STAFF NEWS & ANALYSIS
Bankruptcy of the West: Sovereign Debt Default
By Staff News & Analysis - February 24, 2010

Kenneth Rogoff (left), Harvard professor and former IMF chief economist, sees a series of sovereign debt defaults coming. Ballooning public debt is likely to force several countries to default and the United States to slash spending as a result, Rogoff says. Following banking crises, "we usually see a bunch of sovereign defaults, say in a few years. I predict we will again," Rogoff, a former chief economist at the International Monetary Fund, said at a forum in Tokyo. Rogoff told Bloomberg that financial markets will eventually drive bond yields higher, and European countries such as Greece and Portugal will "have a lot of troubles." "It's very, very hard to call the timing, but it will happen," Rogoff says. "In rich countries – Germany, the United States and maybe Japan – we are going to see slow growth." "They will tighten their belts when the problem hits with interest rates. They will deal with it."- Money News

Dominant Social Theme: How the West will muddle through.

Free-Market Analysis: The last time countries verged on defaulting – in the 1930s – the gold standard evaporated. But this time according to Kenneth Rogoff of Harvard, "rich countries … will deal with [their economic crises]." We wonder if he would be so confident if Dubai hadn't been bailed out by sister state Abu Dhabi. Even the prospect that Abu Dhabi wasn't going to guarantee Dubai's debt nearly bankrupted that tiny, ambitious emirate. The upshot was, of course, that Dubai got its money (some of it) and both implicit and explicit guarantees. The world's tallest building also got a new name.

But when it comes to the rest of the world, we are not so sure of a "happy" ending. The issue is not theory but practice. In theory, as countries offer more attractive bond rates, global hot money will seek a combination of yield and safety. It may be possible for weaker countries to offer attractively priced debt, but the risk of default may outweigh the price – at any price. Thus it is that Greece, Portugal, Spain, et al. (the Pigs) are in jeopardy not just of sky-high interest rates but also ruin regardless.

Rogoff may be fairly sure that the larger, "richer" countries will muddle through, but we begin by questioning his definition of rich. By almost any yardstick the United States is rich in military hardware and foreign military bases (some 1,000 of them) but the country is also tens of trillions of dollars in debt. Not only that, but it has looming obligations regarding baby boomers that will only worsen the federal balance sheet. We don't know exactly how Germany and Japan stand – but we do know both countries have aging populations, debts and obligations that are beyond their means and, even worse, are export oriented.

With the US struggling and the EU teetering, exactly where are the exports that Germany and Japan make supposed to go? We think this question needs to be answered before one can assume as Rogoff does that "rich countries will deal with it." The additional question that looms in the background (like the proverbial 900-pound gorilla) is China. As we have pointed out long ago, and many pundits (much wiser than we) have taken to repeating, China is in the middle of a tremendous, titanic financial and economic bubble that likely goes back a quarter century, ever since Henry Kissinger brokered the fiat money door opening, and encompasses everything from the stock market to real-estate to banking and far beyond.

The Chinese government recently announced a tightening of the money supply but this is the equivalent of dousing a house fire with a paper cup. The conflagration will burn on because the fuel was provided long ago. Anyway, be careful what you wish for. When booms are eventually punctured they tend to deflate dramatically. China has a central bank. It uses fiat money and it is in the grip of tremendous industrial boom. Chinophiles can talk all they want about China's new industrial revolution and how rational it is. If it looks like a bubble, smells like a bubble and inflates like a bubble, it's a bubble.

So there is one big question, a modest one to be sure. What's going to happen to the world economy when Japan and Germany have no one to export to and China's bubble finally begins to implode. The communists running the place have big plans to keep the shell game going by harrying their own billion-plus population into buying the goods it was previously exporting. But we are not sure how many singing Barbies the Chinese will ultimately want to buy for themselves, nor how many cars or summer homes they will wish to splurge on.

Finally there is the United States, the wealth of which we have already tried to put in perspective. While the Afghan war looks set for a longer haul, even the "best" war (a limited one against an impoverished population) when pursued long enough is not a very profitable proposition. Some get rich but the taxpayer tends to grow poorer and poorer. The US Street has tolerated the war for so long because of theories about 9/11, because the conflict is being waged by a volunteer army, and because the body count and general mayhem have not been widely reported. But let the war drag on while the economy worsens and we figure the inch-deep support for the Afghan war will evaporate entirely as it has in Europe (see other article). The support may eventually weaken even more profoundly (ultimately) if there are renewed difficulties in Iraq or if hostilities are pursued with Iran.

As we look around the world, it does not seem to us as if rich countries are any better positioned to weather an exacerbated global hurricane than weaker ones. Economies tend to be moving targets. A couple of sovereign defaults and a real collapse in China would totally change the international financial perspective in our opinion. Even Rogoff might change his mind.

When we predicted the US Federal Reserve was headed toward radically diminished popularity, we believed we were ahead of our time. The same with our perception of the China bubble. Our track record is not so bad, dear reader, and we will not assume a posture of false humility. But perhaps you will, yet, have a hard time believing us when we write that the upcoming sovereign debt may change the way the world works. Rich countries may NOT work it out.

For us once more the issue comes down in Iarge part to the Internet. This collapse is not taking place in the bowels of trading floors or the shadowy environs of parliamentary cloakrooms. This collapse is playing itself out across the spectrum of a brand new electronic communications device that has been making a difference every day in terms of humankind's collective knowledge. The Tea Party movement in the US is a result of bad times, but it is also indisputably a result of the Internet and access to information there. Likewise, we would believe, the EU's increased anti-war movement.

The Internet is the wild card in all this. Economic crises come and go, but this one is playing out in living color. That directly involves the European Street, which like the continually rebellious Iranian Street, will find the Internet a good organizing tool as well as good way to share information and education. And that constitutes the bet, therefore, that savvy investors will have to make. Will this prove to be just a run-of-the-mill ho-hum economic crisis or will it prove to be something much more significant thanks to the 'Net – something that has an impact like the Great Depression which ended up removing the world from the gold standard?

After Thoughts

We are on record, here at the Bell, as predicting that there is certainly a chance if things do unravel badly that the world will adopt by default a kind of private gold and silver standard. But generally the impact of a great unraveling would have an impact on every kind of investment from stocks to bonds to honest money to fiat money itself – and on pensions and a broad spectrum of guaranteed income streams. Nothing would prove sacred. In our opinion nothing is.

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