The Dominos of Default
by John Browne
Senior Market Strategist, Euro Pacific Capital
Posted originally March 4, 2010
THE BAD NEWS FOR GREECE IS THAT DESPITE SOME HELP from abroad, and some attempts at internal reform, investors are still leery of the troubled state. The good news, if you can call it that, is that they will soon have company in the penalty box. Now that investors have come face-to-face with the reality of sovereign default in the developed world, greater scrutiny will befall those countries with fiscal conditions similar to Greece. The United Kingdom is a cause of great concern, with a debt ratio rapidly approaching Greek levels. The economic challenges facing Britain are aggravated by a Labour government that is pushing the country further toward socialism. As a result, in from mid-2008 to today the pound sterling has lost some 25 percent of its value even against the US dollar. Debt and socialism are a toxic mix for investors.
When I served as a Member of Parliament, under Margaret Thatcher, freedom literally burst upon Britain. We dropped the top rate of income tax from 92 percent to 30 percent (generating far higher tax revenue); abolished foreign exchange controls overnight; and demolished socialist controls by, for example, allowing people the basic freedom to own their own telephones! A wave of enterprises sprung up and Britain once again was referred to as ‘Great,’ without causing wry smiles. Though it may be astounding by today’s standards, we instituted a public debt repayment schedule. Thereafter, sterling soared by almost 100 percent between 1985 and 1995.
Great Britain has, until the present, never experienced more than two successive socialist governments. Today, the Conservatives, who covertly support the surrender of UK sovereignty to the socialist European Union, are seen as offering little alternative to socialist Labour. Despite the appalling economic record of the current Labour government, recent polls show a serious risk of a hung parliament after this summer’s general election. Suddenly, investors face the real prospect of a fourth socialist government. This specter, combined with the massive debt and misspending of the past three administrations, has led to serious out-flows from sterling and UK government ‘gilt-edged’ bonds, or ‘Gilts.’
As in the United States, the economic problems encumbering the UK and most of Western Europe are deep-rooted. They stem from many decades of dependence on monetary expansion to ‘paper over’ fiscal irresponsibility. GDP growth has been obtained by government subsidies of consumer demand, financed by debilitating taxation of productive enterprise, unimaginable public debts and massive currency debasement.
Alas, it is also becoming painfully clear to investors that, unlike the past, the problems are now too big for the same old government remedies. Whereas the recent first wave of recession caused individual people and companies to face bankruptcy, the looming second wave threatens entire governments.
Who can bail out governments if a number of them default simultaneously? The IMF is a sort of ‘central bank of central banks,’ but it is largely backstopped by the United States. Will China, Germany, or other creditor states be willing to assume the role of global guarantor? If so, what will this mean for the sovereignty and competitiveness of the old pillars of the Atlantic?
Greece is a small economy. But its debt problems highlight fault-lines undermining the euro, and with it the socialist dream of a United States of Europe. Today, Greek ten-year bonds sell at yields north of 6 percent, nearly 300 basis points higher than similar German, Danish, or French sovereign bonds.
While Britain’s debt has become a cause for some concern, investors have drawn hope that the Conservatives would carry the coming election and restore some semblance of fiscal order. However, recent polling has exposed the risk of a hung parliament. Suddenly, the previously unthinkable notion of a British default crossed into the realm of possibility. Ten-year British Gilts sold off to yield above four percent, a significant premium above the country’s Continental rivals.
In other words, the free market has priced in a loss of the UK’s prized ‘triple A’ credit rating, while the perennially laggard and politicized rating agencies merely issued warnings. As we have said before, the United Kingdom, as one of the two main bulwarks of modern finance, is the figurative ‘canary in the coal mine.’ It is my belief that just as Greece preceded the UK, Britain will precede the United States along the dark and dangerous shaft of excessive debt. Although the United States is nearly five times larger than the UK, our financial difficulties are in nearly the same proportion. In many ways, problems in the U.S. may be more intractable.
Although the Federal Reserve is actively holding down the short end of the yield curve to near zero, 10-year notes are currently yielding more than 3.6 percent. If the Fed were to cease purchasing Treasuries, or the rating agencies were to become realistic, the free market would drive the 10-year into dangerous territory. History is littered with examples showing that socialism kills enterprise. The UK and EU are largely socialist. The US is becoming increasingly so. This political trend, coinciding (unsurprisingly) with a major recession, invites catastrophe.
It is one thing for prudent, rich states like Germany to bail out small states like Greece. But few states have the ability or the will to bail out financial giants like the US, EU, or UK. If such a maneuver were attempted, it would surely drag the entire world into depression – and I don’t take the Chinese or the Germans to be that foolish. Absent a reasonable avenue for rescue, we are increasingly likely to see these formerly steady giants topple. If you’re stuck in their shadow, look out.
We have long alerted readers to the possibility and even likelihood of sovereign defaults. Once a key domino falls, collapse can be devastatingly sudden. Those heeding our warnings should be wary of socialism wherever it lurks. Be glad that darkness strikes first on the other side of the Atlantic, but be wary that are close behind.
John Browne is the Senior Market Strategist for Euro Pacific Capital, Inc. Mr. Brown is a distinguished former member of Britain’s Parliament who served on the Treasury Select Committee, as Chairman of the Conservative Small Business Committee, and as a close associate of then-Prime Minister Margaret Thatcher. Among his many notable assignments, John served as a principal advisor to Mrs. Thatcher’s government on issues related to the Soviet Union, and was the first to convince Thatcher of the growing stature of then Agriculture Minister Mikhail Gorbachev. As a partial result of Brown’s advocacy, Thatcher famously pronounced that Gorbachev was a man the West “could do business with.” A graduate of the Royal Military Academy Sandhurst, Britain’s version of West Point and retired British army major, John served as a pilot, parachutist, and communications specialist in the elite Grenadiers of the Royal Guard.
In addition to careers in British politics and the military, John has a significant background, spanning some 37 years, in finance and business. After graduating from the Harvard Business School, John joined the New York firm of Morgan Stanley & Co as an investment banker. He has also worked with such firms as Barclays Bank and Citigroup. During his career he has served on the boards of numerous banks and international corporations, with a special interest in venture capital. He is a frequent guest on CNBC’s Kudlow & Co. and the former editor of NewsMax Media’s Financial Intelligence Report and Moneynews.com. He holds FINRA series 7 & 63 licenses. Copyright © 2010 John Browne Editorial Archive