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The comparative political economy of the sovereign debt crisis in Italy and Spain

Lucia Quaglia (University of York)1

Sebastin Royo (Suffolk University)


This paper sets out to explain why Spain experienced a fully-fledged sovereign debt crisis
and had to resort to euroarea financial assistance, whereas Italy did not. It dissects the
sovereign debt crisis into a banking crisis and a balance of payment crisis, arguing that banks
business model and distinctive features of national banking systems in Italy and Spain have
considerable analytical leverage in explaining the different playing out of the crisis in the two
countries. External factors, first and foremost, the idiosyncratic behavior of financial markets
and the delayed response of the EU, worsened the crisis. Bond markets spread contagion
effects, which irresolute EU intervention did not prevent.

1 Lucia Quaglia wishes to acknowledged financial support from the European Research
Council (204398 FINGOVEU) and the British Academy (SG 120191). This paper was
written while she was visiting fellow at the Max Planck Institute, the European University
Institute and Hanse Wissenschaftskolleg. All errors and omissions are ours.

1. Introduction

The sovereign debt crisis in Europe dealt a major blow to the international economy. The
periphery of Europe was particularly badly hit by this crisis: Greece was the first victim,
followed by Ireland, Portugal, Spain and Italy. Despite the fact that all these countries often
collectively referred to with the unflattering acronym of PIIGS (Portugal, Italy, Ireland,
Greece and Spain) - were hit by the sovereign debt crisis, there are important differences
concerning the causes, the dynamics and the outcome of the crisis across countries.

This paper sets out to explain why Spain experienced a fully-fledged sovereign debt crisis
and had to resort to Euro-area financial assistance, whereas Italy did not. This is puzzling for
three reasons, which explain why these countries have been chosen for a structure focused
comparison. First, at the onset of the banking crisis in the 2007, Spain had a surplus in its
budget and its public debt was much lower than in Italy, whose public debt exceeded 100% of
GDP. Hence, Italy seemed to be a more likely candidate for a sovereign debt crisis than
Spain, which was on sound fiscal footing (see Table 1).

Second, in the academic literature, Italy and Spain are often lumped together in the same
variety of Southern European capitalism, which admittedly, is a residual category for
countries that cannot fit into liberal market economy and coordinated market economy
models. Consequently, one could have expected similar causes and outcomes of the crisis in
the two countries. Finally, in much of the popular press and policy-makers discourse
(especially in so-called creditor countries, such as Germany) the sovereign debt crisis is
often ascribed to the inability of fiscally lax Southern European countries to adjust to
Economic and Monetary Union (EMU) and to sort out their fiscal imbalances in the boom

years. Yet, as this paper shows, this was the case in Italy but not in Spain, where the main
cause of the crisis laid in a specific part of the banking sector.

Methodologically, the paper engages in a structured focused comparison of the playing out of
the sovereign debt crisis in Italy and Spain. It dissects the sovereign debt crisis into a banking
crisis and balance of payment crisis. Spain experienced a banking crisis: the bailing out of
banks substantially increased the public deficit and debt. By contrast, Italian banks, with one
exception, did not experience significant losses. Spain also experienced an unconventional
balance of payment crisis: when capital flew out of the country, euro-area assistance was
called upon to rescue ailing banks. Spain had a much higher net foreign debt than Italy: a
large part of that debt was private and generated by Spanish banks. Italy suffered from
chronic fiscal imbalances: it had lived with a high level of public debt (mostly domestically
held) for decades, but posted primary surpluses. However, the low growth rate in Italy
challenged the sustainability of the debt.

The paper investigates the domestic causes of the crisis, without ruling out the role of
external factors, first and foremost, the idiosyncratic behavior of financial markets and the
delayed response of the EU in worsening it. It is argued that banks business models and
distinctive features of national banking systems in Italy and Spain have considerable
analytical leverage in explaining the different playing out of the sovereign crisis in these two

By focusing on banks role in the playing out of the crisis, the paper contributes to three
distinct but interconnected bodies of literature in political economy. First, the research
pioneered by Hardie and Howarth (2013; see also Hardie et al. 2013; Deeg 2013) that focuses

on banks activities in order to explain the evolution of national financial systems. Second, the
literature on domestic political economy institutions and economic policies, in particular the
role of these institutions in mediating the effects of external (macro-level) factors. Third, it
contributes to the literature on sovereign debt crisis, which so far has mostly focused on
developing countries. It questions the explanatory power of the literature on varieties of
capitalism with reference to the sovereign debt crisis.

The paper is organised as follows. Section 2 briefly reviews the literature on the macro and
meso level explanations of the crisis. Sections 3 and 4 examine the anatomy of the banking
crisis and the balance of payment crisis in Italy and Spain, pointing out the role played by
banks in fuelling these crises in Spain but not Italy. Section 5 discusses the impact of external
factors, in particular bonds markets; and euroarea interventions in the unfolding of the crisis.

