After a year of small adjustments and big denials, Europe's leaders are finally getting their heads together and preparing the bail-out of Spain that almost everybody knew was coming.
The form of the bailout, as described by Mario Draghi, the European Central Bank president, will be different from those for Greece, Portugal and Ireland. This time, the club of eurozone governments' bailout funds, the EFSF and ESM, will buy part of Spain's issuance of sovereign bonds, while the ECB buys the same on the secondary market.
The bailout could accomplish one of its goals: to persuade markets that the eurozone is not about to splinter. If the Spain bailout is followed up with a deal to cut Greece more slack, that could quell talk of an imminent eurozone breakup -- at least among people who move markets, at least for a while.
But Spain's problems, and the eurozone's crucial weakness, can't be fixed with a bailout.
Spain is no natural basket case, but not much is going well there now. The population is deep in debt. Almost one in six adults wants a job. The entire real estate sector is bust. Banks live on central bank aid and lend only to government. Industry has been dragged down by collapsing domestic demand and now a global slowdown. Farms are hit by drought.
The bailout will do little more than subsidize the interest Spain pays on its public debts. That's just not going to turn things around here.
Spain is a trillion-euro economy, big enough to matter globally. Its slide towards depression will make it tough for northern Europe to avoid recession, and will worsen recession for the rest of southern Europe. As long as Spain is slowing down Europe, Europe will be slowing down the world.
Here are six reasons why Spain is in even worse trouble than you might imagine. Read them and weep.
1. Spain is caught in a strengthening credit riptide
The source of really all Spain's problems is that it blew one of the biggest credit bubbles of modern history. Credit bubbles succumb to credit riptides. We've all seen what that looks like: shrinking credit supply, slowing demand, falling asset prices and rising defaults, all reinforcing each other and dragging the economy out to sea. In Spain, this process is more severe and will last longer.
This chart shows the relative sizes of credit bubbles in the five main crisis-hit European countries against the United States and late 1980s Japan. The measurement used is net credit supply to non-financial sectors, a lowball method of estimating total credit supply to the economy. Financial companies are excluded to avoid double-counting money they borrow and re-lend, although that misses some money they borrow and invest in other ways or consume.
(click images to enlarge)
Spain out-borrowed everybody except the Irish. In the peak bubble year of 2006, Spain's non-financial sectors borrowed 37% of GDP. The equivalent numbers for the United States and Japan were 18% and 27% in 2006 and 1989, respectively.
Most countries had a small bump up in credit supply in 2010, thanks to counter-recessionary borrowing by governments and a shallow recovery of credit to business as global trade recovered. (The big bulges in Portugal and Ireland in 2010-2012 are bail-out loans.) But the credit riptide returned with a vengeance in 2011. With its more fragmented public and financial sectors, bigger local bubbles to unwind and (except Ireland) less adaptable business cultures, Europe buckled.
The next chart looks at the same issue with less comprehensive but more up-to-date data. This time it's only net bank lending to private non-financial sectors. Unfortunately, the data for Greece and Italy includes write-offs as if they were repayments, which slightly distorts their recent numbers downward.
After a shallow recovery in 2010, Spain's banks have been cutting back on lending to the private sector since early 2011. In the 12 months through June 2012, the amount that Spanish banks collected in debt repayments from the private sector exceeded fresh lending by 4.4% of GDP.
Negative net bank lending rates would be more traumatic if not for government and central bank intervention. The national central banks of Europe's crisis-hit countries have been busily replacing shrinking bank deposits with refinancing loans to commercial banks (more on that later). Governments have increased public borrowing, which has kept the total credit supply positive, except recently in hard-up Greece.
A negative total credit supply is rare and indicates a genuine depression. In practice, it's very difficult for lenders as a whole to collect more from an economy in repayments than they supply in new credit. Doing so shrinks the supply of bank deposits, causing a general deflation and widespread defaults.
2. Austerity will bite hard
I don't want to wade into the debate over the pros and cons of fiscal stimulus versus fiscal austerity over the long run. Personally, I'm a stimulus skeptic. But I hope no one doubts that austerity reduces growth in the short term.
And, like it or not, austerity is inevitable for Spain. The best Spain can hope for in its situation is to be kept on a supply of low-interest loans from foreign governments led by Germany, attached to austerity conditions meant to wean Spain off the aid.
That trade-off is behind the austerity package Spain announced in July just after eurozone governments agreed to lend it €100 billion to recapitalize its banks. It's not clear how much austerity is really in the package, since most of the announced measures were described vaguely. But the announced target of a €65 billion reduction of the annual deficit, reducing it from 9% of GDP last year to 3% in 2014, is very aggressive.
