The proposed Irish bail-out has not calmed the financial markets. And now their attention is moving on to new victims in the Iberian peninsula

ON NOVEMBER 21st the Irish government at last gave in. It yielded to pressure from its European Union counterparts to seek an emergency bail-out from the EU and the IMF that may amount to as much as €85 billion ($115 billion). In May, when the Greek government secured a €110 billion bail-out and a joint EU/IMF fund worth a stonking €750 billion was put in place, investors believed and the markets rallied. Not this time. Bond yields in Ireland dropped back to 7.93%, but rose to 4.75% in Spain and 11.75% in Greece.

Why? In short, because rescues need a bit of “shock and awe” to convince investors. The bond markets must be startled by the size of the package, persuaded that the authorities will do whatever is needed—and not be invited to doubt it by talk of making investors foot part of the bill in future. They also have to believe that a country's difficulties concern liquidity (ie, they can repay debt eventually) not solvency (ie, they can't).

In this case the markets felt starved of detail, and bothered by German insistence that private investors must bear part of the burden. They worried whether Ireland, having looked dodgy for so long, could cope with this politically, could ever regain investors' trust, and would ever be able to repay its debts. And, not least, they agonised about where in the euro zone contagion might spread to next.

The lack of clarity is especially crucial. Shares in the big Irish banks fell because investors feared they would suffer as more public capital was injected. Talk of nationalising Bank of Ireland, one of the few big Irish banks that is not already largely in state ownership, was hardly reassuring. Worse, the deal will not eliminate Ireland's debts, but simply refinance them. Nor is there any guarantee that depositors will not shift to safer places within the euro area. The reaction of the big credit-rating agencies was prompt and instructive. Standard & Poor's downgraded Irish government debt from AA- to A, and Moody's promised a “multi-notch downgrade”.

The bail-out's failure was immediately apparent in the spreads of Irish, Portuguese and Spanish government debt over German bonds. Within 24 hours, these had grown wider than before the deal was announced (see chart 1). Ominously, the spread on Spanish bonds reached its highest since the euro's launch in 1999. And on November 23rd Portugal was paying over four percentage points more than Germany to borrow money; Greece was paying a similar spread in mid-April, just weeks before its bail-out.

It was all eerily reminiscent of 2008, when desperate efforts to rescue and revive American and other banks produced only ephemeral rallies. “With each successive bail-out, the appetite for further rescues becomes limited,” comments Julian Jessop of Capital Economics. In March 2008 the rescue of Bear Stearns led to such an outcry that the American authorities were unwilling to save Lehman Brothers in September. The fear this time is that German voters, and their political leaders, will similarly lose patience.

Trouble on the Liffey…

In Ireland the beleaguered prime minister, Brian Cowen, was left this week with a battle on two fronts: to keep his job and to pass the 2011 budget in early December. His credibility was already threadbare, not least because he was finance minister when the Irish bubble inflated to its fullest extent and then prime minister when it burst. Moreover, his government's decision to seek a bail-out came after repeated denials that any such help was either needed or had been asked for.

This humiliating reversal cost Mr Cowen both public support and political backing. Among Irish voters, the arrival of so-called rescuers from Washington and Brussels has met with mixed emotions: in part stoical resignation, but also outrage at their country's mendicant condition and apparent loss of sovereignty. The Irish Times was moved to wonder if the sacrifice of Ireland's freedom fighters during the 1916 Easter rising had been in vain.

The political fallout was swift. The Green Party, a junior partner in the coalition led by Mr Cowen's Fianna Fail, declared on November 22nd that it would walk out in January, triggering an early election. The party was aggrieved by Mr Cowen's mishandling of the bail-out request and his failure to speak clearly to the public. The Greens have at least conceded that they may first help to pass the 2011 budget on December 7th to give effect to the government's four-year plan to cut the budget deficit to 3% of GDP by 2014, and thus comply with the terms of the EU/IMF rescue plan. But even that promise may not be enough to get the budget through.

Some Fianna Fail backbenchers were almost equally damning of Mr Cowen and called for him to resign. As in the past, he defied those critics and won a temporary reprieve for his leadership. But he is sure to face a more serious challenge in the new year, when Fianna Fail seems highly likely to lose the election to a Fine Gael/Labour coalition. In effect, a leadership contest within Fianna Fail has already begun.

Until the election is held, Mr Cowen will head a caretaker government with an uncertain parliamentary position. His majority had already slipped since the 2007 election from 13 to only three. With Fianna Fail almost certain to lose a by-election in Donegal this week, probably to Sinn Fein, that may now shrink to two. Moreover, two independent backbenchers on whom the government has relied for its majority have said they may not vote for the budget. Unless some opposition members abstain, the budget may thus not get through.

