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Bigger EU firewall won't stop financial contagion

(Money Watch) COMMENTARY At the same time as the EU is trying to tell investors its collective economies aren't at risk of disaster, it is desperately trying to increase the size of its emergency relief fund. The problem is that if the former is true, then you have no need for the latter.

Yesterday, the German government reversed itself and backed a $266 billion increase for a firewall supposed to stop the spread of financial contagion in Europe. For weeks Chancellor Angela Merkel had steadfastly opposed any such increase for Europe's permanent bailout fund, the European Stability Mechanism and its temporary fund, the European Financial Stability Facility. There had to be a major reason for Merkel to do this. She faces a major political backlash over this from German taxpayers who are already unhappy at having to pay for the bailouts of Greece, Portugal and Ireland.

The firewall is supposed to reassure investors concerned about what getting their money back if Spain and/or Italy were to run out of money.

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If investors do not find the increase reassuring it is because should either of those things happen, even the new, bigger firewall won't be able to stop the problem from spreading.

This is because Spain, the world's 13th largest economy, has a total public sector debt of $1.3 trillion - that's nearly 90 percent of its GDP. That debt is expected to grow by $79 billion this year alone. Compare this with Greece, which has the world's 32nd largest economy (and falling) and a public sector debt less than half of Spain's.

Over the weekend, Italian Prime Minister Mario Monti warned Spain could quickly reignite the European debt crisis. "It doesn't take much to recreate risks of contagion," he said. Spain "hasn't paid enough attention to its public accounts."

The new and improved firewall will have about $900 billion total funding. Even if we assume no other nation needs help, that's still about $400 billion less than the amount needed if Spain can't pay its bills.

Spain will not be in a condition to help itself any time soon. It has a 23 percent unemployment rate and an economy optimistically forecast to only shrink by 1.7 percent this year. The EU has told the Spanish government it has to cut an additional $53 billion from its budget, which won't help.

All this talk is having some initial impact, though. The amount Madrid has to pay to borrow money dropped slightly today, as 10-year Spanish bonds fell 0.043 to 5.3 percent. That is still up 0.4 percent from where they were just three weeks ago.

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