Fwd: The Three Stages of Delusion - John Mauldin's Outside the Box E-Letter

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From: John Mauldin and InvestorsInsight <wave@frontlinethoughts.com>
Date: Mon, Dec 6, 2010 at 7:31 PM
Subject: The Three Stages of Delusion - John Mauldin's Outside the Box E-Letter
To: jmiller2000@gmail.com

	Contact John Mauldin Print Version Volume 6 - Issue 50 December 6, 2010 The Three Stages of Delusion by Dylan Grice I am back from the Forbes cruise to Mexico and starting to deal with a thousand things, but first on the list is making sure you get this week's Outside the Box. And a good one it is. In fact, it is two short pieces coming to us from friends based in London over the pond. Both of them have to deal with the unfolding crisis that is Europe, which is going to unfold for several years as they lurch from solution to solution. The first is from Dylan Grice of Societe Generale and reminds us why we should put no stock in what leaders say about a crisis. He has lined up the statements of leaders from one crisis after another. He finds a simple, repeating pattern. And shows where we are now. The second is from hedge fund manager Omar Sayed, who I met last time I was sin London. A very bright chap and good guy. He offers us very succinctly four paths that Europe can take. Some of them are not pretty. It all makes for a very interesting OTB. I trust your week will go well. Your over-dosed on guacamole (and it was worth it) analyst, John Mauldin, Editor Outside the Box The Three Stages of Delusion By Dylan Grice The recent sequence of reassurances from various eurozone policymakers suggests we are in the early, not latter, stages of the euro crisis. Only an Anglo-Saxon style QE will prevent dissolution of the euro. Such a radically un-German solution will only be taken with a full acceptance of how serious the euro's problems are. But denial persists. The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us. US policymakers' three steps during the housing crash fit the template well. Asked in 2005 about the danger posed to the economy by the housing bubble, Bernanke responded: "I guess I don't buy your premise. It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis." Here was the denial that there was a problem. But as sub-prime issues arose, Ben Bernanke reassured the world that they would be "contained." And when Bear Stearns collapsed, Hank Paulson promised "The worst is likely to be behind us." Here was denial that there was a big problem. Soon the financial system was on the brink of collapse. There could no longer be any credible denial of the problem, so the locus of delusions shifted: there was a problem, but it was someone else's fault. Thus a ban on naked short selling of financials was implemented in Sept/Oct 2008, as though the crisis was somehow short-sellers' fault. (It certainly wasn't the Fed's fault, according to the Fed. Ben Bernanke argued this year "Economists … have found that only a small portion of the increase in house prices … can be attributed to the stance of US monetary policy.") What's interesting is that the journey Bernanke and Co. took fits the journeys of policymakers presiding over crises past very closely, as I'll show inside. What's worrying is that taken in this context, eurozone policymakers' denials/reassurances sound eerily familiar. And if these past crises are any guide, the euro crisis is still in its early stages. A descent through the three stages of delusion characterises most crises. Dick Fuld went from saying "as long as I live, Lehman will never be sold" in December 2007, to "We have access to Fed funds; we can't fail now" during the summer of 2008, to agreeing with a colleague that half of any capital injection then being negotiated with the Korean Development Bank be used to buy back Lehman stock, to "hurt Einhorn bad." Identical stages can be traced during the Asian Crisis of 1997. For those who don't recall, the Asian Tigers were 'miracle'economies whose dizzying growth rates proved the superiority of export liberalisation, high investment and free markets. Their miracle image was burnished by the 'good crisis' they enjoyed in 1994, when their fixed exchange rate systems (they were pegged to the dollar) successfully withstood the contagion caused by the collapse of the Mexican peso. Bear in mind that the world had bought into the Asian Tiger story hook, line, and sinker. The World Bank wrote a now infamous series of reports called "The East Asian Miracle" from 1993, lauding the strength of the region's institutions and preaching its commitment to an export-driven growth model to anyone who'd listen. And while there was a feeling that some tigers (e.g. Thailand and the Philippines) were riskier than others (Indonesia), the idea that Taiwan or South Korea would be caught up in anything was viewed as utterly preposterous. Early in 1997, Jeffrey Sachs said: "Since the economic structure of Korea is fundamentally different from that of Mexico, there is no possibility of recurrence of the situation that happened to Mexico." But early in 1997, problems emerged. The first sign of trouble came in Korea in January when a large chaebol called Hanbo Steel collapsed under $6bn of debts. Then in February, Thai property company Somprasong Land missed a