In simple terms, Spain has already been through a long period of austerity. If a full-scale European bailout is now required the cuts will become even deeper. Spain is a country that has deep divisions in good times. There is a good chance that it will explode and with that explosion will come a split of the euro, with devastating effects on the European banking system. European bank stocks were hammered last night.
And as I pointed out yesterday (Deposit rates for a European crisis, July 23), that means that the money flow from our pipe to overseas wholesale money will be reduced to a trickle. Australian banks will cover the gap, increasing Australian deposits, but their share prices will be reduced because they will be less profitable.
And, of course, a European breakdown will not be good for China or commodity prices. The Australian budget surplus was always an illusion but we would face a deficit of considerable proportions. If a European break-up is a horror for us then multiply that many times for Europe itself. In situations like this as the looming horror sinks in, usually a way is found to prevent the disaster taking place.
I think that this is what will probably happen this time around and so the world will escape another crisis in the full knowledge that there will be more crises to come.
Its important for Australians is to understand that what is happening in Europe is not some remote event for us. Our banks, during the boom, set in place an umbilical cord with global wholesale money flows, which are dominated by Europe.
The good news is that we have three years to fix the problem because the wholesale maturities and spreads roll over every three years.
As I explained yesterday, our banks have started on a solution via higher deposit rates. They need to proceed with haste but not panic.