Table 1: Main Economic Indicators 2007-2013

Subject Descriptor
% change
% change
Unemployment rate
% labor force
Government structural balance
% potential GDP







Government net debt

Current account balance
GDP, constant prices
Unemployment rate
Government structural balance

% change
% change
% labor force
% potential GDP







Government net debt

Current account balance





49.805 5
-4.521 -3.5

International Monetary Fund, World Economic Outlook Database, October 2012

2. State of the art and research design

A sovereign debt crisis occurs when a government defaults on its debt (Reinhart and Rogoff
2009) or is unable to borrow funds on the markets and has to resort to external financial aid
(Hardie 20121), such as the International Monetary Fund (IMF). A banking crisis occurs
when a country's financial and banking industry experiences a significant number of defaults
andas a consequence a large part of the capital in the banking system is reduced. 2 A
balance of payment crisis is preceded by persistently high current account deficits and net
capital inflows into a country, followed by massive and sudden outflows of capital from the
country, which triggers the crisis.

The literature in economics has paid considerable attention to the economic factors associated
to sovereign debt crises. One of the most extensive studies of financial crises over two
centuries highlighted a strong causal link between banking crises and sovereign defaults in
developed and developing countries (Reinhart and Rogoff 2009). In their book, Reinhart and
Rogoff reached three conclusions: i) private debt surges fuelled by domestic banking credit
growth are recurring antecedents to banking crises, ii) banking crises often precede or
accompany sovereign debt crises; iii) governments often have hidden debts. Another paper
pointed out the link between banking crises and balance of payment crises (the so called
twin crises) (Kaminsky and Rogoff 1999). Kaminsky and Rogoff found that problems in the
banking sector typically precede a currency crisis - the currency crisis deepens the banking
crisis, activating a vicious spiral; financial liberalization often precedes banking crises. Crises
occur as the economy enters a recession, following a prolonged boom in economic activity
that was fueled by credit, capital inflows, and accompanied by an overvalued currency. These
2 accessed in January 2013

accounts, written by economists, are somewhat de-voided of politics and one is left to explain
the causes of banking crises and the balance of payment crises in the first place.

In the political economy literature, several complementary explanations have been put
forward for the occurrence of sovereign debt crises, mainly in developing countries. These
explanations can be articulated at the macro-level (international level), meso-level (ie
national level) and micro-level (Germain 2012). At the macro-level, different authors have
pointed out a variety of factors that can fuel sovereign debt crises, namely: the impact capital
liberalization (XXX); the activity of bond markets (Mosley 2003) and financial innovation,
especially financialisation (Hardie 2011); the spread of neo liberal ideas (Major 2012 ); and
the lack of a proper hegemon in the international system (cf Kindleberger 1973), or more
recently in the European Union (Mabbet and Schelke 2013).

While some elements of the crisis can certainly be explained by international systemic
factors, particularly the withdrawal of foreign funds, macro-level factors are basically the
same for all countries, especially within the relatively homogenous regional block of the
euroarea. Hence, they are not very well suited to explain differences in the playing out and
outcome of the sovereign debt crisis across the euroarea. They are background factors that
have fuelled the sovereign debt crisis, but national level factors are better suited to explain
different dynamics and outcomes of the crisis across countries (see Jabko 2012; Haggard and
Mo 2000).

An obvious starting point in order to investigate the importance of national level factors in
the playing out of the sovereign debt crisis is the literature on varieties of capitalism (for
some comprehensive analyses, see Amable 2003, Hancke, Rhodes, and Thatcher 2007; Hall

and Soskice 2001; Schmidt 2002; for a review, see Jackson and Deeg 2010). This body of
work has examined the main components of varieties of capitalism, namely: industrial
relations institutions; education and training systems; corporate governance and systems of
corporate financing; product markets; social protection systems and welfare states; and public
intervention in the economy. The financial system has also been considered as one of the
components of the variety of capitalism, but the attention has mostly been on the sources of
corporate finance (see Zysman 1983, see also Deeg 2010).

This literature has generally focused on the Anglo-Saxon and continental varieties of
capitalism, characterizing them, respectively as liberal market economies and coordinated
market economies. The Southern European countries have mostly been overlooked or placed
in a residual category of Southern European or State- led model of capitalism (Schmidt
2002; Della Sala 2004).3 The literature on varieties of capitalism is of limited utility in order
to explain the dynamics and outcome of the sovereign debt crisis in Italy and Spain, as it
would predict similar (not different) outcomes. To be fair this literature was not developed
with a view to explaining sovereign debt crises, but rather to tease out institutional
complementarities that can enhance or hinder the competitiveness of national economic
systems in the world economy.

Two other bodies of literature are useful to investigate domestic factors at the origins of the
crisis. The first is the research pioneered by Hardie and Howarth (2013; see also Hardie et al.
2013; Deeg 2013) that focuses on banks activities in order to explain the evolution of national
financial systems. Since banks were at the epicenter of the crisis, it is important to understand
3 Indeed, this literature has been criticized for overlooking of countries that do not fit easily
into liberal market economies and coordinated market economies, for neglecting the role of
the state and the broader macroeconomic framework. An exception is the work of V. Schmidt
(2002) that has brought the state and its macroeconomic institutions back in into the
analysis of varieties of capitalism.

what they were doing in the run up to and during the crisis. Furthermore, the literature on
domestic political economy institutions and economic policies draws our attention to the role
of domestic factors in mediating the effects of external (macro-level) factors, for example
framing the impact of liberalization (Deeg and Perez 2000), and/or bringing about domestic
economic reforms (Perez 1997, Perez and Westrup 2008).

