European Economy in Death Spiral?

The Daily Telegraph reports on the IMF’s latest Global Financial Stability Report.  Perhaps it should be re-named the Instability Report.  (Again, the Telegraph goes where the American media apparently fears to tread.)

This particular chart from the IMF details the steadily increasing drain of assets from Spain and Italy (up to the end of January, and as the article suggests, the situation has worsened considerably since then):

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Likewise, this chart from Credit Suisse details much the same:

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Anyone who can has been getting their money out.  Likewise, any foreign company doing business in Spain and Italy removes the money as soon as they get paid, driven both by concern over the safety of the domestic banking system and the possibility that these countries might end up leaving the euro.  This has been pretty much one way traffic.

So where does this money go, and why hasn’t this already had a catastrophic impact on their economies?  The description involves a round-about trading off between banking systems:

The process thereby becomes something of a money go round.  The foreign investor withdraws his money from the Spanish or Italian bank and deposits it with an apparently "safer" German bank, which in turn lends the money to the Bundesbank, from where it finds its way back through the [European Central Bank] … to the original Spanish or Italian bank.

It sounds like Alice in Wonderland, but in fact is no different from what happens in the money system within national borders.

True enough, but with a sharp distinction (as the article explains).  Within a country, it can struggle with its economy and is only responsible for the welfare and electoral respect of its own constituency.  Despite the utopian idea of a single European currency, the reality of different countries and their cultures simply cannot be whisked away by a bureaucratic decree from the EU 'capitol' in Brussels.  It is thus not so much of a money go round as it is a massive game of musical chairs, with a dwindling number of successes and in the end, instead of a winner there is just the last player holding the bag.  Rather than a circle, it is a downward spiral.

Many years ago, I predicted (not that many of you gentle readers would know, but some of you do) that the Federal Republic of Germany, upon its unification with (actually, absorption of) East Germany in 1983, would essentially check out of the system for some ten to fifteen years, keeping enough contact to maintain viable trade, in order to dedicate itself to getting its house in order by reviving the economic corpse of the formerly communist major sector of its country.  Afterward, Germany would come roaring back into the Eurozone and exert a commanding presence in the European economy, at a time when the euro would be set and widely accepted as a viable currency.  Historically (at least since unification under Bismarck in the mid-1800s, recovered from the lethal devastation of the Thirty Years War some 200 years before), Germany has had the potential of dominating Europe economically – during the last century, they twice almost pulled it off militarily, and during the short reign of the Third Reich throughout most of Europe in World War II, a little known and researched fact was its massive re-organization of the European economy that was actually quite effective (notwithstanding, of course, the severe moral consequences of domination by the Nazis, and all that entailed).

The twist in this story is not so much how Germany has come to command the European economy, but to what extent some of the other countries have willfully prostrated themselves to curry favor with their voters and their demand for a profligate lifestyle by buying them off with borrowed German money.  (Not entirely unlike the current relationship between the United States and China.)

In Germany and other creditor nations, there is growing concern over the consequent build up of contingent liabilities.  Deposits made through German banks are in essence funding Spanish and Italian assets on an ever expanding scale.  If these countries left the euro, then Germany would face massive, unfunded liabilities.  What's building up is as much a disaster for Germany as everyone else.

The flight to safety has prompted a collapse in yields on government bonds in Germany, the US, Switzerland, Sweden, and to some extent the UK too.  Naturally, this has also driven up their currencies, except in the case of Germany, where because of the single currency, no such thing can happen.

With the natural remedy of exchange rate adjustment ruled out, Germany thus becomes a deflationary doomsday machine for the rest of Europe, a leviathan which sucks the life blood out of everyone else.  It hardly needs me to say it's completely unsustainable. [emphasis mine]

To a great extent, the prediction for the Spanish and Italian economies has already happened in Greece, though at a greater rate yet on a smaller scale.  The Greek situation is already enough to cause a mild panic (but a panic nonetheless) in the Eurozone.  And this without a mention of the similar situations in Portugal and Ireland.

(H/T to Donald Sensing at Sense of Events)