Austerity Is The Key To The Eurozone Crisis

Includes: EU, FXE, SAN
by: Gary A

The IMF came out, awhile back, with a pronouncement that austerity doesn't work. The research proves it.

Yet, austerity is exactly what is going down in Cyprus. This destruction of confidence in the banking system has to echo through the Eurozone, because the IMF are liars. They say one thing and do another. That is a lie.

And the imposition of capital controls weaken the bond between Cyprus and the Eurozone. There are good and bad capital controls. Good capital controls prevent too much speculative international money from coming into a country to speculate and then leave. Brazil has employed this method.

The IMF supported inflow capital controls in Brazil and elsewhere. That was sensible.

Perhaps if the US had done the same, there would not have been a bunch of hot money coming in to this country, helping to boost the real estate bubble after the deregulation. That deregulation allowed bank consolidation and CDOs and accompanying swaps to be used extensively, in an ill fated fashion.

However, capital controls on inflow in Brazil were not powerful enough, as the article above points out.

But outgoing capital controls are quite another matter. Controlling outflows is totalitarian in nature. It stifles citizens much like the Berlin Wall did, only in a financial way. It is wrong and unacceptable.

Mauldin quotes Ambrose Evans-Pritchard in saying:

The IMF's Christine Lagarde has given her blessing to the Troika deal, claiming that the package will restore Cyprus to full health, with public debt below 100pc of GDP by 2020.

Yet the Fund has already been through this charade in Greece, and her own staff discredited the doctrine behind EMU crisis measures. It has shown that the "fiscal multiplier" is three times higher than thought for the Club Med bloc. Austerity beyond the therapeutic dose is self-defeating.

That quote hits the nail on the head. Austerity in massive doses doesn't work. And capital controls that start out as temporary have been going on for years in Iceland.

This cannot be good for restoring confidence in the banks of the Eurozone. Outflow Capital controls have not yet been applied to large countries like Italy. Would the IMF be that audacious? Totalitarianism on a small scale is tolerated by the Eurozone, apparently. But this behavior would be a dangerous thing if allowed to rise in a large Eurozone nation.

Italy has a capital control limiting cash transactions now. This is the work of the technocrat, Mario Monte. There has been a huge backlash against this form of capital control, and a government is having difficulty forming in Italy. But can you imagine a capital control that prevented capital from fleeing the nation?

And Cyprus, by all predictions, will face a nasty recession, the direct result of the IMF's implementation of that which the IMF says is a failure. What a bunch of hypocrites in that world bank. It is the New World Order run amok!

So, what is the outcome? There is concern that the Eurozone will simply run out of good collateral for its huge banks, and a Great Depression will result.

This would make betting on the banks in the Eurozone quite dangerous. While it is difficult to short the banking sector in the Eurozone, shorting individual banks could prove profitable. I had mentioned Santander (NYSE:SAN) in the above article. It did have a significant dip and came back a little.

However, there is a continuing problem with the quality of bonds like Spanish T Bills, no longer considered A rated bonds. Crap collateral is no doubt a concern when determining the health of the Eurozone periphery banking system. I have seen no reports that this has been solved.

Not only has the ECB overpaid for collateral from Spanish banks, but now, the French Central bank apparently has done the very same thing this year. Bank received more money from the central banks than they should have based upon the quality of the collateral.

Pretty soon, guarantees by Spanish banks may mean little. Here is the sort of trouble governments and companies can get into if a bank guarantees contracts. This is an argument for why interest rates had better stay low in the Eurozone. The periphery nations' banks will suffer upon any further interest rate spiking. This is why central banks are so willing to force interest rates down and impose the austerity that could kill the patient.

See the curious case of Loveland, Colorado:

Most Loveland taxpayers probably believe their municipality is well insulated from the headline news of the European banking crisis. However, the recent bailout of Spanish banks like BBVA (Banco Bilbao Vizcaya Argentaria S.A.) by the European Union may have not only saved the Spanish economy from an even bigger crisis but also the $130,920,000 public bonds issued for the McWhinney controlled Centerra Metro Districts encompassing nearly 2,000 acres in east Loveland. This is because repayment of the Centerra bonds rely, in part, on performance by
BBVA depending on current interest rates according to Centerra's 2011 financial disclosure to the city.