payment on foreign debt in February. These turned out to be the first cockroaches. The following chart shows the sequence of events which would soon follow. First the small economies fell – then the big ones. Yet denial that there was any problem characterized early observations. Immediately following the Thai government's $3.9bn aid to Thai banks to cover dud property loans, Michel Camdessus – then head of the IMF – said, "I don't see any reason for this crisis to develop further." And on 30th June that year, Chavalit Yongchaiyudh, then Thai Prime Minister, made a televised address to the nation saying "We will never devalue the baht." Yet the baht was floated on 2 July. It was soon followed by the Philippine peso. But the initial denial that there was a problem simply became denial that there was a big problem. Indonesia wasn't Thailand, after all. According to an article in the 8th Oct 1997 New York Times: "Indonesia's financial condition is far better than Thailand's was this summer … while Thailand depleted its foreign-currency reserves in a last-ditch effort to prop up its currency, the baht, Indonesia still holds foreign reserves of about $27 billion." And as the Indonesian crisis began to intensify and the US made financial help available as a precaution, an Administration official said: "We don't expect that Indonesia will need to draw on our direct help, but what we need to address here is an atmosphere of contagion." As it turned out, Indonesia wasn't Thailand. It was worse. It would prove to be the worst affected of the Asian tigers with a near 80% exchange rate collapse bankrupting the corporate sector which had borrowed heavily in dollars. GDP collapsed by 14%, triggering unrest and street violence which ultimately forced out President Suharto. Yet denial that there was a big problem persisted. James Wolfensohn, then president of the World Bank, reassured that the Indonesian bailout marked the end of the crisis: "The worst is over" he proclaimed confidently. Korea wasn't Indonesia. Michel Camdessus, said on Nov 6th: "I don't believe that the situation in South Korea is as alarming as the one in Indonesia a couple of weeks ago." Yet South Korea turned out to be just as vulnerable, and certainly more costly. On December 1st 1997, the government said it had agreed to a $55bn bail-out (which then, was the largest bailout in the history of the world. In today's money it's a mere $75bn, less than the bill for Ireland). The storm moved on. Before petering out it would engulf Latin America, then Russia, and then the once mighty hedge fund LTCM. But for now, Asia had been destroyed. The miracle was myth. The depth of the problems was now undeniable. Yet the denial persisted, only now it emphasised the fault of others to demonstrate that the crisis was in no way related to anything policymakers had done. It was all caused by speculators, international bankers and the foreign media. Most infamous was Malaysia's then Prime Minister Mahathir Mohamed blaming George Soros, who he bizarrely implied was part of some kind of wider plot. "Today we have seen how easily foreigners deliberately bring down our economy by undermining our currency and stock exchange …" and "Soros is part of a worldwide Jewish conspiracy." There's nothing unusual about the emotional need to find a scapegoat when things go wrong. As always, Shakespeare wrote about it four centuries ago. From King Lear: "This is the excellent foppery of the world, that, when we are sick in fortune – often the surfeit of our own behaviour – we make guilty of our disasters the sun, the moon, and the stars: as if we were villains by necessity; fools by heavenly compulsion; knaves, thieves, and treachers by spherical predominance; drunkards, liars, and adulterers, by an enforced obedience of planetary influence; and all that we are evil in, by a divine thrusting on: an admirable evasion of whoremaster man, to lay his goatish disposition to the charge of a star!" And if we're looking for signposts on the way to a crisis' closing chapters, it turns out that the "excellent foppery" of blaming everyone else is a good indication. Thus, as the Greek crisis unfolded in December 2009, George Papandreou went from denial of the problem, insisting it to be "out of the question" that Greece would resort to the IMF, to denial that it was the Greeks' fault, lamenting in March 2010 that "we ourselves were in the last few months the victims of speculators." As the Irish crisis reached its conclusion, Finance Minister Brian Lenihan blamed the "unintended consequences" of various German and French comments for its spiralling borrowing costs. Today Spain is the battlefield. A few weeks ago, the Spanish were in denial that there was a problem. Zapatero said "I believe that the debt crisis affecting Spain, and the eurozone in general, has passed." Now they are in denial that there is a big problem. Last week, Spanish Finance Minister Elena Salgado said there was "absolutely no risk" the country would need an international bailout and stressed the differences between Spain and Ireland, much as the Indonesians stressed the difference between themselves and the Thais thirteen years ago: "Our financial sector has always had the Bank of Spain's supervision and regulation, which is what has probably been missing