The dependent variable of this research is the playing out of the sovereign debt crisis in Italy
and Spain. In June 2012, the Spanish government requested euroarea financial assistance,
which was agreed by the Eurogroup meeting in July. It was agreed that financial assistance
from the euroarea member states was to be provided to the bank recapitalisation fund of the
Spanish government, and then channeled to ailing financial institutions in Spain. In
December 2012, the Spanish government formally requested the disbursement of about 39.5
billion of funds.4 By contrast, the Italian government has not requested outside financial
assistance to date, even though, like Spain, it benefited substantially from the purchase by the
European Central Bank of government bonds in the secondary markets in an attempt to
reduce borrowing costs, as discussed below.

This different outcome of the crisis is explained by the fact that Spain experienced a banking
crisis and balance of payment crisis, whereas Italy did not. In Spain (but not in Italy), there
was also a real estate bubble: the banking crisis cannot be understood without reference to the
real estate bubble. In parallel to the banking crisis, Spain experienced a balance of payment
crisis. Spain had a high net foreign debt, fuelled in the bonanza years by capital inflows.
When the banking crisis gained momentum in Spain and capital flew of the country, external
(euroarea) assistance was called upon. Italy escaped the worst of the sovereign debt crisis
4 accessed in
March 2013.

mainly because of its relatively low external debt and balance of payments imbalances as
compared to Spain. Italy had lived with a high public debt for decade, but the level of private
debt was rather low, and the public debt was mostly domestically owned. For example,
Japans public debt exceeds 200% of its GDP, but is mostly domestically held and the country
has not been threatened by a sovereign debt crisis.

What explain the banking crisis and the balance of payment crisis that conflated into the
sovereign debt crisis and the request for external financial assistance in Spain but not in Italy?
This paper argues that a key role was played by banks. In other words, banks business model
and the distinctive features of the banking sector in Spain and Italy account for the banking
crisis and the property bubble in Spain and for the absence of a banking crisis and a property
bubble in Italy. Banks also contributed to fostering the external imbalances that caused a
balance of payment crisis in Spain, whereas this was less the case for Italian banks.

3. The (late) banking crisis in Spain but not Italy

Initially, after the collapse of the the subprime market in the US in late 2007 and the
bankruptcy of the US financial firm Lehman brothers in October 2008, Italian and Spain
banks weathered the banking crisis rather well: they did not experience major losses and did
not need state recapitalisation. The limited impact of the banking crisis in Italy and Spain is
explained by the banks business model and balance sheets, which were in turn influenced by
the sound regulatory framework in Italy and Spain (see Barth and Levine 2006). 5 Moreover,
Italian and Spanish banks were relatively sheltered from the most intense forces of global
financial contagion in 2008-9: Italian and Spanish banks did not invest in fancy financial
5 The data produced by Barth and Levine (2006) on capital stringency and bank regulation
show the diversity of regulatory practice across countries. Italy and Spain scored high in
terms of stringency of regulation.

products that later proved to be toxic. The expansion abroad of Italian and Spanish banks
was mostly in retail business, with ownership of retail subsidiaries and participation in
banking groups in Central and Eastern Europe, for Italian banks, and Latin America for
Spanish banks.

Nonetheless, in late 2009, major financial problems began for the Spanish saving banks
(cajas), which had to be recapitalised first by the Spanish government and then through
euroarea financial assistance. Italian banks, with the exception of the recent case of the Monte
dei Paschi, did not experience significant losses. The bad performance of Spanish cajas is
explained by bad mortgages and loans to construction companies, which in turn fuelled a
property bubble in Spain. The Bank of Spain had limited supervisory competences on the
cajas, whose management was affected by the interference of local politicians. Italian banks,
less subject to political interference, mainly lent to non financial corporations, especially
small and medium enterprises.


At the outset of the global financial crisis, in Italy (as in Spain) the majority of banks assets
were loans to customers, and a significant part of banks assets involved national government
securities, which at that time were considered among the safest possible asset investments
(Pagoulatos and Quaglia 2013, Royo 2013b). Unlike Spanish banks, Italian banks did not fuel
a property bubble: they lent to households far less than either Spanish or Greek banks.
Lending to Non-Financial Corporations (NFCs) was higher in Spain, than in Italy and
Greece, though not really dramatic. However, in Spain the NFC lending included a very large
proportion of property developers, especially for the cajas, as explained below. Data from the

Bank of Italy (2008c) suggest that Italian banks were predominantly lending to NFCs, and
that amongst NFCs, the bulk of the loans went to services and industry, not building (see
Table 2). Obviously, a property bubble can come also from residential mortgage lending, but
there was no significant rise in consumer lending in the years preceding the crisis.

On the liabilities, Italian and Spanish banks had a broad and stable funding base. Funding
from retail customers, more stable than wholesale funding, constituted a large share of the
total liabilities in both countries (Pagoulatos and Quaglia 2013, Royo 2013b). However,
banks in both countries also depended on wholesale inter-bank funding, which some
importance differences. First, Italian banks tended to lend mostly to each other. The average
home bias for Italy was the highest in the euro areas national banking systems (Manna
2011). At the height of the crisis, banks cut their lending to banks in other countries far more
than their lending to banks in their own country, so the fact that Italian banks lent to each
other suggests that inter-bank borrowing was more stable than in those systems (like Spain)
where inter-bank funding was largely from abroad.

