Monday, April 11, 2011

The Coming Earthquake: Spain and EMU

Spain is already in denial mode: that it won't be the next target in the war to collapse the euro zone. Public finances are suffering due to the general economic downturn. This has to be bitter. It has managed its public finances as well as can be expected, and better than most northern EMU members expected. And as I've said before, Spain has the political wherewithal to make cuts when they're needed. But they also have to be possible.

And yet, none of the political austerity may matter in the end, which would deal a crushing blow to those who argue that public austerity is a public virtue. The problem is Spanish banks. They are enormous, and they are not only exposed to Portugal to the tune of 100 billion euros , but we don't know what toxic assets of their own they have. That makes them (potential) zombie banks. If one or more of them were to fail, the pressure on the Spanish governmment to cover the losses will be enormous. If there is any doubt about that, look toward Iceland, which Britain and the Netherlands are now suing because the Icelandic public rejected a taxpayer-funded bailout of Dutch and British depositors.

It will be interesting to see how the European Banking Authority deals with the stress testing of these banks, in addition to how they deal with stress testing more generally. Will they choose the harsh reality or to assuage public fears about the state the banks are in?

But...if there is some sort of catastrophe, it would be wise for the Spanish government and the Spanish electorate to allow some bank failure if it is required, rather than write a blank check. The government have managed their finances relatively well. If banks fail, it will not be the Spanish government's fault. Other countries (particularly Germany) will say it is, but Madrid should ignore them. The choice between a sharp, deep cut into the economy from which the country can recover quickly and decades of indentured servitude of the Spanish taxpayer to nothern creditors is pretty clear when you look at it in those terms.

When the rage in Spain comes, it should be properly directed at bank practices that have not yet been sufficiently targeted. Yes, the state allowed and encouraged these things and should be critiqued for that, but it is not the same. The corporate governance of banks is still insufficient, and therefore consequences have not been drawn for the causes of the crisis. A good collapse may be just what Europe needs to expose the rot where it really is, in the private sector. Ireland failed to do that. Iceland did do it, but the message hasn't gotten across to the Dutch and the Brits and the Germans. And until it does, the regulatory measures to prevent another crisis won't be forthcoming.

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