Spain: It is worse than is imagined

First of all, my apologies for the limited posting. I have been working on a project which has seen me working fourteen hours a day, and which still has some time to run. My second apology is that, despite my good intentions, this post will again be about the Euro crisis. The first point is that, after the election, the Greek crisis has (at least temporarily) moved off the centre stage, to be replaced with Spain. In particular, the bailout of Spanish banks indirectly through a loan to Spain saw the loan given preferred creditor status:

More worryingly, for holders of Spain’s national debt, this new bank-bailout debt (which is owed by the country of Spain, remember, since the money isn’t going directly to the banks) carries something known as preferred creditor status. That means that if push comes to shove, Spain will repay the bailout debt before repaying any of its bonds.

To take a simplified example: if Spain has €100 billion in bailout debt due and another €200 billion in bond payments due, and only has €150 billion on hand, then an equitable treatment would be to ask each of its creditors to take a 50% haircut. But with preferred creditor status, Europe will get its €100 billion back in full, and bondholders would have to take a 75% haircut. So holding Spanish bonds just became significantly riskier, this weekend.

That this would ratchet the crisis upwards was predicted by many commentators, and the sharp increase in the cost of Spanish borrowing proved the critics to be correct:

As Spain’s creditworthiness deteriorates, bondholders are wary of being subordinated to the EU agencies that might demand priority repayment for supplying aid to the nation. Lenders to Greece lost more than 70 percent of their investments when the nation restructured its debts, while the ECB and other official lenders were exempt from the discounts. 

What finally dragged me back to the posting was the mooted bailout of Spain at the G20 summit. This from the Guardian:

Angela Merkel is poised to allow the eurozone's €750bn (£605bn) bailout fund to buy up the bonds of crisis-hit governments in a desperate effort to drive down borrowing costs for Spain and Italy and prevent the single currency from imploding.

Germany has long opposed allowing the eurozone's rescue fund, the European Financial Stability Facility, to lend directly to troubled eurozone countries, fearing that Berlin would end up paying the bill, and the beneficiaries would escape the strict conditions imposed on Greece, Portugal and Ireland.
But Merkel has come under intense pressure as financial markets have pushed up borrowing costs for Spain to levels that many analysts see as unsustainable.

Analysts are likely to see the decision as the first step towards sharing the burden of troubled countries' debts across the single currency's 17 members, though it falls short of the "eurobonds" proposed by the European commission president, José Manuel Barroso.
A spokeswoman for Merkel said: "Nothing has been decided yet."

The key point in the report is the final point about nothing being decided yet. As Ambrose Evans-Pritchard correctly identifies, there is a big gap between rhetoric and reality:

From what we know, the eurozone's leaders aim to deploy the European Stability Mechanism (ESM) to cap borrowing costs for Spain and Italy by purchasing sovereign bonds on the open market.

Unfortunately, the ESM fund does not yet exist. It has not been ratified by Germany and Italy. When it does come into being, it won't have much money. It has a theoretical limit of €500bn -- a nice wish -- but its paid up capital will start at just €22bn.

Of course, the rescue may be possible, but it nevertheless remains improbable. The major concern that the proposed bailout raises is that any such bailout, should it take place, will serve to spread the problems of Spain into the core of the EU. That this dangerous solution is now being discussed only highlights the degree of the crisis in Europe. My own belief is that the prospects of such a bailout are remote, and that the scale of the problems in Spain have not yet been fully acknowledged. In particular, there are concerns about the true scale of losses for Spain's banks. As the Economist reports, construction and real estate loans grew from 10% of GDP in 1992 to 43% in 2009. The same report highlights the degree and severity of the real estate bust in Spain, and the various (self-defeating) methods the Spanish banks are using to hide or delay the losses.

It perhaps comes as no surprise that there are rumours of delays of an audit of the Spanish banks, although the government denies any delays and is still promising to publish results at the end of July. Even when published, it is not clear how real estate assets might be valued in the context of the broadening problems and downwards spiral of the Spanish economy; the spiral will continue to impact upon real estate prices, and any assessment will only reflect, at best, a guess at the non-performing and underwater loans going forward. In other words, the losses in the Spanish banks are likely to be far greater than is currently accepted, and the Spanish economy likely has a long way to fall yet. When so much of an economy is dedicated to real estate, and real estate goes bust, the damage is going to be huge. As such, even if a large rescue fund were put together, however improbable that prospect remains, the scale of the rescue needed may be larger than is currently imagined.

