Spain has agreed to a $125 billion bailout of its banks. That is good news. It is an important and substantive step towards addressing its credit problems. Spain, however, still faces serious fiscal and economic problems, as does much of Europe.
Spain’s Banking Problem
Spain has many problems. The most immediate and pressing concern is the weakness of its banking system. Spain experienced a massive real estate bubble that, after popping, left its banks crippled with bad loans and devalued assets.
It was critical that Spain provide support (a bailout of some manner) to its banks so that a run on banks did not occur and so that banks could, over time, improve their balance sheets and begin lending again in order to support economic growth.
The banking problems in Spain were thus similar to the problems that Iceland, Ireland, and the US faced.
Spain can be considered unique in this group because it is a much larger economy than either Iceland or Ireland, but unlike the US, it does not have unilateral power to dictate its monetary policy (i.e., it can't simply print euros on its own accord).
Iceland and Ireland have addressed their banking crises in fairly good manner. Iceland has its own currency, which was substantially devalued. The crisis drove GDP sharply lower in 2009-2010, but it has grown over 2% each of the past two years. Unemployment is now near 6% (that is good these days) and the 10-year government note yield is under 6%.
The bailout of Ireland, which is part of the euro region, required a similar amount of credit to Spain. Essentially, Ireland received 85 bln euro from EU authorities and the IMF. Real GDP fell about 12% for 2008-2009, but has now stabilized.
The US banking bailout has been a qualified success similar to Iceland and Ireland. Banks have been able to shore up capital, shed bad loans and assets, and start lending again. As in Iceland and Ireland, real GDP trends have improved.
A stable and functioning banking system is critical to an economy, and Spain is taking actions to ensure that is the case in its country.
Unlike Iceland, Spain was unable to devalue its currency, and unlike the US, receiving credit from the central bank (the lender of last resort) required acceptance by a larger political entity. The crisis thus became much more magnified than it should have been, reflecting the inherent weakness of a currency union not backed by a commensurate political union.
Spain’s Fiscal Problems
The Spanish government will now be able to borrow much more easily given the EU backing. Spanish bond yields have dropped to about 6.25%.
Yet, the bailout does not address Spain’s fiscal or economic problems.
The country has a 24% unemployment rate. Real GDP fell at a 0.8% rate in the first quarter and is likely to contract this year and next. The government fiscal deficit will run 5% to 6% of GDP this year.
The bank bailout reduces the downside risk of a near-term bank run or severe credit crisis, but it will not provide the impetus for economic growth. The global financial markets will remain concerned about Spain until the government’s fiscal condition improves, and it is far from clear when that will happen. As in the US, Spain faces a long grind to improving economic conditions. Credit cycles take time.
The next item on Europe’s continuing credit crisis agenda is the Greek election on Sunday.
Greece has a serious fiscal problem entirely apart from any banking crisis. Government bailouts are likely to be less effective than bank bailouts.
A bailout of a banking crisis caused by the bursting of a real estate bubble can work. The temporary extension of credit to banks helps improve balance sheets and banks can right the ship over time.
Governments are often less responsive to correcting the underlying problem than are banks. Governments need to reform the policies that have caused the fiscal imbalances. This generally means that social services for non-workers and the retired need to be restrained over time. The track record of Western democracies doing this is poor.
If the Greece elections produce a victory for the anti-bailout parties, or are inconclusive, the risk of Greece leaving the euro later this year becomes worrisome. It is a real risk. It would cause significant financial dislocations because of the subsequent uncertain value of Greek government debt and a likely collapse of the Greek economy.
The political problems in Europe are also evident in this weekend’s elections in France. The Socialist party coalition did sufficiently well to indicate that it will have a majority of legislative seats after the runoff on Sunday.
The Socialists are not likely to back necessary long-term reforms to address fiscal imbalances. They have already taken some minor action to roll back the previous government's efforts to increase the retirement age. A retirement age of 60 or even 62 simply does not work mathematically given France’s demographics.
The US, of course, faces similar long-term fiscal problems which also must be addressed. At present, however, the US problems are not causing global concern as reflected by the US government 10-year yield of 1.60%.
France, Spain, Greece, and Portugal in particular face continuing near-term pressures in the global credit markets rooted in fiscal imbalances. The Spanish bank bailout does not address these problems.
What It All Means
A bailout of Spanish banks will provide much needed support to the banks in that country. Bank bailouts can be necessary and can, over time, work. The news is positive.
It isn’t really all that surprising, however. S&P futures jumped 15 points on Sunday in response to the news, but by Monday morning were only up a few points.
A modest bounce of this size seems appropriate. Action to prevent a banking crisis in Spain was expected and in the interest of all of Europe. It was necessary. This isn’t identical to Greece, where a government bailout is tied to demands for specific government actions.
The Spanish bank bailout will merely move the focus to the next potential crisis, and that comes on Sunday with the Greek elections. After that, the prospect of further economic weakness across Europe and fiscal imbalances in countries from France to Italy will continue to create problems in the global financial markets.
The Spanish bank bailout is just one more act in an ongoing drama that will take years to play out.
Founder and Chairman, Briefing.com