Second, although Italian banks have high levels of wholesale funding, this is relatively longer
term: ninety-three per cent of debt securities issued by Italian banks are over two years in
maturity and none are under one year. For Spanish banks, the figures are seventy-three and
twenty-two per cent respectively. Third, several of the debt securities issued by Italian banks
were sold to their customers, which made this sort of funding less subject to the vagaries of
the financial markets. Italian banks have greater access to retail investors for their bond issues
than elsewhere in Europe (Bank of Italy 2011).

Table 2. Italian banks loans distribution by: Customer segment of economic activity

September 2007
TOTAL LOANS (million of euros)


October 2008


General government



Financial companies



Non-financial companies



of which: Industry









Producer households



Consumer households



Bank of Italy (2008). Summary Report of the Statistical Bulletin 2007-2008, Data on credit,
securities business and interest rates, quarter 4, p.3.

The only Italian bank that experienced serious problems as a consequence of the global
financial crisis was the Monte dei Paschi di Siena, which is the worlds oldest bank. In
February 2013, it was the subject of a major scandal involving losses of 730 millions euros
from (toxic) financial products that had previously been hidden from the supervision of the
Bank of Italy. The transactions took place between 2007 and 2009. The scandal discredited
the bank's former management, which was by and large appointed by local politicians (the
municipality of Siena and the region of Tuscany are mostly governed by the Democratic
party). It exposed the close lies between politicians and banks. It also questioned the
supervisory activity of the Italian central bank, the Bank of Italy, which has extensive
supervisory powers. The supervisory department of the Bank of Italy pointed out that the

management of the Monte dei Paschi had hidden from the central bank the toxic
transactions that led to financial losses.

Unlike in Spain, in Italy there was not direct competition between commercial banks and
savings banks, which were subject to the same regulatory framework. The banking reform in
Italy in the late 1990s and early 2000s was instrumental in facilitating the merger of
commercial banks and saving banks, as well as in modernizing the Italian banking system.
Prior to the reform, saving banks in Italy, like the cajas, tended to have close ties with local
communities and local politicians (Deeg 2013), as it was still the case for the Monte dei

Despite the Monte dei Paschi debacle, banking supervision in Italy has been assessed as
systematic and diligent during the crisis and in the years preceding it (IMF 2008). The Bank
of Italy, like the Bank of Spain, discouraged lenders from adopting risky off balance sheet
accounting methods and from acquiring billions of Euros of repackaged US subprime
mortgages and other toxic assets. Moreover, the Bank of Spain and Bank of Italy were
instrumental in forcing banks to focus on conservative risk management and quality of
capital, limiting their leverage and the debt to equity ratio.


In Spain, between 2008 and 2010 the financial system was still one of the least affected by
the crisis in Europe. In December 2010 Moodys ranked the Spanish banking system as the
third strongest of the Eurozone, only behind Finland and France. Spanish banks, like Italian
banks, had a rather traditional business model. As in the case of Italy, in Spain the majority of

banks assets were loans to customers. On the liabilities, Italian and Spanish banks had a
broad and stable funding base, mainly from retail customers (Pagoulatos and Quaglia 2013,
Royo 2013b). However, Spanish banks raised funding on the wholesale market more than
Italian banks, which made the former more vulnerable to the credit crunch (it the freezing of
the interbank market) than the latter. The Bank of Spain had imposed a regulatory framework
that required higher provisioning, which provided cushions to Spanish banks to initially
absorb the losses caused by the outset of the global financial crisis (Royo 2013a).

Nevertheless, the relative success of the Spanish banks proved short lived. The collapse of
the real estate market eventually led to a traditional banking crisis fueled by turbo-charged
lending funded on the interbank-market on the liability side of the Spanish banks balance
sheets. However, Spain was rather unique in the fact that the largest banks did not face large
problems. While the cajas were struggling under the weight of bad mortgages and loans to
construction companies, the exposure of Big Threes large private banks to toxic assets
associated with the Spanish real estate sector was a relatively small problem. BBVA and
Santander diversified internationally gaining access to funding and capital that allowed them
to liquidate the toxic property assets at a lower price than their rivals, and with limited
damage to their earnings.

When looking at the performance of the Spanish financial system, it is very important to
distinguish between the large banks and the cajas - unlisted in the stock market, regionally
based, and often politicized savings banks accounting for half of the financial sectors
assets. The large banks performed relatively well during the crisis while the cajas suffered
from a somewhat traditional financial crisis. Much of what the cajas were doing was lending
to NFCs in construction, rather than just mortgage lending. Yet, a key element that separates

this crisis from a traditional one, particularly on the cajas side, is their heavy borrowing on
the interbank market (Carballo Cruz 2011). This distinction is unique in comparative terms;
in no other country were small banks uniquely hit and large banks left largely unscathed.

