Scenario I
(Probability for this scenario from 2012-2013: 20-30%)
The first scenario is essentially a continuation of the present farces that we witness everyday in the Eurozone: Bond yields jump frequently, banks continue to face problems, EU leaders convene an ‘emergency summit’, the popular press is keenly awaiting the final word, after the photo opportunity there is a official statement drawing attention to the need for drastic action and promises of quick action. Bond yields fall slightly, then a German leader says cries halt to the circus and takes us back to square one. In the interregnum, ECB decides that they have to buy bonds of indebted countries – and the circus continues. The most recent evidence of this is the admission that the Eurozone’s bailout fund will be only half as big as originally announced: Euros 625 billion instead of the Euros 1.2 trillion.
Our Scenario I essentially extends the present trend where the world moves in circles, though each time running faster but ending up in the same place. It contends that the Crisis bleeds Europe gradually, leads to a decline over a period of time. At least one country, if not more, are forced to exit the Euro by 2012-13. This triggers a major Crisis leading to claims and counter-claims and growing counter party risk. EU politicians are predictable breed: they only act when forced. But, it will be a classic case of too little, too late, with costs escalating exponentially. But over the long-term, this scenario will eventually end up inaugurating a generational change, namely, the decline of Germany. If one or more indebted country decides to exit the Euro it will be nothing short of a disaster. UBS has estimated that in the first year, the cost of break up will amount to least 50% of the Eurozone GDP in the first year, in addition to the endless litigation and the attendant dislocation. A natural corollary of this will be a long-term sharp rise in the Euro, leading to an export oriented Germany going into terminal decline.
Any sign of this scenario playing out in Europe beyond the next four months will mean that it would safe for investors to factor in a lost decade for Europe and the World Economy into their calculations. This is because of the nature of the present crisis (that started in 2008). It has (except for the six months immediately after Lehman collapse) gradually embraced various sections – at a crawl speed rather than in the past when the consequences were transmitted more quickly. This could be because of the nature of globalisation where the broader market has increased. But the gradual destruction of the ability of people to consume is clearly discernible – incomes are declining, disparities are increasing and the last nail in the coffin is increasing unemployment, falling wages and falling asset prices. Since the crisis started in USA, the comparison is easier: US Federal Reserve statistics point out that the income of American household is only about 1% more than what it was in 1989. The gradual decline in household netwroth is far worse than in the 1970s period: Household networht has fallen by more than 20% compared just 2.4% fall during the 1970s. Europe unfortunately is at the cusp of such a structural decline over the next few years. UK’s Chancellor of Exchequer’s candid observation indicates as much.
Scenario II
(Probability of this happening in 2012-13: 70%)
As the crisis bleeds European and the Global Economy, with politicians dithering on biting the bullet, one scenario that we can conjure up is that the Central Banks themselves step into the vacuum and once again start intervention. The legacy of Lehman Brothers bankruptcy is that policy makers now have reliable evidence of the magnitude of the problem and hence are more amenable to take immediate action. As the bond markets lunge to the downside with each failed summit, the central banks will be forced to intervene as continuous trouble is detrimental to the real economy due to the inter-linkages between credit and real economic needs. As bond yields go up, and due to the increasingly garrulous nature of the ECB board, it may be left to other central banks to simply start buying bonds of afflicted Eurozone countries. ECB is perpetually shooting itself in the foot due to the obstinate German resistance. The country which has the wherewithal to buy unlimited quantities of bonds is the US Federal Reserve and the Bank of Japan. A helping hand by the Chinese may help, but unfortunately the Chinese always drive a hard bargain so are unlikely to rush into any bail out.
