro exit concluded that a country leaving the common currency would need to exit the EU, and I think there is now a consensus that it wouldn’t need to be like this. So what appear to be inflexible red lines suddenly move if disaster looms.

Largest of all there is the question of whether the new country (were it to exist) would automatically belong to the euro, and have access to eurosystem liquidity. Common sense says it would, whatever the letter of the law, since Catalonia has a financial sector with somewhere in the region of €500 billion in assets (or 2.5 times Catalan GDP – ie significantly larger than Greece) and some, at least, of the institutions concerned could be considered systemic. The Catalan financial sector, like the rest of the financial sector in Spain is surviving on life support from the ECB, so unless you want systemic institutions collapsing in Europe…

No easy way out

But to return to where we started, the most difficult part of this situation is that I see, from the EU point of view, no easy solution. Spain’s economy is a long way from being fixed. There is no “recovery” coming, either this year, next year or the one after. Credit is not about to start flowing freely, whatever the final details of the bad bank – just look at Ireland. Exports have been doing well, but Spain is still in deep recession. Most significant of all, Spanish unemployment is likely to hit 27 percent of the workforce next year. Spain will need at least between now and 2020 simply to get the numbers back down to 20 percent. Any expectation beyond that is totally unrealistic. And in the meantime it isn’t only the Catalans who want to leave – people were leaving Spain at the rate of 20,000 a month (or a quarter of a million a year) as of June, according to data from the National Statistics Office. And the rate of exit is accelerating. If this continues, who is eventually going to live in all those surplus homes, or pay the pensions of all those just about to retire in Spain?

The Catalan drive for independence presents many issues, and many quandaries, most of them stretching well beyond Spain itself, and even beyond the confines of the European Union. Europe’s leaders need now to be bold, if the euro is to be saved it isn’t only Catalonia that needs instruments of state, it is the whole euro area. The integration process needs to be fast-tracked and the base of burden sharing extended. Otherwise the rickety bridge, which was already creaking under the weight of the overloaded carriage that is attempting to cross might just collapse before we get to the other side.