Will Spain Leave The Eurozone?

Includes: EU, EWP
by: Avery Goodman

Most people are worried about the eurozone, but are concentrating their attention mostly on Greece. A decade ago, the former Greek government defrauded its way into the eurozone, with help from two American derivatives dealers. Using a financial instrument known as a "swap", the dealers helped the then-Greek government "cook" the books. This has caused immense trouble for the eurozone.

As everyone now knows, the Greek government is an example of moral hazard gone wild. A decade ago, in order to facilitate entrance into the eurozone, a large part of Greek debt was placed off the official balance sheet. Then, upon entry, foolish European bankers showered the Greek government with all the money a politician could dream of. Greece spent hundreds of billions of dollars it didn't have. It enacted huge social giveaways it couldn't pay for. When European bankers finally wanted to be repaid, the Greek economy began to collapse, requiring a bailout.

The situation in Spain is very different. Spanish government debt, as a percentage of GDP, has traditionally been one of the lowest in Europe. From 1980 to 2011, the ratio averaged 47%. In 2008, for example, just before the start of the world financial crisis, it got as low as 36%. Unlike Greece, the Spanish government was thrifty. Spain never spent money in an irresponsible fashion.

In contrast to Greece, Spain legitimately joined the Euro currency. Its primary problem has not been spendthrift politicians, but, rather, inflexible central bankers at the ECB. From 2001 to 2007, the ECB dramatically lowered, and then, held its refinance rate under 4%. At various times, in fact, the rates were much lower than that. In today's Bernankian low-rate universe, a 2-4% refinance rate seems very high. Historically, however, such rates are very low, especially for young growing economies like that of Spain.

When compared to the extreme behavior of the Federal Reserve during the same time period, the actions of the ECB seems tame. Low interest rates were needed in the highly developed, but economically "quiet" economies, like Germany, Austria, Netherlands and Finland. But low rates are not suitable for a young democracy, which had recently exited the iron hand of Francisco Franco's fascist regime. Years of suppressed economic activity were in the process of unwinding into fast growth.

However, the demand for money in newly free market, high-growth "quasi-emerging" economies is intense, and people have so many dreams and plans that money is not always applied to productive activities unless the interest rates are high enough to quash the malinvestment activity. From 2001 to 2008, Germany did well with low interest rates, but Spain needed high interest rates. As a result of low rates provided by the ECB, Spain suffered a wave of malinvestment, as citizens tried desperately to move out of simple abodes and into dream homes.

Banks all over the continent were drunk on the idea that a common currency equalized the needs of all economies in Europe. They were ready to oblige virtually any level of real estate borrowing. Eventually, the cost of good housing flew so high that the dream died, in spite of impressive growth rates. No one could afford the mortgage payments anymore. Real estate price inflation had gone out of control, resulting in unsustainable high prices.

The subsequent collapse of the hyperinflated Spanish real estate market caused severe damage to what would have otherwise been a robust economy. Soon the dominoes began falling. People stopped buying overvalued real estate. People employed in building trades lost jobs. Then, those people dependent upon them lost jobs. Then companies dependent upon the first two groups saw their sales falling, and their employees began losing their jobs. So on and so forth, until Spain found itself in its current unenviable condition.

Like the USA and other western economies, Spain has a government supported social safety net. The net went into automatic overdrive, as the needs of the Spanish people grew. Government expenses grew. With real estate prices crashing, banks who counted mortgages as 'assets" became insolvent. The Spanish government was forced to support banks, and, most recently, it was being forced to expend billions to rescue a bank that supposedly had already been rescued.

The recent Spanish government plan was to inject 19 billion Euros ($23.6 billion) worth of government bonds into Bankia, allowing the bank to use those bonds to extract cash from regular ECB tender operations. But, the ECB has torpedoed that idea, claiming that it is essentially "under-the-table" monetization. That is absolutely true, and government debt monetization is a violation of the ECB charter. Spain will need to find another way. It might be able to legitimately raise another $23.6 billion if it pays a nice interest rate. But more bank insolvencies are on the way. Interest rates of 6.5-7% are not really very high, in historical terms. But they are unsustainable, now, because of incredibly high levels of borrowing.

From 36% of GDP in 2008, Spain's debt to GDP ratio has expanded rapidly. In 2011, the ratio was almost 62%. For 2012, a conservative estimate is that the ratio will rise to 68%. Based upon recent budgetary statements made by the Spanish government, this author believes the 2012 debt to GDP ratio will be much higher. Investor confidence has been eroded, and 10 year Spanish government bonds are now paying 6.5%.

In truth, rates of interest in the range of 6-7% are not high. But normal interest rates are difficult for bankrupt nations to pay. High rates, if imposed at the right time-- before or during the real estate hyperinflation-- would have prevented Spain from falling into bankruptcy. However, now they are a problem. Yet, we are now living in a time of extreme risk of sovereign default and/or currency debasement. Bond investors who accept normal rates of interest on long term bonds are foolish, whether issued by Spain, the USA, or even Germany.

Spain's future outlook is grim. April retail sales dropped by 9.8%. The current unemployment rate is higher than Greece, having reached 21.3%. Spain's problems can be traced to fallout from artificially low interest rates and loose monetary policies from 2001 to 2007. These central bank behavioral patterns are the same ones that sparked artificial housing booms in the USA and Asia.

All of Spain's problems arise out of the fact that the Euro is a fiat currency. Fiat currency is an inherently flawed concept because it relies on decision-making by human beings. Fiscal union does NOT solve the problem. For example, from 2000 to 2005 the Federal Reserve blew immense housing bubbles in fast developing states like Arizona, California, Florida, and Nevada. The Fed imposed ultra-low rates appropriate for New York City. Like Spain, those states needed higher rates of interest than New York or Germany.

In spite of the fact that the USA is one nation with one fiscal policy, uniform interest rates are inappropriate. Different regions are very different and have very different needs. The static, Politburo-like, rate setting mechanism cannot account for these differences, just as the ECB could not account for the differences between the states of Europe. We have seen the collapse of U.S. state finances, very similar to what we see in Spain and elsewhere in Europe.

The imposition of uniform low rates on fast developing economies and / or imposition of high rates on fully developed economies leads to instability. That is the problem with central banking. A free gold standard solves this problem. If gold floats alongside paper currencies as equally legal tender, it is no longer an "asset". It becomes money and that allows capital gains or losses to not be recognized just as they are not recognized when the buying power of the dollar rises or falls.

Wherever there is growing demand for money-- and the higher risk, such as when lending to fast-growing areas-- the local interest rates on gold loans would automatically rise to the appropriate level, since no rate is set by any central bank. Similarly, when there is lower demand for money, rates will automatically fall. Differential demand for money in the form of freely traded gold GLD, IAU, PHYS depends on the commercial needs of the region.

Although the problem of both the Euro and the U.S. dollar would be solved by a free floating gold money regime, Spain is too small to lead the way. Until a major nation-- like the USA or China-- leads the world from fiat currency, Spain must either keep the Euro, and that means more suffering both now and in the future, or it must replace it with another fiat currency.

The process of reintroducing the Spanish peseta would be traumatic, and would probably have serious side effects around the world. A fall in the DOW (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY) and NASDAQ (NASDAQ:QQQ) indexes in the USA, for example, would be almost assured. But the end of the Euro is inevitable and kicking the can down the road, while possible, will simply make the adjustment process even more painful when it finally takes place. Returning to the peseta, with rates set for a more uniform geographic region and people, by a Spanish central bank in closer touch with Spain's special needs, will help Spain get back on its feet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.