Act II and Opportunity
“But the collapse of the financial system as we know it is real, and the crisis is far from over. Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt.”
— George Soros (June 10, 2010)
“Turn your face to the sun and the shadows fall behind you.”
— Māori Proverb
“Trouble is only opportunity in work clothes.”
— Henry Kissinger
“The Chinese use two brush strokes to write the word ‘crisis.’ One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger – but recognize the opportunity.”
— John F. Kennedy
We are optimists. We’d like to once again emphasize to our readers our firm belief that any situation, no matter how seemingly dire – presents opportunities. It’s our opinion plenty of them exist right now. And the key to taking advantage of opportunity – is to seek and accept the facts, no matter how unpleasant they initially seem.
To Agree or Not to Agree?
George Soros does have an impressive reputation. That said, when anyone of influence makes a pronouncement – we always ask “why.” Based on our own observations, it’s our opinion Soros’s basic assessment of the situation is quite accurate.
Here is an excerpt from his June 10 speech before the Institute of International Finance in Vienna:
“In the week following the bankruptcy of Lehman Brothers on Sept. 15, 2008 – global financial markets actually broke down, and by the end of the week, they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions, which ceased to be acceptable to counter-parties.
As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared, and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and re-establish macroeconomic balance.
This required a delicate two-phase maneuver just as when a car is skidding. First you have to turn the car into the direction of the skid and only when you have regained control can you correct course.
The first phase of the maneuver has been successfully accomplished – a collapse has been averted. In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real, and the crisis is far from over.
Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage, but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930s. Keynes has taught us that budget deficits are essential for counter cyclical policies, yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip…”
To us, there is no doubt the credit-driven global financial system is on very shaky ground. It’s our opinion Greece will struggle to avoid defaulting on its debts. Spain, Portugal, and Italy are on the ropes. We believe the Euro is headed lower and its only hope will be if weaker nations leave the currency. German citizens have had enough of bailing out their fiscally irresponsible neighbors (and European banks who made risky loans to them for higher interest rates).
We’re not Keynesians – and we don’t agree with budget deficits, government intervention in the financial markets, or a currency not backed by gold. We do think however that Soros makes very good points regarding the seriousness of the situation and the potential for a double dip. And we believe he’s correct when he states the attempted cure (excess credit and leverage) for the crisis beginning in 2008 is more of what caused the problem in the first place – and must ultimately be withdrawn. And we’re of the opinion he’s right on the money when he states the current sovereign debt crisis has come at a bad time – in that it’s creating more instability which may prevent the removal of the initial excess credit/leverage cure.
We believe the sovereign debt crisis will require even more of the same money-printing “hair of the dog.” After all no politician wants to preside over a deflationary collapse. So we believe world governments will attempt to print like mad.
Swift Currency Revaluation & the Repudiation of Government Debt
We’ve often mentioned history teaches us governments often repudiate their debt via the inflation/money-printing mechanism. We believe the world has far too much debt – and we’d not be surprised to see a swift, surprising currency revaluation over a very short period of time. In such a scenario, the currency would be quickly valued downward by central banks via intense inflation/money-printing. This would severely erode the value of the currency (and make the national debt far cheaper to pay back by the government). In such a scenario, those who trusted the government the most (bond and CD holders) would have their purchasing-power confiscated most severely.
If such an inflationary scenario would unfold, a significant portion of the debt value (including government bonds) along with a significant portion of credit value (that includes your bonds bondholders) would be cancelled out in a very short time frame – potentially catching investors by surprise before they could act to protect themselves.
To those who think this can’t possibly happen – just check out the Argentine Crisis from 1999-2002. Bank accounts were frozen to prevent Argentines from sending their money out of the country to protect it from government printing/devaluation. The resulting inflation/currency devaluation was about 80% – and it took place in a matter of months. To add insult to injury – salaries stayed at pre-crisis levels.
Gloomy sounding? Nah! On behalf of our clients – we just like to think of all the possibilities which may lie ahead. And to plan for the potential opportunities.
While there is a lot of tough reality going on out there – we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another.
As we enter this critical time – now, more than ever – we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.
Stephan R. Ernharth, JD
Go to www.ernharth.com/economic-commentaries to read past articles from our Economic Commentary series.
1.George Soros; Speech to Institute of International Finance in Vienna; June 10, 2010
2.Wikipedia; Argentine Economic Crisis (1999–2002)