One of the themes of this blog has been the potential for borrowed money to see a restructuring of an economy to utilise the borrowed money. In the case of Spain, the economy restructured around a real estate boom, and the economic structure is now unwinding. When seeing the Economist figures, it is apparent that the only way that Spain's economy can avoid a horrendous crash is to maintain the levels of borrowing that supported the economic structure. However, to do so would be to further entrench the problem that the lending is supposed to solve. At some point, Spain must restructure its economy away from real estate, and that is a transition which must, absolutely must, be a painful process. Too much of the economy was directed at activity that was almost entirely reliant on borrowing, and there is no escape from the fact that this is inherently unsustainable. The problems of Spain run deep, and the best case scenario is to delay the resolution of the problems a little longer, and in doing so just make the problems even greater in the end. The solution to too much borrowing, is not to borrow more.

Eurocalamity

I have been reading many views from an endless number of commentators on the potential roll on effects of a Euro break-up; a new language has sprung up around the Euro crisis, such as the now widely used Grexit, and even less pleasant sounding Spexit (which does not seem to have caught on). What to make of all these scenarios that are being trotted out?

My answer makes this a relatively (and unusually) short post; the answer is that nobody really has any idea at all, and if they say they do, then they are genuinely geniuses, have an outstanding set of tarot cards, or they are just plain guessing. The reason why I argue this is very straightforward. As I argued in my last post, we are entering a special set of circumstances. In particular, the drivers of the world economy long ago ceased to be about market fundamentals, and is instead dominated by state action; whether fiscal or monetary policy. This is largely the result of what I termed as extreme policy making setting up a dynamic in which the extreme policy enacted in economy x, sends ripples out into the markets, leading to a further extreme policy response from country y, which in turn washes back onto economy x, which reacts with further extreme policy.....and so it continues with all of the major economies now acting with increasingly extreme policy to a point where markets are now 'nationalised'.

There are therefore some very basic reasons why it is not possible to predict the roll on effects of a Grexit, or any other exit, from the Eurozone. The only certainty is that, as and when these events take place, the economic policymakers will not stand back, but will again intervene in an even more dramatic fashion, in an attempt to 'save' the world economy. Here I am assuming that the coming Euro-calamity will actually take place in the coming month/s. Quite suprisingly, I am in rare agreement with Paul Krugman that there is currently no plausible avenue out of the current path to crisis in Europe. However, I put a small caveat that there just might be a new action from policymakers, and not just those in Europe, and these might still hold back the tide a little longer.

Like many commentators, I am tempted to hazard a guess at possible outcomes, but keep on trying to grab hold of any scenario which is driven by clear principles, theory or the market. However, as I argued in my last post, any theory or generalisation from past events has been torn up along with the economic textbooks.

Instead of finding any clear scenario, I simply finding myself contemplating what will be done as a large ditch attempt to turn back the tide, and how this will set up even more unpredictable outcomes. One obvious answer will be that the printing presses will roll, and not just in Europe. We might even see concerted and coordinated central bank responses, including the Euro area, Japan, China, the US and the UK. In all events, the central banks will continue to at least try to stand behind the banks, perhaps producing something like an LTRO on steroids.

Perhaps the most interesing question will be the timing of action. At what point will policymakers act; before Grexit, during Grexit, or once the consequences of Grexit are apparent. Also, although Grexit is often seen as the forthcoming trigger for crisis, it may be that the trigger will emerge in one of the larger Euro economies, with Spain, Italy, Portugal, Ireland, and even France, all looking fragile. There is a real risk of events overtaking the current 'magic' date of the Greek elections.

