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European Debt Crisis

Staring into the Abyss


 Events in Europe have developed far more quickly than most people expected or hoped for (at least the European politicians):

  • The Greeks have failed to form a coalition government. Last minute desperation talks where scuttled when Alexis Tsipras of the anti-bailout Syriza party refused to even attend. The Greek President must now attempt to form a care-taker government through consensus or, barring that, through a mandate from the Council of State or Supreme Court. In either case, it will be a wholly ineffectual government unable to pass needed legislation or enforce painful reforms; jeopardizing the agreement with the Troika until the new elections. These will probably be held on June 10th or June 17th. Greece will run out of money in early July.[1]


  • Even assuming that the next round of elections produces a winner, it seems likely that this will be Syriza. Party leader Alexi Tsipras has stated that he wants to keep Greece in the euro, but rejects the current bailout conditions. There are face-saving options that allow a “renegotiation” of the bail-out terms while also allowing the Germans to claim that the essentials of austerity are still in place. It depends on the willingness of Mrs. Merkel to be flexible and not show Greece the door;
  • Mrs. Merkel, however, seems unlikely to be overly keen on giving Greece a pass. Her handpicked candidate and possible successor, Norbert Röttgen, was crushed by the rival SPD in the important North Rhine-Westphalia state. German political analysts attribute this mainly to the high standing enjoyed by the Socialist candidate, Hannelore Kraft, rather than to a repudiation of Mrs. Merkel[2]. In fact, Mrs. Merkel and her policies continue to enjoy high levels of support among German voters. Nevertheless, Mrs. Merkel is not likely to risk a repeat of the beating in NRW in next year’s general elections by suddenly “going soft” on Europe[3]. If Mr. Hollande can hope for some crumbs to save face, Mr. Tsipras can expect all the warmth of a Siberian winter when he visits Berlin;
  • Germans are ready to show a recalcitrant Greece the door. Common Sense has said since last year that the cost of covering the Greek exposure in the German banks was far less than a never ending wealth transfer from north to south, and it is even less now. Mr. Tsipras will quickly learn that the bailout conditions were a diktat, not a negotiation;


  • The slow-motion train wreck called the Spanish financial system has reached the point where a bailout of the Spanish sovereign is now inevitable. There is not much point in going into the sordid detail of who is responsible for this black hole: suffice to say that there is enough blame and to spare for the bankers, central bankers and politicians of both parties. There also isn’t much point in looking at why Spain is now undertaking its fourth reform of the financial system without much more prospect of fixing it than the previous three: suffice to say that the government is using creative accounting (like the systematic understating of non-performing loans through recategorizations) and (like plundering the deposits insurance fund) to avoid the perception of new injections of public funds into the banking system[4];


  • Given the vast size of the non-performing loan book in Spain, and the deterioration of credit quality even in non-real estate lending due to the worsening economic situation (see previous article for detail), a bailout of the Spanish financial sector seems inevitable. [5] This will, in turn, make a bailout of the Spanish sovereign necessary as well, since the public treasury would need to borrow heavily to shore up the banks and that can only come from Europe and the IMF at this point. The “men in black” will soon be landing at Barajas airport;


  • The worst part of the Bankia disaster is the vast damage it has wrought on Spain’s reputation as a serious country. For one thing, the Minister of the Economy, Luis de Guindos, had declared the solvency of the Spanish financial system (April 27th) not two weeks before Bankia cried uncle (May 10th) ; for another, it has become very clear that not only did the Bank of Spain knowingly collude with the creative accounting which permitted the merger of the various cajas composing Bankia to go forward, but that the regulators are almost certainly guilty of outright fraud by permitting Bankia to go public with the figures it published in its prospectus. Thousands, if not hundreds of thousands, of small investors, mostly Bankia customers, are losing their life savings thanks to what can only generously be described as chicanery. It is no wonder that European partners have insisted on an independent audit of the Spanish banking sector – an unheard of invasion of national sovereignty for a serious country, and as good as a slap on the face to Mariano Rajoy’s reputation. It is safe to say that the honeymoon is over.


  • Indeed, markets continue to punish Spanish debt. Since Mr. Rajoy’s faux pas in Brussels at the end of February, when he tried to unilaterally change the deficit target for Spain, markets have viewed Spanish bonds as toxic. The relentless pace of bad news  is driving the 10-year bond above 6.25%, but more worryingly, the 2-year bond has doubled in price from a low of 1.99% at the end of February to 3.98% today.


  • It seems Europe is heading into the perfect storm this summer. If Greece exits the euro, it will be almost impossible to stop the contagion from spreading to Spain and Portugal, and probably Italy. Spain, at least, may have to impose capital controls to prevent massive flight of deposits (the infamous corralito).Unless European leaders show far more vision and decisiveness than they have over the past 2 years, we are going headlong into the Abyss.

Sources and Notes:

 [1] Petrakis, Maria, Weeks, Natalie, and Bensasson, Marcus, “Greek President Proposes Gov’t of Non-Politicians,”, Bloomberg BusinessWeek, 15 May 2012
[2] Nelles, Roland, “Germany’s Social Democrats Return to Relevancy,” Spiegel Online International, 14 May 2012
[3] Crossland, David, “Merkel Won’t Budge on Austerity Despite Setback,” Spiegel Online International, 15 May 2012
[4] Hugh, Edward, “It’s Time to Stop Using Chewing Gum and Chicken Wire in Spain,” EconoMonitor, 13 May 2012
[5] Roubini, Nouriel and Greene, Megan, “Get Ready for the Spanish Bailout,” EconoMonitor, 09 May 2012

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