Imagine you need money. Imagine you can't print money. Imagine you can print bonds that you can exchange for money. How do you feel now? I would feel perfect in this situation... :)))

That is exactly what Spain is doing. Today the government de facto announced that it will recapitalize the defaulted Bankia Group by using newly issued bonds instead of lacking cash. In normal situation these bonds would lose value as flooding the market with bonds leads to bonds-inflation. So the more bonds the government "prints" the less value in all issued bonds remains.

But we live in a land of wonders. So although much printed, bonds does not lose value. This is due to the policy of European Central Bank to print money and give it as a loans, guaranteed with... bonds. So every issued bond de facto is a newly printed Euro... :) It's a kind of magic... :)

And Spain used this wide hole in ECB system not only for bailouting Bankia. It finances its budget deficit this way. The government prints bonds, banks take them and exchange for cash at ECB. Great, isn't it...

It looks as the most weak place in the Euro system is the one that is thought to be the most strong one - the Central Bank. The ECB is besieged by deeply indebted governments that press it to print money. But even when Draghi and his board resist on this, even then the governments have tools to go around the board by using indirect ways to find cash. Obviously ECB is constructed with big holes so in need the governments to have ability to de facto print money.

Another weakness of Euro zone is so called Target-2 system. When too much money go away from a country, its central bank receives cash from other central banks. This way now Spanish and Italian central banks are extracting money from Bundesbank. Clear money, guaranteed with nothing.

Where is the end of this story? When the wonder will crash in brutal reality?

The end is called inflation. When flooded with Euros, the market will devaluate the Euro. If we are to continue the magic system now we will have to exchange the Euros for something else - gold, oil, etc. But these are classic assets, they are not "paper money". There is no Central bank just to issue (print) them. These assets are limited in quantity and will become more expensive, measured in Euros. I.e. inflation will come, this way deleting the old debts, along with all savings... That is the end of the fairy tale. And this end is not too far away...

Dobri
May 28th 2012