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June 18, 2012

Europe Could Happen to US!

In light of the Greek elections, I can't help but think how our politicians can even believe we are remotely impervious to the sovereign debt situation that has engulfed the European Union. The EU has roughly a 90% debt to GDP ratio, compared to the United States which just crossed 100%. So how is the EU so much worse? The key is in the banking system. The banks were hit by the global financial crisis and in some cases (Spain) a deflating real estate bubble. With less capital, EU banks cannot support the massive amounts of new debt their respective countries are taking on. Additionally, the United States has the fortune of greater debt purchases by foreigners than the EU. This, however, does not put us in a secure position. As we've recently learned from JP Morgan Chase, the banking system is still taking risks that it does not deem risky. Additionally, Basel III is giving banks capital requirement exemptions on foreign debt. By doing so, banks are not required to have collateral for government debt purchases. In the event of increased interest rates, banks would have to take write downs on the face value of their government bonds (the old bond rule, interest rates up, price down). This is more dangerous than the real estate write downs from the financial crisis. Additionally, we have the issue of bank runs, which can occur anywhere at anytime, as long as the fear factor is in play. We learned this in 2008 when the Lehman Brothers trustee froze customer funds and prompted a run on the other investment banks. In our technological (and media) environment, these types of runs are more feasible today than during the Great Depression. A bank run could completely cripple the banking system's ability to support the government's debt appetite. Finally, there's the issue of the deficit, or the amount of money the government borrows per year. We believe that a government, at most, should borrow the equivalent of it's GDP growth as a percentage of GDP. For the United States, at most, that would be 2% of GDP. Currently, we are borrowing around 9% of GDP. In order to maintain these levels, an increasing amount of economic activity must be devoted to the financing of government activities. What happens if we take money from productive activities and allocate to less productive activities? We become Europe.

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