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The Coming Age of Defaults

Posted By Guest Author On September 17, 2011 @ 7:00 am In Think Tank | Comments Disabled

The Dismal Optimist started out as a simple letter sent out to clients and friends. Without any advertising, its circulation has reached the point where it has outgrown its simple Hotmail format. My daughter CC, who is a designer and art school graduate, has be complaining to me for months that it needed a more professional look. She has redesigned the format and this is the new look.

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The Coming Age of Defaults

“Some people actually believe government can create jobs by taxing and borrowing from people with jobs and then giving that money to people without jobs. They call this demand stimulus. To make matters worse, other people think these demand-stimulus ideas warrant a serious response.” -Arthur Laffer, Wall Street Journal, Sept 12, 2011

“It’s a good idea to save your money. One day it might be worth something again!” -Alfred E Newman

The Euro – Free At Last?

As I began to write this, the media was reporting that Greece was on the verge of default. I started to write “let’s do it!” Default of one sort or another may be the only way out not just for Greece but for a vast majority of borrowers in the Western world. In my opinion, a Greek default need not bring the end of the euro.

Unfortunately, it now looks like Greece will get bailed again and the country’s default will be put off. All of the top European leadership apparently believes the survival of the euro depends on Greece not defaulting. German Chancellor Angela Merkel, along with French President Nicolas Sarkozy, is doggedly trying to avoid a Greek default. I applaud Merkel’s steadfast backing of the euro concept and European unity. But deep in her East German heart, she doesn’t trust markets or her own electorate for that matter. It’s too bad.

As I look forward, what I see is the coming end of the populist/socialist welfare state. It’s not going to be pretty but depending on the medicine taken, brighter days could lie ahead. The euro crisis is about much more than the euro. Massive unpayable debts and obligations have been accrued by all Western countries and their citizens. Default is the only way out. Investors have to be sure that they are not the ones defaulted on.

The populist/socialist state will need drastic alteration. The bond markets will force this. Intellectually Europe (and to a lesser extent America) is of the left. Barring a massive fiscal conservative sweep in the US 2012 elections, alteration of the populist/socialist welfare state won’t be initiated by politicians. Witness the continued political theater on this subject in the United States. Universal suffrage- based European electorates, along with those of the US and Japan, have voted themselves a cornucopia of welfare benefits. Let the rich pay, we are entitled. The coming demographic tsunami of old people supported by fewer and fewer of their adult children makes this an untenable situation. The days of cornucopia are over.

Dismal vs. Optimist

People have complained that this essay is all “Dismal” and no “Optimist.” Let me set that straight. The long run outlook for humanity (including investors) is bright. While the debt crisis looms and markets are going haywire, globalization and technology will march on as indeed they did even in the dark days of the Depression and WWII. Asia in particular will become a locus of technological progress as millions of Asian scientists and entrepreneurs join the global economy. Smart young Americans and Europeans may migrate to Asia if the US and Asia make the wrong decisions on the debt crisis. In any case American tech firms will become more and more Asian in terms of their own employees and facilities locations.

I have long been a fan of Ray Kurzweil who has written about the law of accelerating returns. Essentially Kurzweil sees technology as accelerating and taking over human evolution. (Kurzweil sees homo sapiens as eventually being replaced by Artificial Intelligence successors. Some people are put off by this. But you don’t have to buy that to accept Kurzweil’s insights on accelerating human progress) The global internet and computer technology links the millions of new minds and entrepreneurs and accelerates progress and technology.

America is renowned for its innovation and technology. If the right decisions are taken as a response to the coming debt crisis, that will continue. Emerging Asia is a growth technology center. Longer run, these are the areas that will reward investors.

What Europe Should Do

Since the beginning of the Greek crisis I have been arguing that Greece, like the American states in the 1840s, should be allowed to default and that the euro would come out of such an event stronger. I have argued that the euro represented a tremendous value-added in both economic and political terms and that the force of history was behind it. Turning the clock back would be a catastrophe.

