Mariano Rajoy, Spain’s prime minister, plans to limit borrowing by the country’s regions, Bloomberg News reported this morning. He’s not actually telling the regions they can’t borrow. Rather, he’s telling them they can’t borrow if they can’t borrow cheaply.
Rajoy’s plan would keep out of the debt markets any region that can’t sell it at a yield of less than 100 basis points over Spain’s sovereign debt. If the market thinks any region is riskier than that, the region is too risky to borrow. According to Serafi Rodriguez, a fixed-income trader at Morabanc who was quoted in the piece, the plan would keep all but three of Spain’s regions—Madrid, the Basque Country, and Navarra—out of the market. It would drive all the rest into the arms of Spain’s €23 billion ($31 billion) regional rescue fund, which provides money in exchange for closer budget supervision.
It’s a stick-and-carrot fiscal union, something Spain desperately needs. Last March the World Bank published a research paper, Why Do Some Countries Default More Often Than Others?, that sought common causes among 70 years of sovereign defaults. The paper showed that countries with weak central institutions are more likely to default. If a central government cannot prevent its regions from running up debt, for example, it is more likely to find itself on the hook for it. From the paper:
The central planner maximizes collective welfare by setting economy-wide expenditure and debt. In contrast, countries with bad institutions are characterized by lack of institutional barriers to limit the influence of powerful groups in the government decision-making process. Powerful groups act in non-cooperative ways, they behave in ways that are optimal from their own point of view, without taking into account the effect of their actions on other groups.
The paper points to Argentina and Brazil in the 1980s, writing of Brazil:
In each of the crises, the first reaction was to demand bailouts from the central government and in each case the federal government federalized state debts. The constitution and the basic structure of intergovernmental relations have sabotaged the most important mechanisms that enforce subnational fiscal discipline. … The central government, despite its proclamations, could not credibly commit to abstain from bailing out the troubled states in case of crisis. This was because the states had influence on relevant central government decisions regarding subnational finance due to their strong representation in the legislature.
Spain can’t change its constitution overnight, but it can make rules. And so it has come up with a rule: If we can’t all coordinate our finances to stay out of debt, and you can’t get into debt responsibly, then you can’t have any more debt. Spain—like Ireland before it—is suffering from a banking crisis, not a public debt crisis. But regional borrowing is a problem and any attempt to rein it in is a good step.
Europe is a fractal. Look at problems between a European state and its regions, and you can find the same problems within the European Union. Italy and Belgium have their own North-South divides, for example. And as with the government in Madrid vs. Spain’s regions, the institutions of the euro zone aren’t strong enough to prevent any single country from building up debt. Ultimately, no matter what Germany and Finland say, that debt will be shared.
The euro zone, too, recognizing that it lacked real democratic and institutional control over the budgets of its states, created rules on debt and inflation. Member countries broke them regularly in the decade before the euro crisis. Today, if we were to apply the Rajoy plan to Europe—no country with debt yields more than 100 basis points over that of Germany can take part in the debt markets—Italy, Spain, Portugal, and Greece wouldn’t make the cut.
Spain will have better luck enforcing its rule. It is an actual state, after all. But rules can be negotiated, then excused, then ignored. They are not a substitute for a constitution that allows a central government that underwrites regional debt to have some democratic, functional control over that debt. Rules preventing debt are a good first step. They are just that—a step. They are not enough on their own. This is true for Spain, and it is true for Europe.