The Bottom Line: European Debt Crisis Escalates

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The Bottom Line: European Debt Crisis Escalates
by Dr. Sherry Cooper
The escalation in the European debt crisis, emanating this time from Spain, has driven U.S. bond yields down to new 60-year lows, sharply reduced commodity prices (including gold), further damaged stock markets and widened the spread between Spanish and German yields to new euro-era highs. Governments and banks everywhere are now openly making contingency plans for the possible break-up of the eurozone or, at least, the exiting of Greece from the monetary union.

The situation is most recently exacerbated by the reported refusal of the ECB to accept Madrid’s plan for bailing out Bankia, which has been followed by the resignation (removal) of the Governor of the Bank of Spain one month earlier than his announced retirement date. The ECB has stressed before that its rules do not allow it to finance governments and the governing council of the ECB might well think Madrid’s proposal comes too close to just that.

The problem is that the eurozone’s tottering banking system is threatening to take down the weakest eurozone governments and their bond markets. The banks are the biggest owners of government debt and governments are increasingly becoming the owners of the banks. Bank losses are increasing sharply, especially in countries, such as Spain, that have suffered huge housing crashes. This, in turn, drives cash out of the banks and sovereign debt, further worsening the dangerous death spiral.

Earlier in the crisis, Ireland was able to keep Anglo Irish Bank from insolvency by giving it a promissory note at the cost of ballooning Ireland’s budget deficit. Prior to 2007, Ireland enjoyed a decade-long real estate boom during which easy bank credit prompted enormous overbuilding as bank stocks surged, mirroring the situations in the U.S. and Spain. With the 2008 financial crisis and housing collapse, Ireland announced a 400 billion euro guarantee scheme covering its six main banks, including Anglo. By early 2009, the government nationalized Anglo, despite later-confirmed rumours of the bank’s fraudulent activity. Irish taxpayers are still paying the price and the Irish government is still unable to borrow money in the open market. Ireland saved the banks at the cost of its own government coffers and it was consequently strong-armed into a eurozone rescue plan.

Greece had to give four of its banks €18 billion worth of bonds from the rest of the eurozone, funnelled via the European Financial Stability Facility bonds.

Spain, earlier this week, announced it would prop up Bankia by giving it €19 billion of Spanish government bonds to take to the ECB as collateral to borrow the funds the bank needed. The ECB has reportedly refused to honour this plan, causing massive gyrations in global capital markets. Spain is engaging in a very risky policy: it runs the risk of causing a dramatic further rise in its borrowing costs, reducing its own solvency, in order to save an already insolvent banking system. The winners, in some sense, become the stronger EU members and the rest of the higher-rated countries whose borrowing costs plummet. Canadian bond yields are at new historical lows as well, as investors scramble for safe havens.

Bottom Line: With the ECB opposing the Bankia idea, Spanish yields are soaring at a time when the government is trying to ward off an international bailout. The Spanish government is reportedly looking at alternative means to fund the Bankia rescue. Stay tuned, this is clearly not over yet.


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