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The Big Picture Following the Worst Crisis Since the Great Depression

Economics / Global Debt Crisis Jun 26, 2010 - 03:52 PM GMT

By: Bryan_Rich

Economics

Best Financial Markets Analysis ArticleLast week, I laid out some important historical context for establishing a solid perspective on the big picture — a broad view of where the global economy stands and what we should expect going forward.

Today, I’d like to continue with the second part of my analysis.


As I said last week, history shows us that financial crises tend to be followed by sovereign debt crises. History also shows us that sovereign debt crises tend to lead to currency crises.

I discussed the stages of a developing sovereign debt crisis — and how it’s playing out. And using history as our guide, it’s reasonable to expect a currency crisis will follow.

There were three memorable currency crises in the 1990s, all of which included a fixed exchange rate system that was under attack. But regardless of the type of currency policy (fixed or free-floating or a monetary union), a currency crisis is broadly defined as a loss of confidence in a country’s currency. Something we’ve seen very clearly in recent months with the euro.

For a reference point on how these trends unfold, there’s a good academic study from MIT on historical currency crises that lays their progression out like this …

Three Stages of a Currency Crisis

Stage #1: Loss of Confidence

The number one cause of a currency crisis is when investors flee a currency because they expect it to be devalued.

Here’s the current situation …

When the euro zone stepped in and threatened to cough up $1 trillion dollars in an attempt to save the euro monetary union, it was a conscious decision to devalue the euro.

Why did they do it?

The euro zone has committed to do whatever it takes to keep its members afloat.
The euro zone has committed to do whatever it takes to keep its members afloat.

They had no choice!

The European banking system was, and still is, too exposed to the sovereign debt of the euro zone’s weak spots. An imminent default of a euro member country would have meant a crushing blow to European banks and likely another wave of global financial crisis — this time worse.

Here’s why: Last year the European Central Bank was flooding the banking system with unlimited loans for a paltry 1 percent. What did the banks do with the money? They bought government debt — specifically, debt from the PIGS (Portugal, Ireland, Greece, Spain).

In all, European banks own $1.5 trillion worth of debt from the fiscally challenged countries of the euro zone. As a result, politicians in Europe felt they had their backs against the wall and their response was one of “all-in.”

All countries involved in the monetary union went headlong into the crisis because they had no choice. The strategy: Buy time and devalue the euro.

Stage #2: Herding

When it’s thought that investors are moving out of a currency, others follow. This is typical “herding” psychology.

Here’s the current situation …

Short positions in the euro hit an all-time high.
Short positions in the euro hit an all-time high.

Every week the Commodity Futures Trading Commission releases its Commitments of Traders (COT) report, which tracks the positioning of market participants. While it’s just an indication of how the general market is positioned, it’s a great reference point.

The recent reports provide an excellent example of this herding mentality that tends to be associated with currency crises. I’m talking specifically about the euro.

In fact, the uncertain outlook has triggered a massive wave of short positions in the euro — the largest in the currency’s 11-year history.

When the market is heavily positioned one way — and the fundamentals support it and an intentional devaluation appears underway — big institutions have to react. Put simply, they have too much to lose by getting caught the wrong way.

Given the euro is the second most widely held currency in the world, there is a lot of unloading that could take place …

For example, Iran’s central bank has announced they will be diversifying euro exposure — trading into gold and U.S. dollars. And China and the UK have shown a significant increased interest in owning U.S. dollars as opposed to euros.

Stage #3: Contagion

The next step is contagion. And contagion is a phenomenon in which a currency crisis in one country triggers crisis in other countries with similar weaknesses.

Here’s the current situation …

Dubai's debt problems were just the beginning of the global sovereign debt crisis.
Dubai’s debt problems were just the beginning of the global sovereign debt crisis.

The catalyst for sovereign debt crises: Bloated debt and deficits. And as I’ve said, sovereign debt crises tend to lead to currency crises.

You don’t have to look far to find countries that carry bloated debt loads and deficit burdens.

Over 40 percent of the world’s GDP comes from countries running deficits in excess of 10 percent of GDP — a level proven to be dangerous territory.

We’ve already seen the sovereign debt contagion. A crisis that started in Dubai now confronts Greece, Spain, Portugal … and will likely spread to the UK, Japan and even the U.S.

It’s clear there are a number of reasons why global investors could lose confidence in currencies in this global economic environment. So a contagion of currency crisis is a reasonable expectation.

The bottom line: The day-to-day ebb and flow of economic data and news can be distracting. That’s why it’s important, especially with all that is going on, to keep the big picture in perspective.

History shows us that a global recession when combined with a financial crisis tends to stifle economic activity longer than normal recessions. History also shows us that financial crises tend to lead to sovereign debt crises, which tend to lead to currency crises.

So with that in mind, it’s fair to say that a V-shaped economic recovery has always been very unlikely. What’s more likely is that we’ll see more shocks to the global economy, more challenges and more investors fleeing risky investments in favor of safe havens.

Regards,

Bryan

P.S. I’ve been showing my World Currency Alert subscribers how to protect their wealth and profit as this currency crisis kicks into high gear. If you’re not a subscriber, you can check it out by clicking here.

Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.


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