August 25, 2011
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The economic and financial landscape looks worse with each coming week. Unemployment, inflation and uncertainty are on the rise. Investment returns, corporate budgets and the strength of the “full faith and credit of the United States” are declining. With so many problems being covered incessantly in the news, it’s easy for everything to morph into one giant “eco-financial mess” from which we want to look away. Not all problems have the same degree of severity. It’s important to identify those problems that could truly lead to a crisis of catastrophic economic proportions.
These problems could serve as catalysts to a financial meltdown within the near term. Unlike the collapse of Long Term Capital Management in the late 1990s or the collapse of Lehman Brothers in 2008, these problems can’t be resolved by a few VIPs in a room. If they come to fruition, they will be too massive to “fix.” The world economy will simply have to live through the consequences for decades.
Catalyst 1: The Euro ceases to exist
From an historical perspective, the Euro as a currency is a baby. It launched on January 1, 1999, and currently 17 countries use it as their official currency. There are over €800 billion in circulation across the world, more than the value of U.S. dollar currency in circulation. Every day over 332 million Europeans use Euros, and an additional 175 million people live in countries that peg the value of their currency directly to the Euro.
The Euro as a currency is in crisis. Since late 2009, certain European countries that adopted the Euro as their official currency have experienced severe financial and economic problems. Just like a company that isn’t performing well, these countries—Greece, Ireland, Portugal and others—are having difficulty paying the interest and principal on their sovereign debt. When a country can’t pay its debt, a common action is to devalue its currency. This makes debt repayments in local currency less expensive, and makes exports more competitive which gives the country access to hard currency. It acts like a released pressure valve.
Euro countries don’t have that option.
Instead, the weaker members must rely on the stronger members, like Germany, to make up the difference by providing money and their “guarantee” to investors. Pools of money, like the European Financial Stability Facility, rely mainly on the support of the stronger members. The problem is that countries like Germany and France have their own problems and it’s become highly unpopular to continue pumping German tax dollars into Greece.
If the situation doesn’t improve for the weaker members and anti-Euro politicians are elected in the stronger member countries, it could very well lead to the collapse of the Euro.
Catalyst 2: The dollar loses its “reserve” status and declines rapidly in value
Since the conclusion of World War II, the U.S. dollar has been the safest currency in the world. The majority of countries that hold foreign currency reserves have most of these reserves in U.S. dollars. The current financial condition of the federal government have led many to questions the wisdom of concentrating reserves in a currency that may not hold its value.
With the rise of viable alternatives, countries could—should another crisis emerge—decide to transfer their reserves to other currencies. Once this shift begins, it will be difficult to stop. Lack of demand for the dollar will cause it to fall in value, further accelerating the exodus for other countries. This process has already begun, albeit at a slow pace. But it could accelerate quickly.
Catalyst 3: The Chinese bubble bursts
China has experienced unprecedented economic growth for the past several decades. Last year China overtook Japan as the second largest economy in the world. Over the past 30 years, GDP has grown between 5 percent and 15 percent annually. It now stands as the world’s largest exporter and manufacturer as well as the second largest importer. Even more surprising is China’s status as the largest creditor, a title once held by the United States a long time ago. Nearly 21 percent of all foreign-owned U.S. Treasury securities are owned by China.
In effect, the world economy now passes through China. This growth, however, has come with severe problems. Inflation, especially in food and fuel prices, has been a problem for many years. Unemployment, underemployment, corruption, poor lending standards and more plague the Chinese economy. The government has tried unsuccessfully to address these problems. Should these problems continue they could lead to a severe recession in China as inflated asset prices implode and domestic demand grinds to a halt.
The impact on us
If one—or several—of these catalysts become reality, the impact to our economy will be severe. Inflation will increase dramatically, as will unemployment. Lending will freeze. Consumers and businesses alike will curtail spending dramatically. Major stock indices could see values decline by 20 percent or more. And these are the known effects. Simple “trust” still forms the backbone of the global economy. If this trust in our institutions disappears, there really is no telling how consumers, companies and governments will react.
The protracted battle over the debt ceiling increase demonstrates the difficulty in reaching negotiated solutions for these types of matters. That battle only required a few additional votes in the legislature of a single country to be resolved. These catalysts would require trillions of dollars in resources plus the coordinated work of many countries to avoid severe results. It’s unlikely that this would happen.
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