Regardless of the 'trigger', if my guess is right, and that there will be a coordinated response, there will likely be a positive spike upwards, as relief grips the market. Commodities and stocks will likely briefly soar in so-called safe haven markets. As with previous state interventions, eventually the markets will fall back down, or even crash. Alternatively, if policy is uncoordinated, then there is likely to be a series of small market rallies, which will extinguish themselves as quickly as they started. This might encourage yet further extreme policy responses. Running to gold is another possibility, as gold in some respects is entirely irrational and that very irrationality is also gold's strength. It just feels safe when all else feels unsafe*.

Nevertheless, this is all speculation, and the only certainty in the policy response is that there absolutely will be a policy response, and it will almost certainly be extreme. As such, the ripples of the actions of each of the policymakers will ripple out and interact in the global economy, and will likely further swamp any market signals that might remain. It is for this reason that I emphasise that my commentary is nothing more than speculation; I am guessing.

As such, we are now in the uncomfortable position that, come what may, the world economy now no longer sits in the hands of markets, firms, banks and individual actions of economic actors. Instead, we now wait upon the action of states to determine the next steps in this economic crisis. The track record of states at managing the crisis is not encouraging. They have tugged and heaved on both fiscal and monetary policy levers, and still the situation in the world economy swings back towards negative outcomes. With each swing back to negative from each policy response, the stakes are being raised ever further. Again, in my last post, I discussed how the LTRO has compounded the problems in Spain, albeit giving both the Spanish banks and state a very, very brief reprieve.

My final guess is to suggest that, at the very least, the economic ride of the coming months will be a turbulent one. In this, I think I am in agreement with everyone. For the rest, and my own comments, treat is all with a big pinch of salt.

* I do not believe that gold is some kind of 'special' form of 'money', but its history as money is what I believe gives it the feeling of safety. 

Note: For my next post, I will try to get away from the Euro crisis and instead take a more analytical look at China or the US going forwards. The European crisis is not the only issue of interest. However, for all my good intention, I keep being distracted by Europe and, for obvious reasons, may be pulled back to Europe. If I do return to the European situation, rather than a very general post such as this one, I will try to focus on some of the detail of the situation (country/market/institution etc.).

Nationalisation of Markets

Every once in a while, the Economist magazine gets it right. In this case, the point is made in the Buttonwood column, titled 'The Nationalisation of Markets':

EACH step taken by the authorities over the past five years has been designed to prop up the economy and save the financial system. But the cumulative effect has been the creeping nationalisation of markets. Central banks are the biggest players in many rich-world government-bond markets. Equity markets seem to perk up only when central banks are expanding the money supply. And banking systems are incredibly reliant on implicit or explicit government support.

It is a very worrying point, and reflects the discussion of Richard Duncan that I considered in a post a while ago. I summarised his position as follows:

The most interesting point about the talk is the dispassionate approach to the current and future situation. He simply accepts that, in a few years time, the world economy will have a horrendous crash, that states are now fully in the driving seat of the world economy, and most importantly that investment choices should now be based upon state action rather than market drivers. In simplistic terms, whenever a government prints money, his answer is buy, buy, buy!

When listening to Richard Duncan, some might suggest that his view is an outlier, or even outlandish. However, we know that, when the Economist reports the same thing (albeit in a column rather than an editorial), there has been a shift in broader perceptions about what is going on in the global economy. For regular readers of the blog, the idea that states are in the driving seats is nothing new. For example, in January 2010 I had the following to say, in a post titled 'Masters of the Universe':

I am not sure that anyone can actually pull apart the increasingly tangled knots between the financial system and the state. They appear to be mutually dependent, with the state providing guarantees, and the financial system funding the state with financial support through bond purchases to shore up their capital ratios, and so forth. How convenient that bank capital adequacy encourages the holding of government debt. Going back to Renaissance Italy, bankers were granted licenses and monopolies if they were willing to lend to the state on preferential terms. Nothing has changed. 

I described how governments were intervening in ever wider areas of their economies. I went on to say the following:

Ambrose Evans-Pritchard is right when he suggests that we should rip up the economics textbooks. What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.

A simple example is the relatively recent Japanese policy of printing money to stave off deflation. With rock bottom interest rates, the newly printed money was simply exported into other countries in the so called 'carry trade'. Within Japan, deflation persisted, whilst the newly printed Japanese money appeared in other countries, contributing to the process of asset price inflation in the countries that were the destination of the carry trade. The policy levers were pulled, but the consequences were far from those that were intended.

