Wednesday, May 8, 2013

Mariano Rajoy And The Great Spanish Depression

“We must all ask ourselves whether the ECB should have the same powers as the rest of central banks in the world. We need to give ourselves the instruments that are available in other regions.”
--Spanish PM Mariano Rajoy, Bloomberg, April 8, 2013

Spain is in a full-blown depression, which began five years ago. The economy is shrinking in real and nominal terms. Prices are falling in a Japanese fashion. M2 is the same today as it was in 2009. Even though government spending is falling, the fiscal deficit remains at an unsustainable 10% of GDP because government revenues are falling as fast as spending. Debt to GDP is headed for 100% in 2014. One out of four Spaniards is looking for work (27%). Half of all young people cannot find jobs. The insolvent banking sector is being propped up with cosmetic accounting and ECB liquidity. Credit to the private sector has dried up, which bodes ill for employment. The public sector is shrinking and the regions are bankrupt. Spain today is the US in 1932, with Mariano Rajoy playing the role of Herbert Hoover.

To his great credit, the prime minister has put his finger on the problem: the fact that Spain’s central bank does not have a growth mandate and--even worse--doesn’t want one. You can’t fix the problem until you have identified it, and Rajoy has identified the problem. What’s he going to do about it? Nothing, it would appear.

What always happens in a protracted economic depression? A banking crisis, which intensifies the deflationary spiral (see: Irving Fisher).

Spanish bank accounting and Spanish bank solvency are currently in separate universes*, which can’t last forever. The insolvency will ultimately become too big to cover up**. At that point, the ECB will demand another recapitalization in the EUR 100B range, which will push Spain’s debt ratio into the red zone. This will trigger a “rescue” by the troika who will force defaults on bank liabilities.***
Hence, a major crisis which will make things much worse (see: early 1933).

What should Rajoy do? He should do what Ambrose Evans-Pritchard at the Telegraph suggests (and what I have been suggesting), which is to form a solid Club Med bloc along with Portugal, Italy and France, and revolt against the deflationary policies of the ECB. 

The Club Med bloc needs to go to war. They must unilaterally end austerity and finance their fiscal deficits in the domestic banking system using ECB money. What could the North do about it? Cut them off and precipitate a disorderly exit? As AEP says, “The Commission bends to power, and will not move unless the rest of EMU mobilises superior counter-power.” Faced with a breakup of the eurozone, Germany may relent and allow the ECB to grow the economy. 

If not, the South should exit, default and redenominate, leaving Germany to pick up the pieces.
*Moody’s:“Asset-quality deterioration is only partially reflected in reported NPLs, as banks have been exchanging loans granted to troubled borrowers for real-estate properties as payment-in-kind or via asset foreclosures. Moody’s estimated adjusted problem loan ratio – more specifically a “non- earning assets” ratio that incorporates the real-estate properties that banks have on their balance sheets – amounts to 13.1%14 as of year-end 2011. If non-earning assets increased roughly in tandem with the volume of problem loans since then, this ratio would be close to 16% as of June 2012.” (Banking System Outlook: Spain, August 2012.)

**The date of the eurozone’s next financial crisis was brought closer today (May 7th) when Jeroen Dijsselbloem, the head of the Eurogroup, said that there will need to be an in-depth asset quality review of eurozone banks as a preliminary to the chimerical “banking union”. An asset-by-asset review is very different and more granular than the discredited top-down stress tests administered in the past. Of course, such reviews can always be fudged, and I have no idea who in Europe would be qualified to conduct such a review. They would need to import some regulatory talent from the US if they want to be remotely credible.

***Moody’s: “The current recapitalisation effort heightens the risk that subordinated and possibly even senior debt holders are forced to incur losses (“bailed-in”) to reduce the cost to taxpayers of recapitalisation.” Ibid.

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