Tuesday, June 21, 2011

The eurozone crisis: Why the US will lose - no matter what

Soon we will hear from Greece, where the parliament is having a vote of no confidence in the government. If the government wins, Greece will comply with demands from the IMF and the EU and cut spending, raise taxes and sell state assets. This won't solve the euro crisis, but it would certainly calm things down for a while.

After analysing the situation, I've reached the conclusion that the US cannot win, no matter what happens. Here are the two scenarios:

1) The eurozone falls. If this happens, it will lead to a banking crisis worst than the one we saw in 2008. The European banks who own Greek bonds will suffer heavy losses, and bank runs will occur in countries like Ireland, Portugal and Spain which are close to default, and that in itself will be enough to push them into default. The problem here is that banks such as Goldman Sachs have made heavy investments in the Eurozone, and soon, the crisis would spread to the US as well.

The banks don't have very good margins right now, having just survived a near-death experience in 2008, which means the government would have to make a choice: Either you bail out your banks again, for the second time in less than three years, or you suffer the financial collapse that you really should have suffered in 2008. It's not just Goldman Sachs, that was just an example. It's everyone really. All banks in the world are more or less connected to one another.

The problem if you bail them out again isn't just the inherent moral hazard in doing so; a second bailout would have very little credibility. The first one where supposed to be the bailout to end all bailouts (or something like that). If there is a second bailout, no-one will ever trust the American banks again, nor will they ever trust the American government's ability to fix the financial system again (and why should anyone trust the government with that in the first place).

This could actually lead to a worldwide currency crisis. The US, EU and China could all go down in a matter of weeks or months. It is a worst-case scenario, for sure, but this could leave us with Russia as the last country standing. Russia has virtually no government debt and a lot of natural resources - exactly what you need in situations like these.

2) The eurozone survives. This sounds like the best scenario, right? Well, it may be, but not so fast: Right now, a lot of investors have bought American treasury bonds because they are afraid to invest in Eurozone, because of the ongoing crisis.

What happens if the crisis is resolved? Suddenly, money will flow back to the eurozone and out of the US. In other words, the US will have to offer a higher interest rate on its bonds to attract investors. Right now, interest rates are artificially low because so many investors are waiting to see what happens in the Eurozone. They keep their money in American bonds because they are about the safest bonds that there are at the moment.

If the Eurozone rebounds, that will change, and the debt burden will then be even heavier for the US. This will deepen the fiscal crisis in the US.

Whatever happens, the US will lose. And now we haven't even mentioned inflation; if the economy actually starts to boom again, then all the money the US has printed during the crisis will flow into the system and create high inflation. High inflation means that investors will demand higher interest rates to lend money to the US, which as I'm sure you understand will make the fiscal situation deteriorate even more (not to mention the fact that American consumers will be hurt by higher prices).

A very dire situation, as you can see. And back there, somewhere in the woods, there's a Russian bear waiting to take over the role as the world's biggest superpower.

/John

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