NEW YORK (Reuters) - Europe's plan to lend money to Spain to heal some of its banks may not work because the government and the country's lenders will in effect be propping each other up, Nobel Prize-winning economist Joseph Stiglitz said.
"The system ... is the Spanish government bails out Spanish banks, and Spanish banks bail out the Spanish government," Stiglitz said in an interview.
The plan to lend Spain up to 100 billion euros ($125 billion), agreed on Saturday by euro zone finance ministers, was bigger than most estimates of the needs of Spanish banks that have been hit by the bursting of a real estate bubble, recession and mass unemployment.
If requested in full by Madrid, the bailout would add another 10 percent to Spain's debt-to-gross domestic product ratio, which was already expected to hit nearly 80 percent at the end of 2012, up from 68.5 at the end of 2011. That could make it harder and more expensive for the government to sell bonds to international investors.
With Spanish banks, including the Bank of Spain, the main buyers of new Spanish debt in 2011 - according to a report by the Spanish central bank - the risk is that the government may have to ask for help from the same institutions that it is now planning to help.
"It's voodoo economics," Stiglitz said in an interview on Friday, before the weekend deal to help Spain and its banks was sealed. "It is not going to work and it's not working."
Instead, Europe should speed up discussion of a common banking system, he said. "There is no way in which when an economy goes into a downturn it will be able to sustain policies that will restore growth without a form of European system."
Stiglitz, a former economic advisor to U.S. President Bill Clinton, is a long-standing critic of austerity packages. He also wrote book attacking the International Monetary Fund for policies it has imposed on developing countries as a precondition for emergency loans.
What the European Union has done so far has been minimal and wrong in its policy direction because austerity measures to restore risk have the effect of reducing growth and increasing debt, he said.
"Having firewalls when you're pouring kerosene on the fire is not going to work. You have to actually face the underlying problem, and that is, you're going to have to promote growth," Stiglitz said.
Instead, sweeping reforms to make Europe more of a fiscal union are needed to solve the debt crisis, reinforce the single currency and ultimately help Germany which, as the richest country in the union, will have to bear the highest cost of guaranteeing any commonly issued debt and providing more resources to boost public spending.
"Germany keeps saying that the strengthening is fiscal discipline, but that is a totally wrong diagnosis," Stiglitz said.
Germany is expected to propose at the end of June a road map toward a European fiscal union, but Berlin favors joint euro bonds, backed by all the area's governments, only as a medium-term goal, once other countries have fixed their high debts and budget deficits through austerity measures so they are not reliant on Berlin's deep pockets.
"Eurobonds is just one institutional arrangement that could work, there are others: a common treasury," said Stiglitz adding that ultimately "there has to be a way of raising revenue across Europe, to support the weaker countries in case of an economic downturn."
While the economies of Spain, Greece, Italy and Portugal are contracting, Germany grew 0.5 percent in the first quarter. The divide in the euro area in many cases reflects austerity programs to tackle debt and deficit problems.
Critics have said the focus on cutting costs is aggravating Europe's crisis and jeopardizing the future of the single currency. Greek elections next week could bring to power parties opposed to the tough conditions attached to the country's EU and IMF-led rescue plan and raise the possibility of Greece leaving the euro zone.
"Germany is going to have to face the question, do they want to pay the price that would follow from the dissolution of the euro, or do they want to pay the price of keeping the euro alive?" Stiglitz said. "I think the price they will pay if the euro falls apart will be greater than the price they will pay for preserving the euro. I hope they will come to realize that, but they may not."
Stiglitz's latest book, "The Price of Inequality: How Today's Divided Society Endangers Our Future," is scheduled to be published on Monday. It challenges the idea that inequality is an unavoidable evil needed to sustain economic expansion.
"We could have more growth and less inequality," Stiglitz said, "so we could do better in both dimensions simultaneously."
Reporting By Tiziana Barghini, Editing by William Schomberg and Stacey Joyce