Raoul Pal, author of the Global Macro Investor and the co-founder of Real Vision TV, is one of my favourite thinkers and investment minds. Regrettably I’ve not met him… yet, though I’ve been fortunate enough to meet his business partner Grant Williams, who is both smart, genuine and intellectually curious.
One of the concepts Raoul discusses is “The Law of Unintended Consequence”. You can and absolutely should go watch it on Real Vision TV!
The unintended consequences of the very decisions being made right now at a macro level set the stage for some particularly catastrophic outcomes. This relates in particular to Europe and China which I’ll delve into over the next few weeks.
The chart above shows the incredible increase in global debt since 2000. The bond market, powered by a powerful combination of kryptonite, dilithium crystals and central bankers who have completely misread the market forces is beginning to crack around the edges.
It’s worth remembering that absolutely no nation has ever survived a debt crisis and it’s equally important to understand that global debt is now about twice the size of the ENTIRE world economy – something the world has never dealt with before.
Greece with 177% debt to GDP just came dangerously close to exiting the euro. Greeks themselves voted to regain their sovereignty but in the end Tsipras caved in to Eurocrat pressure. For the Eurocrats the last thing they need is citizens of Europe choosing their own outcomes. That would mean a rise of multiple fringe political groups. Greece had to be pulled into line and though it’ll inevitably and finally assist in the downfall of the entire European Union, for now it keeps an increasingly angry Europe glued together… just that little bit longer.
The release valve for a country at risk of defaulting on its debt is the currency.
Greece, however, no longer issues its own currency and as such there exists no release valve. Trapped in a deflationary spiral the economy continues to contract: 0.2% in the first quarter of this year following a 0.4% in the last quarter of 2014. When Greece joined the euro, they seeded monetary sovereignty to Brussels, and in doing so stuck a plug its currency release valve.
Tourism, for example, makes up 18% of Greek GDP and remains relatively uncompetitive since everything is still priced in euros. If Greece threw off the shackles of the euro they’d be printing drachma with abandon, defaulting on their debts, and Germans and Brits would be turning lobster pink on their beaches while overindulging on ouzo.
As unbalanced as the pink Germans and Brits would be this would allow for a re-balancing of the market. But it isn’t going to happen and Greece will remain in deflation, except it’ll do so now with ever increasing debts. This promises to simply increase the deflationary forces in play and create a much larger problem in the near future.
These are some of the unintended consequences of the euro and the decisions being made across Europe. This is important since Greece is but one of 19 of the 28 member states officially using the euro.
Greece is fairly meaningless on its own. It accounts for just 2.5% of European GDP – about the same as Maryland in the US. Inconsequential some say.
But why Greece matters can be seen from the following chart:
Clearly Greece has bedfellows. What happens in Greece has the potential to become a trigger point and poster child for what happens elsewhere in Europe.
Global capital flows are probably THE most important macro factor we look at.
Right now we don’t see global capital flows within the EU states quite so clearly since they’re all using the same currency. Where we do see movement is in the spread between Bunds and both other member state bonds but particularly US bonds.
Gavekal wrote an interesting piece on the topic of the widening spread between German and US bonds here. If you look at the chart below taken from Gavekal you’ll see the widening spread between German Bund’s and the US 10 yr.
Bond holders are puking risk and they see risk particularly in European member states debt but they see risk in Europe in general and this includes Germany. This is a clear sign of stress in the system.
An Asian Example
The Asian crisis which began in Thailand provides a text book example of how over-indebted economies can unravel with the speed of a bush fire.
February 5th, 1997, was the date that Somprasong Land, a Thai property developer, announced that it had failed to make a scheduled $3.1 million interest payment on an $80 billion Eurobond loan. Much like the Greeks are now tied to the euro, the Thai baht was pegged to the dollar plugging the currency release valve.
Currency traders saw the anomalies much like bond traders currently see the anomalies between European countries, and began betting against the baht. The Thai central bank spent $5 billion defending the baht, reducing their currency reserves to $33 billion, before the Thai government bowed to the pressures allowing the baht to float freely. Once this took place the Thai debt bomb blew out as many debts priced in dollars became unpayable and the Baht collapsed.
Much like Europe of today, the entire Asian region had taken on unsustainable levels of debt and once Thailand had “shown the way” it didn’t take long for a wave of selling hit Malaysia, Indonesia, South Korea and Japan.
Similarly, consider that the Latam crisis in the early 80s was a direct result of the huge dollar bull market. Currency trends tend to be self-reinforcing in nature which is also why they tend to last longer than other market trends.
This is what Raoul refers to as “unintended consequences”.
As we’ve detailed in our Dollar Bull Report we believe we’re in a dollar bull market. The reasons for this are many though the largest by far is an unwinding of the USD carry trade, something I explained in “The Anatomy of a Carry Trade Bubble”.
Credit bubbles and fixed exchange rates never end well. We have the mechanics of both in Europe. Greece is simply a symptom of a much larger problem. Yes, it’s small but that may be missing a more important point.
Greece matters since the repercussions from what takes place in Greece increase the probability of the following happening:
- Debt holders, largely German banks, risk having to mark to market existing debt held on their balance sheets at par.
- Political fringe parties in neighboring European countries will be provided a blueprint to rally political support and exit the euro.
- Investors noticing all of the above will actively look for the next “ugly girl” to eliminate for the EU popularity contest.
- High levels of debt historically lead to war. Taking away release valves for this debt increases the probability of war.
We’re already in a USD bull market and any of the above will only add fuel to this fire.
Next week I’ll explain how I see this relating to China.
“Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.” – Stone Gossard