European_Contagion-250x300The crowd is breathing a sigh of relief as European leaders have approved a bailout of Greece, staving off a disorderly default and a possible big hit to European banks and to the euro.

This is the sigh of traders — they define their work day in seconds and live off of events and headlines. The debt crisis has ended, for them, for now.

Reality as always, if quite different from the current madness infecting the crowd. Greece will eventually have a disorderly or orderly second default, it will leave the euro, and the crisis will be about containing contagion. The delay by European leaders in arranging this bailout has, in part , been to prepare institutions and the markets for this eventuality. The same is true for Greece – politicians can now say they have done their best, the European are being unreasonable, we cannot take it any more, we should not take it any more, time to default, time to leave the euro and get control of our nation.

The Greeks have been profligate, two-faced, produced fraudulent data to gain entry into the eurozone and fraudulent data to maintain a fiction about their government’s economic health. But they are also right. The prescription of more austerity in the face of an already savage recession is retribution, not intelligent policy, and the Europeans, led by the increasingly sanctimonious and heavy handed Germans, are behaving irrationally. Einstein defined insanity as doing the same thing over and over again and expecting a different outcome. More and more austerity imposed on a nation and economy already in decline is, simply put, nuts.

Fallout for European banks, Portugal, Ireland and beyond

Greece, by itself, is of no import whatsoever to the world economy. It is important due to the fragility of European banks, the fragility of the political support for the euro and the lessons that other nations will learn from failed, externally imposed austerity programs.

European banks – especially German banks, and notably German state banks, are woefully undercapitalized. They cannot afford a writedown of sovereign debt. The European Central bank has maintained the fiction that all sovereign debt, including Greek debt, is good debt and counts towards the capital requirements of banks. If Greece defaults again – excuse me, when Greece defaults again – banks will take a hit. They are preparing for this – but the larger issue is contagion and possible defaults by Portugal.

Political support, among populations and politicians in northern European countries has eroded and there is little appetite for another bailout of any sort – of Greece, of Portugal, of anyone. Politicians have done a miserable job explaining to people in these countries that their banks and their exports are dependent on those bailouts. I do not see Spain or Italy leaving the euro, but I do see Greece and Portugal doing so.

Portugal, Ireland, Spain and Italy are watching the developments in Greece – in the street, at the ballot box – and are hardening their own attitudes about German-driven austerity programs that might work in a nation where, and just ask a German, everything is forbidden until it is permitted, rather than the other way around, but it will not work In most other countries, especially Mediterranean countries. The problems in Greece, Portugal, Spain and Italy are not just about borrowing too much – they are about economic cultures built around extreme protection of workers, craftsmen and professionals, greatly reducing the ability of these economies to heal themselves. And in the case of Spain and Italy, austerity is unwarranted – Spain has a relatively low public debt compared to Greece and Portugal, Italy runs a primary budget surplus, meaning it only runs a deficit after it pays interest on existing debts. The bottom line is this: As Greece melts, then burns, then repudiates austerity, its debt and the euro, other nations will use this as leverage to tell northern European leaders to go to, well, somewhere.

Investors, buy ETFs and prepare for more chaos

What does this all mean for investors? People looking longer term than the crowd?

Be prepared for more chaos in Europe beginning either after the Greek elections in April or in mid to late summer when it becomes clear the austerity programs cannot work and the economy has gone from recession to depression. How? Gold (the ETF is the  SPDR Gold Shares (GLD), its cousins silver (the iShares Silver Trust (SLV) ) and the gold miners (the ETF is the Market Vectors Gold Miners ETF (GDX) ) and the VIX, the measure of market volatility traders can buy through index calls or puts or through an ETF (the iPath S&P 500 VIX Short-Term Futures ETN (VXX) ).

The European economy is already slipping into recession – including Germany – and as austerity in the Mediterranean countries reduces imports, exporting nations will suffer. This will go on for several years. Yes, years. The current slowdown is being exacerbated by the rise in the price of oil due to the crisis in the Persian Gulf. I would stay away from the current optimism about Europe and avoid or considering long term short positions on the indices in Germany and France, you can do this with the purchase of puts in ETFs that track these indices, the iShares MSCI France Index (EWQ) for France, the iShares MSCI Germany Index (EWG) for Germany,

Avoid, at all costs, the European banks. Even without this crisis, these banks are dangerously undercapitalized and need to bulk up in the face of new international capital standards. They will need to raise capital and dilute shareholders. Stay away or short the big names with long term puts.

The euro, perhaps this year, is going to take big hits and that is also good news for the dollar. There are ETFs you can buy to go long the dollar (the UUP) and you can short the euro without getting directly into currency trading with the purchase of puts on ETFs (the FXE) representing the euro.

There is another consequence of all this madness. In five years or so, when housing in the U.S. rebounds and the economy is healed enough to see serious growth, the US will be further ahead of Europe than five years ago and will also have created new distance from China and other Asian countries. China? Did you say Asia? Yes, tune in next week to examine the current madness about China.

 

 

 

 

 

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