The pain in Spain that threatens the eurozone

(CNN) -- If Greece was the focus of markets' angst last week, attention this week has shifted to the other end of the Mediterranean.

Spain's public finances are nothing like as grim as the Greeks', but a worsening banking crisis threatens to deepen an already painful recession and endanger the future of the eurozone.

The immediate cause of the pain in Spain is the need to recapitalize the country's fourth-largest bank, Bankia -- itself an unwieldy amalgam of previously-ailing financial institutions.

The bank asked the government for the not inconsiderable sum of €19 billion ($23.5 billion) last week. The state has already pumped some €20 billion into a banking system crippled by bad debt -- much of it property-related.

Getting the Spanish banking system out of intensive care threatens to become a vicious circle. To provide further help, the government will have to issue yet more bonds - worsening its own finances. The yield on Spain's sovereign 10-year bond has risen to nearly 7%, widely regarded by international markets as unsustainable.

Portugal, Greece and Ireland had to seek international bailouts when their borrowing costs reached such levels.

Too big to fail?

Is Spain too big to fail?

For the eurozone countries, the situation in Spain is far more daunting than that in Greece. According to some analysts, while it may be deemed "too big to fail" it may also be "too big to rescue" with the resources available.

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According to the International Monetary Fund, Greece's GDP is $271 billion; Spain's $1,397 billion.

Failing banks in Spain drag down economy

Professor Peter Morici, of the Robert H. Smith School of Business at the University of Maryland, says "Spain could prove beyond Germany and other northern countries' capacity to rescue, and its collapse would spell the end for the euro."

Bankia troubles put Spain on edge

If Greece was living beyond its means, Spain's problem stems from a property boom that followed its entry to the EU. Northern Europeans escaping to the Mediterranean beaches fed an orgy of hotel and apartment building. Many of those developments are unfinished skeletons or on sale at foreclosure prices. The banks are loaded up with the consequences of that boom and bust.

Pierpaolo Barbieri, Ernest May Fellow at the Harvard Kennedy School's Belfer Center, says that "big, international banks like Santander and BVA are well diversified. Of the others, quite a few need capital -- but how much? That's the unknown and Bankia has undermined faith in financial reporting."

Spain has also become Exhibit A in the fierce debate over whether austerity is actually helping or worsening the situation. Its new conservative government has accentuated public spending cuts -- but those cuts have helped push the country back into recession and destroyed consumer demand -- down one-tenth in the year to April.

Open Mic: Spain's economy

Morici says: "A terrible negative feedback cycle has been unleashed -- a contracting economy lessens Madrid's tax revenues, this further engenders investor doubt and even higher interest rates, higher borrowing costs require more spending cuts, and those further worsen economic contraction."

Analysts say that at the heart of Europe's troubles is the divergence of financial necessity and political will. European Commission President Jose Manuel Barroso wants "an ambitious and structural approach which should include a roadmap and a timetable for a full economic and monetary union in the euro area."

Bad timing. Neither the states in the eurozone nor those EU members outside the single currency (including the UK) want to invest political capital in closer and expensive integration while voters lose faith with the European project.

A poll by the Pew Research Center published this week showed that Spaniards -- rabidly pro-European a few years ago, now believe by a margin of 50% to 46% that European integration has weakened their country. In Italy the margin is 61% to 22%; in Greece 70% to 18%.

Tools of the Trade

The European Central Bank has provided banks with cheap credit and bought sovereign debt to try to restrain yields. But economists believe Europe -- currently -- lacks the tools it needs to tackle the current crisis. And above all it needs U.S.-style banking insurance.

Morici says that "to discourage bank runs, the eurozone has no analog to the FDIC (the Federal Deposit Insurance Corporation), which is backed up by the U.S. Treasury's capacity to tax and sell bonds, and ultimately the Federal Reserve's ability to print money."

Barbieri believes two drastic Europe-wide steps are needed.

The first would be to inject capital into Spanish banks at risk -- directly from the European Stability Mechanism, which comes into operation in July. But that might require a change to a treaty already making its way through the parliaments of member states.

The advantage of using the ESM is that "instead of the Spanish state going to the market and paying 7% on its debt, so that it can then pump money into the banks, the ESM could borrow at 3% or so," Barbieri says.

Then there is what might be called the "NATO principle" -- an attack on one is an attack on all. Creating a European equivalent of the FDIC -- through a banking union -- would pool the eurozone's insurance to guarantee bank deposits, and thus reassure investors.

"Right now Deutsche Bank can attract Spanish savers anxious that their own banks may become insolvent," says Barbieri. "A European FDIC would put a stop to that damaging dynamic."

And savings are emigrating from Spain at an alarming rate. According to Bank of Spain figures a net €66 billion ($82 billion) left the country in March, the highest level since records began 22 years ago.

But there is plenty of resistance to the idea of a European shield for Spain. The European Commission said Thursday that the Spanish government needed to flesh out its plans to restructure Bankia -- but a European rescue was not envisaged.

"There is great reluctance in Germany to go along with such a plan as it might become a large liability and it could worsen moral hazard in the banking sector," says Barbieri.

"But the alternative is even worse: if the banking system in Spain goes under, then attention turns to Italy, where one of the largest banks is owned by a French bank -- and so on. The catastrophe could start in the periphery, but it would spread fast and engulf the core soon enough."

Perhaps in the meantime Spain can take comfort from Sancho Panza's final words of wisdom to Don Quixote: "I've heard tell that Fortune, as they call her, is a drunken and capricious woman and, worse still, blind; and so she doesn't see what she's doing, and doesn't know whom she is casting down or raising up."