in Ireland … We have a solid financial sector and we should remember that it's the financial sector that's provoking the difficult situation in Ireland." When they start blaming everyone else for their problems, we'll know their crisis is nearly over Until then, their plight likely has some way to go. But of course, the real issue isn't Ireland, or Portugal or even Spain. The real crisis is the euro, and the strains continued membership is placing on the relationships between euro members and the attitude of electorates in the member states towards the single currency. Yet policymakers are as in as much denial that there is a big problem (i.e. with the euro rather than any individual country) as Ben Bernanke and Hank Paulson were that there was a housing bust, as Dick Fuld was that Lehman was toast, or as the IMF was that Thailand, let alone Asia, had profound economic weaknesses. Last week the Finnish Central Bank head and ECB Governor Erkki Liikanen said "The euro will survive. It is not questioned." Klaus Regling, heading up the EFSF, said "No country will give up the euro of its own will: for weaker countries that would be economic suicide, likewise for the stronger countries. And politically Europe would only have half the value without the euro." Such logic has been used before. Barry Eichengreen wrote in 2007 that euro membership was effectively irreversible because withdrawal would be too traumatic. But what if the cost of staying in the euro becomes so high that exit is preferable? Surely this is the risk in Germany's current strategy. Peripheral eurozone countries need to default. Traditionally this is done with currency debasement (which the Fed and the BoE have already begun) or by imposing a haircut on lenders. Germany refuses to sanction the former, while flagging up the latter triggered the latest bout of contagion. Instead, they are imposing depressions on countries which lose the bond market's confidence. How many years of austerity before the voters of Greece/Ireland/Spain/wherever blame Germany, France, or the euro for everything that is wrong with their economy? Will this become the blame game signalling the final chapter of the euro's crisis? I certainly hope not. Last week, Axel Weber said: "The European Financial Stability Fund should be sufficient to dissuade markets from speculating against the solvency of Eurozone member countries, and if not, more money will be provided." If and only if that money comes from the ECB's printing presses – in the style of the BoE and the Fed – will Mr. Weber be correct. A large risk rally will ensue. If not, we still have a long, long way to go. On 27 May this year, following the original set-up of the EFSF, I wrote: "The EU's 'shock and awe' $1trillion rescue was certainly a big number and reflected European governments going all in. But going all in is risky if you don't have a strong hand, and the EU's seems weak. Two-thirds of the rescue money comes from the EU itself, which means that the distressed eurozone borrowers are to be saved by more borrowing by … er … the distressed eurozone borrowers." This remains the case. The EFSF is flawed. It invites speculative attack. Simply expanding it in its current form so that the 'solvent core' commits to raise yet more funds for the 'insolvent periphery' fails to address the risk that as more dominos fall the bailers shrink relative to the bailees (Italy and Spain combined – who's spreads have been blowing out this week – are combined bigger than Germany). At what point does the insolvent periphery include so many countries that markets lose confidence in the solvency of the shrinking core to bail them out. Leaving aside for now the unpleasant reality that the solvent core might not actually be so solvent, perhaps the spread between 'insolvent' Greece and solvent France should be narrower? I wish I knew. In the absence of ECB printing, I suspect we're going to find out. The London Brief Omar Sayed The Cypriot banking system holds assets that are seven times Cyprus' GDP.   While the system is almost one hundred percent deposit funded, over one third of these deposits are foreign, mostly from Greeks trying to hide or protect savings by moving them out of Greek banks.  Cyprus banks hold €5 billion of Greek government bonds.  If the bonds received a 30% haircut, the banks Tier I capital would be gone.  Most of the Cyprus bank loan books are to Greeks and non-performing loans are edging sharply upward as a result of the austerity programs. Cyprus' GDP is only $25 billion, a drop in the fiat money printing ocean.  But it's indicative of a major problem governments don't have the tools to solve: volatile and sudden capital flows.   Greeks worry about their banking system and rapidly transfer deposits to Cyprus creating a banking system that is larger than the state's ability to support in a crisis.  Then as a shock hits the banking system, the capital flows violently flow somewhere else creating a new banking crisis. European Crisis An unidentified banker in the Financial Times said, "The ECB needs to use the bazooka option to lift sentiment in a lasting way.  That is the only way to stop this crisis from spreading.  We had a good day today, but yields are only coming down because the ECB is buying.  It has got to continue doing so and in size."  