During the boom years, the cajas successfully captured market shares from the banks,
investing heavily in real estate (lending both to consumers and companies). Significant levels
of interbank liabilities were taken on by both the big Spanish banks and the cajas, but in
particular by the cajas in the context of their efforts to expand and strengthen their national
presence, as illustrated most visibly by a rapid growth in the number of employees and
branches. When the economic recession kicked in, they were exposed to the collapse of that
sector and the payment difficulties of mortgage holders. Cajas, highly dependent on
international wholesale financing, were also forced to turn to the government and the ECB
for liquidity when wholesale markets froze.6 Fortunately for the largest Spanish banks, their
geographical diversification helped them to counterbalance their domestic losses.

In the end in Spain the financial system, to be precise the cajas was unable to decouple itself
from the economic cycle and the huge macroeconomic crisis that has besieged the country.
The deteriorating economic conditions had a severe impact on the banks balance sheets. The
liquidity problems of Spanish banks problems were reflected in their dependence on the ECB.
Spanish banks increased their ECB borrowings by more than six times since June 2011. In
March 2012, they borrowed a record 316bn euro from the ECB, 28 percent of the euroarea
total, the highest level in absolute terms among euro area banking systems (Royo 2013b).

6 By May 2010, 34 of the 45 cajas were involved in merger and restructuring discussions; it
was expected that that would lead to the creation of 11 new cajas.

In Spain, the distinction between banks and cajas is key to understand the banking crisis that
developed from 2010 onward. Indeed, their performance has been very different. A crucial
reason for this divergence was the difference in their regulatory framework. Cajas are very
peculiar credit institutions because they used to dedicate a significant portion of their
provisions (usually over 20 percent) to social causes, and, prior to the crisis, they have strong
links with the regions in which they operate. They are regulated by both the national
government (in charge of basic norms) and by the autonomous communities governments (in
charge of application and development of the rules established by the central government).
Political institutions (parties and unions) participate in their governing bodies. 7 This proved to
be a gaping hole in the regulatory framework, and had devastating consequences.

Since the crisis started, the country adopted five financial reforms in three years, and
implemented three rounds of bank mergers (for more details, see Royo 2013c). Many cajas
were merged and their number dropped from 45 to 9. The Spanish government repeatedly
increased the capital provisions. Those banks unable to meet the new provisioning rules were
able to borrow the additional money in the form of state-backed convertible bonds carrying a
10% interest rate. Furthermore, banks could transfer their riskiest assets to state-guaranteed
asset management companies to help speed the sale of real estate assets the bank holds. Each
bank was forced to create a bad bank into which it will put physical property assets at marked
down valuations, in preparation for potential sales to outside investors.

In May 2012, the Spanish government was forced to nationalize Bankia the countrys largest
real estate lender and the result of the merge of several ailing cajas. This was the largest bank
nationalization in the countrys history and was overseen by the Bank of Spain. The failure of
7 However, it is important to stress that political control was not always detrimental. In the
Basque Country, there was strong political control of the cajas, and still the Kutxa channeled
most credit towards the business sector (Fisham 2012).

Bankia validated some concerns about insufficient regulatory oversight and the perception
that banks and the Bank of Spain had played down the risk posed by real estate loans. In
August 2012, a new financial reform was approved in response to the EU financial rescue
package. It created a bad bank that could absorb the toxic assets from the real estate sector,
and had the authority to buy and sell all kind of assets and to issue bonds. The reform
reinforced the role of the Bank of Spain in the creation of the bad bank. It also established a
new process to restructure and liquidate financial institutions and it gave a central role in that
process to the FROB and the Bank of Spain. Finally, the reform reduced the role of the
regional governments in the restructuring and liquidation of cajas and saving cooperatives.
These five reforms in less than three years were largely perceived as too little and too late,
and failed to sway investors confidence in the Spanish financial sector. Both the Socialists
and Conservative governments were reluctant to admit the depth of the liquidity and solvency
problems of many institutions, particularly the cajas, where politics has continued to play a
role throughout the crisis.

4. The balance of payment crisis in Spain, but not Italy

Both Italy and Spain suffered from internal and external imbalances. As Bini Smaghi put it
(2008) external imbalances are the reflection of internal imbalances. All the periphery
countries hit by the sovereign debt crisis had a persistent current account deficit over the last
decade or so, coupled by significant private capital inflows from 2002 to 2007-9. In
comparison to the other countries, in particular to Spain, which had the largest current
account deficit in the euroarea, Italy had a much smaller current account deficit. It also
experienced very limited capital inflows.

In the first four countries, large current account imbalances were mainly funded through
portfolio debt securities and banks loans (Commission 2006), not so much by foreign direct
investment, with the exception of Ireland. As Merler and Pisani-Ferry (2012) note Such a
financing structure, biased towards banks intermedia-tion, rendered the deficit countries very
exposed to the unwinding of capital inflows... Indeed, when the banking crisis began,
followed by the sovereign debt crisis, the capital inflows of the previous decade were
followed by large capital outflows.

