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ECB bailout plan: Greatest financial bluff ever?


(Moneywatch) The European Central Bank's bailout plan may be the most successful bluff in the history of finance.

On Sept. 6, ECB President Mario Draghi said bailouts were ready for any nation that cared to ask for them. Since then, the once-terrifying tiger of Spain and Italy's bond rates has become about as scary as a sleeping kitten. This has happened even though both nations' economies have continued to fall apart.

The day before Draghi's announcement, the Spanish 10 year bond was at 6.41 and today it closed a full point lower than that. In that time:

  • Spain's unemployment rate has gone broken the 25 percent mark
  • The amount of bad loans held by Spanish banks has hit a record high of $233 billion, including an increase of $7 billion in August alone
  • Hundreds of thousands of people have held protests -- some of them turning violent -- over the government's budgets cuts
  • An increasing number of people in Catalonia -- the nation's wealthiest region -- now favor independence from Madrid

In addition to that, the government is planning to unveil further budget cuts and the Catalan government has scheduled elections for Nov. 25.

There is little doubt that any one of these things would have sent Spain's bond yields skyrocketing without the promise of the ECB backstop. That could have made it impossible for Madrid to afford to borrow the money it needs to stay afloat and forced it to ask for a bailout.

Prime Minister Mariano Rajoy's periodic hints to the press that he will ask for the bailout seems to be enough to keep investors calm despite the fact that Spain's economy is in danger of completely falling apart. This week Rajoy said he would decide "within weeks" whether or not to ask for a bailout. He may or he may just continue to wait for the markets to force him into it.

Italy's interest rates have also continued to fall, despite Prime Minister Mario Monti continuing to say the country would never seek a bailout. On Sept. 5 the Italian 10-year was at 5.51 percent. It is now 4.81 percent.

This rate decrease is likely due to the ECB bailout promise and the fact that while Italy's economy is in bad shape, it looks great compared to Spain.

It is true the government now says Italy's GDP will probably fall 2.4 percent this year, which is twice what it predicted in April. However, the IMF is predicting the GDP will shrink by a comparatively modest -0.7 percent next year and Italy's central bank is expecting it to actually expand. This, along with more government budget cuts and an unemployment rate that has stabilized at 10.7 percent, has investors less worried about the need for a bailout.

So for now Draghi's bluff is working out better than expected by even the most optimistic outside observers. This is letting the EU continue to kick the can down the road and avoid coming up with an actual solution for its economic woes.

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