Considering many of the banks are the ones selling sovereign bonds to the ECB for profit, I can understand the banker's sentiment.  But is ECB bond purchases a real solution?  CDS trading in Irish debt saw opening prints compress with the five year CDS trading at 275/295 and the ten year at 215/235.   Within minutes they were back trading 575/595 and 515/535 respectively.   A few hours later, they were flat to Friday's close and Portugal was widening.  It wasn't until later in the week when the ECB stepped in with €100 million per clip in Irish and Portuguese bond purchases that spreads narrowed. The market realizes the European sovereign crisis is still not solved.  There is wide sentiment that the EU may disintegrate and the euro is a short.  Yet European disintegration is practically unfeasible.  For instance, if Ireland were to pull out of the euro, they would have to force conversion on depositors so that bank assets could match liabilities.  Ireland would have to reintroduce capital controls to prevent people from sending their money overseas.  They might even have to restrict foreign travel or check briefcases at the airports.  There would be caps on bank withdrawals.  It would be a nightmare for Germany too.  Germany's exporters would instantly lose competitiveness and customers.  Germany is the EU's largest creditor and it would see its investments outside Germany sharply decline in value.  Monetary policy would be in disarray.  German banks and pension funds would be in trouble. So in order to preserve this unholy union, what options does the EU have?   I see four: (1) the Marshall Plan II; (2) the Treaty of Versailles II; (3) the printing press option and (4) the Icelandic option.  Each has its challenges and problems.  The first option is the most politically sensitive, but potentially the most effective.  Currently the EU's program can support Portugal, Greece and Ireland, but is too small for Spain and Italy.  Under this option, the EU boosts the size of the rescue fund or turns it into an asset buying program where they buy sovereign bonds.  The EU can also float its own euro-bonds for the periphery or make guarantees that periphery debt is EU debt.  They can cut interest on loans to help states better balance budgets.  The EU could also lighten up on austerity and take a more active role in fiscal programs and auditing.  Then focus on fixing the periphery's lack of export competitiveness.  The EU is sitting on billions of unspent redevelopment funds that could be channelled into projects.  For instance, Greece has certain off-shore power projects that could provide energy for the whole EU but also jobs for Greeks.  Port redevelopment is a major growth initiative from goods coming from the Middle East and Africa.  The rigidities in the Greek system that make it more expensive to move goods around internally than externally could be reformed under a crisis pretext.   Companies like Siemens could be incentivized to build a factory in Portugal or Ireland.  The idea is that rather than make periphery nations deflate, you help them grow and pay their way out of debt.   Political sentiment in Germany in favour of this option is changing because the country is having a good crisis.  GDP grew by 3.5% this year and is expected to grow 2% in 2011.  Retail sales jumped 2.3% in October suggesting rising domestic demand.  Half of Germans now support the Greek bail-out according to an Economist poll versus 20 per cent in April.  For EU integrationists, this could be a dream come true, a way to homogenize fiscal accounts and assume greater EU sovereignty over individual states. The challenges though are execution, the willingness of states to allow the EU to assume fiscal responsibilities, the willingness of northern Europeans to make rival nations more competitive and implementing projects that would take many years before seeing results. Currently, the EU is adopting the Treaty of Versailles II option.  This option entails an internal devaluation or lowering wages to regain export competitiveness.  However, this doesn't work because you are not making capital cheaper.   Debt to GDP gets larger until a frustrated Irish or Greek public elect politicians to take actions to break their slavery through default.   The third option is to get the ECB to keep buying sovereign bonds while the EU works on a way to help Ireland, Greece and Portugal balance their budget so they don't need to issue more bonds.  The ECB can keep monetizing the debt and hope the problem gradually goes away.  The problem is that Spain and potentially Italy are deflating; therefore the problem will not go away.  Also the euro would decline leading to the potential for significant inflation.   My commodity basket is pushing its highs.  At some point debt monetization becomes suicidal.   Finally, there is the Icelandic option.  This involves restructuring the debt and making bond-holders share losses.  Already there are discussions taking place about a managed default where deposits and payment systems would be transported into a "good bank".  Bank loan books would be excised and the bank would be infused with new capital through "bail-in" procedures, where bond-holders receive equity.   A mechanism would be necessary to manage cross-border banks.  