Unfortunately the Europeans so far have managed to do all the wrong things. Once viewed as the Bundesbank reincarnated, the European Central Bank (ECB) has shed that image and has been buying the bonds of the so-called GIIPS countries (Greece, Italy,Ireland,Portugal and Spain—slightly more polite than PIIGS). Now Europe is in the throes of putting together a second bailout for Greece. The new European bailout fund, the European Financial Stability Facility (EFSF), if it is going to bail out countries, is a giant step in wrong direction. Germany, the strong economic man of Europe, will be turned into an ATM machine. Needless to say, the German electorate is less than overjoyed at this and the German electorate is rebelling.

In the twentieth century, catastrophe was something the Europeans seemed to seek out. In 1909 Norman Angell wrote a book called The Great Illusion in which he argued that war among the European powers was outdated and unthinkable because its cost would be so high. He was dead right. Unfortunately in 1914 Europe went on to have its war anyway and then for good measure went on to have an even worse one twenty years later. It made a special effort to massacre its Jewish population, which was in the vanguard of science and finance. In 1914 Europe (including the UK) ruled the world. By mid-century Europe was a morally and financially bankrupt force. Who is to say the Europeans will not choose catastrophe again?

I know that Milton Friedman and Martin Feldstein, recognized gods in the economic profession and both heroes of mine, predicted trouble for the euro. They assumed a European currency in the absence of European political union would eventually founder. So far they are looking pretty prescient. Nevertheless, perhaps with more hubris than brains, I would argue that the euro can get by the current crisis without taking the step towards further political unification.

Here’s how Europe can do this:

1. Embrace the rule that each member state must be responsible for its own fiscal affairs. No sovereign bailouts. Bailouts are just throwing good money after bad. Let the Greeks and all the others default. Let the markets impose the discipline, not the Germans. The weaker member states will simply have to live within their means. They have been living beyond their means since the euro began. They should not be able to rely on a German ATM machine. Somehow the Europeans have lost sight of the concept of responsibility. In this case, it should be the obligation of each member state to conduct its fiscal policy responsibly. The world and Europe needs the euro. The market has finally learned there is a difference between Greek and German debt, even if they are both denominated in euros.

2. Each country should recapitalize its own banks if these banks cannot raise capital on their own. The IMF and the EFSF should step in and help the weaker countries who cannot afford to fully recapitalize their own banks. The banking system cannot be allowed to collapse. The operative word for Europe should be “T A R P”. Thanks to Basel II which treated each member country’s sovereign debt as a risk free asset, the banks of Europe are stuffed to the gills with European sovereign paper. Basel II provided a perverse set of incentives for the bankers to toss risk analysis to the wind. Along the same lines, stress tests that didn’t haircut sovereign debt are an intellectual fraud and a joke. There is a substantial likelihood that a significant number of European banks are insolvent on a genuine market to market basis. IMF chief Christine Lagarde hit the nail right on the head when she ruffled feathers and called for capital injections into the European banks.

3. No country should be encouraged to leave the euro. But the Greeks and others should be allowed to make that decision on their own. I think they will choose to stay in the euro. For any departing country, this would entail the forced conversion of euros into some kind of devalued new national currency. True this would be a type of default. I just argued default is necessary. But I don’t think any European government has the political will to default on its own citizens in such a manner. The Greeks would burn down Athens. And Greece would still owe its sovereign euro denominated debt, upon which it will default anyway. A Greek departure would engender a bank run of unthinkable proportions in neighboring GIIPS countries. (As it is, I don’t understand with all this talk of weaker countries exiting the euro why any Italian or Spaniard or Greek with a brain would leave his or her euro deposits in one of their national banks.) Greece exiting the euro for a bank depositor means a giant capital loss when his or her deposits are forcibly converted into the new debased currency. Staying in the euro means that Greece and the other weaker countries will have to adjust their wages and prices to more competitive levels. I think this is an easier task than a monetary scorched earth policy that leaving the euro will require. The idea of an independent Greek central bank replacing the ECB is not believable. It will turn into a money printing machine and the new drachma will be avoided by all. Greece is not Argentina. In 2002, Argentina got away with breaking its dollar link and devaluing its citizens’ bank accounts. But Argentina is located at the end of the earth. Its citizens had nowhere to go. And Argentina as a major agricultural country got lucky. China was there to buy its exports. Greece is in Europe. No agriculture. They can’t sell China the Acropolis.