What makes the budget harder to swallow is that it is be a fiercely austere measure, including for 2011 €6 billion in spending cuts and tax rises, savage welfare and public-sector pay cuts and a reduction in the minimum wage. This front-loads a four-year plan to make total savings of €15 billion and bring the budget deficit below 3% of GDP by 2014. The government is under huge pressure to pass such a budget. Olli Rehn, the European economic commissioner, this week insisted that Brussels would not interfere in Irish politics, but added grimly that “stability is important”. The only consolation for the Irish is that, so far at least, they have managed to hang on to the principle that they can maintain their trademark low 12.5% corporate-tax rate.

In a last-ditch effort to get help from Fine Gael and Labour, Mr Cowen offered them access to the financial advice underpinning the budget. Yet both parties formally insist that an election should be held before the budget is adopted, not after. That might hasten the arrival of a Fine Gael/Labour coalition—though it will still have to make cuts similar to Mr Cowen's. It is possible that, in a bid to share the blame out in advance, the opposition parties may exercise voting discretion to ease the budget's passage in December. That is what Mr Cowen seems to be counting on. His party's poll rating (17%) is at its lowest ever. It seems that Fianna Fail, the dominant party in Ireland ever since the country's independence in the 1920s, is heading for the greatest electoral reversal in its history.

…on the Tagus…

If the markets are neither persuaded by the Irish bail-out nor reassured that Dublin will push through its budget, they seem almost as fretful about the Iberian countries. After Greece in May and Ireland this month, Portugal is clearly next in line. This week a general strike was called against budget austerity. Yet the Socialist-led government of José Sócrates has no alternative. Portugal's banks may be healthier than Ireland's, but the country is mired in slow growth and a large budget deficit. In the markets' current mood, a bail-out similar to Ireland's seems almost inevitable.

The real concern now is not Portugal but Spain. The Spanish economy is much bigger than those of Greece, Ireland and Portugal combined. The government's financing requirement next year, though comparable as a share of GDP, similarly dwarfs those of Greece, Ireland and Portugal taken together (see chart 2). It is a Spanish mantra, requiring a mere change of name of euro-area countries, to insist that Spain is different. “We're not Greece!” has become “We're not Ireland!”, and will shortly become “We're not Portugal!”

In all three cases the Spanish are correct, though that is not always a comfort. To start with, a bail-out of Spain would be on a different scale. When the €750 billion European Financial Stability Facility was designed in May, few people thought that it would be needed to cope with Spain as well as the other three weak euro-area countries. And there seemed little likelihood that it would have to.

What may help is that Spain has been a lot better behaved than the other three and so seems much less in need of a bail-out. A national debt of only 53% of GDP last year was a full 21 points below the EU average. Spain has neither Ireland's broken banks nor Greece's profligate public finances. Its austerity targets are more credible than Portugal's.

But as a broken Ireland seeks help and a shaky Portugal puts Iberia in the spotlight (not least because Spanish banks are heavily exposed to Portugal), there are understandable fears that Spain will catch the bug next. “Contagion has spread to Greek debt, to Portuguese debt and, to a lesser degree, to our own debt as well as Italy's and even Belgium's,” admitted the Bank of Spain's governor, Miguel Fernández Ordóñez, this week.

Until recently the risk of contagion had seemed small. Spain had successfully dislodged itself from the group of peripheral euro-area countries with the most punishing bond yields. The euro crisis in May forced an ostrich-like Socialist government under José Luis Rodríguez Zapatero to remove its head from the sand, bring in austerity measures to cut the budget deficit, which hit 11% of GDP last year, and even to pass a modest labour-market reform. Those measures seemed to be working. The central government's share of the budget deficit looks like being 2.7 points less in the first ten months of this year than in 2009, and the tax take is up by 10%.

A recent deal with the Basque Nationalist Party has given Mr Zapatero's minority government the parliamentary clout to push through another austerity budget for 2011. Next year's deficit target is just 6% of GDP. The prime minister sounds steely in his resolve to hit it. He has cut civil-service pay by 5%, raised VAT and ridden out a general strike. He has pledged more measures if needed.

So far, so good. But, just as Ireland had unique problems that made it different from Greece, and Portugal presents its own special difficulties, so Spain has its own peculiar set of troubles. It shares an Irish-style housing bust with the meagre growth prospects of Portugal and Greece. Unemployment is over 20%. As the contagion spreads and the markets remain nervous, the pressure is mounting for it to do more to distance itself from those stuck at the bottom of the euro class.

