Monday, May 23, 2011

The Euro-zone Will Split - "It's the incentives, stupid!"

During the financial crisis I found it helpful to ask myself, "what is the worst that could happen?" and "what EXACTLY does that look like?"  By going through the steps of "the worst" it became apparent that the U.S. government could pump money into the system ad infinitum.  Despite the risk of inflation, this was the preferred course of action through stimulus packages and bail-outs.  Politicians knew that if the economy collapsed, in addition to widespread misery and unemployment, they too would lose their jobs come the next election.  As a result, the political imperative was to inflate.

We're seeing a different problem in Europe.  Spending cuts have caused economic malaise and the huge structural inefficiencies in the PIIGS (sorry) will not be addressed in less than 10 years - educational and institutional weakness take a while to progress past. 

Fiscal austerity is leading to economic deflation in vulnerable countries and social unrest.  Most people in Greece and the other PIIGS want employment and dignity.  They will soon be finished with the humiliation of budget cuts, indebtedness to German banks, and 20% unemployment.  Recall that unemployment and losing a sense of dignity inspire anger (and are even the fuel of suicide bombers). These are powerful forces.  The incentive for the populations of these countries is to default, exit the Euro, and start over with a "Junior Euro." 

Democratic citizens will demand a default.  If the current politicians won't do it, eventually they will elect ones who will.  As the political cycle moves forward, and one country successfully defaults (oh, wait, Iceland already did!) all the PIIGS will default (or "restructure" their debts).  No economist can defeat human nature. 

And the consequences?  Well, if you've read the excellent book "This Time Is Different," you'll see tables of data indicating that most countries that default a few years thereafter have better lending conditions.

Personally I'm surprised that this trade opportunity - to short PIIGS European debt and even better, Spanish banks - has remained open for so long.  Maybe another example of delayed learning (it takes us a while to learn and adapt to a new reality like the possibility of "developed" countries defaulting).

And implications of this default for the U.S.?  Near term money will move to U.S. dollars as the safet trade.  Long term?  Less inflation of commodities than you might think - China is going to have its own bubble pop (benignly, hopefully).  Definitely gold will do well.  Yes, gold is in a "bubble", but with real structural momentum behind it, it is likely to go on for a while. 

Happy Investing!
Richard L. Peterson, M.D.
rpeterson- at-

No comments: