I tend to think about financial matters by first looking at worst-case scenarios, deciding on the risk levels, and finally determining on a strategy. So that’s how I will proceed here, first about Europe, then about the US.
1. I recently wrote in the NY Times that as long as governments keep nationalizing the bad loans of their creditor entities, and refuse to make both creditors and taxpayers share the losses in a reasonably fair way, the financial crisis will continue. This thought applies primarily to the current crisis in Greece and Europe. Since I think the people making decisions there are intelligent and knowledgeable, I remain optimistic that the crisis will be properly resolved. But the risk has grown, perhaps to 30%, that it won’t. Clearly, the fair solution demands a lot of sacrifice from privileged people who are ill-disposed to behave that way.
It looks to me as if the IMF, the World Bank, and the private lenders to Greece are insisting on full repayment. While Greek politicians, desperate to keep the bankers happy in order to avoid default and the enormous problems that would befall Greece in that event, have agreed to unilaterally shoulder the losses that the creditors incurred, there seems no possibility that the Greek people will agree to the necessary austerity measures. As with the majority of Americans who oppose raising the debt ceiling, they seem either ignorant or indifferent to the consequences if they fail to do what they are told.
If the creditors force Greece to default, I suspect that the government that would then emerge there, as in Germany during the Depression, would probably be a nationalistic, authoritarian one that in standing defiant would enjoy popular support. Such a government could probably withstand great financial pain, and ultimately force the creditors to accept serious losses. Portugal and Ireland would quickly follow the Greek lead, and Spain and others would either wring major concessions from their creditors or follow suit as well. Credit would dry up everywhere in Europe very quickly. In other words, the whole European financial system would collapse within a matter of weeks or months. US markets would suffer a bit less, but all nations in the Atlantic world would head into a major deflation.
Europe aside, I am more optimistic about the chances for a reasonable agreement about the debt ceiling in the US, entailing a relatively sensible combination of spending cuts and tax increases (by whatever name). We do not face the internal and international pressures that Europe does, and Congress seems to grasp the essence of the problem, as Obama certainly does. Still, it remains a very risky situation with, perhaps, a 5-10% chance of catastrophe.
Being an optimist, however, I also think the debt ceiling negotiations put within reach a number of important and desirable reforms that have previously been unthinkable: sharp cuts to military spending; reorganization and serious cost reductions in Medicare and Medicaid; measures to stabilize Social Security; higher actual taxes on the very wealthy and on corporations; continued payroll tax reductions.
Moreover, by bringing matters to a head over the issue of the debt ceiling, I think the Republicans have created a very interesting negotiation “game.” The negotiations are deadly serious in this game because everyone has implicitly agreed, it seems, to take them seriously, and in the face of apparent crisis they have more of a chance of major success than anything that has come along in a generation or two. But if they fail, it will be easy to just kick the largely artificial debt ceiling “crisis” down the road, with no great harm done.
The major wild card in this negotiation is the Republican primary. If they nominate electable candidates like Romney or Huntsman, who in light of Obama’s weaknesses stand a very good chance winning the Presidency in 2012, then it is hard to see the current Congress making significant progress on the debt ceiling negotiations. The Republicans have too much to gain by deferring the debt ceiling issue until after the 2012 election. Should they then capture the White House and the Senate, the party’s policies—regardless of the inclinations of their President—could well get enacted, with tragic consequences for us all.
Those are the major risks that I see, and they are truly frightening. Indeed, should they materialize I have very little idea about how to avert personal financial losses. I know that many people are buying gold, but that seems primarily a hedge against inflation, which I do not see coming. The risks are all about deflation, resulting from a lack of credit that leads to a lack of demand—in short, Depression. A carefully selected bond portfolio, or even just cash, might preserve capital in a Depression, but the governmental reactions could easily destroy such portfolios as well. Moreover, it would be very difficult to select deflation-proof bonds. In short, I know of no financial strategy, apart from sheer luck, for surviving Depression. That being so, I might as well act as though those risks will not materialize.
Indeed, my current sense is that the risks I have elaborated have already driven stock prices so low that any reduction of the risks would trigger major rebounds. In other words, at the moment the risk/reward ratio in owning stocks seems shifted toward reward.
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