There is an increasing likelihood that the US Fed may be about to undertake such a measure for the simple reason that the US and EU financial markets are too interconnected to remain insulated from any crisis for long. The extraordinary speed with which US Fed moved to enter into currency swaps, innocently stated to be ameliorate the growing shortage of dollars, may be the first of many such steps in this direction. The Foreign Currency swaps announced on 30th November are valid till 1st February 2013. Technically, the ECB and US Fed could enter into such contracts, which would be perfectly legal and something out of the purview of the acrimonious politicians. One could easily assume that the Euros supposedly owed by the ECB to the US Fed could be used to buy European bonds. That would serve multiple purposes: (a) it would be printing money without raising the objections of the German politicians, (b) it could be the ‘nuclear’ option that investors are demanding, (c) it would cause widespread short-term losses to speculators who have been betting against the indebted countries and importantly, (e) it could re-inject very short term liquidity into the European banking system.
However, the above assumptions are prone to various practical difficulties. The most important is that it would have to overcome German resistance in the Central Bank. ECB would have to ‘sterilise’ new dollar flows and what sort of impact such huge dollar inflows have on the local economies may be politically unpalatable.
The above scenario will not cure Europe of its ills. Rather, it will provide breathing space to the beleaguered governments of Southern Europe to introduce reforms. Therein, lies the long-term problem. It is pertinent to note that these reforms will not work as they are dependent on introducing austerity measures at a time when the whole world is about to undertake such an exercise. That would only increase the deflationary pressures. At best such a scenario will provide a respite for about 18-24 months after which the crisis will hit the world with greater intensity. However, in the interregnum, the complacency that the measures will create will be lead to greater problems.
Complacency that government policy interventions are easily discernible in India: each set of intervention leads to a temporary respite, which creates a semblance of normality as new debt if often used to recycle old loans, without actually solving the problems. This in turn convinces individuals and businesses that such a cycle will continue for ever. Businesses also have a wrong notion that markets (and asset prices) always move up in the long-term. Hence, they are witness, first hand to their increase the notional value of the assets they purchased during a down tick in the prices. This, peer pressure and short-term notional rise in asset values reinforces the wrong notion that it is best to buy during such temporary market panics. That notion is often right when there are ‘structural bull markets interlaced with cyclical bear markets’ (as in the past: 1991-2007 in the west and 2001 to 2011 in India). Unfortunately, the people who lose the most are those who continue with this strategy during structural bear markets interlaced cyclical bull markets. The net result is that each down move leads to greater indebtedness, exactly at a time when they should have repaid their debts. Indian corporate history is replete with such examples: prudent businesses that did not rush into any expansion till 2009-10 (if at all they were not carried away by the Bullish prognosis for emerging markets for the next 100 years) decided that they would lose out a golden opportunity to expand their business and decided that they would miss a lifetime opportunity, if they did not expand. The solution was to borrow money, if necessary from foreign lenders (indexed in dollars at a time when the Rupee was trading at 42-44 per USD). They forgot only one minor aspect: nobody told them that the list in the countries that comprised the ‘emerging markets’ saw only one deletion in the last 60 years – Japan. Otherwise the same set of countries have been ‘emerging’ for a long time and there are particularly good reasons why they will always be emerging markets). The net result is a replay of the breakneck expansion mania in the 1994-97 and the resultant overcapacity.
Déjà Vu all over again!!!
Scenario III:
(Probability of this happening from 2012-2020: less than 2%)
The scenario which I would personally like to advocate but am discreet as it is considered to be an insane option. Most of the indebte European Countries are likely to default on their debts in the next few years – though the exact form and nature of default is likely to vary. I have long-held (since at least late 2009) that the world is about to become a mirror image of Japan. Deflation has been rarely witnessed in the past few decades, but the problem with deflation is that once it takes hold, they often last longer than periods of high inflation. The history of 18th and 19th century attests to this fact. The nature of the present global economic structure is such that, once deflation encompasses all regions, it will take decades to overcome it.
Hence, instead of prolonging the pain for the next few years, simply write off the debts on a biblical scale in the next two years. Where necessary provide succour in the form of rescheduling loans and in the case of Individual borrowers simply write off the loans.
Presto! USA, EU and starts on a clean slate!!!
Americans, Greeks, Spanish and the dumber lot can go back to their consumption driven models while, the Germans, the Chinese and remaining of the stingy lot can go back to their savings habits. Easy solution?
The only catch is that the bond markets in their current form will be paralysed for the next 10 years – at least.
