"The pain in Spain falls mainly on the
(With apologies to "My Fair Lady")
There has been a lot of pain in
Spain recently with probably more to come. Unemployment is at 24% while youth
unemployment (under age 24) is about 53% and rising. The economy is in
recession. Debt, both government and private, is excessive and there is
pressure for greater austerity measures. Many Spanish banks are technically
insolvent following the real estate collapse. Spain has a large debt
roll-over of Euro170 billion during 2012/13 and needs to raise a minimum of a
further Euro60 billion per year to cover the government budget deficit.
Recent auctions of Spanish bonds were poorly supported with interest rates in
the region of 6%. Rates on Credit Default Swaps on Spanish debt are near all
time highs. A new government is in place and it has been revealed that the
previous government understated the national debt. It is actually 90% of GDP,
up from 60% disclosed previously.
Much has been written about Spain's problems. An
article this week in "Der Spiegel", at this link: www.spiegel.de/international/business/0,1518,828996,00.html,
covers the more important aspects of the Spanish problem. Spain (and
Portugal) are currently in the spotlight, but it is the European Union (EU)
and the Euro itself that are in need of some serious discussion and a few
The first reality check is to recognize that the
EU is a failed experiment. The EU was a noble idea aimed at allowing the free
flow of people and trade throughout the EU. A further objective was the
development of a common currency, the Euro. There was a flaw in the original
plan which allowed individual countries to retain their sovereign governments
and control of their own fiscal destinies. The EU was in control of the
monetary levers. Individual countries agreed to limit their government
deficits to less than 3% of GDP but there were no measures to deal with
countries that did not comply with this requirement.
Prior to the introduction of the Euro, investors
considering purchasing the sovereign bonds of countries like Greece, Italy,
Spain and Portugal, had to factor in the possibility (probability?) of
currency losses in the drachma, lira, peseta or escudo during the period of
the investment. The arrival of the Euro allowed investors to believe that the
currency risk had been eliminated. They were buying the sovereign bonds of EU
countries denominated in Euros and thus the risk of currency loss was
This enabled those countries involved to issue
vast quantities of new sovereign bonds at very favorable rates, funding
budget deficits well in excess of the 3% of GDP that they were obliged to
respect. These countries now have debts which are incapable of being repaid
under any normal circumstances.
The second reality check is to recognize that
individual EU countries do not have the ability to create vast amounts of new
Euros to inflate their debt problems into oblivion. Thus EU countries that
are experiencing difficulties have limited options. To repay their sovereign
debts these countries must first achieve budget surpluses, which requires
economic growth. To do this they need to improve their competitive positions
relative to their northern neighbors. Denied the ability to quickly improve
their positions by devaluing their currencies, these countries are forced to
adopt austerity policies aimed at deflating internal wages and asset prices
to the point where they eventually become competitive. This is a slow process
that causes a lot of financial pain resulting in social unrest and riots.
If the social unrest gets to be excessive, these
countries may consider another option to get rid of their debt. It is an
option that is being ignored because of the drastic consequences for the EU
and the Euro if this course of action was adopted. This option is to
"wipe the slate clean" by declaring bankruptcy, defaulting on their
debts and starting afresh with a new currency of their own. The new currency
will quickly depreciate to the point where their competitive position will
become attractive. With no debt to service and with a competitive economy,
the country could adopt disciplined monetary and fiscal policies, hopefully
followed by economic growth.
There is no agreed mechanism allowing countries
to voluntarily leave the EU. Countries desiring to leave the EU will probably
need to make a Unilateral Declaration of Independence, a UDI, to separate
from the EU. They then need to make a Unilateral Declaration of Bankruptcy, a
UDB, in which they announce that they will no longer pay interest on their
foreign debt and that they will never be able to repay the original capital.
At that stage, they will need to sever their links with the Euro currency and
introduce their own new currency.
If any EU countries follow this course of action,
they will shatter the dream of a unified Europe operating under a single
currency. Could the EU continue to muddle through with the enlarged ESM that
has been created? It is possible that this will buy some time but it does not
solve the problem of how to improve productivity and competitiveness of the
current deficit nations.
Similarly, aggressive creation of new Euros by
the ECB (if it were ever allowed to do so) would cause the Euro to depreciate
against other world currencies. The EU as a whole would become more
competitive, but the position amongst the existing EU countries would remain
unchanged. The surplus countries would continue to have surpluses and the
weaker countries would still have deficits, albeit slightly smaller deficits.
The imbalances would not have been corrected.
An article in the "Acting-Man" blog
examines the imbalances within the different countries of the EU. The blog is
The chart below shows the dramatic changes in the balance of payments figures
within the EU since August last year. The concern is that these trends seem
to be accelerating. The following is from the above blog:
"We are keeping a wary eye on the euro
area's central bank-directed payments system TARGET-2, where imbalances
continue to pile up at astonishing speed. The most recent data are from
February 2012 and have been compiled and charted by the German website
'Querschüsse'. (as an aside, the German term 'Querschuss' is probably
best translated as 'spanner in the works'). The latest chart is reproduced
GNFL = Germany, Netherlands, Finland and
Luxembourg. PIIGS = Portugal, Italy, Ireland, Greece and Spain. PIIGSBF =
PIIGS plus Belgium and France.
