Spain’s Next

Too big to fail; too big to bail.

December 7, 2010

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bullGreece and Ireland, while sharing common debt difficulties, and now European Union tutelage, are clearly different places. The former has public debts deemed dangerous in no small part because tax dodging is a matter of personal honour. The latter has debts deemed dangerous in no small part because home ownership became a matter of personal pride –and bragging rights.

Blame it on feckless consumers, none too eager to pay their fair share (in Greece and Italy and Spain and perhaps France, too) for what some criticize as generous early retirement schemes and an abundance of  public-sector jobs; or blame it on feckless consumers, none too eager to be prudent as the newly house-proud bought more home than they could afford (in Ireland, but also the U.K., the U.S. and perhaps Canada, too).

Different systems – European-style social democracy and Anglo-American neo-liberalism – united in similar misery thanks to a common denominator: leverage. The source of that leverage: banks, and it is the Irish bailout of its banks that has pushed Éire to the brink, with swingeing cuts to pensioners and state workers among others, as Nobel Laureate Paul Krugman points out.

“ These debts were incurred, not to pay for public programs, but by private wheeler-dealers seeking nothing but their own profit. Yet ordinary Irish citizens are now bearing the burden of those debts.”

But it is not just Irish banks that have found themselves compromised in the balance-sheet rectitude  department. Who are Greece’s public creditors? The biggest, those champions of fiscal prudery, the Germans. But it doesn’t stop with the Germans, nor the Greeks.

Says  Simon Johnson, former chief economist of the International Monetary Fund:

“German banks in particular lost their composure with regard to lending to Ireland – although British, American, French and Belgian banks were not so far behind. … German banks are owed $139 billion, which is 4.2 percent of German G.D.P. British banks are owed $131 billion, or about 5 percent of Britain’s G.D.P. French banks are owed $43.5 billion, which is approaching 2 percent of French G.D.P. But the eye-catching numbers are for Belgium, which is owed $29 billion – in the relatively small Belgian economy, this accounts for around 5 percent of G.D.P.”

With the magic of austerity, perhaps the economies of Greece and Ireland will grow fast enough to repay EU and European bank commitments in good time, while leaving a little left for consumers to save and invest.

Or perhaps not. Perhaps the measures to quarantine the fever – let’s call it bankruptcy in one country, the Argentinian case – are spreading it. That’s the view of Washington’s Blog:

“It is now common knowledge that there is a potential domino effect of European sovereign debt contagion in roughly the following order:

Greece → Ireland → Portugal → Spain → Italy → UK

… [W]hile Greece and Ireland have relatively small economies, there will be real trouble if the Spanish domino falls. Iceland has the world’s 112th biggest economy, Ireland the38th, and Portugal the36th. In contrast, Spain has the world’s 9th biggest economy, Italy the 7th and the UK the 6th. A failure by one of the latter 3 would be devastating for the world economy.”

Of course, European central bankers and financial officials originally said that Greece wouldn’t need a bailout. And later, that Ireland wouldn’t. The New York Times’s Sunday roundup provides a contrarian’s paradise of denial.

If the rain does fall on Spain, Washington’s Blog cites one of the world’s Dr. Glooms, Nouriel Roubini:

“You can try to ring fence Spain. And you can essentially try to provide financing officially to Ireland, Portugal, and Greece for three years. Leave them out of the market. Maybe restructure their debt down the line.”

“But if Spain falls off the cliff, there is not enough official money in this envelope of European resources to bail out Spain. Spain is too big to fail on one side—and also too big to be bailed out.”

Euro-loans keep sovereign debtors liquid enough to recycle money back to their creditors, the European banks. But what if the sovereign debtors and the domestic banks they’ve put on starvation diets aren’t merely illiquid – buying time until the economic cycle changes and individual pay packets and state coffers are awash again in euros? What if, as longtime Milton Friedman collaborator Anna Schwartz said at the beginning of the financial crisis, the banks are actually insolvent?

Then the solution isn’t more liquidity, more emergency loans, more generous repayment terms. It’s restructuring of sovereign debt, a write-down of soured loans, a hefty haircut for the creditors.

If not now, soon,  Black Swan Insights argues: “The real question for Ireland, along with Greece (and soon to be Portugal, Spain, Italy, and maybe Belgium) is: What happens in 2013 when the EU bailout fund is supposed to wind down? All of these countries will still be bankrupt and dependent upon EU loans. Do we simply remove the EU guarantees and let these countries default, or is this a permanent bailout, courtesy of German and French taxpayers?”

His dire prediction: “The market is starting to realize that come 2013, government bond holders (the great gods of capitalism who never take a loss) will be forced to accept a major haircut to the tune of 30-40%.”

Sounds a bit like Scotiabank Quilmes. Europe, the new Argentina?

The liquidity clock is ticking; the insolvency hour approaches.

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