The first scenario is essentially a continuation of the present farces that we witness everyday in the Eurozone: Bond yields jump frequently, banks continue to face problems, EU leaders convene an ‘emergency summit’, the popular press is keenly awaiting the final word, after the photo opportunity there is a official statement drawing attention to the need for drastic action and promises of quick action. Bond yields fall slightly, then a German leader says cries halt to the circus and takes us back to square one. In the interregnum, ECB decides that they have to buy bonds of indebted countries – and the circus continues. The most recent evidence of this is the admission that the Eurozone’s bailout fund will be only half as big as originally announced: Euros 625 billion instead of the Euros 1.2 trillion.
Our Scenario I essentially extends the present trend where the world moves in circles, though each time running faster but ending up in the same place. It contends that the Crisis bleeds Europe gradually, leads to a decline over a period of time. At least one country, if not more, are forced to exit the Euro by 2012-13. This triggers a major Crisis leading to claims and counter-claims and growing counter party risk. EU politicians are predictable breed: they only act when forced. But, it will be a classic case of too little, too late, with costs escalating exponentially. But over the long-term, this scenario will eventually end up inaugurating a generational change, namely, the decline of Germany. If one or more indebted country decides to exit the Euro it will be nothing short of a disaster. UBS has estimated that in the first year, the cost of break up will amount to least 50% of the Eurozone GDP in the first year, in addition to the endless litigation and the attendant dislocation. A natural corollary of this will be a long-term sharp rise in the Euro, leading to an export oriented Germany going into terminal decline.
Any sign of this scenario playing out in Europe beyond the next four months will mean that it would safe for investors to factor in a lost decade for Europe and the World Economy into their calculations. This is because of the nature of the present crisis (that started in 2008). It has (except for the six months immediately after Lehman collapse) gradually embraced various sections – at a crawl speed rather than in the past when the consequences were transmitted more quickly. This could be because of the nature of globalisation where the broader market has increased. But the gradual destruction of the ability of people to consume is clearly discernible – incomes are declining, disparities are increasing and the last nail in the coffin is increasing unemployment, falling wages and falling asset prices. Since the crisis started in USA, the comparison is easier: US Federal Reserve statistics point out that the income of American household is only about 1% more than what it was in 1989. The gradual decline in household netwroth is far worse than in the 1970s period: Household networht has fallen by more than 20% compared just 2.4% fall during the 1970s. Europe unfortunately is at the cusp of such a structural decline over the next few years. UK’s Chancellor of Exchequer’s candid observation indicates as much.
Scenario II
(Probability of this happening in 2012-13: 70%)
As the crisis bleeds European and the Global Economy, with politicians dithering on biting the bullet, one scenario that we can conjure up is that the Central Banks themselves step into the vacuum and once again start intervention. The legacy of Lehman Brothers bankruptcy is that policy makers now have reliable evidence of the magnitude of the problem and hence are more amenable to take immediate action. As the bond markets lunge to the downside with each failed summit, the central banks will be forced to intervene as continuous trouble is detrimental to the real economy due to the inter-linkages between credit and real economic needs. As bond yields go up, and due to the increasingly garrulous nature of the ECB board, it may be left to other central banks to simply start buying bonds of afflicted Eurozone countries. ECB is perpetually shooting itself in the foot due to the obstinate German resistance. The country which has the wherewithal to buy unlimited quantities of bonds is the US Federal Reserve and the Bank of Japan. A helping hand by the Chinese may help, but unfortunately the Chinese always drive a hard bargain so are unlikely to rush into any bail out.
There is an increasing likelihood that the US Fed may be about to undertake such a measure for the simple reason that the US and EU financial markets are too interconnected to remain insulated from any crisis for long. The extraordinary speed with which US Fed moved to enter into currency swaps, innocently stated to be ameliorate the growing shortage of dollars, may be the first of many such steps in this direction. The Foreign Currency swaps announced on 30th November are valid till 1st February 2013. Technically, the ECB and US Fed could enter into such contracts, which would be perfectly legal and something out of the purview of the acrimonious politicians. One could easily assume that the Euros supposedly owed by the ECB to the US Fed could be used to buy European bonds. That would serve multiple purposes: (a) it would be printing money without raising the objections of the German politicians, (b) it could be the ‘nuclear’ option that investors are demanding, (c) it would cause widespread short-term losses to speculators who have been betting against the indebted countries and importantly, (e) it could re-inject very short term liquidity into the European banking system.
