December 2, 2011

It wasn't more than a couple months ago when front pages were filled with news of rescue plans that the European leaders were working on to abate the ongoing debt crisis. Hopes were high that leaders of the Euro-Zone would come up with a grand plan to end the fear of default by either Greece or a large bank. But as weeks went on with no plan in sight--contagion set in. Now it’s the contagion itself that fills the front pages of newspapers and magazines which for the first time, are openly talking about the end of the Euro and the disintegration of the Euro Zone.


The core has now been contaminated. Germany and France are under the same suspicion that their weaker sisters are. Interest rates are going higher for all connected to the Euro Zone. How have the leaders of those nations responded? With more of the same. A few more Euros are being committed to the weakest nations along with more promises of a remedy—eventually. But will "eventually" be too late?


Either we’ll see a massive new plan to stop the contagion in Europe or the contagion will spread with failing banks nationalized as the Euro is dismantled. If this is allowed to happen it will lead to a deflationary recession or possible depression in the Euro-Zone and beyond. Tragically this is all preventable, yet the leaders of Europe sit frozen in their own inaction to address their fundamental problems. Stop-gap measures such as the coordinated international injection of liquidity just employed is important defensively, but only buys time.


Most likely, real action will come only at the point of panic. There is nothing like panic to focus the mind. If the market loses confidence in the government’s ability to pay their bills or questions the solvency of banks, the ball game is over. The consequences would be extreme, which is why we should take a little time to review and prepare for the various scenarios and possible outcomes if this happens.


The first and most likely scenario if panic should set in is that free-falling markets and spiking interest rates would quickly force the governments of the world to step up and throw everything they have at the markets. At that point, all of the plans they have been talking about but unable to agree upon would come together. So, no doubt an international response would be volleyed to try and stop the panic. Their attempt might work—and might not. We just saw evidence that all nations including China are willing to participate in such an attempt. This is at least a first step.


What do they have in their arsenal? They can inflate. The ECB could inject massive amounts of cash into the banking system. The IMF could create reserves in the form of SDR's to serve as an asset backed by a basket of currencies, and then loan these to governments. They also have gold in their coffers which can be used as collateral. And they have the ability to borrow from those that have cash such as China. Finally, they could restructure their debt through amortization or forgiveness at below market interest rates for longer periods of time. If all these efforts failed to stabilize the system they have brute force at their disposal and can impose capital controls, shut down markets, close and nationalize banks, and impose taxes.


Scenario number two is that the Euro breaks apart as Greece returns to the Drachma and other hopelessly indebted nations do the same. Or Germany does the splitting by returning to the Deutsche Mark and refusing to continue support to the weaker countries. One route leads to devaluation and the other to revaluation of currencies, but both would end in major defaults and reversals of trade flows. The German surplus would dwindle and the Greek trade deficit would turn to surplus, but at the end of the day it would primarily be the creditors who suffered the losses. Historically, when push comes to shove, debtors win over creditors. This is in my opinion why we see bank stocks falling throughout the world.


A third scenario is that the status quo just continues. The Euro-Zone buys more time through the application of various half measures and Band-Aids until they eventually get their financial house in order. Fiscal austerity would need to be the order of the day throughout Europe. That would take about five years to accomplish if they are sincere about cutting spending. Assuming they eventually subsidized all financial losses, the price tag would be upwards of three trillion dollars, include a prolonged recession, and a falling Euro.


In addition to these three scenarios there are all the “Armageddon” prophecies that include the breakdown of the monetary system, hyperinflation, or a deflationary depression with all of the social unrest that comes with the breakdown of societies. But what does all this mean for us as investors and traders?


The answer is simpler than you might think: follow the money. The great classical economist Ludwig von Misses taught that it is human action which determines the value of things and the direction of markets. If people panic and sell things we will enter a deflation as cash becomes king just as it was in the Great Depression. Whatever cash you hold could be worth ten times as much in purchasing power at the end of a great deflation. If on the other hand people run from cash and trade it for stocks, or homes, or commodities like gold and silver; we will be in an inflationary world where cash is trash.