Such a program would trigger an instant sell-off in other nations such as Spain, Italy and Belgium and potentially force debt restructurings there too (the contagion effect).  Also the losses from such restructurings could end up creating a Lehman like effect through the shadow banking system, which still exists and is difficult to measure.  This strikes me as the second best solution if a Marshall Plan option is unfeasible. The Marshall Plan II is quite possible given the IMF's (ie – America) willingness to give more money to help Europe.  But I am doubtful that this is the path that is chosen.  Many northern Europeans have adopted the same approach as the French and British did after World War I and want to make the periphery suffer in a bout of self righteousness.  I can understand the sentiment and it can be done to a limited extent, but they will force the people to rebel against austerity.  At that point, the whole experiment unravels.  If the EU wants its venture to succeed, they have to think growth and restructuring, not austerity. John F. Mauldin johnmauldin@investorsinsight.com You are currently subscribed as jmiller2000@gmail.com. To unsubscribe, go here. Reproductions. If you would like to reproduce any of John Mauldin's E-Letters or commentary, you must include the source of your quote and the following email address: JohnMauldin@InvestorsInsight.com. 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Fwd: Texas, Ireland and Ten Little Indians - John Mauldin's Weekly E-Letter

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From: John Mauldin <wave@frontlinethoughts.com>
Date: Fri, Dec 3, 2010 at 11:09 PM
Subject: Texas, Ireland and Ten Little Indians - John Mauldin's Weekly E-Letter
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Thoughts from the Frontline Weekly Newsletter Texas, Ireland and Ten Little Indians by John Mauldin December 3, 2010
In this issue: Ten Little Indians Whither Portugal? How Did You Go Bankrupt? Why Ireland Is Like Texas Cabo and New York
One little, two little, three little Indians Four little, five little, six little Indians Seven little, eight little, nine little Indians Ten little Indian boys - Children's rhyme Why is it that the Irish must take upon themselves the debts of their banks, which in reality are debts owed to German and French banks? Why should the Germans bail out the Greeks and the Spanish? Is the spread of "contagion" starting to taint the debt of Italy and even Belgium, the home of the EU? This week we look over the pond (of the Atlantic) and wonder how all these things will end. As I noted last week, we are getting a string of not so bad news out of the US, so now there are really just two things in the short term to worry about (at least in terms of a positive US GDP): will Congress extend the Bush tax cuts and will Europe sort itself out? While I am on a cruise ship off the coast of Mexico (with a sporadic and very slow internet connection), the news we do get seems to suggest that the former will get done, but the latter looks rather dodgy. This week we look at a few statistics and then I try and give my US readers some perspective on Europe, by comparing Texas to Ireland (or Portugal or…). There is a connection, or at least I will try and make one. It should be fun, if a little controversial. But first, and quickly, my friends from GaveKal will be in Dallas this week, on Wednesday December 8, for a full-day conference. If you are an accredited investor or a fund manager join me, Charles and Louis Gave (and some of their team), and George Friedman of Stratfor for a full day of presentations and analysis of the current world. Just drop me a reply and someone from either my staff or theirs will be in touch with you. Ten Little Indians There is the childhood story and song about the ten little Indians. And of course the Agatha Christie tale of the same name, with 10 people invited to an isolated place, only to find that an unseen person is killing them one by one. And that seems to be what the markets want to do with European sovereign debt. First it was Greece, then it was Ireland. Very soon it will be Portugal, then Spain, and even Italy? Belgium perhaps? How many more Indians till it hits the core of Europe? My friend Dennis Gartman wrote a very humorous note yesterday about the following conversation between two Irishmen, Liam and Paddy, sitting in their local pub. The current Irish government has agreed to borrow something like $88 billion euros to shore up their banking crisis. That is about $27,000 for every man, woman, and baby in Ireland, a rather small country with a little over 4 million people. "Aye, Paddy, now that it's all done, lad, we Irishmen owe the IMF; we owe the countries of the European Union; we owe those damned Englishmen; we owe the Danes; we owe the Swedes for God's sake! Oh, and we owe the banks, and we owe ourselves. Aye, lad; we owe the whole bloody world it seems." That they do. And a lot of that Irish debt is owed to German, French, and UK banks. A lot more debt owed to banks than the Greeks owe, which had everyone worried not so long ago. See the graph below. (For those who are seeing this in black and white, the top section is Spain, then Portugal, Ireland, and Greece. Irish and Spanish debt dwarfs Greek debt. And that chart is