An unavoidable monetary catastrophe is coming

I talked about the next big short a couple of weeks ago (see here) and judging by the comments I got, it seems this is something generating a lot of interest. After all, this is potentially a long term threat to our wealth and we all should take it seriously. So today let me add a bit more flavor into this topic from a different angle, from the US debt crisis to a much more severe debt crisis abroad that appears to be unavoidable. You should not be surprised to hear about this as I have already talked about it a short while ago. Yes, it is Italy, likely the motherland of the next monetary catastrophe!

 

So why the situation in Italy is so precarious not only for Italy itself but for the financial system of the whole world? Let’s first look at its current situation and then what is the possible direction it must go in the next few years.

 

You should know by now that Italy is not small by any means and is the 3^rd largest economy in Europe and the 9^th largest in the world! It has an annual GDP of about $2 trillion. So it is not a small potato that can be just dropped and forgot about. If you don’t know about Italy, it has never being doing well economically in the recent history, even before joining the Eurozone. Italians are great people, warm and friendly with great hospitality. We thoroughly enjoy staying there whenever we visit it. But on the other hand, Italian people have been fooled and spoiled by the decades long stupid economic policies that encourage and promote the mentality of spending beyond means. When anyone who spends more than what is produced, the only way to survive is to borrow and borrow. This is the case for private people and exactly the same for countries. After decades of such uncontrolled lavish spending, Italy has amassed a debt pile worth about 130% of its GDP, or roughly $2.6 trillion. Actually, half of the Italian GDP is from the government spending that is not generating much economic productivity. If we strip this portion out, we are really talking about a debt ratio of 260%, not 130%.  Don’t forget, this is the debt that won’t evaporate without cost and it must be paid back at some point. For countries which hold their own fiat currency, they can prolong the debt cycle by printing as much money as they want and simply kick the can down the road. This is what the US has been doing for decades given its unique world reserve currency prestige and therefor no one seems to care about the huge debt problem that will for sure also explode at some point. For Italy that cannot print its own money now, the reckoning day is fast approaching when the whole world is entering a higher interest era. To be blunt, Italy has already got itself onto the economic death toll although it refuses to face it. The only way to get off the death toll is to go back to the sound economics by balancing the budget with sound money principles, i.e. to spend less and make more. But spending is just like an addiction for any government and it is basically no way to ask any government to spend less. After all, expanding the budget to spend more is the easiest way for politicians to get elected. What is worse for Italy is that the current government is even thinking to spend more, aiming for a flat tax between 15% and 20%, a “universal basic income” of about $1,000 a month for citizens, and scrapping pension reforms designed to cut deficits. It is an economic suicidal move for Italy but it is becoming a real possibility for the new government to pursue.

 

“OK, but this sounds like an Italy’s problem, so why should we be worried about it?” A fair question but it means you haven’t really understood the ramifications associated with the fatal problems in Italy. Here is the rough accounts about the Italian debt owners: ECB (the EU central bank) owns most of the toxic Italian bonds via its QE (€341 billion worth of Italian bonds), followed by the Italian banks (collectively €350 worth of the government bonds). Then foreign banks from France, Spain, and Portugal also have huge exposure to toxic Italian government debt. Although US banks may not directly hold the toxic Italian bonds, it is almost a certainty that they are indirectly holding some assets that have a good deal of exposure to the poison, given how much intertwined the global financial system is nowadays!  The thing is, even without counting on the new suicidal economic policies, Italy has no way to pay back by its own capacity. Remember Italy cannot not print the euro on its own and it has not much income to pay the bond interests. So far it has not yet been a huge issue due to artificially low interest rate (even negative for some years) in the EU. But the situation is changing and fast. It is enviable that the interest rate will move up in the years ahead. So what’s the option Italy has? Not much! Since it cannot print money to pay by itself, it has to ask for leniency, which cannot be offered by the commercial banks and the only potential debt owner that may consider to offer such a ridiculous forgiveness is the ECB. This is exactly what the Italian government has done: it’s already called on the ECB to forgive €250 billion [$296 billion] in Italian debt. Let’s put aside the debate whether or not morally ECB should wipe out this amount of the Italian debt and let’s assume ECB indeed will agree to forgive. But it won’t be offered without a significant string attached. Remember what ECB did when saving the bankrupted Greece? A stringent austerity program in place to significantly cut down the extravagant sending by the government and apply sound economic policies. Ouch! This is exactly what the Italian government in general and especially this new government doesn’t want to do!

 

So here is the likely scenario that may play out: there will be fierce fight between the Italian government vs the ECB/Eurozone countries on how to alleviate the gigantic Italian debt with a term accepted by Italy. If the Greek saga was already very scary for the whole world, just watch what will bring from this new showdown. I’m pretty sure we are going to see a lot of knee-jerking reactions in the market as the fall apart of the Eurozone will be a real possibility. At the end, the ECB will have to step in to save Italy one way or the other as I just cannot imagine and they certainly know how much damage the failing Euro will cause to the whole financial world. Just a Lehman Brothers collapse in 2008 had already nearly collapsed the global financial system, what will happen if the 9^th largest economy fails and defaults? All the banks directly or indirectly holding the toxic Italian bonds that also include the US banks will be wiped out or severely brought down. As I have said many times, if you think the 2008 financial crisis was scary enough, this coming one will make it just like walking on the beach if indeed happens!

 

Well my fear is not just stopped here. Even if the crisis will be contained this round of play, the underlying grave debt problem for Italy won’t be fundamentally resolved. The capricious Italians and the extremist government won’t easily follow the austerity program forced on them. They will do whatever they can to still fight back ferociously over time and eventually I think there is a pretty high chance that Italy will drop from the Euro and go with their own Lira again that they can print as much as possible. This may take a few years to play out but I think it is a real possibility. I hope you can understand better why I’m sounding quite bearish for the long term future. After all, the 10 year long supper bull market is primarily driven by the artificially created liquidity bubble, not by the fundamental economic development, when all the governments around the world are printing money like there is no tomorrow. If you understand this, then it won’t be too difficult to understand the serious consequences to the stock market when the liquidity (the blood to the market) is drawn out in the US as well as in other countries across the globe. The somber situation in Italy is just a time bomb waiting to explode. I just don’t know the exact timing but I know with quite certainty (at least for myself) that the clock is ticking and fast!