Unfortunately, though, Spain's public deficit appears to have been growing in the first half of the year, especially at the regional government level where arrears have built up. The credit riptide and global slowdown is taking its toll on revenues.
Austerity will, of course, knock GDP and revenues down further, working against the goals it's meant to achieve. The rapid growth of Spain's public debt-to-GDP ratio will not slow.
Worse, for Spain austerity poses another problem, which is already wreaking havoc in Greece. With banks withdrawing credit from the private sector, reducing public borrowing brings total credit supply towards the dangerously deflationary zero threshold. Austerity will drive many more over-indebted Spanish companies into bankruptcy and liquidation. It will give Spain a push from recession towards depression.
3. Spaniards are trying too hard to keep up on their mortgages
This problem is difficult to explain without offending people. I sympathize with homeowners who paid bubble-era prices for homes that turned out to be more than they could afford with their post-bubble incomes. I see nothing good about widespread foreclosures and ejections of families from their homes.
But Spain's under-employed, over-indebted population badly needs some kind of path to debt forgiveness. If more Spaniards defaulted on their mortgages, that could force the government to deal with the problem in some way. I like programs that keep people in foreclosed primary homes as renters and, for secondary homes, American-style short sales.
The main reason Spaniards are so reluctant to default is that giving homes back to the bank doesn't fully clear off mortgage debts. If they owe more than the home can be sold for, the bank will pursue them for the difference and sue to seize their income and other assets. That rarely happens in the United States because of forgiving personal bankruptcy laws that allow full discharge of most debts.
Spain introduced personal bankruptcy only in 2003 and in a less forgiving form. At most, half of debts can be discharged, and that's not a sure thing. It's not enough to make bankruptcy an attractive option, even for the deeply indebted.
More debt forgiveness would help Spain unwind its credit bubble faster. Unlike corporate bankruptcies, personal bankruptcies usually don't result in the elimination of productive capacity. Of course, bankruptcies do inflict losses on banks and increase bail-out costs, which is why the government prefers as few as possible.
Spain's alternative to personal bankruptcy is for extended families to band together, straining their common resources to avoid defaults. It sounds romantic, but it's a huge burden on the finances of relatives of the unemployed. And most Spaniards have at least one unemployed relative. If Spaniards don't get some debt relief, they will need to be frugal for another decade.
This chart shows the amounts of bank loans outstanding to the main private non-financial sectors and the portions reported as doubtful. You can see that most of the doubtful loans are to construction and real estate businesses. Also, there's been a big shrinkage of loans to those sectors since 2008, which is largely due to write-offs. The €100 billion recapitalization of Spanish banks is meant mainly to replenish losses on loans to these sectors. I think those losses will be more like €200 billion.
Mortgage and renovation loans to households also exploded during the bubble, but relatively few have been written off or recognized as doubtful. These low rates of default on mortgages are not a sign of resilience. Spain is prioritizing mortgage repayment over economic recovery.
4. Capital flight from Spain is accelerating
The eurozone has a crucial systemic weakness, and it's not the one you've heard about.
Many commentators claim southern Europe and Ireland got into trouble because their national central banks or NCBs can't freely print money. That's not true. The eurozone's NCBs are indeed legally bound to obey ECB rules limiting how much money they can "print," in the important sense of issuing new euros by purchasing assets or making loans. But in practice, the ECB has repeatedly lifted restrictions and encouraged NCBs to issue more euros.
Most of this NCB issuance has been through refinancing loans to banks. These are the classic "lender of last resort" loans that central banks make to commercial banks that are short of money but have other, less liquid assets they can put up as collateral.
Besides, NCBs can issue euros independently through emergency liquidity assistance or ELA, without following the ECB's rules or receiving its prior approval. The ECB has the authority to limit use of ELA or even to order NCBs to recall ELA credit, but there's no evidence it has ever done so.
The ECB, after all, is controlled by the NCBs, whose governors hold 17 of the ECB governing council's 23 seats. The other six EU-appointed members are mostly former NCB governors and executives.
Greece, Ireland and Cyprus have all made liberal use of ELA. Spain appears to have issued about €400 million of ELA in July, a relatively small amount, but notable because it would be Spain's first use of ELA since 2010. I believe I am the first to report the news, which was half-hidden in a Spanish NCB balance sheet published earlier this month.
(NCBs generally don't confirm issuance of ELA, but it's easy to spot because it's included in a balance sheet line that rarely changes much for other reasons. In Spanish that line is "Otros activos en euros frente a entidades de crédito de la zona del euro." It jumped from less than two thousand euros at end-June to €402 million at end-July.)
