For nearly two years, the massive interventions of central banks have repeatedly pulled a fundamentally weak and debt-burdened global economy from the brink of resumed recession. The Federal Reserve's balance sheet is now leveraged 52-to-1, with assets having an average duration of over 5 years, suggesting that if those assets were marked-to-market, an interest rate increase of less than 50 basis points would wipe out the Fed's entire capital base. Of course, the Fed takes no marks on its assets when it reports its balance sheet, though it does occasionally take down the value of the securities in the Maiden Lane shell companies that it illegally set up to bail out Bear Stearns and other entities (in violation of Section 13(3) of the Federal Reserve Act, which Congress had to amend and spell out like a See-Spot-Run book as a result).
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We can't rule out the chance that Europe will cobble together enough temporary liquidity for Greece and troubled banks to kick the can down the road another time or two, but these kicks will become increasingly weak and short-lived in the context of a new recession. Even in the event of various liquidity injections, there is virtually no chance of addressing the solvency of Europe - the ability of each government (much less the banking system) to sustainably pay their debts - within the constraints of the Euro. As long as the Euro exists as a single currency, individual countries can't inflate away the real value of their debt, or restore their trade competitiveness through exchange rate depreciation against other countries.
Under these strains, I expect that the Euro will fracture well beyond a Greek exit. Ultimately, the result might be a "strong Euro" that reflects the union of Europe's most fiscally responsible countries, or we might instead see a "weak Euro" that follows the departure of Germany from the currency union and leaves peripheral members free to inflate. So it's not clear which direction the value of any surviving Euro may take until it is clear which member countries will remain. In any event, however, what we are unlikely to see is a single Euro that combines fiscally responsible and fiscally irresponsible countries, and requires endless one-way transfers of sovereign public resources in order to hold the system together.
We will undoubtedly have moments of promising news that will relieve economic and Euro-area concerns for brief periods of time. Part of the reason that the markets have been fairly complacent despite deterioration on these fronts is exactly the hope and expectation of investors for these transitory but unpredictable moments of relief. If one steps back from the trees to observe the forest, the reality of the situation is that Europe is already largely in recession, the global economy is slipping quickly toward the same outcome, and in my view, the U.S. is also entering a recession that will ultimately be dated as beginning in May or June of 2012 (i.e. now). The economic headwinds already in place are likely to make any meaningful budget progress virtually impossible in the Eurozone, and without meaningful budget progress, the likelihood of continued bailouts to peripheral European states is slim. So while short-lived bouts of hopeful enthusiasm are likely, the reality of the situation is much more challenging.
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We can't rule out the chance that Europe will cobble together enough temporary liquidity for Greece and troubled banks to kick the can down the road another time or two, but these kicks will become increasingly weak and short-lived in the context of a new recession. Even in the event of various liquidity injections, there is virtually no chance of addressing the solvency of Europe - the ability of each government (much less the banking system) to sustainably pay their debts - within the constraints of the Euro. As long as the Euro exists as a single currency, individual countries can't inflate away the real value of their debt, or restore their trade competitiveness through exchange rate depreciation against other countries.
Under these strains, I expect that the Euro will fracture well beyond a Greek exit. Ultimately, the result might be a "strong Euro" that reflects the union of Europe's most fiscally responsible countries, or we might instead see a "weak Euro" that follows the departure of Germany from the currency union and leaves peripheral members free to inflate. So it's not clear which direction the value of any surviving Euro may take until it is clear which member countries will remain. In any event, however, what we are unlikely to see is a single Euro that combines fiscally responsible and fiscally irresponsible countries, and requires endless one-way transfers of sovereign public resources in order to hold the system together.
We will undoubtedly have moments of promising news that will relieve economic and Euro-area concerns for brief periods of time. Part of the reason that the markets have been fairly complacent despite deterioration on these fronts is exactly the hope and expectation of investors for these transitory but unpredictable moments of relief. If one steps back from the trees to observe the forest, the reality of the situation is that Europe is already largely in recession, the global economy is slipping quickly toward the same outcome, and in my view, the U.S. is also entering a recession that will ultimately be dated as beginning in May or June of 2012 (i.e. now). The economic headwinds already in place are likely to make any meaningful budget progress virtually impossible in the Eurozone, and without meaningful budget progress, the likelihood of continued bailouts to peripheral European states is slim. So while short-lived bouts of hopeful enthusiasm are likely, the reality of the situation is much more challenging.
Read the complete commentary
