Standard & Poor’s, the credit ratings agency, believes Spain is caught in a Catch-22 situation. If the government cuts public spending at the level needed to reduce the deficit, it will drag down economic growth and make it more difficult for Spain to emerge from recession. But if the government fails to reduce spending, the chances increase that Spain will default on its debts.

After considering Spain’s no-win situation, Standard & Poor’s on April 28 downgraded the country’s credit rating by one notch to AA from AA+, with a negative outlook. “Our conclusion is that challenging medium-term economic conditions will further pressure Spain’s public finances, and additional measures are likely to be needed to underpin the government’s fiscal consolidation strategy and planned program of structural reforms,” Standard & Poor’s said. “The negative outlook reflects the possibility of [another] downgrade if Spain’s fiscal position underperforms to a greater extent than we currently anticipate.”

Since then, other ratings agencies have also downgraded Spain’s credit rating. Fitch Ratings on May 28 removed Spain’s AAA credit rating, dropping it by a notch, on expectations that moves to cut the country’s debt will slow its economic growth. Fitch said that despite Spain’s promise to cut its budget deficit, government debt is likely to reach 78 percent of GDP by 2013, compared with less than 40 percent before the onset of the financial crisis in 2007 and the subsequent recession. Fitch also expects that the “inflexibility” of Spanish labor markets and the restructuring of Spain’s banking sector will hinder efforts to stabilize the economy.

Moody’s Investors Service on September 30 cut its rating for Spain to Aa1 from Aaa, citing a weak economic outlook. Moody’s said the downgrade reflected the “considerable deterioration” in Spain’s public finances, and added that the slow growth of the Spanish economy would make repairing the public finances far more difficult.

These concerns were subsequently confirmed by Bank of Spain Governor Miguel Ángel Fernández Ordóñez, who recently told the Spanish Senate that the outlook for Spain “is surrounded by uncertainties.”

In any case, the prospect of more cuts in government spending will not be well received by Spanish voters, most of whom view cradle-to-grave social welfare benefits as an inalienable right. With Zapatero — whose 2008 campaign promises alone added up to more than two percent of Spain’s GDP — trailing badly in the opinion polls, it seems unlikely that he will voluntarily implement politically costly fiscal reforms before the next general election, which is tentatively set for 2012. Plans to overhaul the pension system and push through additional changes to wage-bargaining and employment rules have already been postponed until at least next year.

According to Deputy Finance Minister José Manuel Campa, the best thing “to generate credibility in the Spanish economy is to execute the measures we have announced at the time and in the way they were announced, and that implies not taking additional measures.”

But that approach may not be enough to reassure jittery markets that Spain will be able to repay its debts. Economists say that given Spain’s large deficits and poor long-term growth prospects, any failure to achieve government targets for cutting the deficit, and/or any rise in Spanish bank risk, could cause a market panic and turn Spain into the next victim of market contagion.

A financial meltdown in Spain would have repercussions far beyond the Iberian Peninsula. For starters, many analysts believe a debt crisis in Spain would trigger a similar meltdown in Italy, which is the fourth-largest economy in the eurozone, and which suffers from many of the same financial woes that are plaguing Spain. What’s more, Italy has one of the world’s highest public debts, expected to reach a staggering 118 percent of GDP in 2010.

Given the relative size of the Spanish economy, financial turmoil in Spain would likely also doom the single European currency, and with that more than 60 years of European dreams of transforming the continent into a superpower-like United States of Europe capable of counter-balancing the United States of America on the global stage.

Germany, which arguably has more invested in (and also has benefited more from) the European Union than any other country in Europe, is alarmed by the potential unraveling of the euro. German Chancellor Angela Merkel says the prospect of serial European bailouts is “exceptionally serious,” and that while she does not want to “paint a dramatic picture,” it would have been hard a year ago to “imagine the debate” now taking place in Europe.

In an effort to save European monetary union — which like the European Union itself is essentially a political project — Merkel has taken the lead in trying to “reassert the primacy of politics over the financial markets.” She says governments cannot and should not be blackmailed by excessive financial sector risks, carrying all the costs of a crisis while the financial sector collects all the private gains. In quintessentially European fashion, she is demanding more regulation, tougher regulation, and quicker regulation of the financial markets.

In the meanwhile, Spain could solve its most urgent financial problems in one bold (albeit practically difficult) move. Withdrawing from the euro would permit a fiscal devaluation that would instantly increase Spain’s competitiveness and allow the economy to grow. A currency redenomination and devaluation would allow Spain to make its exports and tourism more competitive, and to free the country from the European Central Bank’s tight monetary policy designed for wealthier EU member states.

On the other hand, staying in the euro will mean years of slow growth, making the pain of fiscal adjustment prolonged and more painful. Moreover, as long as Spain remains a part of the euro, it will forfeit full control over many levers of economic policymaking; Madrid’s policy tools are now essentially limited to reducing spending and wages. In this context, some economists believe Spain cannot recover from the current crisis until it breaks free from the euro.

But Spanish pride stands in the way. For many decades Spain — geographically situated at the periphery of Europe — was the butt of an oft-repeated joke which held that “Europe ends at the Pyrenees Mountains.” The implication was that Spain formed part of Africa, not Europe. In this context, the vast majority of Spaniards view Spain’s joining the European Union in 1986 and the European single currency in 1999 as a national rite of passage.

Not surprisingly, most Spaniards if given the option would rather see Spain default on its debts than withdraw from Europe’s single currency. If the financial markets are any gauge, however, both options may become part of Spain’s future.