what is really going on in Europe. It is not about Germany and France wanting to help out Ireland and Greece (and eventually Portugal and Spain). They are not that benevolent. It is that they are worried about their banks going belly up. Look at how upset the UK got when Iceland decided not to back their banks. Never mind that the bank debt was 12 times Iceland's national GDP. Never mind that there was no way in hell that the 300,000 people of Iceland could ever pay that much money back in multiples lifetimes. The Icelanders did the sensible thing: they just said no. Yet Ireland has decided to try and save its banks by taking on massive public debt. The current government is willing to go down to a very resounding defeat in the near future because it thinks this is so important. And it is not clear that, with a slim majority of one vote, it will be able to hold its coalition together to do so. This is what the Bank Credit Analyst sent out this morning: "The different adjustment paths of Ireland and Iceland are classic examples of devaluation versus deflation. "Iceland and Ireland experienced similar economic illnesses prior to their respective crises: Both economies had too much private-sector debt and the banking system was massively overleveraged. Iceland's total external debt reached close to 1000% of its GDP in 2008. By the end of the year, Iceland's entire banking system was crushed and the stock market dropped by more than 95% from its 2007 highs. Since then, Iceland has followed the classic adjustment path of a debt crisis-stricken economy: The krona was devalued by more than 60% against the euro and the government was forced to implement draconian austerity programs. "In Ireland, the boom in real estate prices triggered a massive borrowing binge, driving total private non-financial sector debt to almost 200% of GDP, among the highest in the euro area economy. In stark contrast to the Icelandic situation, however, the Irish economy has become stuck in a debt-deflation spiral. The government has lost all other options but to accept the €85 billion bailout package from the EU and the IMF. The big problem for Ireland is that fiscal austerity without a large currency devaluation is like committing economic suicide - without a cheapened currency to re-create nominal growth, fiscal austerity can only serve to crush aggregate demand and precipitate an economic downward spiral. The sad reality is that unlike Iceland, Ireland does not have the option of devaluing its own currency, implying that further harsh economic adjustment is likely." This is what it looks like in the charts. Notice that Iceland is seeing its nominal GDP rise while Ireland is still in freefall, even after doing the "right thing" by taking on their bank debt. Whither Portugal? Portugal is one of those countries that is on my short-list of places I want to get to. Maybe I have romanticized it in my mind, but I have a wonderful picture of vineyards and mountains and ocean and sleepy little villages. But the country also has a rather staggering amount of debt. As my friend and co-author of my new book, Jonathan Tepper, wrote last week in Variant Perception, Portugal is seeing all sorts of its economic dynamics go into reverse, except: "The only thing that is not likely to move in reverse is debt levels. There are two main reasons for this. First, the measures the government are adopting to reduce the fiscal deficit will likely result in a deflationary dynamic, boosting the debt-to-GDP ratio. "Second is Portugal's strong reliance on international investors to fund its debt. 80% of Portugal's public debt is held by foreigners (Portugal is very similar to Ireland in this respect), and its total external debt position amounts to 90% of its GDP. The deflationary correction elicited by the austerity measures will in itself be a reason for outside investors to stay away from Portuguese debt. "This will continue to be a source of vulnerability because it leaves the country exposed to the continuing risk of having financial markets shutter to its debt. Portugal's government debt, at 82% of GDP, currently sits at less than that of Greece (126%) and Ireland (almost 100%). Yet adding in corporate and private debt, Portugal's debt-to-GDP ratio rises to over 250%. Foreign investors are unlikely to tolerate such situations for much longer. It thus likely Portugal will have to apply for an EU/IMF bailout in a matter of weeks rather than months." Portugal needs to raise €51 billion to cover its fiscal deficits (€24 billion) and roll over its debt that is coming due (€27 billion). It is highly unlikely that foreign markets will be so kind as to lend the money, and the Portuguese economy is too small to finance that internally. It is a matter of sooner rather than later before Portugal is forced to accept the kindness of strangers. But then that brings up the problem of Spain. Earlier this year I documented the difficult and mounting problems that are Spain. 