If you needed any further evidence of how trying to subvert natural forces is utterly destructive over the long run, look no further than Europe…and then perhaps China…and then…where do you stop?
For now, I’ll stick with Europe. The situation there is ruinous. EU elites are sacrificing the Greek and Spanish societies to maintain the façade of a workable monetary union and protect the banking system. The story is an old one, but it’s worth looking into again.
You can’t fight against nature and expect to win. Not in the long run. The European Monetary Union (EMU) is a flawed concept and the depressions in Spain and Greece are testament to that. Making matters worse, the Eurocrats demand fiscal austerity and deny exchange rate flexibility to ‘help’ these countries make the necessary economic adjustments to stay in the Eurozone.
This obviously matters for Australians. Every time Europe flashes red, global markets swoon. Our market and economy – perched on the edge of the world, open and exposed – seem to cop the brunt of the fallout. That won’t change anytime soon.
That might not be a soothing thought. But I want to show you why letting nature take its course in Europe would be a good thing, and why falling share prices would also be a good thing.
Why?
Because it would finally signal nature triumphing over the manipulators’ attempts to create wealth from nothing and ignore losses. Only then would the global economy be in a position to generate wealth – in a sustainable manner – again.
But the longer this game goes on, the more interference and bailouts inflicted on the market, the greater the final denouement will be. Let’s take the recent events in Spain as an example.
Spanish Influenza
The country’s banking system is imploding. Years of abundant credit (a product of the flawed EMU) created a historic housing bubble. Now the market has turned the credit tap off, exposing the overinvestment. Bad debts infect the Spanish banking system.
The Spanish Bank ‘Bankia’ is the poster child for this banking sickness. Formed in December 2010 from the consolidation of seven regional ‘cajas’, the Spanish government initially injected €4.5 billion into the bank.
That amount predictably evaporated and Bankia is now subject to a massive recapitalisation plan. The government has committed another €19 billion to the bank. Except the government doesn’t have the cash. It must borrow it. And the market is not too keen on giving Spain more cash to bail out the banks.
Spanish bond yields reflect this reluctance to lend. The 10-year yield is now over 6%. This is a prohibitive interest rate. It makes it very hard for Spain to grow out of its debts. The interest rate plays a major part in ‘debt dynamics’. This is the trajectory of a country’s debt-to-GDP ratio.
All you need to know to work out a country’s debt dynamics:
- What is its economic growth rate?
- What is the interest rate it pays on its debt? And…
- What is the country’s primary budget balance (i.e. before interest payments) as a percentage of GDP?
To get the change in debt, subtract the growth rate from the interest rate. Then subtract the primary budget balance. To have any hope of reducing debt, you want that equation to produce a positive number.
Spain is in recession, meaning its economic growth rate is negative. It has a budget deficit. And its interest rate is very high. This points to a rapidly deteriorating debt-to-GDP ratio…Spain is on the slippery slope to a bailout.
And given that the problems at Bankia are just a reflection of the whole Spanish banking system it looks like the country will need assistance. I predict you’ll see Spain join Greece, Ireland and Portugal in the bailout lounge.
What does this actually mean? In practice it means the market has shut off Spain’s tab. The EU rescue fund will need to fund Spain at a much lower interest rate to help improve its debt dynamics.
But here’s where things get interesting. The Spanish government is itself not massively indebted (its debt-to-GDP ratio was around 70% at the end of 2011, forecast to rise to 80% in 2012). The problem in Spain is the household and banking sector, weighed down by debts from the property bust.
So if Spain does get a bailout, it will be a bailout of the banking sector.
Greg Canavan
Editor, Sound Money. Sound Investment.
From the Archives…
How Bad Monetary Policy Will End the Welfare State
2012-06-01 – Dan Denning
The Setting Sun of the Japanese Economy
2012-05-31 – Greg Canavan
The US Dollar – The “Strongest of the Weak”
2012-05-30 – Kris Sayce
Europe’s Energy Resource Puzzle
2012-05-29 – Kris Sayce
The Market Has Crashed, But This Graphite Stock Has More Than Doubled
2012-05-28 – Dr. Alex Cowie
