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America Should Bet on Berlin, Not the Basket Cases

As I wrote in an Asia Times essay June 18:

Europe's nominal wealth is embodied disproportionately in national debt and in the banking system, especially in the debt of the banking system. To reduce the paper value of wealth would be an overtly political act, rather than a quasi-market phenomenon as in the United States. All of Europe's politics now revolves around the question of whose wealth gets taxed. If Spanish pensioners are told that their pensions will be reduced by a big margin because the Spanish banks made too many bad loans to construction companies while the government looked on, they rightly will blame the government. This may destroy the delicate fabric of Spanish political life. That is unfortunate, and it may be unavoidable.

There are many ways to write off the nominal wealth to levels that correspond to economic reality. The simplest and best would be for Spain, Italy and so forth simply to impose a wealth tax. But wealthy southern Europeans have been hiding their wealth for generations precisely in order to avert such an eventuality. Another way to have a de facto wealth tax is to devalue the currency, which makes everyone (but especially people of modest means) much poorer, while reducing the real liability of debtors (mainly the government). And yet another way to tax wealth is to wipe out the value of assets.

Americans accepted the overall reduction in wealth because the housing bubble was a people's Ponzi scheme, as I wrote in this space (SeeĀ The people's Ponzi scheme, Asia Times Online, August 16, 2011). Americans speculated on their own houses, and lost. So did the Irish, who glumly accepted the consequences.

Not so the Spanish: the massive misdirection of credit to the construction sector focused on corporate rather than household lending. Financial institutions issued debt in the astonishing volume of 109% of GDP (about three times the level in the United States). The construction sector ballooned to a size large than manufacturing (vs a fifth of the manufacturing sector in Germany and a quarter in the United States).

The massive issuance of financial institutions' securities constitutes a large portion of the wealth of Spaniards; they sit in pension funds and life insurance portfolios. Wipe out their value, and Spaniards will have to accept pension reductions. That is precisely what should be done: the banks are valueless, and their liabilities should be erased so that an external buyer can recapitalize them. The Spanish won't like it a bit. Nor will other Europeans.

The Spanish elite with the connivance of the Spanish government gambled with the retirement funds of the Spanish people and lost them speculating in property. If the nominal wealth of the Spanish people is written down to its fair value, a whole generation of Spaniards will suffer a penurious retirement. If the banks are put through a proper bankruptcy, new capital can be injected by foreign investors to restart the economy (as in Thailand after the 1997 real estate market crash). But the Spanish will be poorer. Will Spain's fragile social fabric hold together? Probably not; the Spanish are still fighting the terrible civil war of 1936-1939. Spain well might descend into political chaos. But I'm not going to write them a check to prevent that. I don't see why Chancellor Merkel should, either. With a fertility rate of just 1.4, Spain won't be around much longer in any case.