Fitch Ratings agency recently downgraded the credit rating of the Spanish bank, BBVA, following an infusion of cash from the European Union to help the faltering financial institutions of Spain like BBVA meet their obligations while holding excessive amounts of their own government's bad debt. Among BBVA's financial obligations, according to Centerra's board, is an interest rate swap agreement with Centerra where the Spanish bank has agreed to repay the Centerra bonds' interest should interest rates increase since revenues from the Centerra Metro Districts is insufficient to cover an increasing cost of its own burgeoning public debt.

So, then, the Spanish bank took the adjustable swap while the Loveland district too the higher fixed rate swap. If the adjustable rate swap goes up on interest that has to be paid, the Spanish bank is on the hook. That is why it is essential to the new financial order that low interest rates stay low or banks everywhere are toast in a potentially massive mega-meltdown.

Spain moves to lower rates of return on savings deposits in order to maintain low rates on loans, and to stabilize the banking system when making interest rate swap deals.

There has been little news out of Spain lately regarding the problems with Spanish banks which have billions of dollars of toxic real estate loans on their books. The quiet should be unnerving to investors in these banks and in the Eurozone in general. Unemployment is increasing and austerity is not working its magic, if it ever had magic.

Capital controls in Spain are not stopping money leaving the country, but are, so far, just like the controls in Italy. They prevent cash transactions over a certain amount. Last I heard it was $2500 in Spain and much less in Italy. This is taking the concept of a cashless society a bit to far, wouldn't you agree?

But the world banks like the IMF and ECB will not take their pedal off the metal with regard to austerity. They proved it by their behavior in Cyprus.

How much can the periphery be hollowed out before the medicine is worse than the disease?

In principal, Spain and Italy are no different than in the US, where the creation of better collateral has to do with fiscal discipline and tight money on Main Street. However it is just much more amplified in Spain and Italy. The human cost can be enormous.

Since austerity is here to stay, it is going to cause a massive backlash, and that is already starting. I look for bank runs in Italy and Spain, and a further weakening of the economies in Spain and Italy. Bankers will lend less, consumers will buy less, and the Eurozone will continue to contract. Will it be a managed contraction?

The Eurozone is now using gimmicks, like the contigent convertable bond, with which banks can hide their dilution of earnings These are called CoCo's, and are an accounting gimmick.

The Eurozone is buying time right now, like the US did after 2008. Whether they can buy enough time is the real question. I think they probably can, by walling off the weaker nations, but there are safer places to put your money.

And if France decides austerity is no longer viable, then the Eurozone is toast. Anyone who is seeking to determine the direction of the Eurozone will look at France and Germany's ability to keep that nation in the austerity camp. Germany is ruthless, but France controls the fate of the Eurozone.

The Euro will likely be sold off, and that will help exports and cause imports to lag. I would avoid the retail sector in the Eurozone since sales fell in February and March. The French bond yields continue to fall, and that reflects a collateral crunch in the Eurozone.

I think it would be risky to short French bonds. Buying French bonds would not be a bad idea for better yield. French bonds were stripped of an AAA rating but are still pretty healthy in a world where good collateral is in demand.

The Eurozone, if it is to continue to exist, cannot afford to allow French bonds to bleed their ratings going forward. With that fact in mind investors can buy a French government bond fund (Lyxor 1-3Y MTS).

This fund can be purchased on the London Exchange. There are no Eurozone bond funds for sale in the US, maybe because they need good bonds, again, for collateral. Perhaps they will be available in the future.

US companies that rely on Europe for most of their profits could face a rough time going forward until the ECB buys enough time to turn the economy around. Oracle (NASDAQ:ORCL) and other tech companies could be seriously impacted both by a slowing economy in Europe and a stronger US dollar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.