11/18/2011 06:37 pm ET

Interest Rate On Spanish Sovereign Debt Soars, As Investor Panic Spreads

As the eurozone crisis drags on, calls are growing louder for a big bailout from the European Central Bank. Yet the fate of the euro -- and possibly the global economy -- also hinges on the ability of Spanish and Italian leaders to seize the moment and whip their economies into shape.

Italy hit the rails last week when its borrowing costs reached unsustainable levels. The European Central Bank swept in and bought some of the country's debt, bringing down interest rates -- for the moment. The same thing happened to Spain on Thursday when its borrowing costs rose to a record high, falling only after the ECB bought some Spanish sovereign debt.

These rescues are just quick fixes, however. Many economists are calling for two drastic measures: First, allow the ECB to buy trillions of dollars in troubled sovereign debt to drive down borrowing costs and calm the markets. Longer-term, Spain and Italy must implement credible structural economic reforms that will allow troubled European economies to grow their way out of crisis. Like the U.S., these countries need to create jobs, fix housing problems and reduce their deficits.

"At the end of the day, you've got to get them growing again," said Jay Bryson, global economist at Wells Fargo Securities. "The ECB can get you a backstop, but it's not a permanent solution."

The 10-year interest rate on Spanish sovereign debt spiked to a record 6.975 percent on Thursday -- a rate many economists view as unsustainable -- before the ECB's actions eased it down to 6.42 percent on Friday.

"When the ECB's buying the debt, that means nobody wants it," said Lance Roberts, chief strategist at Streettalk Advisors.

Spain was one of the last European economies to pull itself out of the most recent recession because of a particularly harsh housing boom and bust. Now the country appears to be heading back into recession. IHS Global Insight forecasts that the Spanish economy will shrink for the next six months and that the unemployment rate will stay elevated at 21 percent into 2012: the highest unemployment rate in the eurozone.

Spain is reportedly likely to vote for conservative leader Mariano Rajoy for prime minister in general elections on Sunday, replacing the current socialist government. Since Rajoy doesn't have ties to unions, he is more likely than the current administration to push through labor market reforms, said Raj Badiani, senior economist at IHS Global Insight.

Badiani and others say that Spain needs to make it easier to fire workers on full-time contracts, encouraging companies to hire more workers full-time rather than on a temporary basis. This creates an incentive for companies to train workers, Badiani said, and would theoretically boost productivity. Plus, banks would be more likely to give mortgages to full-time contracted workers -- a lift for the still-ailing Spanish housing market.

Italy needs to make similar changes to its workforce, several economists said. Mario Monti, a technocrat, was appointed Italy's prime minister on Wednesday after the resignation of longtime Prime Minister Silvio Berlusconi, who had lost the political capital needed to implement serious reform.

Both Rajoy and Monti have a window of opportunity available to implement real change, but they need to use their popularity swiftly to accomplish it, Bryson said. "President Obama was pretty popular too. Over time, when you start to put policies into place and people start to feel pain and get hurt, your popularity starts to go down."

If the ECB and Spanish and Italian governments do not act, Bryson said, the countries may eventually default on their debts and kick off a spiral of pain: They'd leave the eurozone, he said, likely causing it to break up. That could spark major losses for European and American banks and make global borrowing costs spike. The result could be an immediate recession in the U.S. and Europe.

Bart van Ark, chief economist at the Conference Board, agreed that it is essential for Spain and Italy to implement credible structural economic reforms to restore investor confidence.

"It needs to be bold and radical enough so that the markets generally feel these countries are going to go on another trajectory," van Ark said. "The political and economic damage of a [eurozone] breakup would be too large. Policymakers do realize these risks."

But he warned that he hadn't seen much political courage in Europe yet.

"Sometimes, even if everybody knows what the right decision is, it doesn't mean those decisions are going to be taken."