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At the EU summit on June 29th , 2012, Spanish Prime Minister Mariano Rajoy was granted his wish that the ESM (European Stability Mechanism) be enabled to directly bail out Spanish banks, rather than Spain having to increase its sovereign debt to bailout its own nation's banks.

At the EU summit on June 29th , 2012 Italian Prime Minister Mario Monti was granted his wish that the ESM be enabled to purchase the sovereign bonds of Italy and other European states as a means of "backstopping" their fiscal financing needs.

However, Rajoy and Monti's wishes have been fulfilled at a cost -- one that has not been understood by political, economic and financial commentators.

Rajoy and Monti have struck a Faustian bargain with German Prime Minister Angela Merkel.

What Spain and Italy appear to have gained in the short term (a temporary reprieve from financial market pressures), pales in comparison to the power over their nations' fates that they have ceded to Germany in the medium and long-term.

Spain Sells Sovereignty In Exchange For A Bank Bailout

The Spanish government needs for the deeply troubled banks in its nation to be bailed out. But Mr. Rajoy does not want Spain to pay for the bailout. Thus, in order to get somebody else to pay for the Spanish bank bailout, Rajoy has struck a Faustian bargain: In exchange for getting somebody else to assume the cost of bailing out Spanish banks, the entire Spanish banking system and economy has been placed at the mercy of the Germans.

How, you ask? It is very actually very clear.

Under the original EFSF Spanish bank bailout scheme, the Spanish sovereign merely needed to request the 100 billion euros of pre-approved funding and it would receive the funds on loan from the EFSF at low cost and with few strings attached. The Spanish government could then proceed to restructure its banking system however it pleased - placing as much or as few conditions on Spanish banks as the Spanish sovereign government wished. In addition, under the original EFSF bailout scheme for Spanish banks, no additional conditions were placed on the Spanish sovereign regarding the management of its broader macro economy (such as raising taxes or cutting government spending). In sum, under the original EFSF scheme, Spain was required carry the cost of the bailout on its sovereign balance sheet, but it could also manage the bailout however it wished, and it could do so with virtually no strings attached to the management of its economic policy and/or fiscal affairs.

By contrast, under the bargain agreed to at the recent Brussels summit, Spain avoids carrying the cost of the bailout on its sovereign balance sheet -- but it also relinquishes all power to manage the bailout of its own banks. Furthermore, under the terms of the summit agreement, the Spanish sovereign government can be subjected to additional macroeconomic policy requirements as a condition for bank bailout disbursements.

Under the bargain struck at Brussels on June 29th, the Spanish bank bailout process will not be controlled by the Spanish sovereign, but will now be managed and controlled by a yet-to-be-created central European bureaucracy. In fact, not a single penny of ESM money can be disbursed until the new pan-European bank regulator is in place. In this regard, it is important to understand that the new central regulatory institution will likely have a strong German "flavor" since Germany can exercise an absolute veto power in the negotiations that set up said institution. Therefore, as a practical matter, Germany can exercise an absolute veto on the commitment of any ESM funds to the Spanish bank bailout. Unless the structure and composition of the newly created regulatory body is to the complete satisfaction of the Germans, the ESM cannot assume a single penny of the Spanish bank bailout debt.

Most importantly, under the terms of the bargain, Germany has gained for itself total control over the entire Spanish bank bailout process through its absolute veto power over every penny of ESM funds that are disbursed.

Yes, that is correct: Germany has secured for itself absolute power over every penny that is provided to the Spanish banks and is in a position to impose any and all conditions that it wishes. It is also in a position to provide no bailout funds at all, if its demands are not met.

You see, the ESM charter states that any and all disbursements are subject to prior signing of a memorandum of understanding (MOU) by all 17 signatory states. That means that not only Germany, but even tiny nations such as Finland and Lithuania can exercise absolute control over the disbursement of funds through use of their veto power. For example, Finland could block the commitment of any ESM funds towards the Spanish Bank bailout unless its stringent demands are met.

The ESM charter provides an exception to the unanimous MOU requirement in the event of "emergencies." However, even in the event of such emergencies, any and all ESM disbursements, however minor, must be approved by a "qualified majority" of 85% of ESM capital shares. And guess what? Since Germany has over 27% of the ESM's capital shares, it retains absolute veto power over any and all funds disbursed, even under the "emergency" clause (France is the only other nation that maintains absolute veto power under the ESM).

In sum, in exchange for keeping the cost of the sovereign debt bailout off of Spain's sovereign balance sheet, Mariano Rajoy has struck a Faustian bargain in which Spain has ceded absolutely all control of the bailout of Spanish banks to the Germans. Indeed, not only has Rajoy ceded control over the entire Spanish banking system over to Germany, he has subjected the Spanish sovereign to the whims of the Germans given that any and all ESM commitments to the Spanish banks can be made conditional by Germany on the Spanish sovereign meeting certain conditions.

And what did Angela Merkel give up in this Faustian bargain? If you read the analyses of the vast majority of journalistic reports that covered the EU summit you would get the impression that the German's were completely bowled over by the Spaniards and Italians. However, the facts are otherwise: In exchange for absolute control over the entire European banking system (via its veto power in setting the bank regulatory mechanism) and in exchange for the ability to impose all kinds of conditions on sovereign nations whose banks are being bailed out, Merkel "conceded" that ESM funds will be guaranteed by bank assets rather than by sovereign states. Again, contrary to popular belief, that is in fact a victory for Merkel and the German state!