This trend was reflected by the positions of the eurosystem central banks in the TARGET 2
the interbank payment system of the Eurosystem. Until 2007, TARGET 2 positions were
close to balance. When the global financial crisis began in 2007 and even more so when the
sovereign debt crisis broke out in 2010, imbalances emerged within TARGET 2, whereby
Germany was the largest creditor and Greece, Spain, Ireland and Portugal were net creditors.
Italy became a major net debtor in TARGET 2 in the summer of 2011. As Merler and PisaniFerry explain Once the crisis broke out in the euroarea, sub-stitution of private-capital
inflows by public inflows, especially Eurosystem financing, helped accommodate persistent
current-account deficits 8


Despite the tendency to lump Spain, Italy, Greece, Portugal and Ireland together and view the
crisis as caused by fiscally irresponsible governments, Spains public finances were in robust
shape prior to the European sovereign debt crisis: public debt was only 36.3% of GDP, and
the country had budget surpluses from 2003 through 2007. In Spain, the public deficits and
8 Merler and Pisani-Ferry (2012) estimated that the cumulated net position of the northern
euro-area central banks reached 800 billion in December2011, being matched by the
southern euro-area central banks' equivalent negative position.

then the debt soared as a consequence of the crisis, in response to which the government
implemented an 8 billion public-works stimulus. These expenses, combined with the fall in
revenues, the need to recapitalize a large number of Spanish banks (see previous section) and
the deficits run by the regions, blew an enormous hole in the public accounts (see Table 1).

The regions struggled to cut their budget deficits, were shut out of the credit markets, and
were crippled by mountains of debt accumulated during the boom years. Many of these
regions asked the national government for emergency financing, tapping into the 18bn fund
set up by the central government to help regional governments meet their debt repayment
obligations. The regional governments combined debts of 140bn euros, of which 35bn euros
matured in 2012. Hence, Spains regional state structure, and with the exception of the
Basque Country and Navarra, the very limited fiscal powers of the regional governments
worsened the state of public finance.

The key problem for Spain, unlike Italy, was not so much the public sector debt in as much as
the private-sector debt, driven by record-low interest rates after the country joined EMU and
fuelled by reckless banks investments and loans (see Table 3). These, in turn, fuelled a
property bubble, which Italy, unlike Spain, did not experience. Land prices increased 500
percent in Spain between 1997 and 2007. At the end of 2010, the International Monetary
Fund (IMF) reported that Spain had the largest real estate bubble in the developed world. But
the global financial crisis burst it: because of high unemployment and lower wages caused by
the economic crisis many mortgage holders were unable to repay their debt.

By the end of 2011, land prices, adjusted for inflation, had fallen about 30 percent from the
2007 peak, and home prices were off about 22 percent. House prices fell by 11.2 percent in

2011 alone, while in Madrid, prices went down by 29.5 percent. Expectations, however, are
that the entire original house price increases may be reversed, so prices would have to fall
40% from that level.9 The implosion of the real estate market exposed the vulnerability of the
banking sector to that market, which constituted 60 percent of the banking loans (i.e., loans to
families, enterprises in the real estate sector or direct real estate assets), as explained in the
previous section, which pointed out the role of banks and municipalities in fostering the
bubble. In Spain, the decision by the cajas to channel funding disproportionally to the
construction sector (both to construction companies and real estate developers) and toward
private mortgages (their reticence to lend to SMEs outside of the construction and real estate
sectors) was critical to fuel the bubble in that sector (see Serra Ramoneda 2011). Moreover,
restrictive lending to SMEs was one of the reasons that accounts for the poor labor market
performance of the country because it undercut these firms efforts to create jobs and
innovate (Fishman 2010, 293299).

Unlike in Italy, the main fiscal problem in Spain was not the total amount of its public debt,
but rather the fact that it is mostly held abroad. Hence, the countrys problems intensified
when foreign investors became more reluctant to refinance its debt, as reflected from the
increasing yields in the last two years (see Figure 1). This high degree of Spains external
indebtedness was partly the consequence of the record current account deficits that Spain
suffered during the first decade of EMU membership. Since joining the final stage of EMU
the current account has been in deficit in Spain. In 2007, it reached the record of almost 10%
of GDP, one of the highest in the euro area. These current account imbalances were funded
through portfolio debt securities and banks loans (Commission 2006). As Merler and PisaniFerry (2012) note banks intermediation played a key role in attracting capital inflows and
9 A complacent Europe must realize that Spain will be next, in Financial Times, April 11,

channeling them in the construction sector, rendering the Spanish economy vulnerable to the
sudden withdrawal of these funds.

Figure 1. Debt Burden in Selected Advanced Economies (Percent of GDP)

Source IMF Global Financial Stability Assessment 2012.


In Italy the gross public debt was very high before the crisis. Italy has managed a public debt
above 100 GDP for the last three decades. On the negative side, the Italian government failed
to take advantage of the low interest rates following the entry of the country into EMU in
order to substantially reduce the outstanding public debt (refs needed). On the positive side,

Italy has run a primary surplus from 1992 onwards, with the exception of a primary deficit in
2009 and 2010, which were mainly due to a falling growth rate (see Table 1).

The main problem in the Italian case was not so much the high level of public debt, especially
taking into account that the relatively low level of private debt and the fact that the public
debt is mostly held abroad. Italy had lived with a high public debt for decades. However, the
very low growth rate raised serious issues about the sustainability of the public debt (Jones
2011). Italy has been suffering from low economic growth for more than a decade: 0.54 per
cent annual average real GDP growth between 2000 and 2010 versus 1.37 per cent for the
euroarea, whereas economic performance in Spain was significantly better during the decade
prior to the crisis (thanks largely to the state bubble). Since the beginning of the crisis, the
low or negative economic growth and rising unemployment in Italy and Spain worsened the
state of the public finance.

