economics

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A lot of people don’t even know that Greece’s debt is a problem that is threatening to bring down the European Union. And of those that have heard about, few realize its significance and potential impact on the US. John Mauldin has done a fine job explaining that in his most recent newsletter. It’s written as a letter to his kids explaining how the current economic situation affects them.

Why is Greece important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth. And just a few years ago this seemed like a good thing. The rating agencies made Greek debt AAA, and banks could use massive leverage (almost 40 times in some European banks) and buy these bonds and make good money in the process. (Don’t ask Dad why people still trust rating agencies. Some things just can’t be explained.)

Except, now that Greek debt is risky. Today, it appears there will be some kind of bailout for Greece. But that is just a band-aid on a very serious wound. The crisis will not go away. It will come back, unless the Greeks willingly go into their own Great Depression by slashing their spending and raising taxes to a level that no one in the US could even contemplate. What is being demanded of them is really bad for them, but they did it to themselves.

But those European banks? When that debt goes bad, and it will, they will react to each other just like they did in 2008. Trust will evaporate. Will taxpayers shoulder the burden? Maybe, maybe not. It will be a huge crisis. There are other countries in Europe, like Spain and Portugal, that are almost as bad as Greece. Great Britain is not too far behind.

The European economy is as large as that of the US. We feel it when they go into recessions, for many of our largest companies make a lot of money in Europe. A crisis will also make the euro go down, which reduces corporate profits and makes it harder for us to sell our products into Europe, not to mention compete with European companies for global trade. And that means we all buy less from China, which means they will buy less of our bonds, and on and on go the connections. And it will all make it much harder to start new companies, which are the source of real growth in jobs.

And then in January of 2011 we are going to have the largest tax increase in US history. The research shows that tax increases have a negative 3-times effect on GDP, or the growth of the economy. As I will show in a letter in a few weeks, I think it is likely that the level of tax increases, when combined with the increase in state and local taxes (or the reductions in spending), will be enough to throw us back into recession, even without problems coming from Europe. (And no, Melissa, that is not some Republican research conspiracy. The research was done by Christina Romer, who is Obama’s chairperson of the Joint Council of Economic Advisors.)

And sadly, that means even higher unemployment. It means sales at the bar where you work, Melissa, will fall farther as more of your friends lose jobs. And commissions at the electronics store where you work, Chad, will be even lower than the miserable level they’re at now. And Henry, it means the hours you work at UPS will be even more difficult to come by. You are smart to be looking for more part-time work. Abbi and Amanda? People may eat out a little less, and your fellow workers will all want more hours. And Trey? Greece has little to do with the fact that you do not do your homework on time.

And this next time, we won’t be able to fight the recession with even greater debt and lower interest rates, as we did this last time. Rates are as low as they can go, and this week the bond market is showing that it does not like the massive borrowing the US is engaged in. It is worried about the possibility of “Greece R Us.”

Bond markets require confidence above all else. If Greece defaults, then how far away is Spain or Japan? What makes the US so different, if we do not control our debt? As Reinhart and Rogoff show, when confidence goes, the end is very near. And it always comes faster than anyone expects.

The good news? We will get through this. We pulled through some rough times as a nation in the ’70s. No one, in 2020, is going to want to go back to the good old days of 2010, as the amazing innovations in medicine and other technologies will have made life so much better. You guys are going to live a very long time (and I hope I get a few extra years to enjoy those grandkids as well!). In 1975 we did not know where the new jobs would come from. It was fairly bleak. But the jobs did come, as they will once again.

At least there is some good news in the end!

The underlying issue is the size of the country’s debt. At some point, either it becomes too big to service, or creditors get cold feet about the ability to service the debt and demand repayment – usually at the worst possible time. This is what happened to Iceland. They defaulted on $50 Billion euros of debt, not a large amount by US standards, but 488% of their GDP and a huge amount to their tiny population of less than 350,000. Greece, Portugual, Spain, Ireland and the UK are all in a similar situation.

Even the US isn’t too far behind. Currently our debt is nearly 400% of our GDP. At what point do our creditors stop lending us money?
USdebt-vs-gdp

Byron Wien, chief investment strategist for Pequot Capital, has once again published his annual list of economic, market and political surprises. Last year, he got about half of his predictions right. He predicted gold bullion at $800, oil at $80, surging grain prices, and the rise in Latin America’s economies.

Wien believes that his ten surprises have at least a 50% chance of success in 2008. Although not a very high probability, they still make for interesting reading. Here’s his list for 2008, courtesy of Portfolio.com.

