This column originally appeared on Real Money at 6:30 a.m. EDT on June 6.
NEW YORK (
) -- Readers will no doubt recall the famous experiment by Russian scientist Ivan Pavlov, but here's a reminder. Dr. Pavlov would ring a bell and then give a group of dogs a tasty treat. After repeating this process many times, the dog would display a physical reaction -- in particular, salivating -- as soon as the bell would ring.
Investors, too, are becoming conditioned -- by European policymakers. Every time a major eurozone sovereign bond starts trading above 6% or so, we all know some policy response is coming. Like the dog expecting a treat, we start buying risk assets, knowing that a big relief rally is coming. Indeed, on Tuesday, the stock rally was fueled by talk of Europe creating a union-wide banking supervision ahead of a G20 summit. Traders were scared to be short, knowing such a position could blow them up with just one wrong headline. So a rally gets triggered by any sort of story about Europe having a plan.
The reality is that Europe is rapidly running out of options. We know Spain has experienced serious deposit flight in recent weeks. Similar to Pavlov's dogs, we can discern a great deal about people's mentality by their reactions. The Spanish citizenry has conducted a simple cost-benefit analysis: either leave my account in a shaky bank, or transfer it to a foreign bank. If one chooses the former, there is a chance, however slight, that the government may eventually force a redenomination to pesetas. If one transfers the money to a foreign bank, there is no risk of this. As long as a person believes there is any nontrivial chance of a Spanish exit from the euro, the choice is easy.
As soon as some people start drawing this conclusion, more and more will follow. I don't need to lecture the reader on the nature of bank runs, so suffice to say that this situation is liable to become self-feeding. We also know Spain doesn't have the funds to keep its banking system afloat. For the moment, Spanish banks can remain liquid because of funding from the European Central Bank. But depositors -- and the market -- know this can't continue forever. If the banks can't even attract depositors, they certainly can't attract fresh private capital.
Something needs to change to stem the tide of Spanish deposit flight, and merely having a continent-wide banking supervisor is not going to do it. Bringing in new supervision isn't going to turn a functionally insolvent bank into a solvent one. It isn't even going to buy that bank some time to get solvent.
Spain cannot allow their banks to collapse. In any sophisticated economy, a great deal of day-to-day transactions require financing. Should the Spanish banking system collapse, it would throw Spain's economy into a depression. Large declines in gross domestic product mean less tax collection, which will eventually result in a Spanish default.
In order to solve this problem, there has to be a material shift of either money from Germany to Spain and Italy, or risk from Spain and Italy to Germany. There are no other options. There are many potential forms this could take, but most of these are politically or practically out of the question. Eurobonds, for example, have plenty of political problems. But, more important, such a scheme probably couldn't be implemented fast enough. Spain has a month or two -- that's it. Europe won't agree to a Eurobond scheme that quickly.
Other options, such as another round of the long-term refinancing operation (LTRO), could buy some time. But it isn't clear this remains politically acceptable. Further, it may be much less effective if banks are suffering deposit flight. Most important, we know that the first LTRO didn't "solve" the problem -- so, unless LTRO is much larger and/or more permanent, the market may consider it too little, too late. A permanent LTRO-style program would be fine (except for the massive moral hazard, but that's another story), but it doesn't seem to be politically possible.
The only action that would really work would be a Euro-wide bank deposit guarantee. If that were put into effect, Spanish bank customers wouldn't consider their banks any more or less safe than foreign banks -- so why not just leave the deposits local? That would buy both the Spanish government and Spanish banks time to work through their problems.
Everything gets better with time. I'm convinced this is the only solution left. So, if markets rally on other possibilities, I'll be a seller.
This complementary article originally appeared in Real Money, a premium investment information service from TheStreet, Inc. Click Here to start your free two week trial of Real Money courtesy of TheStreet.
At the time of publication, Graff had no positions in the securities mentioned.
Tom Graff trades taxable fixed income for
, an independent investment advisory firm in Baltimore, Maryland.
Prior to joining Brown, Graff was a Managing Director and taxable fixed-income trader for Cavanaugh Capital Management in Baltimore. Graff earned a CFA charter in 2001.
The opinions expressed here are Graff's own and in no way the statements of Brown Advisory, and may or may not reflect the strategies being pursued for clients of Brown Advisory.
Tom welcomes your questions and can be reached at email@example.com.