Table 3. Indebtedness and Leverage in Selected Advanced

(Percent of WEO projections for 2012)

General Government Debt

Primary balance
Household Debt
Nonfinancial Corporate Debt
Debt divided by equity (percent)
Financial Institution
Gross debt






123 79
102 67




171 -72


112 196
139 149





Leverage of domestic banks

Bank claims on public sector
External Liabilities
Government debt held abroad
Source. IMF Global Financial Stability





142 221
23 93
49 28

Assessment 2012
Unlike Spain, Italy had a limited degree of external indebtedness and did not experience the
high level of capital inflows that Spain had. This was the consequence of the relatively small
current account deficits that Italy suffered during the first decade of EMU membership and
the high saving rate in the country. Far more export-led than all other Southerners, Italy had a
lower current account deficit (see Table 1). Unlike Spain, Italy has the second-largest
manufacturing and industrial base in Europe, after Germany, and is one of the biggest exportoriented economies in the euro zone. Made in Italy is still a valuable brand the over the
world. Moreover, Italian banks did not perform the intermediating function that Spanish
banks had by channeling capital inflows into a property bubble.

Both Spain and Italy suffered from a loss of competitiveness since joining EMU, hence once
they gave up the possibility of devaluing their currency. Between the introduction of the euro
and 2008, unit labor costs in the manufacturing sector, the strongest indicator of the
economys competitiveness, increased substantially in Italy and Spain (see Figure 2). During
that period, the countries productivity increased marginally. According to the World
Economic Forums annual 2012 competitiveness ranking one of the shared features of the
current situation in all these [Southern European] economies is their persistent lack of
competitiveness.Over all, low levels of productivity and competitiveness do not warrant
the salaries that workers in Southern Europe enjoy and have led to unsustainable imbalances,
follow by high and rising unemployment.

Figure 2

Source: OECD.

5. Macro level factors: Bond markets and euroarea assistance

There are two types of external factors that are important in the playing out of the sovereign
debt crisis in Italy and Spain: the reactions of the bond markets as manifested by the spread
between Italian and Spanish bonds yields and German ones, and external financial assistance.
In Spain, there was no IMF financial assistance. euroarea financial assistance has taken three
forms in Spain: provision by the Eurosystem of liquidity to the banking sector through
TARGET 2 (see Section 3); ECB purchases of sovereign bonds under the SMP and euroarea
assistance programmes. Both in the case of Italy and Spain these external factors were mostly
a function of the domestic development in the two countries, rather than being causes of the

sovereign debt crisis. Bond markets contributed to the contagion effect that hit Spain and
especially Italy. Delayed and ad hoc euroarea financial assistance also contributed to this.

When the sovereign debt crisis broke out in Greece in 2009-2010, Italy and Spain were
initially unaffected, as suggested by the ten years spreads on government bonds for Italy and
Spain versus the German bunds (see Table 4). Spain began to face serious problem in the
bond market in the second half of 2010 because of rising concerns about the crisis in the
financial sector, the continuing decline of the real estate sector, and the impact of the
economic recession. The Socialist led government overestimated the capitalization of Spanish
companies, the resilience of the Spanish financial system, the strength of the counter cyclical
dynamic provision system; and the openness and competitiveness of the Spanish economy. At
the same time, the attempt to force restructuring through mergers backfired, as proven by the
Bankia fiasco (a savings and loan that had to be nationalized in the Spring of 2012): the
governments failed to recognize that merging weak banks does not create a strong one.

Italy began to face serious problem in the bond market in the summer of 2011: the spread
between Italian ten-year bonds and their German counterparts widened; Italian sovereign debt
yields moved above those charged to Spain; and rating agencies downgraded the
creditworthiness of the Italian government and consequently of Italian banks. [Beside the
economic crisis, Italy was also facing a political crisis, with several scandals (including sex
with an underage woman) involving the then Prime Minister Silvio Berlusconi. There was
also an open conflict within the government between the Prime Minister and the Treasury
Minister Giulio Tremonti, which weakened the government coalition. The deterioration of the
fiscal situation and the inability of the centre-right government of Silvio Berlusconi to put
together a convincing adjustment package, together with strong diplomatic pressure from

abroad, led to the government resignation and the nomination of the technocratic
government headed by Mario Monti in November 2011 (Jones 2011).

Spain also underwent a change of government, though not to a technocratic one. The Partido
Popular government, which came to power at the end of 2011, sought to convince the market
of the governments commitment to austerity and structural reforms, but without positive
results. They tried to execute a hail Mary in the form of deep cuts and structural reforms,
but this shock and awe strategy did not work. If anything, the PP government policies in the
first half of 2012 were also mired in parochialism, often showing more concern about
political interests than doing the right thing.

