The global credit crunch of 2008 burst Spain's property bubble, throwing hundreds of thousands of low-skill construction workers on to the unemployment line.
Today Spain's jobless represent a staggering 22.9 percent of the work force, far and away the highest in the eurozone. The International Monetary Fund estimates Spain's 2012 economic output, as measured in gross domestic product, will contract 1.7 percent, meaning even less tax and fewer jobs. Spain forecasts unemployment will average 24.3 percent this year.
Yet the EU expects Spain to cut its annual deficits, which last year reached 8.5 percent of GDP, back to the EU limit of 3 percent in 2013. This means two more years of tax rises and spending cuts that, in turn, will depress GDP further.
"There's a real risk that the Spanish economy will get caught in a downward spiral and need a bailout," said Simon Tilford, chief economist at the Centre for European Reform, a London-based think tank.
"Unless the EU changes strategy radically and permits Spain to rein in the extent of austerity, all they're going to do is fuel social tension and destroy Spain's growth potential," Tilford said.
Sensing the danger, the new Conservative government of Prime Minister Mariano Roy this month flatly told the EU it couldn't cut its 2012 deficit to 4.4 percent as previously pledged. It set a new target of 5.8 percent.
For now, Spain's borrowing costs are under control and the threat of a default is receding. Its €700 billion in government debt represents less than 70 percent of GDP.
But the debt exposure of Spanish banks exceeds €2.4 trillion, representing a further 230 percent of GDP. These banks are facing massive write-offs from defaulting construction companies and home owners. This raises concerns because — as witnessed when Ireland's government had to nationalize five banks to prevent their collapse — privately held debt can end up as public property and overwhelm the state's ability to finance itself.
ITALY: Land of terminal debt
The level of Italy's government debt has long appeared to defy economic gravity. In 2010, Portugal and Ireland faced huge pressure to seek a bailout as their national debts climbed toward 100 percent of GDP. Italy, even in good times, has been free to finance itself at a level much higher than that.
Italy's debt, currently at a dizzying 120 percent of GDP — second only to Greece in Europe — is forecast to keep on rising. Economists agree that something has to give.
The European Union's fiscal treaty, due to become law next year, binds countries to reduce their debt gradually to below 60 percent of GDP, a goal also contained in previous EU agreements. In Italy's case, that would mean repaying close to half its current debt of €1.9 trillion ($2.5 trillion), or €16,000 per man, woman and child in the country.
The 4-month-old government of Prime Minister Mario Monti is committed to raising taxes, cutting spending, fighting tax evasion and promoting competition in many professions, from cabbies to pharmacists.
Such austerity will ramp up the pressure on Italy's economy, forecast to contract by 1.5 percent this year, and increase its unemployment rate of 8.9 percent.
Compared to Spain, Italians have been cautious borrowers and stronger savers over the past decade. Still, their private debts exceed €2 trillion or 130 percent of GDP.
Despite their differences, Spain and Italy are put into the same risk basket by bond investors. This means a credibility crisis for one could mean bailouts for both.
Commerzbank's Rondorf said this might be unfair on Italy, given the strengths of its banking sector, but the country's huge debt and weak growth do merit concern.
She said the solution was for the eurozone, chiefly Germany, to finance a European Stability Mechanism firewall big enough to convince creditors that neither Spain nor Italy represented a plausible risk of default. Otherwise, she said, both countries could experience a second round of last year's aggressive sell-off of their bonds, raising their borrowing costs to unsustainably high levels.