RUTHFULLY YOURS

Great swathes of southern Europe operated as a fiscal scam within the European Monetary Union, we know now. Greece lied about its economy to get into EMU and then ran its national debt up to 130% of GDP to feed a kleptocratic patronage machine. Spain’s banks fed a real estate bubble that, in relative economic terms, is three times as big as America’s, by issuing bank bonds that amount to an astonishing 110% of GDP. The difference between America’s subprime bubble and the European equivalent is that the latter was concentrated in a few countries where the government and financial institutions conspired to misuse the borrowing capacity they derived from membership in the monetary union to turn the local economy into a Ponzi scheme. Greece is now bankrupt, with its debt worth 20% to 30% on the dollar depending on the trading day.

Now the European Commission bureaucracy wants European countries to cede sovereignty to Brussels in return for a German-financed bailout. Germany, the only major European economy with financial resources to spare, faces an unpleasant choice: either it will assert its own interest and refuse to bail out the Bernie Madoffs of Club Med Europe, or it will endorse the bureaucracy’s pitch to dissolve Europe’s states into a regional government. Germany’s conservative newspaper Die Welt broke the story over the weekend, and today’s Wall Street Journal writes:

Germany is sending strong signals that it would eventually be willing to lift its objections to ideas such as common euro-zone bonds or mutual support for European banks if other European governments were to agree to transfer further powers to Europe.

If embraced, the move would deepen in fundamental ways Europe’s political and fiscal union and represent one of the boldest steps taken by the bloc since the euro was launched. Germany has never before been willing to discuss the conditions it believes necessary to move toward assuming common risks within the euro zone. Now, although the end may be a long way off, it appears willing to discuss those conditions.

“The more that other member states get involved with this development and are prepared to give up sovereign rights to get European institutions more involved, the more we will be prepared to play an active role in developing things like a banking union,” a German official familiar with the discussions told The Wall Street Journal. “You can’t have one without the other.”

The Obama administration, George Soros, the International Monetary Fund, and liberal opinion in general believe that no crisis should be wasted: an enlightened supranational bureaucracy should emerge as the ruler of Europe.

I find this repulsive for the most elemental of reasons: the further that government is removed from the electorate, the more prone it is to abuse. The Brussels bureaucracy is responsible for the catastrophe in the first place, and one doesn’t normally give the gasoline monopoly to a bunch of arsonists.

As an old investment banker, though, I think that consolidating all the European scams into supranational entities will fail disastrously. The lifeboat itself will sink under the weight. Some of the scams are simply too outrageous to be rescued. The same Keynesian quackery that has kept the US in recession for the past four years festers among the Eurocrats.

In today’s Asia Times, I published an open letter to German Chancellor Angela Merkel proposing that Germany take the situation in hand instead. Spain can’t be bailed out; France must be, at least in part.

Here are some extracts from my open letter:

….Ultimately, you will have to sacrifice Spain. That will compromise the French banks, which in turn will require German support. Spain is unsalvageable. It is better to take the pain early and deliberately, rather than later and chaotically. Dealing expeditiously with Spain, moreover, should convince Italy to adopt the reforms which can prevent it from following Spain and Greece into de facto national bankruptcy.

The facts are that:

• Spain’s construction sector dominates the national economy.
• Delinquent loans to the construction sector reportedly total about 20% of GDP, and probably exceed twice that amount.
• The debt of Spanish financial institutions stands at 109% of GDP, double the ratio in France or Germany, and triple the ratio in the United States.
• The debt of Spanish financial institutions since 2003 grew at twice the rate of the US or the UK, and four times the rate of Germany.
  The trouble with Spain is that its construction sector is enormous relative to the overall economy, as large as the manufacturing sector. By contrast, America’s construction sector at the height of the real estate bubble was only a third the size of its manufacturing sector. In Germany, construction is just a fifth the size of manufacturing.Exhibit 1: Why Spain is in trouble – construction contribution to GDP as % of manufacturing contribution to GDP
• 
  Source:Eurostat.This distortion in Spain’s real economy — the massive misallocation of resources to the construction sector — is reflected in an enormous expansion of the banking sector. Spanish banks’ debt on the international bond market grew twice as fast as in the United States during the past decade, and several times as fast as in Germany.Exhibit 2: Bank debt grew much faster in Spain than elsewhere

