The Pain in Spain...and in Ireland
Financial markets underestimate just how deep the rot extends into the euro zone’s banking systems and economies. Since early 2010, when credit spreads on the euro zone’s periphery started blowing out, I’ve viewed the EU bailouts as futile efforts to refinance themselves out of a solvency crisis. If you’re truly bankrupt, trying to put it off by refinancing never works out.
European asset values and GDP, taken together, will not be sufficient to satisfy both debts and unfunded liabilities. In other words, the real economy in the euro zone is too small to subsidize enormous banking systems and bloated government budgets.
Greece was the first sizeable bailout, and Ireland is the second. There will be others, including Spain. The problem with Greece and Ireland – at least from the perspective of pro-Euro EU bureaucrats – is that the political will to stick with austerity programs is weak. Irish citizens are rightfully upset that their economy has suffered in order to bail out reckless Irish banks. We’re already seeing the emergence of a popular revolt against the bailout from the Irish Green Party. As Greece’s economy continues to spiral downward, we’ll see a popular drive to end plans of budget austerity, and a movement to default on Greek government debt.
Europe faces a solvency crisis because its banking systems grew wildly out of proportion to its economies. Also, when you start to appreciate its terrible demographic profiles, most European countries owe far too much in the way of unfunded liabilities (like pensions and healthcare).
Bureaucrats, nevertheless, will always seek to sustain an unsustainable status quo. They have gone to great lengths to avoid a painful but necessary restructuring of the banking system and welfare state. The parallels to the US financial crisis are clear: bureaucrats are imposing huge current and future costs on taxpayers and innocent bystanders in order to bail out reckless banks and government budgets.
Since early October, yields on 10-year Spanish bonds have jumped from 4% to 5%. They will continue to rise. Interest expense will start eating up a larger and larger amount of Spanish GDP. This is bad news for an economy that saw capital misallocation on a monumental scale into residential housing and “green energy.” Both of those sectors remain on life support, propped up by the government, and there’s little hope for growth or employment in other sectors. Just like in the US, housing will remain in a depression as long as the government prevents markets from clearing and title from changing hands to better-capitalized owners.
The problems in Spain lie not so much in its government debt, but in its banking system. The opaque accounting for bad mortgage and construction loans throughout the Spanish banking system makes the US look like a model of transparency.
Consider the shenanigans these banks are employing just to maintain access to European Central Bank lending facilities. In his excellent Inner Workings blog, David Goldman describes how Spanish banks are buying defaulted loans out of the mortgage backed securities they sponsor in order to avoid ratings downgrades for these MBS. The ECB requires minimum investment-grade ratings for the mortgage securities it’s willing to accept as collateral for loans.
Spanish banks must take capital charges when they repurchase soured loans out of MBS. They must also shoulder the costs of bringing more non-performing real estate onto their balance sheets, so this is truly an act of desperation. Goldman calls this process “the financial equivalent of a derelict selling blood to buy booze.”
“Spain will have to cut government spending drastically,” Goldman continues. “The trouble is that government is nearly 50% of GDP, so that the economic effect of cuts in government spending and its adumbrations upon the failing real estate market are all the worse.”
Considering this backdrop, I had to laugh when I saw Spanish government officials recently denying that they have any problems. It reminded me of former Treasury Secretary Hank Paulson’s misleading statements about the health of Fannie Mae and the US banking system in mid-2008.
The bottom line regarding why this matters for US financial markets: the Euro is likely to continue falling against the US dollar. Many holders of Euros will soon conclude that the ECB will dramatically debase the currency in the near future, much to the chagrin of what you might call the “Bundesbank honest money” camp.
The inflationists at the ECB will eventually win out as we see more riots, strikes, and social turmoil in Europe. The ECB has a lot of catching up to do in order to match Ben Bernanke’s turbocharged printing press. A falling Euro is bearish for risky assets, so we’re likely to see a continuation of the “risk off” trade.