Gold is one commodity that should fare well either way. However, gold could fall in a deflation and do worse than paper money guaranteed by the FDIC. There are no guarantees that any one position will preserve or make money during a panic. The best we can do in preparation for the possibility of panic is to diversify, identify where money is heading, and lean into that trend.


I have always been an optimist when it comes to America and I can even see a bright side for the US if the Euro-Zone busts apart and goes into what I think would be a deflationary depression much like Japans, especially if you add an additional shock to the system like an economic downturn in China. If that were to occur we’d be assured of a deflationary recession, worldwide. Yet, North America in general could fare well, as I will explain.


I’ve been sending my readers reports of newly constructed vacant train stations in China, and quoting Chinese insiders who are predicting a housing crash there. I'm worried about a stealth crash in China that would bring more chaos to an already chaotic world. Fox News recently showed footage of an entire “ghost city” in China, complete with a state of the art convention center and a beautiful modern library surrounded by hundreds of high rise condos. Yet it sits virtually deserted. Built to house a million people this city has no industry, no businesses, and no one living or working there.


This is reminiscent of previous “five-year plans” where a bunch of bureaucrats sat around deciding what they should spend people’s money on. These plans always create an initial illusion of prosperity but cannot be sustained and inevitably fail. China has been pretty lucky, parlaying its artificial boom into an impressive expansion. If however it is about to fail, the whole world will be thrown into a deflationary recession or even depression as all of Asia is dragged down with China.


Interestingly, if this were to happen, the only country that would be able to stand on its own two feet would be the US. We will be affected adversely of course, but we are not dependent on exporting like almost every other nation in the world. Exports account for only about 1.7% of our 14 trillion dollar economy. Other nations will fight to export to us with cheaper and cheaper goods—an obvious benefit to the American consumer. Nor are we dependent on the value of other nation’s money. The supply and value of the US dollar is within our control. And we have most of the resources we need right here at home and won’t need to import them, although you can bet other nations will fight to provide them to us first, for less.


Canada and Mexico are our major trading partners, and between the three of us, we could move quickly to compensate for the loss of other trading partners if need be. In fact, if we handled a worldwide deflationary recession correctly, we could become energy independent in a few years and be one of the only growth areas in the world, all by tapping our huge oil and natural gas reserves. A North American block would become a formidable economic power in the world.


Europe, Japan, and Asia would go into a depression for years. Even Germany and England would not survive a collapse like that. North America, however, wouldn’t necessarily do all that bad. Yes it would be scary. But at the end of the day, anyone who had liquid cash would be able to gain big time. I have no idea whether such a collapse will happen in China, but the reports leaking out of China must be monitored as closely as any information we can get about Europe. There is still plenty of time to liquidate and raise more cash if that becomes necessary. The key is when to pull the trigger in order to position oneself to ride out the chaos and still be in a position to pick up the pieces after.


So when is the right time? At the point of panic. If people panic governments will react vigorously to stem it. That is when we would see what decision governments make, and people make regarding their money; that’s when we follow the money. Sell or buy into the developing trend by either raising more cash, or buying more gold or silver, or buying the stock market if the market took off due to real solutions being instituted. In the meantime it's 50/50 as to what might happen.


The coordinated move by governments to lower interest and supply liquidity to banks and governments, has tipped the hand of world leaders. It will be seen as inflationary, but it is actually an anti-deflationary move. It is a concerted action to off-set deleveraging. In my opinion it is a test run leading to further action as necessary, and it will involve almost every major nation in the world. The immediate reaction this time was money flying into equity markets around the world. The following days and weeks should tell us much more about the direction we are headed. Hopefully we will be able to avert a panic. If not…stay tuned.


Paul Nathan is author of “The New Gold Standard”.


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