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Supranational Government in Europe?

Exhibit 4: Capitalizing interest on bad loans - Spanish bank assets rise sharply since the crisis

Source: Banco de EspanaSpain'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. 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.