Where Now for Europe?

Bans on short-selling are as futile as they are predictable...

WHAT IS to become of Spain's economy and the Eurozone? asks Greg Canavan in the Daily Reckoning Australia. 

We are but weeks away from the Spanish economy losing access to capital markets entirely. Overnight, yields on all government debt maturities shot up to extreme levels. The 10-year yield hit a peak of 7.56%. The two year bond yield jumped a huge 100 basis points to a peak of 6.74%, indicating investors have no faith in the European Central Bank's (ECB) efforts to calm markets (via its Long Term Refinancing Operation — LTRO).

Before the recent sharp spike in yields, the International Monetary Fund (IMF) forecast Spanish debt-to-GDP to hit 96% next year, up from 84% this year. This is some deterioration. The terrible equation of 'debt dynamics' for Spain's economy consists of starting with the current debt-to-GDP ratio. You then add economic growth, the budget surplus or deficit and subtract the yield on 10-year bonds to work out whether the ratio is improving or deteriorating.

When economic growth is negative, the budget is in deficit, and 10-year yields are north of 7%, Spain's debt-to-GDP ratio is clearly deteriorating. And with the Spanish government on the hook for its insolvent banks and insolvent regional governments, it's only going to get worse. That's why capital markets are shutting off access to funding, and why another bailout for Spain is on its way.

So where to now for Europe? At last month's summit, Europe's leaders tried to come up with a solution to break the nexus between bank debt and sovereign government debt. It was an attempt to use bailout money (largely contributed by Germany) to recapitalize the banks directly, and buy government debt directly. The current bailout process involves loaning money to the government in question, effectively increasing its debt (albeit at a lower cost than otherwise would be available) to help it get out of debt.

Sounds insane right? It is. But this is where politics and finance meet head on. The nexus between banks and sovereigns is a crucial one for the modern welfare state. Governments spend money to buy a short term stay in power. Banks provide them with the money by buying government bonds.

This system can work smoothly for years, and indeed it has. But when debts become problematic and you don't have your own central bank to print what you need (as is the case in Europe) it implodes. Right now, for Spain and soon Italy, the German government is the equivalent of their central bank. It's the last source of money when everything else has run out.

But politics precludes the government acting like a real central bank. The German population will not stand for taking direct credit risk (and funding the apparently easier lifestyles) of its southern European neighbors.

This is why Germany blocked the deal agreed to at the June summit to directly recapitalize Spain's banks with €100 billion. It will now be a loan to the Spanish government.

Europe kicked the can down the road in June but just a month later events have again caught up with it. Decision time is now approaching. Europe's peripheral nations will exit the Euro and turn to inflation to 'save' them or Germany will guarantee their debts.

The days of can-kicking and muddling through are over. It's decision time for Europe...jump or be pushed.

So what do the Spanish authorities do in the midst of this maelstrom? They ban short selling.

This happens in just about every crisis. It's monotonous in its stupidity. We're sure we've written this somewhere before, but every time we read about a ban on short selling we turn to the classic Once in Golconda, A True Drama of Wall Street 1920-1938

It tells the story of the US economy in 1932. It's in a depression; the stock market is in free fall. An election is coming up.

'Hoover and the Republicans badly needed a scapegoat to blame for the general disaster. The one they found most readily at hand was Wall Street, and the particular aspect of Wall Street that they chose was that old bugaboo, short selling on the stock exchange.'

Short selling was a

'prime political target then; and the more so because the defense of short selling, to the eternal frustration of its defenders, has to be based on more sophisticated and therefore less readily grasped concepts.'

What are these less readily grasped concepts?

'...every short sale necessarily implies a later purchase by the short seller; thus short selling can be looked upon as creating a reservoir of potential buying power that will ultimately work not to depress the market but to buoy it. In the absence of short selling...stocks would tend to gyrate all the more wildly, increasing the risk to the unwary investor...all recorded efforts to forbid or severely restrict short selling on stock exchanges over extended periods - in Holland in the seventeenth century, in France in the eighteenth, in England in the nineteenth, in Germany at the opening of the twentieth - had ended in failure. The short sale like the earth worm is an unprepossessing object that plays a useful role.'

Bans on short selling don't solve anything, so expect more volatility in Spanish bond and equity markets.

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