Rajoy was hoodwinked and now Spain faces a debt deflationary spiral

Two weeks ago I told you that Spanish Prime Minister Mariano Rajoy’s humiliating defeat to Merkel had narrowed options to sovereign bailout, monetisation or default for Spain. Now that the Spanish bank bailout is unraveling and Catalonia is threatening secession, I want to revisit this theme. I believe the basic conclusions are the same but I want to update you with my thinking given the most recent events.

The boom in the periphery and bust in the core

Let me give you a roundhouse review of how we got here. During the euro’s first decade, Germany, and to a lesser degree the Netherlands, were mired in slow-growth economic slumps. The slump in Germany, the euro zone’s economic center, was especially severe in the wake of a property and capital spending binge after reunification that left a wake of malinvestment. It is what I have called a soft depression. Moreover, as Edward Hugh puts it, Germany has been slowing for decades along with Japan and Italy as one of the three oldest economies in the world. Demographics play a huge role in the country’s turn to mercantilism to supplement its lack of domestic growth.

The European Central Bank responded to slow growth in the euro zone’s core (which includes Italy, the Benelux countries, France, Germany and Austria) by cutting rates and keeping them low for years. In higher growth countries like Spain and Ireland, this created a serious and unsustainable boom as real interest rates were negative throughout this period in Spain and Ireland. While Spain and Ireland had budget surpluses during this period, proving the crisis is not about fiscal probity, the surpluses were fictional in the sense that they were predicated on phantom income and wealth that emanated from a massive malinvestment. In short, the ECB wrecked the Spanish economy as I put it in June.

I am not the only one saying this. Today, Ambrose Evans-Pritchard of the Telegraph wrote a post about Europe’s betrayal of Spain that also stressed the role of negative real rates. I will get to the betrayal aspect later in this essay. For now, let’s focus on this:

The Spanish bubble was after all a joint venture. Spain was flooded with cheap capital from Germany and Holland that it could not prevent or control under the EMU system. Did the German and Dutch regulators recognise the danger, or try to stop the excesses? Not really. They were complicit.

The ECB’s uber-loose money (to help Germany when it was in slump) led to negative real interest rates for Spain – minus 2pc for years – that fuelled a massive credit boom. Policy was far too lax for a fast-growing Tiger economy.

Did the Spanish make big mistakes? Of course. But the ECB and the European Commission did not make that critique at the relevant moment. They too were smoking weed.

That’s it exactly. And how ironic it is that the boom in the periphery and bust in the core has exactly reversed, with Germany experiencing much better prospects than the periphery.

Recent machinations

Now let’s fast-forward past the burst bubble to recent events. In June, Spain’s bond yields were skyrocketing and the situation looked desperate for the country, already in the throes of a austerity-enhanced debt-deflationary depression. Not only was the sovereign’s debt load skyrocketing under the pressures from a bust housing bubble and 25% unemployment, but Spain also was having to contend with contingent liabilities in its banking sector and for regional governments. Capital flight was rampant.

The question was what to do. And the Europeans acted to shore up the banks’ capital. When the deal came out I wrote of Monti and Rajoy forcing Europe into a true EuroTARP:

“Overall, this summit represents a significant move because of the reversal on the bank bailout. Last Friday I talked about Europe moving from smaller bailouts plus austerity to bigger bailouts plus austerity lite, predicting that we would see the second and third points of the bailout package. What is a surprise is the bank – sovereign decoupling element that Monti and Rajoy were able to get through. In the absence of that, the EU summit would have been a dismal failure.”

But, then it was revealed that Merkel was backtracking on the deal. There would be no EuroTARP that saddled German taxpayers with Spanish bank debts. Before that happened, there would have to be bank shareholder and bondholder losses.

This was a disaster. I wrote:

“My analysis of the events says that:

  1. Spain was forced into a bailout because it was clear that the Spanish government was going to have to bail out several large Spanish institutions and the market for Spanish bonds doubted the Spanish government’s ability to do so.
  2. Originally the bailout carried less conditionality but did not break the sovereign-bank tie.
  3. After the market rejected this deal by forcing Spanish yields higher, a new deal was struck at the euro summit by which Europe claimed “We affirm that it is imperative to break the vicious circle between banks and sovereigns“. No mention was made of conditionality.
  4. Now, the Troika has backtracked on this deal and not only is there huge conditionality in the Memorandum of Understanding but Spain is also still on the hook for the bailouts.

“Nothing has been accomplished. The Spanish bailout is a failure.”

As I wrote at the time of the German betrayal in July, “German Chancellor Angela Merkel is a brilliant political tactician. After the latest EU Summit, it seemed she had capitulated after being rounded on by France’s Hollande in an effort by Italy’s Monti and Spain’s Rajoy to prevent the market for their government debt from collapsing. The talk was of a Spanish bank bailout with practically no strings attached. Understandably, Mariano Rajoy was speaking of the summit as a clear victory for Spain while Angela Merkel was pilloried in the German press.

