With Greece experiencing political instability & embarking on a slow banking run, attention must be paid to other — more important — countries.

While the exit of Greece from the Euro may be of great importance to the Greeks, it won’t make much difference to the rest of Europe. However, what does become critical is preventing “follow on” — breaking the chain of dominoes, before failure ricochets across Europe.

Spain’s banking sector is in trouble, and with it likely next after Greece, action is needed now. The future of the Euro, may well play out in front of us over the next 2 months…

Greek exit, or remaining in the Euro, is largely irrelevant. It affects (for everybody else) only the price of holidays in the Greek Isles — which would become cheaper.

But Spain is a productive, vibrant, major country — one of the cornerstones of the Mediterranean — with thriving and innovative manufacture, food, fashion & culture. The loss of Spain would see the rapid dissolution of the euro, and 4 years (or more) of downturn and economic gloom, worldwide.

On Wednesday, credit-default swaps protecting Spanish debt hit record highs, and yields on 10-year Government bonds surged above 6% — a level that in previous crises precipitated sell-off.

While the Spanish economy is a strong animal, and not yet run to ground, both these signals provide clear warning signs. Action should be taken, and taken early. Spain, Italy, Ireland, should be backstopped now to safeguard the Euro.

Spain’s major problem is the banking sector. Enthusiastic development & construction during the boom years, have translated into broad swathes of bad debt, under-performing and failed loans in the banking sector.

On Thursday night, Moody’s Investors Service downgraded 16 Spanish banks — citing the nation’s recession, reduced funding access & deterioration in loan quality. With the continuing Spanish recession, Moody’s expect loan issues to spread beyond real estate to affect household and company lending.

The Spanish government has also part-nationalized a major bank, Bankia SA, and is trying to quash rumours of a run on deposits. A report in El Mundo newspaper suggested that about 1 billion euros ($1.3 billion) of deposits had been pulled from Bankia, leading it’s shares to plunge by 29%.

Given these signs, and the ongoing turmoil in Greece — a clear conclusion can be reached. Now is the time to take action, to protected the Euro & enable Greece to either exit — or remain — without causing contagion.

But what action?

Given the weak state of the Spanish and PIGS banking sector, this must be definitively stabilized. The ECB must provide open-ended financing support, followed with a ‘loan restructuring’ program to separate out & take over bad loans from bank’s books.

In the absence, of course, banks will continue to absorb ECB support anyway — but without any resumption of lending, into their economies. (Spanish bank mortgage lending is only half what it was, the previous year). Without lending, business activity & economies in the area will remain strictly moribund.

But monetary & banking policy, are not enough. German & European policy must move away from solely austerity — towards achieving growth.

Senseless & unproductive spending should of course be cut, but Spain, Italy, Portugal and Ireland must be given hope & a path towards economic improvement. Prior to the crisis, Spain had a low debt & a budget surplus — arguments of profligacy are entirely false.

With Spain now reaching 24.4% unemployment & exceeding 50% youth unemployment, austerity is crippling any chance of recovery. The deepest austerity effort in 30 years, has not encouraged recovery — but rather, has caused Spain to re-enter recession for the second time since 2009.

The effect of austerity policies, causing economic contraction & unemployment, can be seen to further exacerbate economic weakness. This renders debt payment & financial stability further out of reach.

As we have seen, the bond market dislikes severe economic contraction — yields have shot up, on Spanish bonds. Such contraction obviously places severe constraint on the likelihood of a debtor nation repaying..  and “austerity” as a solution is right now being rejected, by the bond market.

The obstacle we do run into, is the Germans and the ECB.

These have, to date, been almost totally fixated on austerity & price stability — ironic, since German banks were major beneficiaries of the Eurozone opening investment in Southern Europe.

German attitudes of self-congratulation, for their own balance-of-payments surplus & fiscal beautitude, ignore the reality that they placed major bets and enjoyed enormous profits from buoyant PIGS economies, up until the recession.

Having contributed to loaning money, they should uphold their responsibilities & accept a managed rebalance — or risk losing their loans, & the entire European project, altogether.

As Paul Krugman says, the only way to achieve a growth environment in Southern Europe is for the central bank to drop its obsession with price stability. Europe and the ECB must accept & encourage several years, of 3 or 4 percent inflation overall & more in Germany, to allow jobs & growth to return to Europe.

This would provide a reasonable guarantee of backstopping the troubled economies, and saving the Euro.

However — this deal is not yet done, or even on the table.  Will they accept it, before it is too late?

• WSJ: Spanish Debt Insurance Costs Rise, Bond Auction Eyed
• Bloomberg:  Spanish Banks’ Bad Loans Worsen As Recession Bites
• Spain’s Unemployment Rate Rises To Highest In 18 Years
• Eurozone debt crisis: bond yields explained
• Spanish banks 1, Spanish mortgages 0
• Spain Banks Face Moody’s Cut as Bankia Deposit Run Denied
• WRAPUP 4-Europe thinks the unthinkable on Greece

• Europe must balance austerity with growth – Olli Rehn
• Obama presses ailing Europe to focus on growth
• Joseph Stiglitz:  After Austerity
• Paul Krugman:  Apocalypse Fairly Soon
• With austerity failing, Europe turns its focus toward growth
• Europe’s Economic Suicide

Can the Euro be saved?  Add your comment now.