The third reality check is to accept that the EU
countries in the PIIGS group will never repay their international debts.
Despite protestations to the contrary, that money has been lost. Debt can
only be repaid out of budget surpluses which can only be achieved by economic
growth. That is unlikely to happen under current circumstances. These
countries cannot grow without an improvement in their competitive positions
with their northern neighbors. While they are locked into the Euro, they
cannot achieve this by a devaluation of their currencies.
This is simply a recognition of the reality of
the situation. That means that sooner or later one or more of these countries
will find the UDI/UDB option to be an attractive alternative to ongoing
austerity, deflation, lower wages and social unrest. Greece has gone part of
the way along this route but remains a member of the EU and uses the Euro as
its currency. New elections in Greece next month may change the outlook for
There is a growing awareness amongst EU nations
that austerity measures are not the way to go. They simply aggravate the
economic decline of the countries involved. More EU politicians are now
admitting this and saying that growth is the solution to the problem. Pouring
more debt onto already excessive debt is the recipe that caused the problem
in the first place. It is not working now and will not work in the future.
Growth comes from savings. Growth in individual countries requires the elimination
of onerous debt burdens, a fresh start with a new currency combined with
disciplined monetary and fiscal policies. This applies to many world
countries, not only EU countries.
The EU as presently constituted is an
unsustainable entity. Even if all countries agree to a policy change which
brings their fiscal arrangements under the umbrella of the EU central
authority, (which is a highly unlikely expectation), it is too late to change
the underlying situation of excessive debt. The aggregation of all individual
countries debt into a single European Central Bond guaranteed by all EU
nations is something that the surplus countries will never agree to.
In November 2011 the US Fed was so concerned
about a possible collapse of the European banking system that they agreed to
provide unlimited US Dollar swap agreements with other central
banks until 1 February 2013. This allowed the ECB in December 2011 to launch
its first tranche of LTRO (Long Term Refinancing Operation). Some 523
European banks participated in the first tranche and borrowed a total of
Euro489 billion for 3 years at a subsidized rate of 2%. In the second
tranche, issued at the end of February 2012, Euro529.5 billion was loaned to
over 800 banks at an interest rate reduced to 1%.
A total of over Euro1 trillion has
been injected into Euro-zone banks in 3 months via this "back door"
quantitative easing program. The banks borrowed the money at 1% to buy the
debt of their own countries. So the Spanish banks bought Spanish bonds
yielding around 5.8%, making a very nice turn on the 1% cost. The idea is to
assist the banks to earn profits sufficient to write off their bad loans. So
insolvent, over-leveraged banks are getting even more over-leveraged. If an
increase in interest rates on Spanish debt occurs, the market value of their
bonds decline. What happens if one of the PIIGS countries decides to go the
UDI/UDB route? Another, even worse, banking crisis will be the result.
Nationalization of banks in these circumstances seems to be inevitable.
It is possible that one of the surplus countries,
perhaps Germany or Netherlands, may get tired of making ever greater
contributions towards bailing out their deficit neighbors. Pressures may
escalate on these countries to the point where they decide to go the UDI
route and go back to the D Mark and Guilder. This would also be disastrous
for the EU and the Euro.
When a situation is obviously unsustainable, it
will eventually end. The pressures mounting in the EU suggests that sooner or
later some countries will opt for the UDI or UDI/UDB route. The consequences
of this action by one or more countries will be serious. The entire EU
banking system will almost certainly be facing bankruptcy.
The world now operates on an electronic money
transfer system which is routed through the world's banks. If this system
were to fail due to a banking collapse, world trade would grind to a halt.
Credit cards and ATM's would not operate. Payments by bank transfers (e.g.
direct debit instructions) would no longer exist. The economic consequences
of such a banking collapse are too ghastly to contemplate. It is vital that
the world's banks continue to function and that depositor's funds are
Some method must be found to keep the world's
banks operating and the electronic money transfer system functioning. This is
why the US Fed made the November 2011 commitment to grant unlimited
swap arrangements to other central banks around the world until February
2013. The US Fed has become the lender of last resort to the world.
The crisis in Europe, which seems destined to
come to a head soon, will bring this arrangement with the US Fed into focus.
This is the time when the precious metals may make a dramatic upward move.
Warren Buffett may not understand it, but this is why people buy gold and
other precious metals, as an insurance to protect their savings and wealth in
times when the threat of financial or economic catastrophe appears to be
William Shakespeare said it first. The following
quote is by Polonius in "Hamlet", Act III.
"Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry."
Elliott Wave Gold Update: In the article "What Happened to Gold"
dated 1 march 2012, the "other possibilities" mentioned in the
event of gold dropping below $1650 related firstly to the 61.8% retracement
of the prior rise. The prior rise was from $1523 to $1792, so the 61.8%
retracement was $1626. There was a further possibility of the retracement
being 2/3 of the prior rise, also a Fibonacci relationship. That produced a
figure of $1612. The first number $1626 did provide some support to the
market but the absolute low was $1612.8 on 4 April 2012. This low came at the
culmination of a double zig-zag correction, which adds to the validity of
that low. The odds now suggest that the gold correction bottomed at $1612.8
on 4 April 2012 and that the gold market is in the early stages of a sharp