The European Central Bank (ECB) has acted much too slowly and without the consensus of its constituent countries during the current European sovereign debt crises.  Rather than learning the lessons taught by the American Fed Reserve, Treasury and Congress in 2008, the ECB has equivocated, delayed actions and then subsequently had to reverse itself damaging its own credibility in the process.  The head of the ECB, Jean-Claude Trichet, likely initiated the path to disaster by moving to raise European interest rates in early 2010 against the advice of other central bankers, including American US Treasury Secretary,  Tim Geithner.  This had the effect of further eroding already crippled Euro state economies including those of the southern tier of states: Greece, Italy, Portugal and Spain.

In the past two months, sovereign debt problems have grown worse with the indebted states paying higher interest rates, in large part because of the early 2010 ECB announced actions to tighten money supply.  The lack of ECB commitment to support the over-levered states and work with them to reduce debt also contributed to the unwillingness of bond holders to continue lending at reasonable interest rates, pushing rates and budget deficits higher.  It doesn't help government insolvency prospects that the debt has become more expensive to refinance and that higher interest payments further undermine national budget deficits. 

There are only two ways out of these crises.  And until very recently, Trichet and the ECB didn't appear interested in either approach.  The least favored, other than breaking up the EU altogether, is to undergo sovereign defaults on the debt owed.  This would allow for restructuring of the terms of payment through a process similar to bankruptcy, but without a court or judge.  The resetting of bonds would lower interest payments and possibly principal payments reducing the burden on the distressed states.  The problem with defaulting on debt is the ripple effects it will have through the global financial system.  It would likely result in an unwinding of derivatives and a series of bank and investment fund failures in a replay of 2008.  This would be very unsettling for world capital markets and could result in a second and deeper recession than in 2008-09 as lending and consumption freezes up.  Higher unemployment and even civil chaos could be the result.

A second approach, more desirable for its less onerous consequences, would be to devalue the Euro by monetary quantitative expansion (QE), i.e. printing money.  Of course, today money is not physically printed to increase the amount in circulation.  It happens via accounting entries to each countries currency account at the ECB.  A CNBC story today proposed that 10% of GNP be credited to each EU country's account.  This would immediately increase national currency balances in Euro terms.  Currency is an asset on the national balance sheets, so immediately goes to reduce the deficit, if artificially so.  By having more currency in circulation without any commensurate liabilities or national productivity increase as measured by GNP, it would also serve to devalue the Euro by the same 10% amount.  This is essentially what has been taking place in the marketplace anyway, as the Euro has lost over 20% of its value versus the American dollar so far in 2010.  But to have the market make the adjustment can be unsettling for global markets and not as controlled as if the ECB manages the process.

The devalued Euro currency would be used to repay sovereign bond debt.  Since the Euro would be worth less (an additional 10% reduction on top of the 20% devaluation to date in 2010), the bonds would be worth 30% less in an alternate currency, including gold.  Interest payments on the bond principal would also cost 30% less in alternate currencies.  So, in this way, bonds are reset to a lower principal level, without the negative global consequences associated with forcing bond holders to accept changed terms through the process of default.

If this inflationary action is not taken, the debt reduction programs underway in Europe will reduce currency in circulation and will act to deflate the Euro.  Deflations result in a higher value currency versus alternate forms of currency, including gold.  Without any counteracting inflating of the Euro, it will rise against the US dollar, possibly to 1.50 or 1.60 EU to the $1.00.  This will further hurt European competitiveness and will extend the global economic contraction.

Here is a link to the CNBC article by Warren Mosler that recommends devaluing / inflating the Euro.

As I post this article, the economic leaders of the G20 nations are meeting in Busan, South Korea to discuss global economies and the policies needed to continue the recovery from the 2008-09 debt crisis.  We are at a critical moment and the central bankers and government leaders must make the right policy moves on monetary policy, debt management and economic growth.  Tim Geithner has been pressing the European nations and Japan to encourage consumption so that America and China do not have to bear the entire global load. 

