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January 9, 2012

Armageddon Out of Here

By Spear's

So the eurozone has had to bow to the inevitable: Greece is insolvent, is unable to pay its debts and has defaulted. The EU Summit came up with a ‘solution’ for Greece and the three principal players all gave ground: Merkel accepted French demands for a haircut of 20 per cent for the private sector; the ECB accepted a default had to happen; and the EFSF abandoned its pretence of exercising moral hazard by reducing its interest rate from 5.5 per cent to 3.5 per cent for the stuffed PIG — Portugal, Ireland and Greece. The EFSF will also be authorised in future to conduct market operations to buy bonds of countries under pressure and conduct bail-ins. Greece will still be left with €340 billion in debts.

Since the summer of 2011, we have witnessed the slow but inevitable crash of the failing eurozone at an endless stream of summits that couldn’t agree on anything and provided no solutions. The obvious short-term fix is an ECB-backed €2.5 trillion bond, but Germany steadfastly refuses this. Europe remains deadlocked and in Washington the politicians are unable to agree on anything to deal with their debt crisis, whether cutting expenditure or raising taxes, other than raising the already bloated federal deficit total to $16.4 trillion.

The politicians and the central banks have lost control of the situation, to the point where no-one can work out the numbers or predict anything with any certainty any more, a point admitted very publicly by the redoubtable Sir Mervyn King on a recent Monday: ‘I cannot even forecast what will happen on Tuesday!’

At Spear’s, we forecast the banking and credit crisis in July 2007; we forecast the inevitable double-dip and banking crisis 2, which are now breaking, over a year ago; we forecast the break-up of the eurozone as currently constituted earlier this year. So what do we, what can we forecast now, other than the absolute worst, and hope for something better? If you don’t want to know the score, look away now.

The break-up of the eurozone, with the PIGS leaving, would cause enormous and unsustainable losses for banks and investors, as the old euro-denominated debts will be practically worthless in the ensuing crisis. The economic dislocation and consequent banking collapse will plunge Europe into a deep recession and possibly Great Depression 2, which in turn will help send the global economy into recession, and possibly worse.

Two factors will drive this downturn, neither of which are measurable: confidence and contagion, and in the global economy they could both go global, but to what degree no one can tell. It seems reasonable to assume, however, that the collateral damage to the over-indebted American economy could be as severe as in Europe, which would ensure a global depression.

In this scenario, the US and UK would have no option but to fire up their printing presses to cope with the growing government deficits, already far too high, and hyper-inflation would be the eventual and inevitable result, along with rising interest rates. This would have the positive effect for them of inflating away their debts, but at the expense of their lenders, like China and their own institutions.

At some point in all this mayhem, fiat currencies would have to have the decimal point moved one or two places to the left, so that $100.0 becomes $10.0 or just $1.00, as they all go back to the Gold Standard and the price of gold soars through the thousands of dollars per ounce. Keynesian and Friedmanite solutions would be proved to be equally misplaced by this outcome.

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In Europe, Germany and France would preside over a much smaller eurozone and would be left to ruminate on whether it was worth continuing it — unless France was also dragged down by its banks and their loans to the PIGS, that is. This scenario is referred to as a disorderly break-up of the monetary union, indicating that the markets moved faster and more effectively than the politicians and their crony bankers. Such an outcome should surprise no-one, based on the record to date.

The middle classes would wake up to find their pensions and houses and other financial assets are pretty much valueless; today’s strikers for higher pensions would find they had wasted their own and everyone else’s time; unemployment will reach 30 per cent or more; strikes and civil strife will be widespread; soup kitchens will have to be available in the worst hit spots. The world would be a very unstable place, and conflicts would be inevitable, as every nation struggles to save its own economy. This absolutely worst-case scenario is completely possible given the failure of the world’s leaders so far in this four year-old crisis.

Indeed, the situation is approximate to what happened in the Great Depression, which ended in World War II. The similarities between 1931 and 2011 are extremely uncomfortable, to put it mildly. Indeed, it would not surprise anyone to hear tomorrow that a major bank, or two, in Europe or America, has folded, à la CreditAnstalt, and that the domino-effect of Armageddon beckons. As we said: this is the worst-case scenario.

And the root cause, as Spear’s has consistently said, is the excessive level of debts accumulated just about everywhere in the G7 in the uncontrolled boom since 9/11, when interest rates were left far too low for far too long. These debts swamped the banking system, which was bailed out by the public finances, which in turn are now themselves swamped in debt.

These debts are a break on the supply side of the economy, and real growth is negative, in turn compounding the negative debt dynamics of central exchequers. Indeed, as the world racks up yet more unsustainable debt and higher deficits, and now with zero growth in the G7 economies as well, some sort of outcome along the lines of Armageddon becomes more probable by the day — unless…

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