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EU Struggles Between Bailouts and Money Printing

Jul 20, 2012
DARYL MONTGOMERY

The bailout for Spanish banks was approved by the German parliament on Thursday, but not as expected. They insisted the bailout had to be structured as a loan to the Spanish government, which will damage its fiscal position even further. The recent IMF call for massive money printing may be the only option now left for the EU.

Today, yields on Spanish 10-year sovereigns tested their yearly high yield of 7.28%, while Italian rates reached 6.16%. This was after funds for the Spanish bank bailout were approved by the EU, although the money won't be going directly to the banks. Earlier in the week, the IMF admitted that the only solution to Europe’s debt woes was to run the printing presses at full speed.

The situation in Spain is ugly and getting worse. Unemployment is almost 25% there and the country is in a recession. The Spanish economy is dependent on public spending and building empty houses that no one buys. The government has recently announced severe spending cuts and higher taxes, both of which will lower future growth. Yet, until today Spain was forecasting GDP growth of 0.2% for next year. It now thinks that GDP will decline by 0.5% in 2013. This is not just an optimistic scenario; it's a Harry Potter fantasy scenario. As is the case with Greece, Spanish economic and financial numbers cannot be trusted. Greece in the early stages of its bailout also produced optimistic projections of how easily and quickly everything would be fixed. Instead, its financial problems escalated out of control. The same outcome should be expected in Spain.

Bailed-out Bankia is a good example of the how reliable the books are for Spanish banks. Bankia claimed to have earned a €300 million in profits in 2011, but in late May revised that to a €3 billion loss. Now Spain is in line for a €100 billion bailout from the EU, although it has claimed that it needs less. Based on how Bankia did its accounting, Spanish banks are likely to need more, maybe ten times more than that amount. This does not include money for bailing out the bankrupt Spanish government.

Originally, the EU planned on providing the bank bailout money (structured as a long-term loan) directly to Spain, who would in turn distribute it internally. When this caused Spain's sovereign debt rating to be downgraded, creating greater fiscal problems for the struggling government, the EU then decided to route the loan directly to the banks. Yesterday, the German parliament refused to go along. They were only willing to approve a loan directly to the Spain itself. It wasn't easy to get even that passed. Twenty-two members of Angela Merkel's coalition voted against it. The leader of the Free-Democrats described the bailout as "a bottomless pit". It doesn't look like German legislators have an appetite for any further bailouts and this is bad news for Spain and Italy as well.

The IMF has an idea of what to do instead, but its solution could hardly be described as constructive. In a report issued on Wednesday, the organization essentially advised the EU to engage in every type of money printing possible, do a lot of it, and to start doing it immediately. The ECB has already expanded its balance sheet by more than the U.S. has and it hasn't solved the EU's problems so far. Massive money printing as suggested by the IMF would debase the euro significantly. So, in order to save the currency union, the currency it issues must be destroyed. Somehow, there seems to be a logic flaw in this line of reasoning (sort of like, a debt crisis can be solved by incurring more debt).

The bailout news today was disastrous for Spain and Italy. The Spanish IBEX index was down 5.79% dislocations — a mini-crash and the worst drop in the two years. The Italian market was down 4.4%. The euro hit a new yearly low. The ETF FXE traded down to 120.78. This is below its bottom during the Credit Crisis, but still above the 2010 low made when the debt crisis first appeared. As the situation continues to unravel, more selling should be expected.

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

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