The next 2-4 weeks will tell the story whether the Europeans get it right and manage their currency and sovereign debt in a way that does not panic the capital markets and kill the global economic recovery.  There is some promising news as on June 2, Trichet reversed the course previously set and offered to extend the low rate environment to ease the pressure on the over-indebted Euro states.

Tags: Bond Holders, Constituent Countries, Credibility, Crises, Debt Issues, Debt Problems, Distressed States, Ecb, European Economy, European Interest Rates, Fed Reserve, Global Financial System, Greece Italy, Insolvency, Interest Payments, Jean Claude Trichet, National Budget Deficits, Principal Payments, Ripple Effects, Sovereign Debt, State Economies, Tim Geithner, Us Treasury Secretary

There has been much hand-wringing over Dubai and other countries and their sovereign debt problems since the end of November.  There is a fear that the exposure of this debt might be the tip of the iceberg.  It is feared that the government debt crisis will spread from the small and traditionally weak and underfunded economies of Portugal, Spain, Greece, Italy and Ireland (the PIIGS) to the more substantial and traditionally strong economies of France, Germany, Japan and the United States bringing with it the fear of a global sovereign debt melt-down.  This opinion is emotional and uninformed

All the "sovereign debt default" talk about Dubai, Greece and Spain is old news that is just now getting press because what was already in motion at the top of the debt bubble in 2007 is finally coming to fruition.  Now that the commercial bank crisis has been for the most part averted, the sovereign debt issues that are closely related come to the fore. The Dubai problems were obvious two years ago or more. And Abu Dhabi and other UAE brethren have little patience for the profligacy of Dubai. They will backstop Dubai only after those who overextended get taken out. Then they will ride to the rescue and take control of many of the assets.

Same thing in Spain or Greece. Spain dug itself a deep hole by committing significant debt to aggressive expansion of public works, most notably the 3GW solar power expansion.  The EU will backstop those countries, but only at a price. It is in no one's interest to let the fire burn out of control. I compare this to hot spots after a forest fire. If they don't threaten to flare up and ignite new fires, you let them die out on their own.  Other times you douse them (with financial liquidity in this case) to put them out before they spread. If the infection spreads to Japan, that would be a much more serious event than Dubai, only because of the size of the Japanese economy and the relative importance of the yen. But I think the global central bank leaders have an eye on this and will prevent a Japanese economic collapse. As long as all major economies pull together, there is no reason to think we will have a financial calamity. Economic collapses require the public to panic (and stop spending). Panic is totally a psychological phenomena and can only be brought about by careless or reckless political actions (or inactions).

It is very important to note that the countries that are in danger of defaulting, are not key world economies. The talk of a major economic power like Germany, Japan or the USA being forced into insolvency is from someone ignorant of what it takes to force a financial default. Defaults don't just happen, they are initiated by a creditor. If the debtor is large enough as compared to the creditor, then it is non-sensical or impossible for the creditor to force the default. The punishment will fall as much or more on the creditor as compared to the debtor. To force a smaller debtor to default, though, makes sense. Assets can be seized and held or resold to recoup the investment. Just who would force the USA, Germany or Japan into default? Who could gain? Who could manage the assets that were forfeited for the debt? There is no private money (hedge funds, ala John Paulsen) with the size to force a large sovereign to default.  China is the only creditor nation with the size to force such a default. But China won't do it because it would be suicidal. China, the creditor, needs the developed world as much as the debtors need China and other developing, export-driven creditor nations. It is totally symbiotic, or co-dependent if one wants to be cynical about the situation.