“But in the days since that summit, Angela Merkel has somehow forced Rajoy into a corner and he has now capitulated, completely reversing himself on taxes and adding a heap of new austerity measures as a pre-condition for bank bailout money that will still be guaranteed by the Spanish sovereign. Rajoy is promising 65 billion euros in austerity to close the budget gap by 2014, including new taxes that raise the value added tax from 18 to 21%.

This is an unmitigated disaster for the Spanish economy and will likely mean default unless Spain is bailed out.”

Treachery and betrayal

Ambrose Evans Pritchard rightly calls this train of events betrayal. And he points to the language in the memorandum of understanding as evidence:


– 29 June 2012 –

  • We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution specific, sector-specific or economy-wide and would be formalised in a Memorandum of Understanding. The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.
  • We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.

It is clear here that the intent of Spanish bank bailout was “to break the vicious circle between banks and sovereigns.” You can’t do that by saddling the Spanish sovereign with the losses. Any fool reading this could see the intent of the document was different from the interpretation that Merkel came out with after the fact. The question is why.

What people miss is that Germany is already highly indebted and in jeopardy of being downgraded from the number of bailouts it has been conducting. In September of 2011, S&P warned a downgrade was coming if Germany continued to offer bailouts. I wrote at the time that “Germany’s ability and willingness to pay will decrease as the economy falters. Remember, Germany is more indebted than Spain and has also long been in violation the Maastricht Treaty’s stability and growth pact provision on government debt to GDP. Germany is not a ‘paragon of fiscal probity’ nor is it a “rock to which all other shipwrecked European economies must turn in their hour of need”. It is has done well. But Germany is also a country that is aging and, hence,dependent on exports for economic growth. Germany too has limited resources. And this is important to note since Germany as a currency user can also be pulled into the sovereign debt crisis.”

So, it has to be clear that the Germans were saying ‘no mas’. In fact, Merkel’s approval ratings have soared due to her hard line on this.

Monetisation or bust

Immediately after the Spanish betrayal, Spanish sovereign yields shot right back up, leading to the existential crisis I predicted at the beginning of the year would force the ECB to monetize Spanish and Italian debt. The OMT was born.

In August I added more color on why the OMT was going to happen. “The basic dilemma here is that almost all of the eurozone governments including Germany carry high debt burdens in excess of the Maastricht Treaty. For example, Germany has been in breach of Maastricht Treaty in 8 of 10 years since 2002, has been over the Maastricht 60% hurdle in each of those ten years, and now carries a debt to GDP burden above 80%. The ratings agencies are onto this and Moody’s has recently downgraded all of the remaining AAA credits in the euro zone except Finland (whose fiscal health is buoyed artificially by a property bubble, I might add). If you look at the contributions to the ESM then, you can see that it cannot be a AAA-rated facility.” 

You can’t go into an general election and expect to win when you are bailing everyone out, larding up your country’s balance sheet in a way that causes ratings downgrades. Remember Merkel is much more popular than her party and she could lose the general election in Germany in 2013 if she did not draw a hard line. So Merkel sided with Mario Draghi that monetizing was the only way forward and threw her former confidant Bundesbank head Jens Weidmann under the bus.

Moreover, there is the pesky issue of German, Dutch and French bank writedowns. If you throw Spain to the wolves, then your banks, the ones whose lending  created the property bubble to begin with, will see huge writedowns on those loans. That means bailouts – not for Spanish banks, but German ones. And however more palatable that may be, it is still  unpalatable to an electorate during a general election.

This was a purely politically-motivated but necessary tactical move by Merkel, ever the pragmatist.

But the paradigm of austerity as a pre-condition for monetsation won’t work any more than the prior austerity as a pre-condition for bailouts did. You still have the current account imbalances. You still have the bank runs. And you still have the debt deflation. Now Mario Draghi says he is taking denomination risk off the table. But how can he fully do that when you have these three problems that are only made worse by austerity? The best case scenario here is Spain’s capitulation and sovereign bailout, followed by a descent into Greek-style depression and anarchy.

Euro watchers like Ambrose Evans-Pritchard and Marshall Auerback are concerned about economic nationalism. So am I. The news that Catalonia wants to threaten secession at this pivotal moment in Spanish history tells you that nationalism is always resurgent when you are going through a depression. It’s amazing chutzpah given the fact that Catalonia is the largest regional debtor government and has already requested a bailout from the sovereign.

Bottom line: Spain is a disaster. There is almost no upside given the present policy course. The country is on the hook for bank and regional bailouts. It faces a secession threat from the richest region. And civil unrest is becoming violent. None of this will change because of monetization. Rather, Spain will still be forced into a sovereign bailout that could have terms that makes all of this worse.

Can they ride it out? Rajoy certainly cannot. Knowing this makes him unpredictable and makes the situation in Europe equally unpredictable. The only thing we can be sure of at this point is continued depression in Spain.

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