20% unemployment. Large fiscal deficits. An external debt situation that is worse than Portugal's. Yet Spain must figure out how to get €635 billion over the next few years to finance its deficits and bond repayments, which it hopes to roll over into brand new bonds. David Rosenberg wrote a few days ago: "What is remarkable is that since the Greek bailout was unveiled back in May, instead of alleviating fiscal concerns in the Eurozone periphery, contagion risks have actually intensified. Even with German 10-year bond yields declining 25bps, they have risen nearly 70bps in Italy, 150bps in Spain, 225bps in Portugal, 420bps in Greece and 460bps in Ireland. Once the stabilization fund ends in 2013, there is no way these countries can fund themselves at current debt-service cost levels. "Ireland may have secured funding, but at a 5.8% interest with nominal GDP declining, the situation is untenable in terms of sustaining any balance sheet improvement. Debt restructuring is inevitable. Looking at current CDS spreads, we are up to around 80% on default risks in Greece, 60% in Ireland, over 50% in Portugal, nearly 40% in Spain (this is big), nearly 30% in Italy and 20% in Belgium. No wonder the VIX is breaking out. "The risk is one of financial contagion to be sure, but there is the added macro risk as U.S. exports to the EU account for over 20% of the total volume of shipments sent abroad — about double the relative importance of the B.R.I.C.s in relation to U.S. producers. Plus, there is the added deflationary thrust from the strengthening U.S. dollar, which will come home to roost in that large share of corporate earnings derived from foreign sources." The US stock market gave a resounding sigh of relief this week when the Irish bailout was announced. This surely solved the problem, right? Right: Let's solve the debt problem by making them take on more debt. Oh, that the world could be that easy. "How did you go bankrupt? Two ways. Gradually, then suddenly." - Ernest Hemingway, The Sun Also Rises Why Ireland is Like Texas Let me quickly claim a point of personal privilege here and go into a little personal history that will hopefully offer some insight into the problems facing Europe. My grandfather was born in West Texas in 1859 (not a typo). His uncle (a Kelly and Irish) was a charter member of the Texas Rangers, which was formed around 1836. When the mayor of Waco telegraphed the Rangers in the 1870s that there was a riot in town and to please send the Rangers, he got a telegram back saying they would be there on the noon train. The mayor met the train and was dismayed to see that only one Ranger got off. When asked why he didn't have more men with him, the Ranger supposedly replied, "There's only one riot, isn't there?" That became the motto of the Rangers: "One riot, one Ranger." These were the toughest SOBs in a tough state. And the uncle was Irish to boot. Texas started out as a republic and was independent for nine years. The treaty that made us a state allows us to either split into five states (wouldn't that change the balance in the Senate?) or to leave the union, at our choice. I was once in a hotel bar (a shock, I know) somewhere in Africa and was asked where I was from. "Texas," I replied. "Interesting," came back the response; "Whenever I meet someone from America they always say they are from the US or America. Except when they are from Texas. Then they are always from Texas." Yep. Texas is a state of mind, and those who come here eventually adopt the state as their own. Just seems to happen. Now, a thought game. What would happen if California and Illinois and New York came to Texas and said, "We think your taxes should double so that we can finance our debt, and please buy even more of our debt next year to pay for our unfunded pensions. Oh, and while you are doing that the Fed is going to print massive amounts of dollars (far, far more than they are now) and destroy the value of the dollar, so your Texas pensions will be worthless. My guess is that my fellow Texans would look around and decide which Ranger to set on these guys, and make it clear that this was not the ride we had signed on for, and dust off that old treaty and work out an exit strategy. Understand, in the runup to the recent election our sitting governor talked about secession. I was been in meetings with Very Serious Texas Politicians where secession was earnestly discussed 15 years ago - maybe over some whiskey, but with the conclusion that Texas might be better off without the crushing debt that was coming down the pike. Do I think that could happen? No. The Fed will never choose hyperinflation, and I do not think you can find 60 Senators to decide that bailing out the states that let their own spending and taxes get out of control would be acceptable with their voters. Further, even though I am a very proud Texan, after 9/11 it was not the Texas flag that brought a tear to my eye, it was the Stars and Stripes. It would have to take a series of massively stupid decisions to bring Texas to the place where it would even remotely consider leaving the union. Now consider, if I have some pride in being Texan, with less than 200 years of history, proud as it is, what is it like to be Greek or Irish or French or German or any of the European mix? What deep cultural roots must they have? Nearly every country at one point was on top of the heap, and all have rich heritages. There is history around every corner in Europe. Except a history of unity. If you ask a European in that African bar where he is from, does he say Europe? No, he is from a country. (Unless he is Basque. Or Catalonian. Or