What textbook might be able to predict the outcome of such a dynamic system? Despite this, we see the policymakers pulling on their levers, and offering confidence that they know what they are doing. Apparently, the masters of the universe are in control.

I wrote this a long while ago, and we can now see that states are now firmly in the driving seats of global markets. The problem that I long ago identified is now playing out on the world stage. The 'masters of the universe' kept pulling on their policy levers, the ripples radiated out, interacted with the ripples of other policy levers being pulled, and the result is ever more pulling on policy levers. That we are now in a position in which governments are driving markets is unsurprising, and was the inevitable result of the dynamic that states set into action.

The fundamental problem is that, as the world situation deteriorates, the policy actions are becoming ever more extreme. The LTRO was but one example of the escalation, and there is surely more to come. The worrying part of these actions is that those who are pulling the levers are doing so in the belief that they are taking actions to correct problems in their economies, when the reality is that they are now fundamentally in the driving seats of their economies, and the problems that they seek to resolve are problems that they, and their colleagues in other countries, are creating. The markets are now resting on government policy actions, and they created the situation where this was the case. It did not happen by magic, but specifically because the extremes of policy interventions were overtaking 'normal' market signals.

At this point, the sane response would be to pull back. However, as the 'masters of the universe', policy makers are simply too arrogant. They think that they know what they are doing. They cannot see that the current parlous situation is being derived from their own policy responses. They are dealing with a system of such huge complexity that each action that they take can never have a predictable response.  This has always been true to some degree, but the extremes of current policy have changed the degree of the outcomes, and the intensity and the complexity of the feedback from each policy provision. A very simple illustration can be found in the LTRO, as I discussed a short while ago:

The problem is simple. No external investors believe that there is any real commitment to policy that might allow borrowers to pay back their debts. The only way any sane person will purchase the debt is if it sold at fire-sale prices, which means big losses for current holder of 'periphery' European debt. Instead, the only way forwards is for the European Central Bank (ECB) to continue its backdoor bailouts, by continuing to lend to bankrupt European banks so that they can buy their home country sovereign debt, and thereby expose themselves to ever more bad debt.

Having bought so much euro zone debt, banks in the periphery are now major holders of their governments’ liabilities and will be sitting on losses, given recent selling of peripheral debt, according to Das.

“As with the sovereigns, the LTRO does not solve the longer term problems of the solvency or funding of the banks, which now remain heavily dependent on the largesse of the central banks,” said Das, who fears deep recession. “It is a government-sponsored Ponzi scheme where weak banks are supporting weak sovereigns, who in turn are standing behind the banks — a process which can be described as two drowning people clinging to each other for mutual support.”

The analogy in the quote is quite apt. For those that have not read about it, the LTRO (Long-Term Refinancing Operation) is the ECB's complete abandonment of Germanic prudence, whereby bankrupt European banks are being bailed out by the ECB. As one wag put it, the ECB is accepting bus tickets as security for the lending at below market rates. The really stunning part of this is that it is possible to find commentators and analysts who support this lunacy. I mean really, bankrupt sovereigns supported by bankrupt banks, which in turn are supported by bankrupt sovereigns? And this is a good idea?

A good idea? Pour money into banks in countries like Spain, encourage the banks to buy their own sovereign debt and this will fix both the states and the banks. The result of this madness can be seen emerging into the financial headlines. When we read those headlines, we absolutely must remember that someone in a meeting/presentation actually said this was a good idea. This person was one of the self-selected 'masters of the universe', undoubtedly supported their good idea with reams of economic theory, but nevertheless was unable to foresee that their actions have left, for example in Spain, governments and banks in worse condition than before they started.

And here is the rub. As the situation continues downhill, there will likely be another policy response. It will now, as a matter of necessity, have to be even more extreme response than the last policy response. The problem has grown larger, not smaller, and the only 'solution' to the ever growing crisis will be a larger and more extreme policy responses. The illusion of control of the situation continues, but those who think they are in control just do not have any idea (or acceptance) that they are the problem, not the solution.