As we have expected ever since the emergence of the Dubai crisis, sovereign debt problems have come to the fore as a major threat to the global economy and financial system. The catalyst was renewed fears that Greece and Portugal will not be able to fund their deficits without a bail-out following the failure of a Portuguese bond auction. As a result world stock markets plunged, Southern European bond yields soared, the Euro plunged and the spreads on credit default swaps (CDS) hit record highs for a number of countries.
In our comment on December 10, entitled "Why the Stock Market Looks Vulnerable", we expressed our concern that Dubai's debt problems indicated that other sovereign nations were exposed as well to the severe decline in asset values that left debtors with too little cash flow to service their debts. We particularly singled out the vulnerability of Greece, Portugal and Spain and the problems involved with their being members of the European Union (EU). In another comment on January 21st, entitled "Banks Are Not the Only Problem", we cited a list of negative factors facing the market and then added that "The Greek problem may end up having even more market impact than any of the above".
EU president Jean-Claude Trichet at first tried to play down the concerns over Greece, stating that he was "confident that the Greek government would take all the decisions that will permit it to reach" the goal of cutting its budget deficit substantially. Indeed, Greek premier George Papandreou did put forth a plan to raise taxes and slash spending to close the gap, although this was more a statement of intent than a substantive thought-out program. And even this weak attempt was met with an announcement by Greek labor unions that they would start a general strike rather than submit to any cuts.
Joaquin Almunia, The EU economics commissioner, said that tough measures were "extremely urgent" to prevent a further flight from Greek debt. He said that concerns had spread to other EU countries where deficits are soaring out of control, specifically mentioning Portugal and Spain. The big problem, however, is that EU nations forced to undertake draconian measures to rein in their deficits are not able to offset the severe economic drag with a devaluation of their currencies. This probably means that rescuing Greece is not possible without an EU bailout that hardliners within the community are stiffly resisting on the grounds that if they bail out Greece they may have to do the same for Portugal and Spain. The only other option is for these nations to leave the EU, a move that would likely lead to a dismantling of the union and the abandonment of the Euro currency.
The emergence of the crisis is reminiscent of the first indications that Bear Stearns was facing financial difficulty, and could be the proverbial "canary in the coal mine" indicating the potential contagion to a slew of other sovereign nations. Moreover, it's an indication that the severe global debt problems we have been talking about for so long are still with us and getting worse rather than better. (For more detail see our most recent special report, entitled "The Total Debt Relative to GDP Trumps Everything Else".) The lesson the world never seems to learn is that whenever and wherever we get an explosion of debt we also get a series of asset bubbles that are sure to implode. When that happens assets disappear, but the debt remains and there is not enough income to service the interest payments or to pay off the debt at maturity.
That is what is happening now and that is why this is no ordinary recession that is undergoing a V-shaped recovery as many seem to think. This is a credit-induced recession, and history indicates that these take many years to work out. Too many economists are still working with models based on the garden-variety recessions of the post World War ll period. They will find that these models do not work in the current environment. We believe that the market rally off the March bottom is over and that a major downturn is in store.