To make my point about the relative size of creditors and debtors as it relates to default: I just made a good return recently on General Growth Properties (GGWPQ.pk) because I understood this dynamic. GGP was in technical default because of the financial crisis and its inability to roll forward short term debt taken on during the two to three years prior to the financial collapse. It was / is still cash flow positive and can cover the costs of its interest obligations, much like sovereigns with their ongoing ability to raise revenue from tax.  But GGP wisely had filed for bankruptcy as a single entity and had pulled all its various mall properties under the single corporate parent umbrella. This made GGP in effect, too big to fail. No single creditor had the legal power to force all the properties into a firesale. The court (Judge Gropper) saw it the same way and made the decision to force the parties to work out the mortgagtes (to refinance). When the creditors found out they were not going to be able to drive a hard bargain and take away the mortgaged property for much less than market value, they had to deal. Now GGP is close to exiting bankruptcy with all its property intact.

Even though sovereigns are unlikely to default in a cascading way, the global economy still remains weak.  It will take consumers and businesses a long time to regain their confidence to buy and bankers to lend.  For the overall American market, from this point on, the economy must improve significantly to get the SP500 much above 1200. But I think that is the higher probability over the next year or two as compared to a melt-down. Politically, I think President Obama is finding out that it isn't prudent to be too anti-business. He seems to have finally gotten the point that the top priority is jobs. Health care and environment are lower priority since there is no money to pay for them if we don't have near full employment and full tax revenues. We aren't hearing too much health care talk from the Admin or Congress the past 2-3 weeks. To demonstrate his new-found love for business, Obama just had T-Sec Geithner spell out the capital gains tax freeze and investment tax credits for 2010. This will help jump start business and improve consumer sentiment as people start getting jobs.

As Obama and other world government leaders turn their attention towards restarting business, the world economy will heal and the markets will respond. Asian stock markets might be a little overdone just because of being the crowded trade, so I have backed off on them, for now. I have moved almost everything back to domestic large cap stocks or energy / commodities. I think 2010 will be a "consolidation" year with only a little index movement, maybe from 1100 to 1250. 2011 might be a similar year, with gradual improvement from 1250 to 1400. That would get us back to May 2008 which was about where the final dive started (down to 666). Maybe we pull back 100 points (10-12%) somewhere in the next 2-3 years. But by 2014 we can pass 1550 and set new highs, if the government continues to be supportive of business and doesn't get too radical (seems more likely right now than 6 months ago).

I am buying up some of the banks that look like they are turning the corner and will be survivors. I have a bunch of the leveraged financial index, UYG, which is weighted towards the survivors like GS, JPM or WFC. But I also am buying some BAC now (as of two weeks ago). Even Citi might be a buy at this point, now that they have a plan to exit TARP. But I am passing on them for now.

Otherwise, my theme is Tech, commodities, energy and materials. Tech is due for a positive replacement / upgrade cycle after 10 years of being down.  Microsoft's (MSFT) Windows 7 should be the catalyst in 2010 once the IT budgets are approved. Just buy the XLK if you don't have any favorites. SMH is the semicon index which has more beta than the XLK. My favorites in commodities tend to the miners and energy stocks, though I have recently picked up some Potash (POT).  I also have call options on (FCX) and (BHP).  This is a better way to play the weak dollar trade than gold, in my book, as operating leverage contributes to performance and generates cash flow which actually has value to an investor.  They have all outperformed Gold in 2009.  Commodities and Energy will benefit from the global economic expansion that is the natural reaction to the collapse. I find it interesting that Suncor (SU) was going up the last two days while oil futures are going down. I find that a very positive sign. I have really loaded up on Pennwest (PWE) and Provident Energy (PVX) .

Tags: Aggressive Expansion, BAC, Backstop, Bank Crisis, BHP, Debt Bubble, Debt Crisis, Debt Default, Debt Issues, Debt Problems, Deep Hole, Deflation, Depression, Dubai, FCX, Forest Fire, Germany Japan, GGWPQ.PK, Global Economy, Government Debt, Greece, Greece Italy, GS, Ireland, Italy, Japan And The United States, Japanese Economy, JPM, PIIGS, Portugal, Portugal Spain, POT, Power Expansion, Profligacy, pvx, PWE, SMH, Sovereign Debt, Spain, su, XLK