SPENGLER Open letter to Chancellor Merkel:
Sacrifice Spain By Spengler
Dear Federal Chancellor:
Friedrich
Schiller wrote of the Thirty Years War that
history had brought forth a great moment, but the
moment encountered a mediocre people. The world
today finds itself by contrast in a mediocre
moment, but it still may find adept leadership.
No-one would have expected that Germany
would decide the fate of the world financial
system. International financial institutions - the
International Monetary Fund, the Bank for
International Settlements, and the European
Central Banks - used to formulate
the consensus of major
governments and elite opinion. For understandable
reasons, Germany was content to take guidance from
the international financial community and act as a
member of Europe rather than as a national power.
Now the international consensus has
collapsed, elite opinion is confused and Germany
has become the arbiter of the European financial
crisis. The US administration's economic policy
has produced poor results and the American
president wants to blame his problems on you. Your
neighbors, the IMF, and the Obama administration
are trying to persuade you to extend Germany's
credit to paper over the indebtedness of the rest
of Europe. Yet common sense makes clear that
Germany's resources are finite, while German
voters fail to understand why they should put
their future in jeopardy to support countries
plagued by corruption and inefficiency.
It
is impossible to prevent the destruction of large
amounts of nominal wealth, but it is indispensable
to preserve the functioning of the banking system.
Germany cannot bail out everyone, but it must
create a firewall in the right location. This is a
practical rather than an ideological matter. There
are two questions: where should Germany provide
support, and how? It is not enough to refuse the
unreasonable demands of your partners, for
example, to issue so-called eurobonds (guaranteed
de facto by Germany but spent by Europe's
laggards). You also must make clear to the markets
what the worst-case scenario might be.
At
present, Germany appears to respond to events
rather than anticipate them. That increases
uncertainty and the risk of a major financial
crisis. If Germany acted with clarity, though, the
outcome would not be a crisis, but rather the
deliberate amputation of gangrenous parts of the
financial system in order to salvage the whole.
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.
Whether Greece chooses national bankruptcy
putting the left in power on June 17 or not is a
minor matter. The decisive question before you is
Spain. Spain has lied and continues to lie
systematically about the scale of its financial
problems. Its banking system is worthless, and its
debt as well as equity should be written down to
zero. 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 Settlements
Exhibit
3: Financial institution debt as % of GDP Source:
Bank for International Settlements, IMF
What 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. At great cost, and
with considerable pain, America has reduced
leverage. As the McKinsey Global Institute
reported in its January 2012 report on global
deleveraging:
Since the end of 2008, all
categories of US private-sector debt have fallen
as a percent of GDP. The reduction by financial
institutions has been most striking. By mid-2011
the ratio of financial-sector debt relative to
GDP had fallen below where it stood in 2000. In
dollar terms, it declined from US$8 trillion to
$6.1 trillion. Nearly $1 trillion of this
decline can be attributed to the collapse of
Lehman Brothers, JPMorgan Chase's purchase of
Bear Stearns, and the Bank of America-Merrill
Lynch merger. Since 2008, banks also have been
funding themselves with more deposits and less
debt. Among US households, debt has fallen by 4%
in absolute terms, or $584 billion. Some
two-thirds of that reduction is from defaults on
home loans and other consumer debt.
In America, the tumor was operable -
just barely. In Spain, where the tumor is three
times the size in relative economic terms, it is
inoperable. That is why 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.
It would be something
of a revolution in world affairs for Germany to
ignore the international consensus and undertake
to resolve the crisis on its own initiative. I
submit to you, Federal Chancellor, that it is time
for such a revolution.
You are the most
experienced and best qualified among the leaders
of the Free World. America is led by a man who was
a first-term state senator in Illinois when you
were in your second year in office; France is led
by a man who has never held high government
office; Italy is led by a technocrat with no
political base; it doesn't matter who leads Japan,
and one can only have sympathy for whoever
governs Spain. For the time being the head seat at
the table is yours by default. It is in your power
to avert this crisis, if you act decisively.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
