Spain will test the Euro to the brink of destruction
One of the big fears at the Bundesbank over the European Central Bank's commitment to give unlimited support to the bond markets of struggling peripheral Eurozone states, even in exchange for strict budget discipline, is that it could lead to the unlimited creation of new Euros.
And those fears are well founded. In exchange for support the ECB says struggling Eurozone countries must first ask for help from the Eurozone bailout fund, which will come with conditions attached such as lowering budget deficits. Admittedly, this is stricter than anything being demand by the US Federal Reserve or the Bank of England in their respective jurisdictions.
The ECB threatens to cut support if those countries don't follow through on their bailout terms. But therein lies a problem. What if at some point Spain starts to backtrack against austerity and the ECB does indeed withdraw support? It's foreseeable that Spanish bond yields would soar towards the stratosphere meaning that the country could no longer finance itself in the bond markets, which would be disastrous as it would lead to eventual default. Spanish default would wreck Europe's already fragile banking system. Either that or it leaves the Euro and all its bonds are re-denominated into heavily devalued pesetas, which would also hurt the banks and spell the end of the Euro.
It would set the scene for huge uncertainty and a game of chicken, which Spain would probably win given the alternatives are too dire to contemplate for the ECB. From a German perspective it would mean that moral hazard had triumphed with southern countries effectively being financed by the central bank – something that was never supposed to happen. That could see Germany itself decide to leave the Euro or spur the implementation of Eurozone bonds to replace national bonds along with the centralisation of economic decision making. Whether it ever comes to that, it is clear that the Eurozone crisis is far from over and that the Euro will remain a volatile currency. Some signs of a return to economic growth in Italy and Spain would of course alter this gloomy picture considerably.