Mutually assured destruction: Eurozone crisis in historical perspective

Larry McDonald urges the Eurozone to reach fiscal union or suffer the consequences

As Europe agrees to pay €100 billion to recapitalize Spanish banks—and Germany faces mounting pressure to bail out its unstable neighbors—author and former bond trader Larry McDonald is urging the E.U. to reach a fiscal and banking union soon, or face “mutually assured destruction.”

In a recent newsletter, McDonald put the global financial crisis into a historical context, comparing the current economic situation to that of the 1930s, when a U.S. recession crossed the ocean to Europe, only to return to American soil. He also points out that sovereign debt and default are not uncommon.

But, he says, this historical precedent does not mean that Europe shouldn’t be worried. “We are living in an elevated period of earnings, GDP and stock market volatility,” McDonald says, owing to the fact that “we are surrounded with 1000x the systemic risk factors the global equity markets faced from 1980 to 2000.”

This risk, and the resulting economic uncertainty, has pushed Spanish 10-year bond rates to highs above 7 percent. According to McDonald, this spells trouble for U.S. equities, which “don't move higher with the unresolved systemic risk sitting in the banks in Spain.”

Notwithstanding the exodus of foreign capital from Spain’s banks, Prime Minister Mariano Rajoy has reportedly resisted making concessions during bailout negotiations, evidently assuming that Germany will eventually agree to rehabilitate Spanish banks without conditions.

Meanwhile, German Chancellor Angela Merkel has dismissed proposals to guarantee bank deposits or issue joint euro bonds as “miracle solutions.” But Germany has much to lose if the Eurozone fails. McDonald cites a study from investment bank KfW showing that Europe’s currency union has netted Germany profits of €50 to €60 billion in the last two years.

For his part, McDonald supports a “deep and detailed stress test with a right sized bank recapitalization plan” to remove the ceiling on U.S. equities (results of an independent audit of Spain’s banks are expected later this month).  He also enumerates the European Stability Mechanism’s options, including direct lending to banks, Eurobonds and deposit guarantees.

Futures interview with Larry McDonald

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