To comprehend why this was a victory for Merkel and the German state, one must understand that is far more feasible for the ESM (on behalf of the German state) to use current legal mechanisms to seize private assets such as bank claims on private real-estate than to seize assets in a sovereign bankruptcy. To seize bank assets in a private bankruptcy, you merely need to work through currently existing legal channels; to seize sovereign assets, you may need to go to war. Thus, with one stroke of a pen, Frau Merkel has enabled the German state to guarantee its ESM investments via seizure of valuable private assets in nations such as Spain - and Germany has been enabled to do so through well established and respected political and legal means rather than via much more controversial and costly belligerent means.

Italy Subjects Itself To Becoming A German Vassal In Exchange For ESM Bond Purchases

As stated in the previous section, under the ESM charter, Germany has absolute veto power over every penny of ESM money that is disbursed - whether it be under the normal MOU regime or the emergency procedure. As such Germany can make any and all demands it wishes in exchange for the disbursement of ESM funds.

If Germany asks Italy to "bend over" so as to enable the ESM to buy a few Euros worth of Italian sovereign bonds, Italy must "bend over" if it wishes the ESM bond purchase to take place.

Unlike what Italian Prime Minister Mario Monti had requested, there will be no "automatic" mechanism in which so-called "virtuous" countries are entitled to have the ESM purchase their bonds. The entire disbursement process remains dependent on the whims of the German government. Whatever conditions Germany wishes to impose, Italy must accept them in order for any funds to be disbursed.

What is even more notable is this: German leaders have already stated that any disbursements will be made conditional on meeting the requirements of the "fiscal union" pact signed in December of 2011. The problem is that these requirements, simply cannot be reasonably met by Italy or Spain. Therefore the entire debate over sovereign bailouts by the ESM may become entirely academic.

Germany can and probably will demand compliance with the fiscal union pact and perhaps other draconian terms and conditions in order to approve of any ESM bond purchase. The practical effect is that it is quite possible that not a single bond purchase will be made by the ESM.

Finally, most observers have overlooked the fact that the ESM assuming responsibility for sovereign bond purchases essentially takes the ECB out of play. In fact, ECB officials, including its president Mario Draghi, have all along stated that sovereign bond purchases should be carried out by an institution such as the ESM that is an instrument of fiscal policy rather than by the ECB that is merely a monetary authority that is prohibited by treaty to intervene in fiscal affairs. Therefore, granting authority to the ESM to carry out sovereign bond purchases enables the ECB to shield itself from demands on it to take responsibility for a function that its members are deeply ambivalent about and where the ECB is quite possibly is legally prohibited from meddling. The problem with the ECB being absolved from responsibility in this matter is that all knowledgeable observers understand that the ECB is, in fact, is the only institution that can make a sovereign bond backstop credible. And now the ECB has, for all intents and purposes, been taken out of play by the bargain struck by Prime Minister Monti.

In sum, in the Faustian bargain so "skillfully" negotiated by Prime Minister Monti regarding sovereign bond purchases, Germany gained three hugely important strategic goals. First, the Germans have all along vehemently opposed ECB bond purchases, and the explicit granting of bond purchasing powers to the ESM essentially takes the ECB out of the bond-buying business. Second, in exchange for receiving any sort of support from the ESM - whether it be sovereign bond purchases or otherwise -- Italy will be subjected to any whim the Germans feel like conjuring up as a condition for aid. Finally, Germany has never wanted to spend a penny on bailing out PIIGS, and now Germany has created a perfectly respectable political and legal pretext for avoiding assumption of such liabilities: Since there is really no way that Italy or Spain are going to be able to meet the conditions imposed under the fiscal union treaty - much less any new conditions that the Germans may see fit to impose - Germany may in fact never have to be placed on the hook for a single penny of ESM bailout disbursements. In all events, if they ever do choose to consider approving any ESM disbursements, the Germans are in an unassailable position to ask for extraordinary concessions in return.

Conclusion

When one carefully reads the EU summit statement and works through its implications, it is clear that Italy and Spain have signed off on a Faustian bargain.

Italy and Spain have gained a small modicum of financial market calm in exchange for ceding massive amounts of sovereign power to Germany and a German-dominated EU. By contrast, Germany has given up virtually nothing in exchange for amassing the sort of economic and political power and control over the European banking system and the macroeconomic policies of nations such as Italy and Spain that could normally not even be obtained through military conquest.

Ultimately, none of this Faustian bargaining can avert an EU-wide economic crisis that will be brought about, in the first instance, by sharply contracting economies in Spain and Italy and by the consequent ballooning of their fiscal deficits. How the EU will ultimately deals with this crisis remains to be seen. However, for now, what can reasonably be foreseen is that a deep economic recession and financial crisis in Europe will take hold. Furthermore, German austerity policies which have been made even more inescapable by the June 29th EU summit agreement will continue to make matters worse. In this context, global risk assets will perform poorly. Broad index ETFs such as (SPY) and (DIA) will suffer major declines while index ETFs with cyclical exposure such as (XLB) and (XLY) will perform even more poorly. Not even stocks with strong fundamentals such as Apple (AAPL) or Google (GOOG) will be exempt from the global equity bear market that I believe will see the S&P 500 ultimately test the area between 950-1020.

Source: Spain And Italy's Faustian Bargain With Germany