Author : John E. Charalambakis
Date : April 8, 2011
We live in peculiar, maybe schizophrenic days. The drama that started unfolding in August 2007 pertained to Act I – known as the bursting of credit bubbles – that carry with them significant negative effects for equity and debt markets and in their own way they in turn, destroy capital (physical, financial, human, and institutional), paper wealth, and economic prospects.
Act II of the drama, is known as the socialization of costs (while prior to Act I i.e. during the creation of the credit bubbles, the profits were privatized) where the fat cows eat the grass of the common field where all the cows are being fed a.k.a. the tragedy of the commons. The result is that some cows on the edges (read periphery of the EU) are starving and eventually die due to the fact that the large fat cows ate all the grass. Countries start bailing out beloved special groups through deficit explosion, hence the socialization of costs. The explosion of deficits and consequently of debts, do not allow all the cows to be saved because the assets are not there to support further credit creation for everyone. The result of this drama is that nations-cows are led to starvation via austerity programs which frequently lead to sovereign defaults as the following two graphs clearly show. The first graph shows that banking crisis (caused by overextension of credit) lead to debt cycles, which – as the second graph demonstrates-lead in turn to sovereign defaults.
However, the second graph above makes another clear implication. The two Acts are also followed by inflationary periods that destroy paper/fiat money. This is Act III in the unfolding drama, where all paper money loses value and ground against hard assets. In the incoming Act III all currencies will be devalued against precious metals and other hard assets that are capable of retaining their value in times of crises.
The following graph shows that when debt cycles reach their apotheosis, the recession that follows (with or without austerity) leads to a long period of instability where the economy stays down for an abnormally long period.
During this long period of instability the percentage of nations that default reaches high levels as the following graph demonstrates.
The new era that will dawn (besides the New Silk Road which may – we hope not – take a backstage until things clear) will be characterized by greater market volatility, frequent recessions, high and long-term unemployment, social and political instability, more deleveraging, corporate bankruptcies, sovereign defaults, and shaky prospects even for debt-free institutions given the contraction of credit and of consumption.
As I am drafting these lines, I am traveling overseas, where Portugal just a day ago announced her need for an IMF/EU bailout. People are interested mainly in three things: First, what the consequences of a bond haircut would be; second, what the effects of a potential sovereign default would be; and third, what is a potential way out (more on the latter in an upcoming commentary).
In a nutshell here is a brief synopsis of my reply (of course, there are many more things that someone could add):
Would it be too much, if we pronounce again, Ode to hard assets?