Those four countries and Belgium, Italy, Portugal and Slovenia have all issued large amounts of refinancing loans. Cumulative issuance of refinancing and ELA by those eight countries' NCBs came to more than €1 trillion as of the end of June. Their refinancing issuance is the main cause of growing base money supply in the eurozone.
Other commentators claim eurozone countries are facing sell-offs of their sovereign bonds because their NCBs aren't allowed to buy them. That wouldn't save them. When central banks try to combat a sell-off of sovereign bonds by issuing currency to purchase them, the crisis shifts to one of currency devaluation, inflation and high interest rates. Recent U.S., U.K. and Japanese central bank purchases of domestic sovereign bonds are not comparable because they were not up against selling.
And then there are those who say southern Europe is suffering because it can't devalue its currency relative to northern Europe. They're right. Southern Europe's wages and asset prices were inflated by over-borrowing, lowering the average producer's competitiveness, and that must be reversed. That adjustment is much harder within a common currency zone.
But regional credit bubbles create similar problems within national currency zones. No currency area is ideal. Most of the people who think this is a good reason to abandon the euro are Englishmen who never liked the euro anyway. The eurozone has another, much more important weakness.
Because the eurozone has a common currency but separate national banking systems, it's uniquely vulnerable to an unusual kind of internal capital flight that leaves national banking systems short of funds and unable to lend. As quickly as the NCBs of crisis-hit countries have been issuing euros, those euros have been exported across national borders to other parts of the eurozone.
In standard capital flight, from a country with a national currency, people sell the country's assets and its currency. The asset sales push down nominal asset prices, while the currency sales push down the currency's exchange rate. The compounding effect makes big losses for sellers, but also helps bring in bargain-hunters and stabilizes the outflows.
Capital flight within the eurozone works very differently. People who want to reduce their exposure to a particular country sell its assets, but keep the euros and transfer them to a bank in a stronger eurozone country. Those exports of euros drain money out of the affected countries' banks, leaving the entire national banking system short of money.
That creates a stigma over the country's banks and makes it impossible for them to borrow on international interbank markets. So the flight-hit country's banks can only raise cash by applying to their NCB for refinancing loans or ELA, or by reducing lending to below what they can collect in repayments.
Countries with national currencies don't face that same threat. The only way it's even possible to export a national currency is to transport banknotes. Bank transfers of national currency to a foreign bank go to a correspondent account at a domestic bank, where the funds remain available to the domestic interbank market.
The eurozone's troubles with internal capital flight began back in 2007 and erupted with the Lehman Brothers bankruptcy in 2008. Many participants in the euro interbank market pulled away from lending to banks that appeared vulnerable. The ECB responded by allowing NCBs to offer commercial banks unlimited amounts of refinancing loans. The ECB also lowered the standards of collateral that NCBs could accept.
Then internal capital flight worsened as foreigners sold the sovereign bonds of Greece, Ireland and Portugal in 2010 and Italy, Spain and Cyprus in 2011. Meanwhile all but a handful of those countries' banks were cut off from international interbank lending.
Greece in 2010 and Spain in 2011 progressed to a third and worse stage of capital flight, in which local depositors withdraw funds from banks and send them elsewhere in the eurozone, or stash banknotes in proverbial cookie jars.
The next pair of charts shows the cumulative capital flight from the eight eurozone countries most affected, and below, the cumulative volumes of refinancing loans and ELA issued by their NCBs. Capital flight is represented by each country's so-called Target deficit, a count of cumulative net outflows from a country that leave by bank transfer to other eurozone banks.
Notice how similar these two charts are. That's because NCB refinancing has been funding the capital flight -- or, if you prefer, because the capital flight has been forcing the NCBs to issue refinancing to replace the money that capital flight pulls out of banks. Some countries fund part of their Target deficits with inflows of banknotes from tourists.
Notice that all five countries that have requested foreign aid did so after they were suffering from severe capital flight and their NCBs had issued large amounts of refinancing loans. The marked data points are the last reported Target deficits and outstanding amounts of refinancing loans (including ELA) before the country applied for foreign aid.
In most of these countries, refinancing issuance has also been funding trade deficits.
Several eurozone countries have issued huge amounts of refinancing relative to their GDPs. For comparison, total central bank assets of all kinds in the U.S., U.K. and Japan were 19%, 25% and 31% of their respective annual GDPs as of early August.
So eurozone NCBs can and do "print" plenty of euros. Their problem is, they can't keep those euros within their national banking systems. Instead of boosting their own money supply, they boost the money supply of Germany and other, stronger eurozone countries that receive their fled capital.
