The Eurozone: Reality Bites

The eurozone crisis continues to head towards meltdown, and stands a fair chance of taking a portion of the world economy with it.

Spain, the latest problem child to surface has seen major currency flight as it calls for a huge EU rescue package of €370bn to €450bn to bail out its crippled banks and make it to 2014. If Spain were to receive it, the new loans would push Spain's public debt into Greece territory - a mere 110% of its gross domestic product. This is roughly the equivalent of earning $1,000 per month and owing $1,100.

"If",of course, is the operative word. Spain's Prime Minister Mariano Rajoy has utterly rejected the kind of austerity programs that drove the Greek government out of office and triggered widespread rioting and unrest. And even if the Spaniards were willing to adopt these kind of measures, there's no indication that the EU bail-out fund could raise that kind of money on the global markets at any kind of financially realistic interest rates.

What Rajoy and other fiscally unsound eurozone countries want is to spread the infection to whatever healthy financial institutions remain by forming a “banking union” in the eurozone involving a centralized system to 'recapitalize' troubled banks. Again, to use another comparison, this is rather like spreading gangrene to the healthy parts of the body in order to lessen it temporarily in an already diseased leg.

The banking union proposition would involve eurobonds that would be sold to investors to pay off the cost of bail outs. Who would buy these debts and what kind of interest rates would have to be offered to attract any buyers is another question no one seems to be willing to answer.

Actually, the market already has. Switzerland is talking seriously about taking the unheard of step of enforcing controls to stop currency flight from the eurozone into the Swiss banking system in order to avoid corrupting the integrity of the Swiss franc. As it is, Swiss short term notes have fallen slightly.

Other major European financial institutions who are out of the eurozone and whom thus still have a choice are doing the same. Denmark's central bank said in a statement that it is already implementing contingency plans for the breaking apart of the eurozone. It has cut interest rates twice and taken steps to defend the krone by keeping euros from pouring into its banking system.The Bank of England is taking similar steps.

If major banks are treating the euro like some kind of weird, third world currency, that's a fair indication of where things are going.

Even Germany, the strongest economy in the eurzone has been affected. Just last week, yields on German two-year notes fell below zero for the first time ever as investors fled. By comparison, Spanish bonds 10-year rates are above 6.5 percent - with few takers.

And that's a good synopsis of the heart of the matter. This is a standoff between Germany and the less robust economies of southern Europe, who have been living in a fool's paradise for decades.Merkel is adamant that she's opposed to a 'banking union' or any sort of eurobonds an dcontinues to insist on austerity measures as the price for any future bailouts. In truth she has little choice since German taxpayers would boot her and her party out of office if she put them on the hook for yet another bailout without them, and perhaps even withthem if th erecent German state elections are any indication. She sees that the day of reckoning is here and it's time to face the music, while the Greeks, Spaniards, Italians and others want to keep dancing without paying the band.Lately, the French have joined the chorus, even suggesting that 'growth' (Socialist-speak for increased government spending)could be positively managed by injecting money into banks rather than giving it to governments. Of course, since most of the eurozone countries have central banks subservient to the respective governments,that's just another smokescreen.

The one card they have to play, quite simply, is blackmail. The Spaniards, like the Greeks are threatening to repudiate their debts and simply leave the euro. Italy's ex-Prime Minister Silvio Berlusconi made an even more sinister threat in a speech last week.If the ECB rescue fund refuses to bail out countries like Spain and Italy, "We should use our own mint to print euros," he said. "If Europe refuses to listen to our demands, we should say 'bye, bye’ and leave the euro. Or tell the Germans to leave the euro if they are not happy."

This isn't a mere threat by a disgruntled former politician. Berlusconi controls the largest voting bloc in the Italian parliament and could bring the present Italian government down easily.

If all this were limited to the eurozone, that would be one thing. Unfortunately, it isn't.

China and Japan have substantial investments in the eurozone, as do U.S. financial institutions. As anyone tuned in to the banking business knows, U.S. banks have been very leery of making commercial or property loans given the multi-billion settlements, mandated loan modifications and government controls enforced by the Obama administration and the low rate of return on fixed long term debt like mortgages. Instead, they've largely used the TARP funds to bolster their existing outstanding portfolios, and to make investments elsewhere, the eurozone among other places.

If the eurozone implodes, there could be nasty effects globally. And unlike the U.S., the eurozone banks involved do not have any sort of uniform deposit insurance, which is why depositors have been desperately attempting to pull their cash out and get it someplace outside the euro, even at a loss.

The markets give every indication of preparing for a sell off and a deflation...and the next few months should tell the story.