  Source: Bank for International SettlementsExhibit 3: Financial institution debt as % of GDP
  
  Source: Bank for International Settlements, IMFWhat is this 109% of GDP, the debt of Spanish financial institutions, actually worth? According to Spain’s own data, delinquent loans amount to nearly a fifth of GDP, or 184 billion euros (US$228 billion). That would wipe out all the remaining shareholder value attached to the Spanish banking system.It seems obvious from the data, however, that Spanish banks’ bad loans are far in excess of the reported 184 billion euros. Alone in the world, Spanish banks drastically increased their lending after the 2008 crisis — by nearly two and a half times — while overall bank lending in the United States and the eurozone barely changed due to weak economic conditions. It is widely reported that Spanish banks are piling new loans of bad old loans in order to avoid reporting losses that now probably exceed two-fifths of GDP.

  Exhibit 4: Capitalizing interest on bad loans – Spanish bank assets rise sharply since the crisis
  
  Source: Banco de Espana

  Spain’s economy is dominated by a real estate bubble with an economic weight three times as great as the American real estate bubble at its height. Spain continues to increase leverage rather than reduce it. The patient (namely the Spanish banking system) must die with the tumor, and with it a very large part of Spanish private wealth, including Spanish bank debt held by Spanish households, pension funds, and insurance companies. Pensions and insurance payments will be reduced and the Spanish will be poorer.

Nonetheless, the deposits and other short-term obligations of the Spanish financial sector (and all European banks) must be guaranteed. Once its equity and $1.6 trillion in debt is reduced to zero, the Spanish financial sector will become a desirable investment for an outside investor with ready cash — the Chinese, or Canadians, or sovereign wealth funds. Maintaining the day-to-day functioning of the financial sector must be preserved in anticipation of the intervention of an outside buyer; it is an investment that will be repaid. The Spanish won’t like having foreigners take over their finances, but they will have only themselves to blame.

All of this will make clear to the Italians why reform is a much better idea than bankruptcy. Italy’s condition is much better than Spain’s. It never had much of a real estate bubble; it has relatively little private debt; it has hundreds of first-rate companies with secure niches in world export markets; and it has valuable national assets whose sale could reduce its sovereign debt considerably. What Italy lacks is political clarity. The appropriate handling of Spain will provide the required object lesson.You should ignore pressure from the Spanish government and the international institutions to support the debt of Spanish banks. It is worthless, and there is no point impairing Germany’s credit to support a $1.6 trillion pile of worthless paper. The international institutions will tell you that a Spanish bankruptcy will compromise the French and British banking systems, because French banks are massively invested in the public and private debt of other European nations. The old capital coverage rules for commercial banks made it prohibitively expensive to own subordinated debt, but very cheap to own senior debt.

You should ignore these warnings. If necessary, bail out the French banks after Spain’s bank debt has been written down to an appropriate valuation, which probably will be close to zero.

• Exhibit 5: Net direct exposure to debt of Greece, Italy, Ireland, Portugal and Spain by banks participating in ECB stress test

Source: European Banking Authority, McKinsey Global Institute

The subordinated debt of French banks may not survive. But that is owned by households directly or through pension funds and insurance companies, and is mostly in French hands. If the French banks’ subordinated debt is valued at zero, the French people will be poorer, but there will be no systemic consequences. French savers will be angry, but that is a matter between them and President Francois Hollande. The senior debt of the French banks, though, is viable –because the French economy is viable — and supporting the French banks’ senior obligations is required to prevent a financial crisis and economic collapse.
thumbnail image courtesy shutterstock/Daniel Alvarez