Courtesy of Mish.
Via email, Michael Pettis at China Financial Markets makes a compelling case why Spain is destined to leave the euro. For ease in reading, I added the subtitles in bold.
In my forthcoming book (Princeton University Press, February 2012) I argue that there is little chance that the euro survives the next few years, or that we avoid major sovereign restructurings and/or defaults. I am not just talking about Greece, by the way. I think a Spanish devaluation (accompanied inevitably by a sovereign debt restructuring) is pretty much a sure thing too, along with devaluations among many of the other obvious suspects.
After I turned in the completed manuscript of my upcoming book, my editors were a little worried about my extreme pessimism over the euro, and suggested that I hedge a little so as not to look foolish if these things didn’t happen, but honestly I am less worried about that possibility than I am worried that by the time my book comes out Spain will have already abandoned the euro. I really don’t see any progress at all in resolving the euro crisis, and the longer it takes to resolve, the more financial distress peripheral Europe will suffer, making a resolution of the crisis all the more difficult and urgent.
Last week the Financial Times had an editorial, “Politics is adding to Spanish woes”, which they ended with the following:
While they wait, Madrid should stick with the policies it is pursuing but intensify its work on the banking sector. If high yields persist, Spain can bear it for a while – no one should buy the kabbalism according to which a certain level of yields marks the entrance to a black hole. The eurozone needs to convince investors it will be able to act if panic persists, which it can best do by giving the new rescue fund a banking license.
But the best remedy against panic is reassurance. A greater sense of political competence in Madrid and of decisiveness in Brussels would do wonders.
I see it very differently. Policy is certainly adding to the problems in Spain, but I don’t think it is because, as the editorial claims, Prime Minister Mariano Rajoy has mismanaged the political process, and I am not sure that greater political competence in Madrid, or decisiveness in Brussels (!), will do anything at all, let alone wonders.
Too Late to Save Spain
The problem, I think, is much more serious than Rajoy’s flunking hard choices, and I don’t think there was anything he could do to increase the country’s credibility in a significant way. We have long passed that stage.
Why? Because, as I have been suggesting for the last six to twelve months, Spain has already started on its downward spiral and there is almost nothing Rajoy or anyone else can do to prevent all parts of the economy – workers, small businesses, large businesses, creditors, depositors, and yes, policymakers – from acting each in their own way to increase the debt burden, increase economic uncertainty, make the balance sheet more fragile, and reduce growth. These different economic agents by now are simply behaving rationally in response to declining credibility, and unless we expect from them a huge burst of irrational cheer, there is no reason to expect them to change their behavior.
All of their actions, of course, reduce credibility further, and as credibility drops it simply reinforces the adverse behavior of all the rationally misbehaving economic agents. This is the dreaded self-reinforcing loop typical of countries in the nightmare stage of a debt crisis.
We have seen this process many times before in the history of sovereign debt crises, and it is mind-numbingly mechanical. No matter how well Rajoy implements fiscal austerity (assuming that this is indeed the right thing to do), no matter how many times policymakers plead with markets to give them time to implement reforms, no matter how often the government begs workers and businesses to have more confidence, at this point it is going to be incredibly difficult for Spain to escape from this cycle.
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