This is about a lot more than fiscal austerity. The change of course signalled by the government's modest labour-market reform in June will surely have to be taken further. But the markets' concern is that Mr Zapatero acts not from conviction, but only when he must. “Every time international markets put some pressure on our debt, the Spanish government indicates it is going to do some reform,” says Juan Rubio-Ramírez, a Spanish economist at Duke University. “And as the pressure waters down, it relaxes.”

Thus pension reform, first flagged as long ago as January, has been postponed until the first quarter of next year. Discussions about the antiquated collective-bargaining mechanism are going agonisingly slowly. Serious reform of the health-care system, where much of the money sent from Madrid to regional governments is spent, is barely even being talked about.

Another worry is that, although the big Spanish banks look strong and well-capitalised, the same cannot be said of the savings banks or cajas. Some 40 out of 45 cajas are involved in tortuous merger negotiations, aided by €14.4 billion from Spain's Fund for Orderly Bank Restructuring (FROB) and a deposit guarantee fund. Frustrated by the slow pace, the Bank of Spain and the government have given them until year-end to complete their deals.

One problem for the cajas is wholesale funding. Spanish lenders (unlike Irish banks) have sharply reduced their dependence on short-term financing from the European Central Bank, from a peak reached in July. Stronger banks and cajas have also been able to borrow from the wholesale markets, even if only at high rates and, in some cases, using state guarantees. But a number of cajas, representing as much as 12% of the financial system by assets, are shut out of the markets, according to Analistas Financieros Internacionales, a consultancy. It reckons the system as a whole needs to roll over some €100 billion a year for the next two years.

The market shutdown reflects uncertainty over the extent of restructuring needed for the cajas. Spain is overbanked and profitability is sinking quickly at these institutions, thanks to a higher cost of funding and shrinking credit. The worry is that FROB money is being used to close down branches and reduce staff, leaving less firepower to deal with more hidden losses from the banking system's staggering €323 billion of exposure to property developers. Most bankers expect the cajas will have to go through another round of consolidation in the next few months, perhaps helped by more government money. The hope is that the FROB, which has a capacity of €99 billion, will be big enough to deal with it.

Both to reassure markets and to return to growth, Spain needs further structural reforms. “We are doing what should be done, but not with the necessary energy or conviction,” says Juan José Toribio of the IESE business school. Budget cuts may also eat into economic growth in the short term. Even Mr Zapatero has admitted that the recovery is slow and uncertain. He has recently added a new realism to his speeches. “We cannot yet be sure that there is an irreversible change in the trend,” he told a parliamentary debate on joblessness on November 18th. The OECD predicts that Spain's GDP will shrink slightly this year and grow by just 0.9% next year.

Mr Zapatero claims to have had a moment of market epiphany in May. In a recent interview with the editor of the newspaper El País, he denied that Spain had put the euro at risk by resisting change before then. The measures he took helped to convince investors that his country was not a potential default risk. But in today's nervous markets he will have to do more to prove his commitment.

…and across the Rhine

Merkel digs her heels in

It is not only the bond markets that countries like Greece, Ireland, Portugal and Spain must satisfy. The most concerned onlooker is Germany, which sees its credit lying behind the entire euro area. As ever, Europe's biggest tabloid, Bild, captured the mood this week, asking “First the Greeks, then the Irish, then…will we end up having to pay for everyone in Europe?”

Chancellor Angela Merkel and her finance minister, Wolfgang Schäuble, are keenly aware of German voters' resentment of euro bail-outs. They are also uneasily conscious of the German constitutional court, which endorsed European economic and monetary union prescribed in the 1992 Maastricht treaty only on the basis of the treaty's no-bail-out provisions. For these reasons, Mrs Merkel and Mr Schäuble are continuing to insist on two proposals.

One is that the EU treaties must be amended to give permanent status to the European Financial Stability Facility. Without this, they say, the rescue fund will expire in 2013. But investors know from experience that treaty amendment is neither simple nor quick (it took years to push through the Lisbon treaty). Insistence on treaty change makes them nervous.

So, even more, does the second German demand: that future bail-outs must include debt-restructuring provisions to impose some losses (“haircuts”) on investors. This is an understandable, even desirable, idea—if investors never lost money on sovereign bonds, why bother to distinguish among countries according to their credit rating? But it was Mrs Merkel's vague public touting of the idea that set off the latest bout of nerves. If leaders cannot speak without unintentionally spreading alarm, they should not speak at all.

It might also help if European leaders stopped talking of the euro crisis in quite such apocalyptic terms. Recently the president of the European Council, Herman Van Rompuy, suggested that, if the euro did not survive, neither would the EU. This week Mrs Merkel said the euro was in an “exceptionally serious” situation. Mr Schäuble added that “our common currency is at stake.” That may be true, but it hardly inspires confidence.