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It was
announced this weekend that Spain will receive $125 billion (100 billion Euros)
to recapitalize their banking system. The money for the bailout will be
channeled through the Fund for Orderly Bank Restructuring (FROB), whose funds
count towards public debt.
The
consequences will prove to be dire from bailing out banks by increasing
European sovereign debt levels. Nations already teetering on bankruptcy will
now borrow more money at higher market rates and then hope to get paid
back a measly 3% from Spain. In spite of that ridiculous
"solution", the current view among global financial markets is that
Europe can solve its problems by applying the same elixir as the U.S. did
during our credit crisis back in 2008.
Namely, the
European Union now claims that by ring-fencing their banking system, starting
with Spain, the European debt crisis will simply disappear. By adopting this
philosophy, politicians have illustrated their complete lack of understanding
regarding the true structure of the problem.
Regardless of
how successful the bank bailout will become, it ignores the difference between
the American credit crisis of 2008 and the current debt crisis over in
Europe. The U.S. housing and credit crisis was primarily a banking problem
caused by eroding real estate related assets that rendered many banks
insolvent.
Therefore,
all that needed to be done was: Have the government borrow money to inject
capital into banks, for the Fed to liquefy the financial system, to increase
the level of deposit insurance, to guarantee bank debt and interbank lending
and then to repeal the mark-to-market account rule that required bank assets
to be valued at their current market price. Problem solved. Except that we
expedited the U.S. a few years closer to a complete currency and bond market
collapse ... but that's a commentary for another day.
The basic belief now held on both sides of the Atlantic is that if you can
fix the banks, you've solved all of the problems. But the U.S. enjoyed a debt
to GDP ratio of just 60% at the start of our credit crisis -- a level that
would have even met the qualifications of the Maastricht Treaty. And it owned
the world's reserve currency as well.
At that time, the U.S. was able to borrow the money needed to recapitalize
the banks. That allowed the U.S. a few more years before having to address
the unsustainable level of aggregate debt. It basically amounted to a balance
sheet shell game where the private sector's bank debt was dumped onto the
public sector, which now has a debt to GDP ratio of over 100%. So I guess we
shouldn't try that trick again.
Turning to Europe today, their gross debt is just about 90% of GDP and the
euro isn't used as the world's reserve currency. The onerous level of public
sector debt was already high enough to send bond markets in Southern Europe
and Ireland into full revolt.
So here's the
big difference; U.S. financial institutions were insolvent due to
rapidly-depreciating real estate related assets. But European banks are
insolvent in part because they own the bad debt of insolvent European
nations. If Europe's sovereigns are already insolvent because they owe too
much money, how can they go further into debt to bail out their banking
system?
Even if they
are willing and able to borrow more money, their debt to GDP ratios would
soar even higher and cause further downgrades of their debt. Therefore, sovereign
bond prices would decline much lower and cause Europe's banks to fall further
into insolvency.
The truth is
that the only entity outside of China that can bail out Europe is the ECB.
That, I believe, is the eventual "solution" that will be applied to
Europe's mess. Of course, the inflationary default on European debt will
wreak havoc on their economies, bond markets and currency.
So there is
simply no magic bullet or elixir that can save Europe from a tremendous
amount of pain -- and you can add Japan and America into that mix as well.
The market rallied last week in anticipation of some banking solution in
Europe -- or at least the re-entry of massive central bank intervention. All
we have right now is an insufficient bailout of certain Spanish banks, which
will do little to address spiking debt service payments on European bonds and
nothing to bring down debt to GDP ratios of other European nations.
However, once
this latest "solution" fails as well, all eyes will turn back
toward Mario Draghi and his printing press to
finally attempt to inflate the debt away.
After the
euphoria from the Spanish bailout ends, look for sovereign bond yields to
once again rise, along with credit default swaps on
that debt. Also, look for the dollar to carry on rising against the euro, and
for global markets to continue lower.
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