Table 5: Ten Years Government Spreads for Italy and Spain (2009-2012)

Bonds-Ten Years Government Spreads (September 30th, 2009)

Bid Yield

Spread Vs. Bund


Bonds-Ten Years Government Spreads (September 30th, 2010)

Bid Yield

Spread Vs. Bund


Bonds-Ten Years Government Spreads (September 30th, 2011)

Bid Yield

Spread Vs. Bund


Bonds-Ten Years Government Spreads (September 28th, 2012)

Bid Yield

Spread Vs. Bund


Bonds-Ten Years Government Spreads (November 23rd, 2012)

Bid Yield

Spread Vs. Bund

Source: Thomson-Reuters



In December 2011, the ECB launched a program of Long Term Refinancing Operations
(LTRO), issuing loans at the interest rate one per cent for a period of three years to European
banks, accepting government bonds, mortgage securities and other commercial papers in the
portfolio of the banks as collaterals. At the same time, the ECB changed its rules on
collaterals, accepting lower quality collaterals in return for its loans. Under this program, the
ECB loaned 489 billion to 523 banks, mainly in Greece, Ireland, Italy and Spain. Indeed,
Italian and Spanish banks took about sixty per cent of all the net new loans from the ECB,
with Spain's overstretched banks taking marginally more than Italy's. 10 The banks used these
funds to buy government bonds, effectively easing the debt crisis. In February 2012, the ECB
held a second three year auction of 529 billion to 800 European banks. Although the ECB
program did not target specifically Italy, the country benefited through a temporary reduction
of its borrowing costs. The ECB lent to euro area banks, which in turn lend to euro area
governments, and then used the government debt they bought as collateral for yet more loans
from the ECB.

Market instability in the euroarea and the unsustainable borrowing costs for countries such as
Spain and Italy led to ECBs decision, announced on 6 September 2012, to purchase euroarea
countries short-term bonds in the secondary markets, as part of the new program dubbed
Outright Monetary Transactions (OMT). However, government from the beneficiaries
countries were required to apply for aid from the euroarea rescue funds and to comply with
conditions in exchange for the support. In the fall and early winter of 2012, Spain was


considering whether to apply for this aid. The Spanish government, facing regional elections
in the Basque Country, Galicia, and Catalonia, was keen to avoid the humiliation of
requesting another bailout and having European authorities dictate the conditions of a rescue.

The Italian government has repeatedly ruled out the possibility of requesting EU financial
assistance, pointing out that the economic situation of Italy was different from that of the
countries that had requested EU financial assistance. The Italian authorities often highlighted
the permanent risk of contagion, portraying Italy as a bystander in the crisis, and argued that
the strengthening the euro zone is of collective interest (New York Times, 11 June 2012). At
the EU level, in June 2012, together with the Spanish government, the Italian government
called for and obtained the creation of an anti-spread shield, that is a mechanism to stabilize
markets and to fix a ceiling for interest rates of so-called virtuous countries (Sole 24 Ore, 5
July 2012). The Italian Prime Minister made it clear; however, that Italy would not use the
measure for the moment.


Despite the fact that Italy and Spain are often considered as belonging to the Mediterranean
variety of capitalism, there are important differences in the way in which the crisis played out
in these two countries. This is because a coherent variety of Mediterranean capitalism is
missing and certain domestic political economy institutions namely, banks - that are key in
order to explain the outcome of the sovereign debt crisis are overlooked by the literature on
varieties of capitalism.

This analysis highlights the important role that banks had in the playing out of the crisis.
Banks in Spain (to be precise, the cajas) turbo charged a property bubble. The implosion of
this bubble in Spain, together with the dependence on wholesale market liabilities, and the
depth of the economic crisis got the Spanish cajas into trouble, triggering a rather traditional
banking crisis. The Spanish government did not have the fund to recapitalize these banks and
had to resort to EU funds. Hence, the sovereign debt crisis in Spain was triggered by the
banking crisis, worsened by a balance of payment crisis, which was caused by a high net
foreign debt and sudden capital outflows. In both countries the accumulated loss of
competitiveness worsened the current account deficit, which was however much larger in
Spain than in Italy. Unlike Italy or Greece, at the outset of the crisis Spain had a strong fiscal
position, hence the financial crisis in Spain originated from private sector overindebtedness
(as in Ireland). The soaring public deficit and debt were largely a result of the banking crisis.

By contrast, Italian banks did not fuel property bubble and did not experience significant
losses during the global financial crisis. It was the high level of debt (which increased, though
not substantially, during the crisis) and the low level of growth that raised concern about the
debt sustainability. Unlike in Spain, Italian banks were not instrumental in fostering
significant capital inflows, making the country less vulnerable to a balance of payment crisis
as a consequence of sudden capital outflows. All this explain why Spain had a fully-fledged
sovereign debt crisis, resorting to EU financial aid, whereas Italy did not.

The Italian and Spanish experiences show the importance of domestic political economy
institutions, to be precise of banks business models and regulatory/supervisory framework in
the development of the two crises that conflated into the sovereign debt crisis. The collusion
between local politicians and the management of the cajas proved to be a toxic mix for the

Spanish banking system. Moreover, the cajas partly managed to escape regulation and
supervision of the Banco de Espana. The Spanish commercial banks remained sound and
profitable, and so did Italian banks. The main toxic product in the portfolio of Italian banks
are currently Italian public bonds.


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