When the Pain From Spain Moves Across the Plain

Here we go again…

Markets are under heavy selling pressure…the fear is back. And once again Europe is the flashpoint. Spain’s economy is on the brink of a bailout, set to join Greece, Portugal, and Ireland in the pauper’s club.

But the Spanish economy is in a different league to the others. Greece and Portugal’s government finances had grown out of control and needed reining in. Ireland’s government was travelling ok until it decided to bailout the banking sector following the property boom and bust there. The assumption of those debts crippled it and shut off access to external funding.

Spanish Government Debt

Spanish government debt is not too bad…in a relative sense. Its debt-to-GDP ratio is around 80%. But its banking system is busted…insolvent. Unlike Ireland, it won’t be able to mortgage its taxpayers’ future wealth to recapitalise the banks. Don’t worry – it’s not through want of trying. The Spanish government would love to bailout the banks. But the ‘markets’ won’t let it.

Overnight, Spain’s borrowing costs jumped to 6.65%, very close to the highs reached last November (6.7%). Trying to raise large sums of money to rescue the banking system, with such high borrowing costs, is an impossible task.

That’s why a few days ago, in a ‘hey presto’ moment of inspiration, Spain attempted the novel plan of issuing €19 billion in debt to itself. It would then ‘invest’ that debt in the stricken Bankia (the conglomerate basket-case Spanish bank teetering on the edge) and have Bankia post the debt at the European Central Bank (ECB) as collateral in exchange for euros at 1% for three years.

Turning debt into equity never seemed easier…

Of course, it was a moment of lunacy even Don Quixote would have been proud of. It’s the bureaucratic equivalent of swinging at windmills. Obviously, the ECB told Spain they were dreamin’. Only a central bank can conjure money from thin air…perhaps the ECB were worried about losing their monopoly.

So Spain’s economy is stuck with high borrowing costs and an insolvent banking system. That a bailout is coming is obvious…the real question is which acronym will supply the funds. Or perhaps there’s a new plan in the works.

Political Meddling and Central Bank Tinkering

The danger (or benefit, depending on how you view these things) is that this latest chapter in the breakdown (or breakup) of the European Monetary Union (EMU) is happening just as summer gets underway. That means all the clowns who have presided over this mess are packing their bags for a little break from all their meddling. And judging by the havoc they have created, they must be exhausted.

This is where the irony comes into it. The many great problems we are faced with today in global financial markets (and by implication, the real economy) are largely the result of political meddling and central bank tinkering. Yet these are the people the mainstream media respectfully expects to come up with a new solution for the problems that they are largely responsible for.

Take the LTRO (long term re-financing operations) scheme that ECB boss Mario Draghi came up with. At the time everyone cheered…simply because it sent share prices soaring. What no one really cared about was the fact it further weakened the foundations of the financial system. Giving banks cheap money with which to buy government bonds was another Don Quixote moment. Insolvent banks lending to insolvent governments…windmill punching.

All we can say is, ‘Where is Sancho?’ We need a clear thinker amidst the lunacy.

Will the USA Be a “Thinker” Or Just Another Tinkerer for the Spanish Economy?

Barack Obama is not our Sancho. He wants to offer solutions, but not for Europe’s benefit. Like President Nixon in 1972, who famously said, ‘I don’t give a s*** about the lira,’ on concerns about Italy’s predicament in the post-Bretton Woods currency debacle, Obama is fighting for his political life.

Earlier this week he sent someone from his administration to see what was happening in Europe. According to the Wall Street Journal:

‘The Obama administration dispatched one of its top economic officials to Europe on Tuesday to press officials in Greece, Spain, France and Germany to calm a widening crisis that threatens to spark new trouble for the U.S. economy.

‘The latest push by the Treasury Department’s under secretary for international affairs, Lael Brainard, comes as the debt troubles in Europe mount amid Greece’s political standoff and renewed threats to Spain’s financial system.

‘U.S. officials are pressing Europe on several fronts, including a broader role for the Continent’s €700 billion ($878 billion) rescue fund, according to people familiar with the matter. Allowing the fund to directly recapitalize European banks – instead of forcing troubled nations to borrow from the fund for that purpose, potentially putting them under even more market pressure – could calm fears of cascading bank runs in Spain and other nations even before Greece’s June 17 election.’

A threat to Spain’s financial system is a threat to the US financial system. The link is the derivative market. One bank blow-up would set off a chain reaction and blow up the rest. Short term pain for long term gain, we say.

But banking and politics are inextricably linked. Power is the glue that binds them. Dan Denning touched on this money/power link in his latest Australian Wealth Gameplan report:

‘Control of the money people use IS power. All Empires are built on this power over money. This control over money confers tremendous competitive and military advantages on an Empire. An Empire is no good if it does not bring economic benefits to the Imperial power. That’s the whole point of Empire anyway, control of real resources, wealth and land.’

He was talking about Imperial Japan, but the point remains…banking, through the control of money, is the source of power. But to ensure that power you need a central bank. This is where Spain – and the other bailout nations – got it wrong. They gave up their central banks to join the euro club. With that decision, they gave up their power.

Now in Spain the banks and the government are going down together. It’s a fate Obama wants to avoid. He wants to stay in power. He therefore needs the banking system and the economy to maintain some semblance of recovery so that he can have a chance at re-election in November.

Good luck with that…and good luck with poking your nose into European politics. Although it does put Ben Bernanke under massive pressure to ‘do something’ soon so as not to look too political by acting closer to election time.

But whatever Bernanke does, we reckon the days of political and central bank meddling in the market to drive certain outcomes are just about over. The moneyed elites have created a monster (the financial markets) so big that they can no longer control it. The ‘benefits’ of each bout of stimulation are becoming increasingly short-lived.

Capital, utterly confused, is rushing around the globe trying to find a safe home. That in itself is causing all sorts of distortions. More on that, and the prospects of QE III, tomorrow…


Greg Canavan
for Markets and Money

From the Archives…

Investing in Gold as World Economies Falter
2012-05-25 – Eric Fry

A Hard Dose of Medicine for the Greek Economy
2012-05-24 – Greg Canavan

Why Sooner or Later in Europe Someone Will Have to Pay
2012-05-23 – Dan Denning

To the Class of 2012
2012-05-22 – Bill Bonner

The Early Stages of a European Bank Run
2012-04-21 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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Jim Bartlett
Dear All, Thanks for your newsletters, advice , tips , and education. Please keep up the good work. Would someone please try to explain to me where all this money for European bailout is coming from. When Benarke issues more money he just prints it. Not good but self explanatory . When Brussels lends money where does this come from. As I understand it they do not print any more without all countries approving. Germany does not appear to be in favour so this method has problems. The only reasonable ??? explanation I have heard is that Brussels guarantees the… Read more »
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