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Market Commentary
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The Euro crisis finally reached the big fish last week as a $125 billion dollar bailout fund for Spain was announced. It was widely expected that Spanish banks would need aid for some time because of the poor loans they issued during the Spanish property boom. However, the timing of this bailout was accelerated by fears of adverse results from the Greek election. This is a big step because it acknowledges that there is no way to limit the Euro crisis to its periphery nations. It has taken over two years to get to this point (and if you are feeling a little Euro-crisis fatigue, the timeline below gives you a recap of its lowpoints).
As we have noted several times over the last couple of years, at some point Germany and the other northern European nations are going to have to pay in order to keep the Euro alive. The Germans have pushed the Southern nations to instill the fiscal discipline and structural reform needed in those economies but it will take actual cash injections, or large scale money printing, to get the Euro through the short to mid term. At the same time, Germany must realize that while they some reforms have been initiated, the fiscal condition of most of Europe has gotten worse. The chart below shows the deficit and debt (both as a percentage of GDP) of Germany, Spain and Italy over the time of the crisis. The financial condition of Spain and Italy has not improved over the last couple years, despite the reforms they have implemented. It is likely they cannot get out of this crisis without direct aid from Germany at some point.
 The lack of improvement in the fiscal condition of these Southern countries puts them at greater risk of being forced out of the Euro. That would be calamitous for all involved, including Germany, as it would almost certainly lead to a severe recession or depression in Europe. Germany has rightly recognized that their ability to force change in the rest of Europe remains greatest up to the time when they acquiesce to a large scale bailout. We think last week's Spanish rescue marks the point where Germany realizes that it has hit the point where it must put real money on the table. Even as things stand today, Germany is already starting to feel the blowback from the crisis as rising yields on Italian and Spanish debt put extreme strain on the European banking system. There are further imbalances occurring within the European finance system such as the balance of payments within Target2, the European inter-bank payment system for cross-border transfers (chart from Credit Writedowns). This is a result of people moving their Euros from Italian and Spanish banks to German financial institutions.
While the Spanish bailout and thus the expansion of bailouts to the core countries has been precipitated by the Greek elections we doubt that Greece will remain in the Euro. We think that Germany, in many ways, wants Greece to be forced out. We feel this is evidenced by the more harsh manner they have dealt with Greece, particularly relative to the treatment just given to Spain. Perhaps the Germans feel that a Greek exit would serve as a sharp lesson for any of the other Euro nations that might be tempted to backtrack on reform measures, especially now as the Germans have started giving aid to the core Euro countries. The election victory of the pro-bailout New Democracy party this past weekend allows the Greeks to pretend they will continue implementing reforms and the Germans to pretend they want Greece to remain in the Euro. The best case scenario is that this gives time for the parties to orchestrate a more organized, graceful separation. The uglier scenario would see the new Greek government falling in a few months and the anti-austerity SYRIZA gaining control of parliament. The pretense on both sides would stop immediately then.
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