On Monday I first learned that Spain was to partially nationalise its banking system via the Financial Times Deutschland. The title of this article is the most appropriate I have seen discussing the issue, "Madrid riskiert für Cajas seine Staatsfinanzen", which means "Madrid risks state finances for savings banks". Appropriately, the article began with a photo of the visibly relieved recipients of government largesse. Here is the image via AFP.
Here’s what is happening in Spain. After prodigious growth, due in large part to a property bubble aided and abetted by interest rates in Euroland geared for the slow-growth core of Germany, France, the Benelux and Italy, the Spanish are seeing a horrific bust. Along with the US, the UK and Ireland, Spain is one of the credit crisis’ four biggest losers in the developed world. In each of these nations, the banking system is insolvent, as Mervyn King, the governor of the Bank of England has attested.
During the bust, the cajas, mostly state-owned, were the most reckless of the Spanish financial institutions in doling out loans for property developers and mortgage loans. Now, during the bust, many of these institutions, all but five of which passed the bogus European bank stress tests, are insolvent. The question is what to do about it.
The Irish case is instructive. In anticipating the likely insolvency of Irish institutions in June 2008, I said the following:
This is the core of the problem in Ireland. The housing bust. Prices are falling and will continue to fall for some time. Ireland has seen the fastest housing growth in the developed economy over the past 10 years. Their housing sector will fall more than others.
And with the fall in house prices in Ireland, the pride in its ‘Tiger Economy’ has turned to anger as jobs are lost and Ireland slips into recession. This anger is a large part of the ‘no’ vote on the Lisbon Treaty. It also stems from the fact that people were under the illusion that the good times were going to last forever. And now that its gone a bit pear shaped, people are in disbelief.
In the end, all of this will pass. Ireland will go through its own lost decade much as Japan and Germany did after their own property bubbles in the 1980s and 1990s. However, the underlying dynamism of the Irish economy will help to pull Ireland out of its funk sooner than either Japan or Germany with their statist-lite economic paradigms.
What would be a cause for concern is if Ireland began to intervene in the unwind process, propping up zombie companies and bailing out the financial sector. The U.S. seems on this road as we speak. Hopefully, Ireland will not follow its example. If the calls for government to do something, anything, lead to a statist model of dealing with the bust, expect a very long and difficult decade. [emphasis added]
Let me explain the highlighted part and how it relates to Spain and the other property bust nations. Now that we see all four bailing out their insolvent banks and socialising losses onto the taxpayer, the question should be: what are the likely consequences?
Michael Pettis’ piece on non-performing loans in China this morning has useful lessons here. He writes:
Throughout modern history, and in nearly every economic system whether we are talking about China, the US, France, Brazil or any other country, there has really only been one meaningful way to resolve banking crises. Whenever non-performing loans or contingent liabilities surge to the point where the solvency of the banking system is threatened, the regulators ensure that wealth is transferred in sufficient amounts from the household sector to borrowers or banks to replenish bank capital and bring them back to solvency. The household sector, in other words, always pays to clean up the banks.
There are many ways to make them pay. In some cases, and certainly in the US before the 1930s, banks simply defaulted and their depositors absorbed the full loss. In that case it was the actual bank depositors, mainly households, who directly bore the full cost of the losses, in the form of reduced, or sometimes no, repayment of their deposits.
Largely because this kind of system creates incentives for bank runs, regulators developed alternative systems, by which governments guaranteed deposits and otherwise bailed out the banks, and paid for the bailout by raising taxes. In that case the household sector still paid for the losses, but they did so largely in the form of taxes, and the losses were spread out throughout the population.
Notice that Michael is suggesting that the lesson from the Great Depression was that default and debt deflation leads to bank runs, dead weight loss and a crushing Depression. Policy makers look to avoid this. So when Tim Geithner, a chief architect of the bailout of the insolvent US banks says "The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives." he is saying he believes the bailouts are better than the alternative.
Jusqu’ici tu va bien. But, again, the ultimate consequences of the bailouts are still unknown because the crisis continues. For example, in the US, Bank of America just reported a quarterly $1.2 billion loss due in great measure to mortgage credit writedowns. The bank had $12.4 billion in writedowns on the year and still carries many underwater or defaulted loans at full value on its books.
In each case, in Spain, Ireland, the US, and the UK, the socialisation of losses onto taxpayers and the household sector has meant a ballooning in deficits and national debt. In the U.S. and the U.K., this debt increase has not led to a liquidity crisis as it has in Spain and Ireland, increasing debt service costs. The reason: a sovereign currency controlled by a national government. The central bank can supply unlimited monetary liquidity if need be. In the U.S., the Federal Reserve is actively providing this liquidity via quantitative easing- not in an arms length fashion with the Treasury, I might add. Take this revelation from FT Alphaville, for example, regarding quantitative easing:
The Federal Reserve bought $7.72bn worth of US Treasuries on Wednesday, and specifically $675m of Cusip No. 912828PL8 and some $7bn of Cusip No. 912828PQ7.
Why do we bring it up?
Because the US Treasury only just auctioned off that second Cusip:…
Primary dealers, the Fed’s official trading partners, bought about $14bn of the debt.
Primary dealers are also the financial institutions able to sell US Treasuries to the Fed under the Pomo programme. And boy, did they ever. To the tune of $7bn, or about half of the original amount that they bought just a week ago…
This can go on for a long time and will help keep rates low. If the Fed wanted (or needed) to, it could buy up all of the outstanding Treasury debt in the secondary market. The same is true for the Bank of England. So there is no imminent day of reckoning in these nations. The real worry has to be inflation and currency depreciation.