  1. In spite of Federal Reserve easing, and other policy measures, the United States economy suffers its first recession since 2001 as housing starts stay soft and banks are reluctant to lend to anyone where a whiff of risk is apparent. Federal funds drop below 3%. The unemployment rate moves definitively above 5% and consumer spending is lackluster.
  2. I think this is highly likely to come true. I’ve been saying there’s a chance of recession for a while, so maybe I’m biased, but I think there’s a 90% likelihood of this prediction coming true.

  3. Standard and Poor’s 500 earnings decline year-over-year and the index drops another 10%. Energy and materials stocks hold up relatively well in what is viewed as a correction rather than a bear market. Market conditions start to improve during the summer.
  4. Again, I agree with most of this. If the economy does go into recession, S&P500 stocks will see their earnings shrink. I’m heavily weighted in energy and commodity and I think they’ll do well. Don’t know about the summer prediction though. I thought the market usually went through summer doldrums as everyone goes on vacation! Maybe due to the weak dollar, inflationary climate and recession people might not go on vacations this summer!!!!

  5. The dollar strengthens in the first half reaching US$1.35 against the euro and weakens in the second exceeding US$1.50. The European Central Bank begins an accommodative monetary policy. Foreign investors flock in to buy cheap assets in the US early in the year but the dollar declines later as several countries holding large reserves diversify into other assets.
  6. Not sure if the dollar will strengthen that much, but at the end of the year, I’m definitely expecting it to be weaker than it is today. It seems that me that most countries are in a race to weaken their currencies and so-far the US is “winning”. I think that foreign investors and sovereign wealth funds will definitely start to pick up US assets as their currencies become stronger. Not that its necessarily a wise thing to do, but it’ll probably happen anyway.

  7. Inflation rises above 5% on the Consumer Price Index as higher commodity prices and oil finally begin to have an impact in spite of modest wage increases. The 10-year US Treasury yield rises to 5%. Stagflation becomes a frequent presidential campaign and Op-Ed discussion topic.
  8. I agree with the inflation part. I think that the 10 year US Treasury yield will drop a little bit. Its currently at 3.9%. I think it’ll go to 3% rather than 5%. Stagflation is definitely on the cards.

  9. The price of oil goes down early in the year and up later, sinking to US$80 a barrel in the first half as western economies slow and inventories are drawn down, and rising to US$115 in the second. Established wells continue to decline in production while China, India and the Middle East increase their consumption.
  10. Very likely scenario. That’s why I’ve been buying Canroys on dips.

  11. Agricultural commodities remain strong. Corn rises to US$6 a bushel and cotton to US$0.85 a pound. Gold reaches US$1,000 an ounce as disillusionment with paper currencies spreads across Asia.
  12. Bush’s great ethanol idea will cause Corn prices spike. As more crops are replaced to plant Corn, they’ll start rising too. Since corn is used as animal-feed, milk prices might also increase along with meat prices. I definitely agree with Gold rising further. I’ve been bullish since it was $505/oz and I think it’ll eventually exceed $3,000/oz.

  13. The recession in the United States slows the Chinese economy modestly but its stock market declines sharply. Investors recognize that paying biotechnology stock multiples for highly cyclical companies doesn’t make sense. The Chinese revalue the renminbi by another 10% to control inflation and as a gesture to foreign governments participating in the Olympic Games who complain that Chinese terms of trade are unfair. Several long distance runners refuse to compete in certain Olympic events because of continuing air pollution problems.
  14. The Chinese market correcting definitely sounds plausible. Not too sure about the Olympic runners though. I think the Chinese Government will ban all polluting vehicles and industries 2 months before the games!!! Heck, they might even enforce a ban on cooking!

  15. The new Russian President Dmitry Medvedev, under the tutelage of Vladimir Putin, becomes more assertive in world affairs. He insists that Russian oil and gas be paid for in rubles and demands a Russian seat at major world conferences. Russia and Brazil stock markets lead the BRICs. The Gulf Cooperation Council markets begin to attract interest among emerging market investors.
  16. The Petro-Rubble? Well, why not? Seems like the smart thing to do!

  17. Infrastructure improvement becomes an important election theme for both parties and construction and engineering stocks rally in anticipation of huge programs beginning after the new President’s inauguration. Water becomes a critical problem world-wide and desalination stocks soar.
  18. After the bridge that collapsed in Mississippi, I hope infrastructure development does become more important. Water is probably the next “oil”.

  19. Barack Obama becomes the 44th President in a landslide victory over Mitt Romney. With conditions in Iraq improving, the weak economy becomes the determining issue in voters’ minds. They want to make sure that gridlock ends and Congress gets something done for a change. The Democrats end up with 60 Senate seats and a clear majority in the House of Representatives.
  20. I hope not! I’m keen on Ron Paul winning.