The Race to the Bottom

"There's a rumor going around that states cannot go bankrupt. This rumor is not true."
- Angela Merkel speaking at a private bank event last month in Frankfurt

We've got a strong field, one where I feel anybody could - but nobody wants to - win it. Iceland almost showed everybody how it's done a few month back, now the other competitors seem to be jockeying for position to see which country will be next to go. While many fingers are being pointed at the US for causing much of the current financial pain, one need only look at the strength of the dollar to see that most investors at least are betting it won't be the US winning the race to national bankruptcy. Based on currency values, again the Euro nations must be in a good position, right? Not so fast, Italy and Ireland are both looking like prime candidates to cause the collapse of the grand experiment. Looking further east however, at those EU members who aren't yet part of the monetary union, we see a few more likely victims. The falling value of the zloty, forint, leu and koruna seem to be trumpeting the possibility that it will be Poland, Hungary, Romania or the Czech Republic to be first to the finishing line in a race nobody wants to win. The Baltic states are making a stronger case that it may be one of them. Even wackier, how's this for a dark horse - Austria.

While the US continues to look for new ways to throw money into a dark pit by giving away money to banks and car companies, the value of their dollar seems to be living in an alternate universe as it climbs against most of the world. Arguments for this occurring centre around the fact that in times of crisis investors move their capital to traditional 'safe' bets; here the dollar reigns supreme. But what about that ballooning debt? Well, not to worry, the government is sinking trillions of dollars into the banking industries et al to ensure a growing economy, so the numbers will come down eventually, right? Wrong. Without discussing the complete waste of money that are the bailout and stimulus packages, (ie. throwing good money after bad, not investing in the future - school and green technology anyone?) even if there hadn't been an economic meltdown, the US economy was already well on the road to disaster. Simple math, income statement stuff - aging population with the baby-boomers on the verge of retirement (that's right 2009 means those born in 1946 turn 63!) equals lowered income from taxes plus higher medical and social security expenses spelling disaster. Even the days of dollar hegemony in world trade (read: oil), bond auctions and other nations foreign reserves seem numbered. From Kish in Iran to Beijing's planned experiment to make the yuan the new dollar in the east, their are ominous signs that the world has finally tired of financing the US debt. I've argued on more than one occasion that the dollar's days are numbered and there are others who do it better than I.

But I digress, if the US dollar is going up, there must be a lot worse currencies to be holding onto. Unfortunately, I find myself holding onto a lot of Polish zloty as I'm living here in Poland and I can attest to the fact that I'm a lot poorer today vis-a-vis the US and Western Europe than 6 months ago. The situation is similar in the other newer EU states. Faced with the double whammy of falling economic activity and even faster falling currencies, many of these nations are facing bankruptcy. Not only are the prices of imports going up, financing prices are skyrocketing for both individuals and governments. Consumers who were suckered by banks into taking low interest Swiss franc loans are now paying much higher payments and governments are being forced to pay higher rates to issue sovereign debt. Standard and Poor's seems to be dividing the Eastern European countries into 2 groups: the first includes The Czech Republic, Poland, and Slovakia who are likely to fare better in the current crisis because of their more resilient private demand and greater fiscal flexibility, while in the second group are the three Baltic countries, Bulgaria, Hungary and Romania, all of which are highly vulnerable. In fact, S&P downgraded Latvia's debt to junk status last week and threatened the same action for the other Baltic states following the fall of the the Latvian government.

While these countries don't have a printing press as powerful as the US Federal Reserve, they do have the EU to play white knight. However, even here there are big cracks appearing in the foundations. When word leaked that Germany was mulling some bailout options for their eastern neighbours this drew a sharp warning from the ECB as such a move would be against the EU treaty's “no bail-out” clause which prevents members of the eurozone from supporting other members that are facing rising public debt. Members of the euro currency club are feeling the pinch as well. Thanks to monetary union, you can no longer bet on individual nation's exchange rates. But thanks to credit default swaps, you can place convenient bets on the break-up of the eurozone. Last week, speculators bet on an Irish default, these bets make it more expensive for Ireland to refinance its debt, thus threatening to turn into a self-fulfilling prophecy. The cost of insuring Irish debt hit 350 basis points 2 weeks ago, meaning that for every £100 of debt it would cost £3.50 to insure against default; a year ago it would have cost 10p. Ireland isn't alone in the Union with messy finances, Italy, Greece, Spain and Portugal don't look much better as spreads on government bond issues are soaring as credit ratings are lowered. Italy's public debt is the third largest in the world, 104% of GDP, what the Economist calls the 'ogre in the attic'. Welfare minister Maurizio Sacconi said back in December, "There is something worse than recession, and that’s state bankruptcy: an improbable, but nevertheless possible, hypothesis." Meanwhile, the crisis in the east could reinforce the problems in the west as their banks hold $1.74 trillion in former Soviet-bloc nations' debt. Austrian banks are the most exposed, with eastern European loans totalling 75 per cent of gross domestic product. Over half of Austrian bank Raffeisen's debt portfolio is based in the east.

The world is facing an economic crisis of unknown proportions and thus far the financial gurus have been trying to put a band-aid on the flow of red ink by administering the same cure that got us into this problem, issuing more debt. I haven't even considered the problems facing nations outside the US and EU; the Ukraine looks even worse, Ecuador and the Seychelles have already defaulted. The question is who's going to suck up all the new debt? With the US looking to secure $2 trillion and other developed nations about a $1 trillion in new debt, the problem becomes who is there left to finance it? Hillary Clinton went to China to beg them to keep buying treasuries while others are looking to the IMF and World Bank. Eurozone countries are getting into a bad habit of failing to meet bond auction targets. The IMF has already extended over $50 billion in emergency credit to Hungary, Ukraine, Iceland, Pakistan and Hungary. With other nations lining up they are desperately trying to raise more funds, world leaders are calling for a doubling in IMF resources to $500 billion. According to ING Wholesale Banking, emerging-market governments and corporations need to repay some $6.8 trillion of debt this year. In an effort to stop the free fall of Eastern European currencies the central banks issued joint statements to the effect of 'hey, the market doesn't reflect economic fundamentals, besides, we'll join the Eurozone soon'! Sometimes you have to know when you can't help everyone, a tipping point can be reached where the attempt to save one more costs the lives of everyone. That's why lifeboats have a maximum capacity posted - though I'd imagine it would have to be one helluva tough bastard who'd be able to watch someone drown while the rest watched in silence. There can no longer be any doubt that the world is faced with the prospect of financial Armageddon and it's time to decide who to let on to the escape pods. I know, I know, it's human nature to save a drowning person, but trying to save everyone is financial suicide.