With the ECB, the Bank of Spain, and the Central Bank of Ireland, you have a problem. The Irish have already nationalised their banks, guaranteeing the deposits and debt of those institutions in the process. This has ballooned the Irish debt ratios from well under the Maastricht 60% debt to GDP hurdle to nearly 100% this year. The Spanish have also seen their debt ratios rise, although not nearly as much to date; debt-to-GDP in Spain is still lower than in Germany, which is well above the Maastricht hurdle.
If the Spanish could adopt the US approach of letting its banks buy national debt at auction and then having the Bank of Spain buy that debt from the banks two weeks later in a round of quantitative easing, I guarantee you interest rates wouldn’t be a problem for Spain. The same goes for the Irish. But the Bank of Spain and the Bank of Ireland can’t do that. And the ECB won’t do that enough to bring rates down… yet. So you have a national solvency problem then.
As I argued with Ireland, the Spanish should have resisted nationalising their banks without forcing creditors to take haircuts first. Moreover, Spanish property prices haven’t fallen anywhere near enough to clear the market, and that means more writedowns are to come. Do the authorities really think they can see this through without vastly more bailouts? And if those bailouts happen, it will surely create a flight from Spanish sovereign debt. But, the Spanish, like the Americans, Irish and British before them, think bailouts are going to work.
As an aside, I should point out that Ireland and Spain never had a ‘profligacy problem’ before the crisis. Just yesterday I was listening to a German Tagesscahau news podcast using this kind of terminology. It was the Germans, the French with the Italians, Greeks and Portuguese which had the deficits pre-crisis. It is a constant source of irritation to me to hear politicians bloviating about reckless policies in this revisionist way. Even now, German politicians are saying ‘reckless fiscal policy caused the crisis’ when it is clear that the countries most affected like Ireland and Spain were meeting all of the Maastricht criteria while the Germans were not. Clearly, the euro countries are going to try to shoehorn deficit language into its new monetary and fiscal arrangements at the behest of these politicians, meaning the likely solution will be misguided. Rant off.
All of this is a non-sequitir now because the Spanish have foisted the liabilities of the cajas onto the sovereign. Before the partial bailout, one could have argued that the sovereign and financial sector debt issues were separate, that there were limited contingent liabilities for the sovereign. When looking at Spanish debt, you now have to see it as a consolidated national/financial sector play. The same is true in Ireland. This is not the case in the US and the UK where, ironically, the sovereign currency would have made this kind of a bailout less problematic. And because the financial sectors in Spain and Ireland are insolvent, that threatens the national governments with insolvency.
This makes Spanish sovereign debt toxic. It is not AA-paper by any stretch of the imagination, less so now than ever. And given the "Debt Dynamics In Europe" with increasing interest rates, large primary deficits, and negative changes in GDP levels in the periphery, there is no escape from some form of default or bailout.
Two months ago, I wrote Three options for the euro zone: monetisation, default, or break-up, saying the following:
My takeaway here is that any sort of [euro zone] dissolution is problematic. For example, in my German-framed post "How Belgian debt, Italian anarchy and Greek profligacy lead to economic chaos in Europe" I commented on how Belgium and Italy, founding members of the EU, were also major debtors. Wouldn’t any currency union with Germany have to have one of these countries in it? From a political perspective, it would be disastrous not to, as it would be seen as an act of German economic aggression against the rest of Europe.
We are now seeing euro zone divergence as investors are becoming increasingly aware of the different risk profiles within the euro zone core. But even France and Austria have worsened here. Finland, Austria, France, Germany, and the Netherlands are probably the core of the less indebted nations (see More Charts on Debt in Europe, Germany and the Periphery). Could we see a union of these nations along with Luxembourg, Cyprus, Slovenia and Slovakia (and maybe Estonia) but leaving out two of the founding members of the EU? I doubt it seriously. So, either the euro zone dissolves entirely or it remains intact and creates more mechanisms that bind it together. I still think it will be the latter.
My view is that some combination of monetisation and default is the most likely scenario for Europe.
Now that the Spanish have decided on a Caja bailout, I see monetisation as an increasingly likely option. The Irish central bank is already printing money. I expect the same from the Bank of Spain and the ECB in due course. Given the talk about fiscal profligacy in the euro zone, I also expect the euro zone to attempt to amend the Lisbon Treaty to facilitate a new bailout mechanism only along German lines i.e. First the penalties, then the European Monetary Fund. But that will almost certainly not be enough to solve this. Greece will default. At this point, Ireland will likely default as well. Portugal will be forced into a bailout under the existing EFSF mechanism. That leaves Spain. I am less optimistic here now that we see the Caja recapitalisation scheme as the first move. It’s another attempt to paper over the problem. Meanwhile the Spanish government has already pulled two debt auctions slated for this month, because the interest rates were too high. Eventually, the Spanish will have to face the music and seek a bailout. The EFSF is too small to facilitate this. So, if more plans have not been put into place, it is at that point that crisis will re-emerge as I indicated in the origins of the next crisis. The earliest I see the Portuguese and Spanish bailouts coming into play is the second half of 2011. The defaults would be later. Euroland can handle Portugal. Hopefully, the Spanish crisis will not be a 2011 event because there is no time for Euroland to get adequately prepared for a Spanish bailout in that time frame. In that event, my cautious optimism will look misplaced.