Spain has so far managed to avoid being sucked into the Eurozone periphery financial abyss. But that might be about to change. This week protesters rallied against the relatively modest cuts in government spending implemented so far. And upcoming elections are a nearly-certain source of more instability:

Spain Vote Threatens to Uncover Debt

As Socialists Risk Losing Key Areas, Economists Fear 'Hidden' Bills

MADRID--Weekend elections that threaten to drive Spain's ruling Socialist party from power in several regions and cities also promise a potentially nasty surprise: the revelation of piles of undisclosed debt in local governments that could undercut the country's drive to avoid an international bailout.

Five months ago, a government change in Spain's Catalonia region revealed a budget deficit more than twice as big as previously reported. Now, a growing chorus of economists, local politicians and business leaders say that new governments are likely to discover, as Catalonia did, piles of "hidden debt" owed to health clinics and other suppliers.

Economists, analysts and anecdotal reports from companies that supply local governments suggest there is widespread, unrecorded debt among once-free-spending local governments. Some companies are complaining that fiscally frail administrations are pressuring them to do business off the books and not immediately bill for goods and services, said Fernando Eguidazu, vice president of the Circulo de Empresarios business lobby group in Madrid.

Such bills could add tens of billions of euros to the official debt figures reported by local and regional governments. If such skeletons come out of the closet in coming weeks, Spain's cost of funding could continue to rise--throwing the country back into the limelight after it has struggled to demonstrate it doesn't need to be bailed out like Greece, Ireland and Portugal.

"Investors are worried about the regions, given that there has been a precedent in Spain and other countries of debt not being recorded properly," said Luigi Speranza, a BNP Paribas economist.

Sunday's elections, which will be held in 13 of the country's 17 regions and its more than 8,000 municipalities, threaten to be hard on Prime Minister José Luis Rodriguez Zapatero's Socialists. Polls show Socialist-led governments could be unseated in Castilla-La Mancha, the Balearic Islands, Asturias and Extremadura regions. Undermined by a 21% unemployment rate and a perceived slowness in reacting to the country's economic crisis, the Socialists could also lose control of the municipal governments of Barcelona and Seville, the country's second- and third-largest cities.

The social fallout from the poor economic conditions is evident in Spain this week as waves of protests swept the country. Young people took to main squares in Madrid, Barcelona and Valencia on Thursday to protest unemployment among those in their 20s and 30s, which has reached 50% in some areas, and the government's austerity program. Demonstrators are hoping their ranks will swell over the weekend as people head to the polls.

Nearly a year ahead of March 2012 Spanish national elections, a poll last month by the state-owned Center of Sociological Investigations, or CIS, forecast the opposition Popular Party could capture 43.8% of the vote, while the Socialists could get 33.4%.In the 2008 elections, the Socialists won 43.6% of the vote, compared with 40.1% for the conservative PP.

Some thoughts:

Spain has three problems, each of which is manageable in isolation. But they're all coming to a head at the same time and threatening to combine into something serious. They are:

• The next-domino syndrome. Greece is clearly going to default in the not too distant future, which will cause 1) the other bailed-out Eurozone countries to demand better terms for their own debt repayment, and 2) analysts and money managers to speculate even more intensely about who is next. Spain is an obvious candidate.

• The fear that this weekend's elections will uncover a bunch of off-balance sheet debt is well-founded. Many US states and cities are hiding their true pension obligations, so it should come as no surprise that their Spanish counterparts are running similar scams. The incentive to spend on constituents and use accounting tricks to hide the resulting debt has apparently become overwhelming, so we should expect to find lots of skeleton-filled closets in coming years.

• Spain's voters are already rebelling against the current austerity program -- which sliced a measly two percent of GDP from public spending. With another six percentage points to go just to reach the Eurozone's mandated deficit threshold, the next round of cuts might turn unrest into regime change.

Meanwhile, Spain's credit rating is Aa2 (Moody's third-highest) and its 10-year bonds yield 5.2%. Which takes us back to the question that has been nagging euro-skeptics for over a year: Why would anyone buy a Spanish bond? Is it reasonable to lend money for ten years at such a low rate to a country facing this much uncertainty -- in a currency bloc that's under this much stress?

Think it through: If the stronger economies bail out the weaker ones on terms that allow the weaker governments to remain in place, then the balance sheets of the stronger countries become so junk-laden that they're no longer AAA credits. But if the Eurozone insists on austerity to bring peripheral countries back into fiscal balance, voters will simply say no, resulting in Greek-style crises being repeated four or five more times. Either way, the euro is tarnished by instability, and investors who lock themselves into a ten-year euro income stream will be sweating for a long, long time.

Two final notes:

• First, why pick on Spain when so many European countries have budget issues? Because Spain is the firewall. The Eurozone could bail out Greece and Portugal without missing a beat, but Spain is too big to fail. Either it gets its financial house in order very soon, or the Eurozone's problems grow by an order of magnitude.

• Second, a very reasonable complaint about US-based criticism of the Eurozone is that it's motivated by a desire for the euro to fail and the dollar or pound to succeed by default. So let's address that here: The dollar and pound are in worse shape than the euro because the Fed and Bank of England are blatantly, systematically destroying their currencies in order to prop up a banking system/welfare state/military industrial complex that could never survive in a sound money environment, while the European Central Bank is at least trying to maintain the euro's value. As a result, long term US Treasury bonds are horrendous investments -- probably worse than the average euro-denominated sovereign bond.

• But in the search for the catalyst that finally pushes the dollar over the edge, Europe's problems are interesting. The final stage of a currency collapse is more about confidence than supply and demand. When a society loses faith in its currency, it abandons it. Prices in that currency soar and savings evaporate. So as we inflate away the dollar, the key question is: what brings us to this tipping point? It might be the US just finally spinning out of control, or it might be an event in Japan, Europe, or the Middle East that calls the whole concept of fiat currency into question. Whatever it is, it's coming. For better or worse, we live in an interconnected world.