Rising Spanish yields have thrust Europe back into crisis mode. Policy makers thought the European Central Bank’s three-year loans had bought the euro zone some time, but markets are catching up fast.

The flashpoint is Spain. The country’s apparent inability to control its fiscal deficit – which was 2.5 percentage points higher than its target last year – and its decision to raise this year’s target shortfall to 5.3 per cent, from 4.4 per cent, has spooked investors. Bond-buying by Spanish banks helped to keep yields in check for a while. But the ECB-funded stimulus is wearing off. Yields on the country’s 10-year bonds are back above 5.8 per cent.

The government’s decision to relax fiscal targets has placed it at loggerheads with the European Commission. However, the obsession with austerity may be self-defeating. The government is struggling to rein in spending by the autonomous regions, which were largely responsible for the budget spillover. Meanwhile, markets fret about growth; youth unemployment is shockingly high at over 50 per cent, and the banking system is still weighed down by real estate exposures. Banks could face losses of €203-billion ($265-billion) under a stressed scenario, according to Citigroup.

There are few easy solutions. The ECB could throw more money at banks to help them buy government debt. But Spanish lenders are overloaded with government debt having increased holdings by €52-billion in the two months to January, according to Citigroup. A full-scale bailout also looks difficult, as it would exhaust the euro zone’s recently-expanded bailout fund.

One option is a targeted bailout for Spanish banks, perhaps in conjunction with an external audit, as has already happened in Ireland. That would at least ease persistent concerns about property exposures, which in turn might lift some of the pressure on the government finances.

In the end, however, Spain will have to fix itself. Investors would probably tolerate a loosening of fiscal targets, provided there was evidence that over-spending regions were under control. Spain also needs to press ahead with reforms to boost growth. That means labour reform, and reducing the burden on employers by lowering social security contributions.

There are some bright spots: Spain has raised about 47 per cent of its funding for this year, which limits the impact of high bond yields. Still, Madrid, and the euro zone, are heading for another rocky period.