If the eurozone's NCBs weren't able to issue such large amounts of euros, most of the eight countries featured in the charts above would have suffered systemic banking collapses. They would have followed the course of dollarized Argentina, which adopted a foreign currency that would be exported in a crisis and that it couldn't print. In 2001, Argentinian bank deposits were forcibly converted into new domestic currency at a fraction of their former value.
That's the grim outcome that much of Europe has been running in front of for the last four years. Like dollarized Argentina, eurozone members have a currency that is exported during crisis. Unlike dollarized Argentina, eurozone members can make more of their currency. No other countries have ever been in a predicament that's quite the same.
To avoid this kind of crisis in the future, Europe will need truly international banks that take deposits and lend throughout the eurozone. I think that's probably coming someday. But don't hold your breath.
5. Bail-out funds won't reach Spain's real economy
The bail-out that's being planned for Spain will work very similarly to the NCB refinancing issuance that Spain has relied on till now. It will supply enough money to fund the Spanish deficit, but that money will continue to leave Spain through its trade deficit and capital flight.
The bailout will also buy out most of the remaining foreigners who still own Spanish state bonds. That money will hardly get a glimpse of Spain.
The ECB, EFSF and ESM will apparently buy exclusively shorter-dated bonds, judging from Draghi's comments. That will limit the bailout's costs and the subsidy value for the Spanish government. Presumably, Spain will be required to include some percentage of longer-dated bonds in its issuance, for which it will have to find other buyers.
The bailout will also relieve the Spanish NCB and commercial banks from the responsibility of funding the Spanish state debt. Spanish banks borrowed an additional €227 billion from their NCB in the first half of this year, and took on an additional €73 billion of credit exposure to the Spanish public sector. That latter figure represents about 14% of first-half GDP.
Once the ECB and EFSF start buying, Spanish banks will shift into the role of bail-out intermediaries. They will buy the longer-dated bonds at primary auctions and sell shorter-dated bonds to the ECB, initially out of their existing stocks. They and others will try to profit from price appreciation of bonds approaching eligibility for sale to the ECB.
Foreigners will continue selling out. I estimate they already hold less than €140 billion, down from a peak of about €240 billion in 2010. In his comments, Draghi hinted that some effort will be made to reassure foreign investors that they wouldn't be obliterated in a restructuring, as happened to foreign investors in Greek state bonds. Whatever that reassurance turns out to be, I doubt many will want to miss the opportunity to sell into the ECB bid.
I estimate this program will cost about €400 billion through the end of 2014, assuming no big improvement or deterioration of the global economy. That includes €140 billion to take out foreign investors, €210 billion to fund the Spanish public deficit and €50 billion to take out some Spanish non-bank private investors.
My estimate assumes Spain will make no progress in reducing its public deficit, for three reasons: austerity implementation will fall short of the 6% of GDP target, the austerity that is implemented will partly undermine itself, and other underlying economic trends will be pushing against deficit reduction.
Of that €400 billion, I would count only the €50 billion to Spanish non-bank private investors as a new flow to the Spanish economy. Will it be re-invested locally? Hmm...maybe some.
In the U.S., U.K. and Japan, the main reason for central bank purchases of domestic sovereign bonds is to swell the domestic money supply. In Europe, ECB purchases of individual countries' sovereign bonds bring money to that country, but the money goes right back out again. It's a crucial difference.
6. Spanish exports are weakening
From 2009 through 2011, the savior of Spain's economy was its strong export sector. Despite the damage to Spanish competitiveness from bubble-era wage inflation, Spanish exports bounced back vigorously. By September 2011, monthly exports were 15% over their 2008 peak, not adjusted for inflation.
Older folks may remember that Spain used to be one of Europe's fastest-growing economies, led by its aggressive export sector. That was back before it took that fateful wrong turn and decided to refocus on building several times more houses for itself than it needs.
While Spain's domestic demand plunged in 2008 and stayed below, exports re-emerged as the one vital sector and turned what could have been a depression into merely a bad recession. The industrial goods and commodities that Spain exports were in strong demand as China's big stimulus filtered through via Germany. By 2010, Spain's GDP was recovering, although unemployment remained very high.
But global trade growth slowed during the second half of 2011. China and other emerging markets, reacting to wage and commodity inflation, tightened their credit supplies. Spain's exports stopped growing and this year have been slightly shrinking. Here's a quick chart.
No one knows how long this global trade weakness will last, or if it will get worse before it gets better. Some think China is heading towards a great unwind of its own real estate bubble that will hit global trade hard. Others think a big new stimulus to construction will be the first priority of the new Chinese leadership that will take over later this year. It seems fairly sure though that global trade will remain soft at least into 2013.
The Spanish export sector's reversal of fortune has been an important factor in this year's intensifying crisis. Spain's bad recession is back, and it looks like it could turn into a depression after all.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.