Dominoes

By: Ian Campbell | Wed, Jul 13, 2011
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On Monday morning, in advance of seeing any report arising from the emergency meeting called by the European Council President, I read two articles that caused me to focus on the role Rating Agencies might play in a Sovereign Debt driven financial crisis. The two articles are 'Uh Oh - Italy Is Coming Apart Like A 20 Dollar Suit' - reading time 3 minutes, and 'Italy and Spain must pray for a miracle' - reading time 4 minutes.

The articles report that on July 8 investors began selling Italian financial assets, and that Italy's five largest banks have as a group lost 27% of their value since January 1. Italian national debt is said to be 120% of Italian GDP. There is a maxim that I have drawn from all that I have read about country debt, being that a country's ability to deal with high debt/GDP levels is a direct function of interest rates. Simply stated, the lower the interest rate on a country's debt, the greater is that country's ability to maintain a high relationship of debt to GDP. Reciprocally, the higher the interest rate on a country's debt, the less able is that country's ability to maintain a high relationship of debt to GDP.

With that background, enter Rating Agencies from stage left. I was well aware of the influence Rating Agencies had on financing activity in what I will describe as a 'normal economic environment'. However, until this morning, I had not focused on what I will call the 'potential fulcrum effect' Rating Agencies might have in 'an abnormal economic environment'. Having thought about it, in the worrisome Sovereign Debt environment we face today, the Moody's and Standard & Poor's of the world to some (perhaps large) degree perhaps can be thought of as the person whose finger is capable of pushing the first domino into the second domino and thus starting a chain reaction. That is an enormous responsibility and, if I am right, one far more onerous in the current world economic climate than the responsibility the Rating Agencies shoulder in what we think of a 'more normal economic times'.

The second of the two articles says that a year ago Jean-Claude Trichet of the European Central Bank then claimed "Europe was on the brink of a 1930's financial cataclysm, and that "it is hard (to) see how the threat is any less serious now". Indeed, I would have thought it virtually certain that the Sovereign Debt risks in the Eurozone are greater today than they were a year ago. In the past year Ireland, Greece, Portugal, Spain and now Italy have all made financial headlines, with yields on both Italian and Spanish bonds making new highs last week - and some believe the Eurozone Sovereign Debt risks are such that a new phase of concern that contagion (read 'falling dominoes') may be reaching the larger (Italy, Spain) economies. The second article says the implications are "profound", as Germany may have to either buy Italian and Spanish debt that in turn may have to lead to fiscal and political union, or that Germany will have to accept that the European Economic and Monetary Union ('EMU') has to break up.

In the end, I have concluded that the most important things to watch as the Eurozone Sovereign Debt issues continue to unfold are (1) the finding of the Rating Agencies with respect to the Debt of each Eurozone country, and in particular downgrades to specific country credit ratings if those occur, and (2) yield increases on specific country debt which, if they occur, will signal increases Eurozone Sovereign Debt risk.


My Underlying Message On The U.S. Federal Government and Economy

This past Monday I wrote a commentary called 'U.S. Mired in Quicksand'. My wife reads most of my e-mails, and based on her comments to me I concluded that I may not have been clearly conveying over the past several months the message I have been attempting to convey with respect to the U.S. Federal Government and economy.

As I see it, most media writers and commentators convey thoughts and conclusions about specific economic or world events - i.e. job reports, trade deficits, Federal Government deficits, the riot in a given country or city, and so on. Many of the commentaries I make in these e-mails could be so characterized. That said, I do try to bring a 10,000 foot view to what I write about.

What I have been addressing in the context of the United States Federal Government and its economy going forward, perhaps not well, is what I see as the structure of the U.S. Political system and its underpinnings from a high level, and the effect of that structure on the U.S. economy. To me, if the fundamental structure of any organization does not lend itself to the generation of a positive long-term result, either the existing structure needs to be amended or replaced, or the ultimate result must be at best 'less than could have been accomplished', or a worst must 'end in failure'. As I see it, the U.S. Federal Government operates with a highly partisan two party Democrat system that is inefficient, where both parties seem to be operating as if this is 1975 and not 2011, and where the problems that it currently faces require incisive decision making based on reality and not hope and dreams.

Irrespective of the outcome of the current 'top of news' U.S. Debt Ceiling negotiation, which I at the moment don't see as a 'crisis' because I think it will be settled in the end, I see little or no hope for material change in how Washington thinks, works, and makes decisions. In fact, unfortunately I see no real possibility of any 'real change' until a major financial, military, terrorism or societal crisis forces 'real and permanent change'. From 10,000 feet my concern is that if and when one or more of those four things occur, and the way things are headed I think one or more of them will occur at some point - perhaps in a shockingly short time span, it will be too late for such 'real change' in Government Structure to be effective.

Given the importance of the U.S. in the context of the world economy, I hope to be proven wrong.

 


 

Ian Campbell

Author: Ian Campbell

Ian R. Campbell, FCA, FCBV
Economic Straight Talk

Through the Economic Straight Talk Newsletter Ian R. Campbell shares his perspective on the world economy, the financial markets, and natural resources. A recognized business valuation authority, he founded Toronto based Campbell Valuation Partners (1976), Stock Research Portal (2007) a source of resource companies market data and analytic tools, and Economic Straight Talk (2012). The CICBV* annually funds business valuation research in his name**. Contact him at icampbell@srddi.com.
* Canadian Institute of Chartered Business Valuators
** through The Ian R. Campbell Research Initiative

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