Europe's Unfolding Crisis

Brian Hicks

Updated August 23, 2011

Many years ago, some nameless Department of Defense bureaucrat decreed your editor would best serve his country in Frankfurt, Germany. 

When I first arrived at my overpriced, government-paid-for apartment in the sprawling Frankfurt suburbs, it was an exceptionally hot summer afternoon.

I pulled up and parked my BMW on the street next to my place. There were a few retired folks who came out to see what was going on. We waved. We exchanged Germenglish pleasantries.

As I was carrying in my first box, someone called out, “Hallo, nachbar!” I turned around and there was Olaf.

He was about 40 years old, 250 pounds (at least!), and wearing nothing more than slippers and a thong, a garment only a stereotypical German would be comfortable walking around in.

He had the day to himself, nothing pressing to do, and was nice enough to help me move my stuff in.

Over the next few weeks, when I went to work, Olaf was there. When I’d come home, Olaf was there.

Everywhere and always, Olaf was there.

He didn’t have a job or anything close to it; he wasn’t disabled or unable to work, but he still had an ample apartment in a nice neighborhood, and clearly the man hadn’t missed too many meals…

He simply didn’t work because he didn’t want to or have to.

Olaf was your typical European. And there are tens of millions of people out there just like him…

Together, they are bringing down Europe. And the implications of it all are coming to a head right now.

No More Room Left on the Wagon

Olaf is one of the millions of Europeans who has been freeloading on the redistribution of the wealth wagon for decades.

His free ride has come at a price. His neighbors and his government’s credit have paid for it all.

Today that’s all coming to an end. There’s no more room left on the wagon. There are already too many riders and not enough pullers. The government’s credit limit is near its max.

Something has to give. And what gives will be an all-too familiar story we’ve seen play out many times before — and will see many times again — of reduced economic growth, higher unemployment, more financial system instability, and increased market volatility.

But here’s the thing you must understand about Europe: The market already knows about Europe’s problems and understands what the solution will be far better than any financial pundit commenting on the recent market volatility.

Here’s what you need to know…

Baked in the Cake

The entire financial world knows Europe is mired in debt.

The holders of that debt and speculators are betting heavily on insurance policies against default on that debt.

The common way to “insure” that debt is through the financial market equivalent of insurance known as Credit Default Swaps (CDS).

The table below shows the cost to insure against a sovereign default can be exceptionally higher relative to sovereign credit risk:


As you can see, the cost of insuring against defaults of the worst sovereign credit risks are multitudes higher than the perceived credit-worthiness of Germany, Sweden, and the United States.

Clearly, Mr. Market knows about the risks and is acting like it.

But that’s just the first part of the story; the second affects the timing.

We’ve Already Seen This Movie

Nations basically have three options when it comes to dealing with debt:

  1. Pay it back
  2. Default on it
  3. Inflate it away

The first two are economically and politically impossible.

In order to pay down the debt, tax rates would have to go up substantially. The tax rates required to pay it back would lead to less growth and, as a result, less net government revenue. It’s an economic death spiral.

Any outright default would be catastrophic. The political consequences of ripping the debt Band-Aid off would be far too risky and costly.

The only economically and politically viable solution will be to slowly tear the Band-Aid off and simply inflate the debt away. There’s no other practical or likely solution. But it’s not going to happen in the next week, month, or year.

And understanding the when is critical to surviving the current market turmoil.

One More Rung on the Ladder

There’s one more stage most investors haven’t accounted for yet in this process.

If you’ll notice, since 2008, the debt cans have not been kicked down the road. They’ve actually been bumped up the ladder in that the next level of responsibility has almost always assumed the debt loads.

In the United States, for example, the government took on trillions of dollars of new responsibilities. The largest were Fannie Mae and Freddie Mac. Those two alone have put Uncle Sam on the hook for as much as $5 trillion in additional debt.

There were also countless more which didn’t receive as much attention. The government ramped up export-import guarantees. It took on the responsibility and costs of nearly $1 trillion in student loan debt as part of Obamacare. It added even more with the Build America Bonds program. (Of course, these programs have no explicit guarantee — much like Fannie Mae and Freddie Mac).

The Europeans have made strikingly similar moves.

With each new European bailout, Eurozone governments have assumed responsibility for an ever-growing portion of its members’ sovereign debts. It started off as just a few billion dollars’ worth of debts…

A few “emergency measures” later and it’s over a trillion dollars. There are surely more to come.

Germany, France, and others can still borrow more, and as long as their credit-worthiness is on the line, their European neighbors will be able to borrow as well.

At some point it all has to end.

When governments have assumed all the debts, there is only one way to go from there — and that’s down.

The New Era Has Begun

In the end, beware of large German men wearing inadequate thongs. They have, are, and will cause more volatility in the markets.

But if you understand why it’s happening, what the eventual result will be, and a reasonable time line for it all to happen, you can safely ride it all out and position yourself for the opportunities that present themselves as a result.

The Era of Financial Repression is here. The financial world will be jumping from temporary crisis to temporary crisis. The solution will always be to borrow and print more money.

The best move you can make right now is to prepare for it.

Good investing,

Andrew Mickey
Editor, Wealth Daily

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