Editor's note: Edward is a respected macro economist whose focus is on the effects of democratic changes on economies. He is regularly quoted in international publications such as the Financial Times, the New York Times, the Wall Street Journal and Time magazine. Edward has spoken to BcnIn before including this in-depth look at the crisis from November 2011. He contributes to a number of economics blogs as well as overseeing a lively Facebook community page which you can find here. Part 2 of this interview can be found here.

Edward, you have previously stated that Spain is too big to rescue, yet the subject of bail-outs is back in the headlines. What are your current thoughts on the situation?

Well in one sense, Spain is too big to rescue, but in another it is also too big just to let it go to the dogs. In fact, when I say it is too big to rescue, I mean it is too big to rescue using the now classic model put into practice in Greece, Ireland and Portugal. Spain and Italy are simply too large (both in terms of GDP and in terms of population) to put under the tuteledge of the Troika in this way. The political risks of facing a runaway train are just too great.

On the other hand, if we think about it, Spain has already had a partial bailout, via the ECB bond purchases, and then via the support for the banking system through the ECB liquidity lending LTROs. It should also be borne in mind that the EU is also steadily implementing a new set of governance procedures which will leave individual Euro Area countries with a lot less freedom to decide for themselves on economic matters, as Mariano Rajoy discovered to his cost when he went to Brussels and asserted that his country, being sovereign, could decide its own deficit target. So rather than one dramatic intervention what I expect to see are a steadily tightening set of pincers.

If Spain did eventually need a bail-out, and if one were forthcoming, what would be the likely strings attached? What would be the consequences for the general populace?

Basically the liquidity measures implemented by the ECB via the LTROs have solved one problem -- the difficulties the country's banks were having financing themselves -- but they have not done anything to help with the other key issue, the lack of credit in the economy. Indeed by making it easier and more profitable for the banks to buy government debt they have arguably made it even more difficult for the private sector to obtain credit. In some ways what we are seeing is a form of "crowding out" of new investment projects by property developers and the public sector.

Even as I write, pressure is obviously building up for Spain to accept some sort of additional funding from the EU. With 10 year bond spreads back over the red-line level of 6% there is little sign of ECB intervention, or even of pressure on the ECB to intervene. There seems to be a consensus in Brussels, Frankfurt, Berlin and Paris that Spain needs more help than it is willing to accept right now. That is to say, the more seasoned leaders can see that the problem Spain is facing isn't simply going to fade away, especially with the "mission impossible" deficit objectives the government is facing.

The background to the present crisis is that Spain urgently needs to find the finance to clean up its banking sector -- possibly we are talking about something in the region of 200 billion euros when you take into account both the problematic developer loans and the need to help householders who will increasingly struggle to finance their mortgages. Over 1.5 million housholds in Spain now have no-one working, and have exhausted their unemployment benefit entitlement. They now live from savings, family support and the 420 euros a month minimum payment. Clearly it is hard for such people to meet their repayment commitments, and their number is growing. Finance Minister Noonan deliberately over-capitalised the Irish banks because he could see this problem coming, and it would be a good idea for Spain to follow his lead.

Interestingly, Spain's finance minister Cristobal Montoro chose his words very carefully at last Friday's government press conference. When asked how the government planned to finance the ongoing financial system reform, he replied: "Estamos trabjando en ello, en la fórmula financiera que permita que el instrumento utilizado no aumente el déficit público en 2012 y 2013, de acuerdo con la normativa europea y de contabilidad nacional", which in plain English is, "we are working on it, on the financial formula which will allow the instrument we use not to increase the public deficit in 2012 and 2013, in accordance with national and European accounting protocols".

The point to notice is that he said "deficit" not debt. So what they are trying to do is find a formula which will allow the funding to be added to debt in the longer run, but which will not count as part of the annual deficit in the short term. This is what I call the "chewing gum and chicken wire" approach to financial reform. The starting point is that nothing must add to deficit, and you work back from there to see how much money you can afford to inject, and how you can do it. If the economy is strangled to death by lack of credit, well, too bad, the government will fulfil its deficit targets. (But then again,if the result is that the economy shrinks further, then maybe they won't even manage to do that).

The latest (it surely won't be the last) attempt at financial reform involves banks merging and receiving support in cleaning up the property loans via an Asset Protection Scheme (that guarantees the purchaser against losses) to be financed from a fund known as the Deposit Guarantee Fund. Basically this fund is itself financed by contributions from the banks, so it is something like the situation where you have one patient who needs a liver transplant and another who needs a heart one, so you give the good heart to one patient and the good liver to the other while it remains far from clear what you have actually achieved in doing so except to give work to the doctors.

The latest technique for raising money which is currently going the rounds in the Spanish press is unlikely to meet approval in Brussels -- the basic idea seems to be to have the banks lend a quantity equivalent to the contributions which will fall due over the next 8 years to the deposit guarantee fund. This will raise something like 20 billion euros. But what if the quantity needed is not 20 billion, but 100 billion or more? And what if at some point during the next 8 years more money is needed. And what is the property market doesn't recover in the short term and the banks don't start making profits. You can't constantly rob Peter to pay Paul, in the end it all becomes a Ponzi scheme. And meanwhile, as I say, the real economy is one of the walking dead.

Some say that Spain has carried out the reforms it needs, and what we have now is simply a crisis of confidence. Do you agree?

According to one popular current of opinion in the Spanish press, the economy is rebalancing nicely, competitiveness is being steadily restored while exports are going well. The strange thing is how the economy continues to go badly. I don't suppose rising unemployment and falling house prices have anything to do with the way this outcome continues and continues.

On this kind of view the only thing, apparently, which is standing in the way of full blown recovery is the lack of investor confidence, and the rising cost of financing government debt (the huge quantities of money the commercial banks need from the ECB -- 220 billion Euros in March --apparently isn't an issue to worry to much about). So Spain needs help from European partners to bring down borrowing costs on government debt, then all will be well, and "comeremos perdices" (we'll all live happily ever after).

The question I ask myself is, "which world these people are living in?" The biggest source of increase in government borrowing costs comes from the rapid growth in the size of the debt. So why is the debt growing so quickly? Aha, that must be a trick question, since normally the argument gets stuck precisely at this point.

Going back to gum and chicken wire, I remember reading in the report on the Three Mile Island nuclear accident, that in the run-in to the problem maintenance had either been neglected or completely ad hoc. The archetypal example for this was that a hole in a cooling pipe had been plugged using a basketball. There you go Cristobal, that's your missing link, go find a basketball!

Read Part 2 of this interview here