Ticking Time Bombs: More Volatility on the Horizon

To put it more graphically:  the world has been lurching from financial crisis to financial crisis over the past few years.  There are enough time bombs ticking on the horizon, that one might expect the world to continue lurching from crisis to crisis for the foreseeable future.  So what are some of these ticking time bombs?

Eurozone issues.  

Greece is currently at the epicentre of the Eurozone crisis, but there are broader issues.  While the Eurozone has a common currency, and the European Central Bank has the power to print money, there is no body empowered to issue Euro bonds.  Nor is there a Central Government that can carry on a common fiscal policy for the European Union or for the Eurozone.  In an organisation such as the Eurozone, there are always likely to be one or two countries lacking fiscal discipline, who may bring instability to the entire Eurozone (as Greece does today).  If this were to be a larger country such as Italy or Spain, this would even more severely test the will of German taxpayers to bail out the union.   Questions are becoming increasingly frequent as to whether the Eurozone, in its current form, is sustainable.  There was once a revolution fought over the principle of “no taxation without representation”.  German taxpayers are now footing the bill for decisions made in Greece years ago, where they had no say.  The only workable and sustainable quid pro quo is for the Germans and wealthier European countries to take responsibility for all of Europe (what Germans refer to as a “Transfer Union”), in exchange for which the more profligate countries submit themselves to a common fiscal discipline.  As any banker will tell you, he who pays the piper calls the tune.  A more integrated Eurozone would issue Eurobonds and have a common budget and fiscal policy.  Until then, there is every likelihood that the Eurozone will lurch from crisis to crisis.  The crises may serve to catalyse integration, or may weaken the Eurozone, by causing one or more members to drop out.  And given the lack of political or popular will for integration, integration is far from pre-ordained.

US debt and money supply.   While Federal Government debt in the US seems tenable (in the range of 70-80% of GDP), and easily within the capability of the US Government to service, when you add State debt, municipal debt, private and corporate debt, according to Federal Reserve estimates, total debt is in the range of 370% of GDP.  This is an ocean of debt!  And this does not include unfunded pension liabilities, liabilities with respect to Medicare/Medicaid, etc.   While in the 1990’s, the US demonstrated that it could rapidly convert a deficit to a surplus, the degree of political will or consensus necessary to fight deficits does not seem to exist today.  The crisis with respect to raising the debt limit experienced last summer gave a graphic illustration as to the current polarization or lack of consensus in the US.

US money supply has been expanding at an alarming rate over the past five or six years.  While the rapidly expanding money supply, large deficits and debt overhang would predispose the US dollar to a major devaluation, the demand for US dollars from international investors seeking refuge in US treasuries, for want of a better repository of value, remains unabated.  How ironic.  And how unstable!

In addition to the two major systemic risks in the global financial system above, there are also a host of other risks bubbling under the surface:   

A major terrorist attack could disrupt markets.  (Remember how 9/11 disrupted financial markets?)

What if Fukushima turns out to be a much larger problem than most people realize?  Larger swathes of Japan might require evacuation, radiation detected in the US has also been attributed to Fukushima.

What if China’s development becomes unstuck (remember how the collapse of the Soviet Union caught us by surprise)?  Remember, Chinese banks are still largely State-owned, doing a huge amount of lending to State Owned Enterprises.  A country that has not seen a recession in decades may face a very serious downward adjustment when a recession does come.

It will take years for the US and Europe to work through their issues, and the other risks described above are unlikely to go away quickly as well.  So expect volatility to be with us for years to come. If you accept my prognosis for volatility, what should a business owner or CEO do?  This will be the subject of my next column in two weeks.