The Spailout

10 Jun

Between 2000 and 2007 Spain’s the gross debt-to-GDP ratio declined from 59.3 to 36.2 percent of GDP. The government’s budget balance shifted from small deficits to surpluses for the last three years of the expansion (2005-2007), with surpluses of about two percent of GDP in 2006 and 2007. Moreover, interest payments on Spain’s debt were just 1.8 percent of GDP for 2009. The cesspool that festered in Spain was not public debt, but private debt. Moreover, in the past two years Spain saw savage fiscal cuts. First timidly, under Zapatero and then in full swing, as part of the LTRO-for-blood deal extracted by ECB in December last year. Since then, Spain has cut 27 billion from its budget this year and has promised to repeat this bloodbath next year. In short, Europe has already exacted its pound of flesh from Spain during the past few months. All this bloodletting has predictably failed to save Spain. This Sunday, the country placed itself in the itchy rescue bag of the EU via the so-called Spailout

The weekend’s Spailout has its virtues. The EU’s action was uncharacteristically swift and showed that European leaders can coordinate when spooked. Also the amount thrown into the game (100 billion) was overwhelming, given the estimated needs of the Spanish banking sector.

Yet its horrors are bigger still. First, Europe’s taxpayers’ money will end up in failing Spanish banks yet without receiving equity in return. You may say that the Spanish citizens would, as their increasing debt means equity in these failing banks but they would do so in exchange for more austerity, higher unemployment and so on. Hardly a blessing, one can argue.

Second, this Euromagic fooled no one. Already by Tuesday it became obvious that it was little more than a band aid. FT reports that the €100bn committed to Spain’s banking recapitalisation fund over the weekend made private bond investors worry that they could become “subordinated”, or ranked below the eurozone’s rescue funds in any Spanish sovereign debt restructuring.The result is that Spain’s bond yields reached euro era heights.

Third,by giving the money to the Spanish government rather than to the banks (as equity), the EU increased Spain’s public debt burden directly. Which means that the banking crisis feeds into a sovreign fiscal crisis that can then escalate into a sovereign debt crisis on the Greco-Irish-Lusitan model.

The link between the Spanish sovereign and the banks is particularly interesting in Spain. FT notes that “the European Central Bank’s December and February longer-term refinancing operation led to Spanish banks, far more than most, recycling the cash into sovereign bonds – buying €83bn since December.Spanish banks account for a more than a third of Spanish sovereign bond ownership, nearly double the tally five years ago.The increase has helped offset international investors’ dimming faith in Madrid – making Spain’s banks a valuable stabilising force in the country’s economy. Without them, Madrid would have little hope of financing itself.”

How can this European bank run be put out? The most important step is the unification of the European banking sector. You can’t have national banking sectors whose fate depends on the sacrifices of nation state citizens while allowing anyone in the EU to freely wire their deposits from one jurisdiction to another. What does this banking union entail? In short, it means a European banking authority and capital injections into banks from ESFS in exchange for common shares. More on this in a future post.

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