4. Problems with the euro payment system have to be addressed. This problem is described in detail in a recent paper entitled “Europe on the Brink” from the Peterson Institute. According to this report, obligations of over three hundred billion have been incurred by the GIIPS central banks to the German central bank. According to the Peterson report, the ECB has effectively guaranteed these obligations. But this form of backdoor financing for the GIIPS should be ended.

5. The ECB should provide liquidity to the European banking system which will be needed during the turbulent months ahead as Greece and possibly other countries need to restructure their debts. The just announced support for the ECB by other central banks is a positive step towards maintaining a functioning banking system. The ECB will be needed until the sovereign debts are restructured and the banks are recapitalized. Bank liquidity not solvency should be the ECB’s problem.

6. Bloated governments have to be cut and growth oriented supply side policies implemented including tax simplifications and reductions, privatizations and the elimination of regulations. The austerity plan imposed on Greece with its tax increases is already killing growth. Warren Buffet excepted, no sane citizen is going to be happy to pay more taxes to finance a bloated welfare state. Regardless of whether Greece stays in the euro or not, if the Greek government doesn’t implement growth policies the best and the brightest of Greece will emigrate. Greece as a country will be finished.

Investment Survival in a World of Near Term Chaos and Long Term Technological Progress

Investing in the current environment is extremely difficult. Short rates are near zero and returns on cash inflation-adjusted are negative. Extreme volatility has become the new normal. The Fed and other central banks have recklessly thrown caution to the wind with their various quantitative easing programs. And the prospect of global defaults lies ahead. The US and Europe are verging on a new recession. Asia faces inflation and at least a slowdown. There’s no place to hide.

I continue to see recommendations that investors buy emerging market and American tech stocks. The former are located in countries without excessive levels of sovereign debt and with relatively high GDP growth rates. The latter have loads of cash, in some cases pay significant dividends, have come down price and, as I have argued, technology is accelerating. The trouble is that near term—and that means the next year or so at least—nobody can promise that a drop in stocks similar to 2008 cannot happen. Long term investors may be able to ignore a let’s say thirty percent decline in their holdings near term so long as they make some multiple on their money say five years out. But most investors don’t have that kind of staying power. The decline of the populist/socialist state will not be pretty and accompanying defaults may pull markets down all over the world.

I have written extensively on the imperfections of the current dollar based fiat money international monetary system. I view gold as one way to hedge against that system’s eventual downfall. Asian central banks and retail buyers both have discovered gold. Living part time Hong Kong as I do, I detect huge enthusiasm for buying gold among Mainland visitors who come to Hong Kong. Gold recently has run up in a rocket-like manner. No doubt it needs to consolidate near term. Various people have come up with ways of valuing gold including comparing gold with inflation or calculating how much gold would be needed if some version of the gold standard were to be reinstated. I don’t have a formula for calculating the value of gold and I don’t have some kind of target price. Clearly there isn’t enough gold at current prices to support an entire global monetary system and a revived gold standard. Looking at gold that way leads to the conclusion it is substantially undervalued. Gold in my opinion is an alternative currency. So long as the current dollar based fiat money system remains in place, gold remains an important hedge. But what the gold price will do near term is anybody’s guess.

The historian Daniel J Boorstin once said “The greatest obstacle to discovery is not ignorance – it is the illusion of knowledge.” Lots of investment advice is coming from all sides from people suffering from the illusion of knowledge. We are in a difficult period without historical precedent. The illusion of knowledge could be fatal.

-Peter T. Treadway

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Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.

Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.


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