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In my writings in the past year, I have placed Spain's economy at the epicenter of the ongoing economic disaster in Europe. While it must be recognized that the capacity of global governments and central banks to avert a financial markets crisis has thus far surpassed my expectations, my projections regarding the deterioration of the underlying economic fundamentals in Spain and the rest of Europe have been, if anything, too optimistic.

My thesis regarding troubles emanating from Europe was largely based upon my projections of a steep economic contraction in Spain and that, in this context, the Iberian nation would become a severe and serial violator of fiscal deficit targets. On January 20, 2012, I wrote:

In my view, the absolute best-case scenario for Spain's GDP growth in 2012 will be a contraction of -2.0%. My own base case estimate is for a contraction of -3.5%. A contraction that exceeds -5.0% is entirely plausible.

Even under the best-case assumption, Spain will miss its fiscal target by an extremely wide margin. A swing from +2.3% GDP growth to a contraction of -2.0% will necessarily bring about an enormous shortfall in fiscal revenue. Indeed, considering the economic contraction that it must endure in 2012, Spain will be lucky if it can keep its deficit below its 2011 level of -8.0%+. My own base case for Spain is for a deficit of about -9.0% of GDP. A much larger miss is entirely possible.

Spain started 2012 with a fiscal deficit target of 4.4%. This was promptly revised to 5.3%. The last revision raised the target to 6.3%.

Spain recently announced that its fiscal deficit between January and August of 2012 has already reached 4.77% of GDP. This represents a 23.8% increase relative to the same period during 2011. And note that this figure does not even fully reflect "extras" such as a higher social security deficit nor higher deficits in the regions. It also does not reflect the projected cost of bank bailouts. Furthermore, even excluding all of the above "extras," there is absolutely no reason whatsoever to believe that Spain's central government's fiscal finances will improve between September and December on a year-over-year basis.

Spain's fiscal deficit for the full year in 2011 was at least 8.9% of GDP. Thus, my projection of a 8%-9% of GDP deficit for full year 2012 now seems optimistic. A deficit in excess of 10% of GDP seems more likely.

Now, it is true that the ECB has essentially promised to finance Spain's gargantuan deficit - provided only that Spain asks for assistance and submits to more strict conditionality and even more austerity. So, in theory, there is nothing to worry about, right?

Well, I would tend to agree that in the short term, it would seem that the ECB backstop, plus the Fed's aggressive policy in the U.S. should keep markets distracted.

But, under the surface, there is an economic and fiscal collapse going on in Spain that cannot be reversed by central bank policies. And perhaps even more ominous is the political collapse that is developing parallel to the economic collapse in Spain. Please note that due to fiscal tensions with the central government in Madrid, Catalonia has just recently called for a national referendum and has officially consulted the EU on the subject of secession from Spain. Similar requests from Basque and other regions may follow.

So nimble traders may elect to capitalize on the policy-induced rally for the next few weeks/months. However, longer-term investors should remain very cautious. One of the central tenets of a long-term investment discipline is the recognition that the financial market can become forward-looking at the most unexpected of times. This means that the sharp rallies in (NYSEARCA:SPY), (NYSEARCA:DIA), (NASDAQ:QQQ) (NYSEARCA:EWP), (NYSEARCA:EWQ) and (NYSEARCA:EWI) may prove ephemeral and could be reversed at any time.

The unwinding of massive fiscal deficits in Europe and the U.S. as well as the unwinding of ultra-expansionary monetary policies in the U.S. are going to involve a great deal of pain. And in the midst of this pain will be the time to take long-term positions - not now while the anesthesia has just been applied.

Source: Underlying Disaster In Europe Accelerating: Spain's Finances Collapsing