However, the above assumptions are prone to various practical difficulties. The most important is that it would have to overcome German resistance in the Central Bank. ECB would have to ‘sterilise’ new dollar flows and what sort of impact such huge dollar inflows have on the local economies may be politically unpalatable.
The above scenario will not cure Europe of its ills. Rather, it will provide breathing space to the beleaguered governments of Southern Europe to introduce reforms. Therein, lies the long-term problem. It is pertinent to note that these reforms will not work as they are dependent on introducing austerity measures at a time when the whole world is about to undertake such an exercise. That would only increase the deflationary pressures. At best such a scenario will provide a respite for about 18-24 months after which the crisis will hit the world with greater intensity. However, in the interregnum, the complacency that the measures will create will be lead to greater problems.
Complacency that government policy interventions are easily discernible in India: each set of intervention leads to a temporary respite, which creates a semblance of normality as new debt if often used to recycle old loans, without actually solving the problems. This in turn convinces individuals and businesses that such a cycle will continue for ever. Businesses also have a wrong notion that markets (and asset prices) always move up in the long-term. Hence, they are witness, first hand to their increase the notional value of the assets they purchased during a down tick in the prices. This, peer pressure and short-term notional rise in asset values reinforces the wrong notion that it is best to buy during such temporary market panics. That notion is often right when there are ‘structural bull markets interlaced with cyclical bear markets’ (as in the past: 1991-2007 in the west and 2001 to 2011 in India). Unfortunately, the people who lose the most are those who continue with this strategy during structural bear markets interlaced cyclical bull markets. The net result is that each down move leads to greater indebtedness, exactly at a time when they should have repaid their debts. Indian corporate history is replete with such examples: prudent businesses that did not rush into any expansion till 2009-10 (if at all they were not carried away by the Bullish prognosis for emerging markets for the next 100 years) decided that they would lose out a golden opportunity to expand their business and decided that they would miss a lifetime opportunity, if they did not expand. The solution was to borrow money, if necessary from foreign lenders (indexed in dollars at a time when the Rupee was trading at 42-44 per USD). They forgot only one minor aspect: nobody told them that the list in the countries that comprised the ‘emerging markets’ saw only one deletion in the last 60 years – Japan. Otherwise the same set of countries have been ‘emerging’ for a long time and there are particularly good reasons why they will always be emerging markets). The net result is a replay of the breakneck expansion mania in the 1994-97 and the resultant overcapacity.
Déjà Vu all over again!!!
Scenario III:
(Probability of this happening from 2012-2020: less than 2%)
The scenario which I would personally like to advocate but am discreet as it is considered to be an insane option. Most of the indebte European Countries are likely to default on their debts in the next few years – though the exact form and nature of default is likely to vary. I have long-held (since at least late 2009) that the world is about to become a mirror image of Japan. Deflation has been rarely witnessed in the past few decades, but the problem with deflation is that once it takes hold, they often last longer than periods of high inflation. The history of 18th and 19th century attests to this fact. The nature of the present global economic structure is such that, once deflation encompasses all regions, it will take decades to overcome it.
Hence, instead of prolonging the pain for the next few years, simply write off the debts on a biblical scale in the next two years. Where necessary provide succour in the form of rescheduling loans and in the case of Individual borrowers simply write off the loans.
Presto! USA, EU and starts on a clean slate!!!
Americans, Greeks, Spanish and the dumber lot can go back to their consumption driven models while, the Germans, the Chinese and remaining of the stingy lot can go back to their savings habits. Easy solution?
The only catch is that the bond markets in their current form will be paralysed for the next 10 years – at least.
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