Let’s recall the basic situation: The Spanish government is running a large budget deficit. It needs to borrow at least $42 billion this year alone to fund its day-to-day operations. To raise those funds, the country sells various types of bonds, including 10-year-bonds. In return for cash from investors, the Spanish government promises to pay a fixed rate of interest — say, 5 percent — every year for 10 years. At the end of that period, the investors get all of their original cash back.
Now, when investors are nervous that the Spanish government might not repay in full, they demand higher interest rates on these bonds as a sweetener. And that’s what is happening right now. Investors are skeptical about Spain’s ability to repay, especially since the country has a yawning budget deficit and is enacting new tax hikes and spending cuts that could sink its economy deeper into recession. So, investors aren’t willing to buy up Spanish bonds unless they come with a 7 percent interest rate. A very big, very fat sweetener.
The trouble is that 7 percent rate is likely to be unsustainable if it persists for too long. If Spain has to pay that much to borrow money, its deficit will grow even bigger — especially since euro zone inflation is low and Spain can’t just print more money to repay its debts. That, in turn, makes investors even more leery. So they demand even higher interest rates. A cycle of doom starts swirling.