Welsh.) One is not from Great Britain but from one of the divers components of the UK. And a large number of Scots want out. Could Belgium split apart? Possibly. But essentially, what the eurozone is asking Germany (and the Dutch and the rest of "core" Europe) to do is bail out Greece and perhaps much of the rest of the periphery, and to assume massive deficits and rising taxes. Because for there to be enough money for the deficit nations to borrow cheaply, there must be an AAA rating and a 30% cash-to-loan deposit, as I understand it. Spain or Ireland may try and borrow their share of the bailout fund (such irony), but they do not get that AAA rating. For all intents and purposes, it is on the back of Germany and, to some extent, France. Will German taxpayers go along with that? Will France? Will the Germans still finance the Greeks in 2013 when they have not whittled down their deficit and the Greeks still want to retire at 50 on full pensions? Will the Irish decide that it is in their best interests to take on massive debt so that French and German and UK banks are paid back? Can the solution to a debt problem be more debt? Will Texas singlehandedly bail out California so their prison guards can continue to make $100,000 a year? Tough questions. Next Monday's Outside the Box will be from Dylan Grice, who choreographs a three-part dance in which those in authority first deny there is a problem, then say it is a minor problem and then, when it becomes a large problem, deny it was ever their fault. He lays bare a rich vein of recent history. Those who are denying that the euro is at risk are still in the first steps of that dance. I have long been a euro skeptic. But that does not mean I am not in favor of the euro. The world is better off with the euro, I think. But for it to survive there must be a huge (as in trillions) stability fund created, and/or the ECB will have to print euros on a level that would make the Fed blush, simply to get the various national debt levels down to where the peripheral countries can actually pay them down. Can that happen? Maybe. The euro never was an economic currency. It is a political currency, and for it to remain a currency or at some point in the future become an economic currency, it will take massive political resolve on the part of the members of the EU. I wrote last year that there are only a few paths in front of us. The peripheral European countries can simply default - Greece did so just 20 years ago. Rates got up to 20% for them. Banks would take losses, but the ECB can be the backstop. And after a while people would forget and lend the Greeks money again. Or some of the peripheral countries can leave and go back to their own currencies, taking the path to devaluation, like Iceland did. Or Germany can decide to go its own way after what will be a very volatile and controversial election in the future. Or the ECB can print euros and buy out the debt on European banks' balance sheets. Or create a massively large stability fund and combine that with some haircuts for euro bond holders. There are no good solutions, just very difficult ones. And not one that I see that is euro-bullish in the medium term. Ten Little Indians. How many will remain in a few years? I wish them well. I really do. Cabo and New York I got an email from someone a week or so ago who is in Cabo San Lucas but have misplaced it. If you get this, please write back. I get back home on Sunday night to a very packed schedule for the next few weeks. Absurdly so, even when I am in town. I will go to New York for a day next Sunday and then back to Texas. The Forbes cruise has been fun. Renewing acquaintances with the Aden sisters and Rich Karlgaard and being on a panel with Steve Forbes was good times. It was good to get back to Puerto Vallarta and visit Chico's Paradise. It is a treasure of a restaurant about an hour south of PV and is one of my "must do" things when I get to the area. You should check it out if you are ever in PV. I enjoyed getting to meet Ken Fisher. His speech was very persuasive. He almost made me go out and buy an index fund. Did you know that it has been 70 years since the markets went down the year after a midterm election? Finally, I was sitting with Tiffani and Ryan in a wonderful little place somewhere on the beach in Cabo, eating guacamole and ceviche. At the end of the meal I reached into my billfold to get the credit card to pay the tab. Tiffani noted that I brought out a business card and rolled her eyes. Even though I do think the entire trip is a business expense, Tiffani said, "Dad, you so cannot make this a business expense," with that little sigh that means Dad is pushing it. It is tough when your travel companion and business partner is also your conscience. But that is why I let her run the show. Keeps Dad out of trouble. Time to hit the send button. I have to run off to another speaking session, but this one is mostly Q and A with a lot of interaction, so it will be fun. Have a great week, and if you come to the GaveKal conference be sure and say hello. Your really enjoying Mexico analyst, John Mauldin John@FrontLineThoughts.com Copyright 2010 John Mauldin. All Rights Reserved Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.
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