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That Vast Sucking Sound


It’s the sound of the bulkheads giving way in Europe and the waters flooding in. Germany’s “Dutch boy” approach to crisis management – putting fingers in the holes in the dykes, while the dykes themselves are crumbling – has now brought Europe to the edge of disintegration. And more quickly than most people would have suspected.

It is not just markets that are panicking. World leaders are now making apocalyptic statements which would have been inconceivable even 2 months ago. The multiple hammer blows in May of Greek electoral paralysis, Bankia in Spain, and now a Cypriot bailout has reinforced the cycle of negativity and defeatism to new lows:

  • Mario Draghi, head of the ECB, has said that the current structure of the euro is rapidly becoming unsustainable[1];
  • Robert Zoellick, departing head of the World Bank, has called on Europe to “break the glass” in handling the current crisis and to implement large, visionary steps before it is too late[2];
  • Silvio Berlusconi, Italy’s former PM and still the leader of the largest bloc of delegates in the Parliament, has called on the ECB to either become the lender of last resort, or for Italy to say “ciao” to the single currency[3];
  • George Soros, guru of global finance, has said that Europe (Germany, in fact) has three months to save the euro before markets become so pessimistic as to make a rescue impossible[4],

Spain: Leading the Way

While Greece is still the leading candidate for an early euro exit, it is Spain that has markets truly worried. Unlike  Greece, whose departure is already priced into the market, Spain’s economy is too large and too interconnected to the rest of Europe to simply “go it alone”. And despite Italy having been an early target for markets, Rome’s fundamentals look far better than Madrid’s[5]

It is also a question of leadership. Mario Monti, though not elected democratically, enjoys a high reputation as a “technocrat” and so far has managed both markets and his volatile countrymen with remarkable adeptness. Mr. Rajoy, though winning an absolute majority in his country’s general elections last November, has so far underwhelmed domestic and international observers by breaking numerous campaign promises almost immediately, numerous gaffes, and a remarkable lack of touch in Parliament and with fellow Spaniards.

Notably, Mr. Rajoy has been incredibly tactless in his public declarations:

  • In March, a day before a Euro summit meeting, Mr. Rajoy announced a unilateral revision of the Spanish debt targets for the year, sending markets and EU partner into turmoil;
  • Mr. Rajoy refused to release Spain’s austerity budget until after the regional elections in Andalucía, to the anger of Brussels, and to no avail – the Partido Popular won a plurality, but he opposition Socialists nevertheless were able to form a minority coalition government of the left;
  • On April 27th, Spanish Economy Minister Luis de Guindos announced that the country’s financial system was perfectly solvent. On May 10th, Bankia requested €4 billion in equity from the state to cover loss provisions on non-performing real estate loans. That was subsequently raised to $23 billion. Brussels was so upset that it demanded an independent audit of the Spanish banking system by two separate companies;
  • On 28 May, Mr. Rajoy said that sharp increase in the risk premium on Spanish bonds had nothing to do with the Bankia rescue. In an effort to calm the markets, Mr. Rajoy only succeed in making himself ludicrous: either he believed that investors are monumentally stupid, or he displayed an inconceivably vast ignorance of markets. The risk premium rose further that day, needless to say[6].
  • Mr. Rajoy has insisted that there is no capital flight from Spain and that Spain will not require an EU-led rescue. Given that the FROB, the bank restructuring fund, has only €5 billion left to it, and Spanish NPL’s sum to hundreds of billions, it is hard to see how the second point is possible. ECB data also seems to contradict Mr. Rajoy on the first point;
  • So abysmal has Mr. Rajoy’s handling of his country’s crisis been to date, that even the ultra-conservative Wall Street Journal has suggested that he has been “more useless” than the Zapatero administration[7]. Given the ideological divided between the WSJ and the Spanish socialists, as well as the immense bumbling of the Zapatero government, such a declaration is astonishing, to say the least.

Capital Flight

Indeed, capital has been flowing out of the Eurozone periphery to the “core north”, not in a trickle, but in a flood.


Meanwhile, foreign investors have been shedding Spanish bonds and Spanish banks are no longer able to take up the slack, leading to an increase in the bond price. Spaniards are focused on the risk premium of the 10-year bond, but far more worrying is the fact that the 2-year bond has shot up in price far more quickly. The Spanish 2-year bond has now lost any discount it had against the riskier 10-year issue, indicating that investors are now getting seriously worried about “the short-term”.


Meanwhile, Angela Merkel seems intent on ratcheting up the pressure on Madrid just a wee bit more. Rather than permit ECB intervention to cap Spanish borrowing costs, Germany’s Chancellor seems intent on making sure that Mr. Rajoy implements even greater austerity measures and reforms before getting any relief[8]. One could argue that Germany is being blind to the possibility of Spanish default, but on the other hand, Spain has demonstrated a cavalier lack of seriousness over the past four years in actually bearing the pain of deep reforms.

And speaking of capital flight, the anemic economies of the UK and US remain beneficiaries of Europe’s woes as investors abandon the euro in droves to seek safer investments, even in negative interest German bunds.


Europe needs a Constitutional Convention and a definitive agreement to form a United States of Europe before the end of the summer. Just convening such a convention would buy Europeans a few months of tolerance from the markets. The alternative is disastrous to contemplate: for the world economy, for democracy in Europe and for a global system based on liberalism and free markets.

Mr. Obama, your reelection prospects run through Brussels. Are you listening? Time to intervene decisively.

Sources and Notes:

[1] Rooney, Ben, “Draghi Says Euro Is ‘Unsustainable’ Without Action,” CNN Money, 31 May 2012
[2] Torbati, Yaganeh, “European Leaders Should Ready Big Steps – Zoellick,” Reuters, 31 May 2012
[3] Totaro, Lorenzo and Donovan, Jeffrey, “ECB Must Print Euros Or Italy May Say ‘Ciao:’ Berlusconi” Bloomberg, 01 June 2012
[4] Levine, Deborah, “Europe Has 3 Months To Address Crisis: Soros,” MarketWatch, 03 June 2012
[5] Italy has far lower unemployment, a primary fiscal budget in surplus, a current account which is almost balanced and a larger pool of domestic reserves to draw from to finance public and private debt.
[6] “The Bankia Catastrophe,” El País, 29 May 2012
[7] “Bank Bail-Out Lessons,” Review and Outlook, Wall Street Journal, 31 May 2012
[8] “Berlin Wants Spain To Accept Bailout Money,” Der Spiegel Online, 04 June 2012

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