The markets got it right, the rally in the Spanish bond market was all but non-existent, the one in the equity markets lasted for a couple of hours. Basically, what the Spanish bank bail-out amounts to, is providing aspirin to a very sick patient whilst the underlying serious illness isn't addressed.
It's not stopping the debt-deflationary spiral
Spain is in the throes of a really awful debt-deflationary spiral in which ever more debt weighs on shrinking assets and incomes. Since much of the credit was provided by the banks (to finance a housing bubble that has now turned south), such a debt-deflationary spiral ravishes bank balance sheets.
ALL levers of policy are working in reverse in Spain:
- The country cannot devalue to restore lost competitiveness
- The country cannot print money
- The country cannot reduce interest rates
- The private sector is bulging under the housing bust (house prices were 12.6% lower in Q1 compared to last year) and the terrible economy
- Banks are bulging under the housing bust, the terrible economy and higher capital requirements and losses on their sovereign bond holdings
- The public sector is beholden to austerity, rising financing cost, decreasing tax revenues and increased social spending as a result of the crisis.
The result is as simple as it is predictable. Demand from every possible category is shrinking. But demand from one is income for another, so incomes are shrinking, increasing the debt burdens and reducing house prices further, which, sooner or later, will worsen bank balance sheets to such an extent that they will require a new bailout.
It is adding to Spanish sovereign debt
The full amount of the bail-out weighs on the public sector balance sheet. Unfortunately there is no such thing as a euro TARP mechanism by which banks can be directly infused with capital.
Tentative steps to that might be on the agenda, but as of now, the visions of a eurozone banking union, with unified oversight, deposit insurance, and intervention mechanisms is but a pipe dream.
Subordination
The funds for the Spanish bank bailout come out of the eurozone rescue funds (most likely the EMS, the permanent fund). That means that the new Spanish debt will be prioritized, that is, excluded from debt restructuring. Which increases the burden of the private sovereign debt holders in case such restructuring becomes necessary.
So existing Spanish sovereign debt holders are kicked down the pecking order, making holding existing debt less attractive, hence the rise in the rates to compensate for the higher risk. It is also deeply ironic that much, if not most of Spanish sovereign debt sits on the balance of Spanish banks. Yes, the very same banks that are being bailed out by this money. Here is Reuters:
While a positive move in principle, the eurozone's offer to lend Spain up to 100 billion euros ($125 billion) to recapitalize its banks could even worsen its problems because of growing doubts about the wisdom of holding Spanish debt.
Indeed. Is there a better way? In theory, yes. Here are a few suggestions
Lender of last resort
The eurozone as a whole has less public debt and smaller deficits than Japan, the US or the UK. Yet much of it suffers from unbearably high interest rates on their debt. What it doesn't have is a lender of last resort to support that debt. Countries essentially borrow in a foreign currency over which they have no control.
So one solution could be to let the ECB play the lender of last resort, just as these other central banks (the BoJ, the Fed, the BoE) do. That would bring down rates immediately and would douse the flame of the euro crisis. Quite possibly, the ECB doesn't even have to do much, just say the words.
There are some legal arguments against this, but we think with the future of the eurozone at stake, a way around should be found.
As we write (Thursday afternoon), the markets have spiked on a rumor central banks would intervene in a coordinated manner should that becomes necessary after the Greek elections.
With Spanish 10-year yields approaching 7%, we would argue: what are they waiting for?
Capital controls
You might wonder why the US, the UK, and Japan bask in such record low interest rates despite the fact that their public finances are in a worse (in the case of Japan in a much worse) state compared to the eurozone as a whole. Well, it's not terribly complex.
In a balance sheet recession, when the private sector is paying down debt, rather than incurring new debt, one effect is (apart from reduced demand) that this generates excess savings.
That is, countries in a balance sheet recession generate savings in excess of investment, hence the plunging rates. Excess savings simply leave plenty of savings for the public sector to finance deficits.
The problem in the eurozone is that these savings can be moved elsewhere, without incurring any currency risk. Which is why the Greek, Spanish, Portuguese, and Italian savings are moving to the center, which is why rates are sky high in these countries, and at record lows in the center.
Following this to its logical conclusion one could impose capital controls to keep more of the savings domestically. This is indeed the solution that Richard Koo proposed. It runs counter to the provisions of the Single Market, but once again, where there is a will there usually is a way.
Redemption pact
The German 'wise men' (top economic advisers) came with a plan that tries to square two principles that vexes other plans of common debt (eurobonds), accountability versus solidarity.
The respective positions appear almost impossible to reconcile. Proponents of solidarity are stunned that their Eurozone peers let them stand in the rain even at the risk of their own peril, while proponents of accountability maintain that they have been disappointed by empty promises once too often. [Bofinger et al.]
The solidarity is necessary to make the problem manageable, but that could easily come at the cost of accountability, weakening the incentives for countries to solve their own problems. The Redemption Pact proposal (which has the support of the German opposition and is gaining traction in Germany) is solving that.
We've already explained the workings of such a Redemption Pact, it's a 25 year fund in which all the debt in excess of 60% of GDP of eurozone member countries is pooled. Here is the essential way it functions:
While each country will henceforth have to service its own debt financed via the new Fund until it is completely redeemed and the new Fund expires, participants will be jointly liable for the debt, thus ascertaining affordable refinancing cost for all participants. [Bofinger et al.]
Countries have 25 years to redeem their debt so it even provides an automatic budget restructuring. Since rates would be a lot lower for peripheral countries, fiscal consolidation would be helped considerably and much of the sting of the markets would be neutralized. Traders and investors wouldn't have to look at the 10 year Spanish or Italian bond yields first thing every morning.
Turn the ESM into a bank
This seems to be the newest French play. The advantages are clear. The ESM would be able to borrow from the ECB at low rates. If another obstacle would be removed, using the ESM directly for recapitalizing banks in trouble, this would restore a lot of confidence in the banking system at a stroke. Here is Charles Dumas from Lombard Street:
Spanish banks needed equity, not debt funding that would leave them as insolvent as before.
The direct ESM loans to banks in trouble could even be turned into equity, improving bank balance sheets further and let bank owners share in the problems. We think this is a good idea but the Germans, predictably, are not in favor. Another problem is that a Treaty change is necessary, which would take time.
But in emergencies, a lot which seemed impossible for so long might suddenly become possible.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
