Cloudy With A Chance of Armageddon

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The European debt crisis is rapidly coming to a head. As I write this, press reports indicate a deal is in the works to recapitalize Europe's banks to the tune of about 108 billion Euros. Negotiations continue on other issues such as a Greek debt restructuring but expectations for a comprehensive deal are running high. Whether Germany and Europe can cut the Gordian knot of European debt by their self imposed deadline of Wednesday will likely determine the course of the markets in the near term. As Jeremy Grantham recently said, this is no market for young men so if you are prone to motion sickness, I'd suggest a strong dose of Dramamine.

Even if the European debt situation is stabilized in the short term, the long term forecast for the global economy still looks cloudy with a chance of Armageddon. Assuming Europe can keep their banks solvent, they will still face the reality of a sclerotic economy burdened by government spending over 50% of GDP. The Greeks will continue to evade taxes, the Italians will continue to lurch from one government scandal to the next, the Spanish will still have 20% unemployment and the EU will continue to depend on German growth to foot the bill. And Germany, it should be noted, is rapidly approaching the 90% level of debt identified by Reinhart and Rogoff as growth limiting.

Meanwhile , China is finding that pyramid building (or luxury condo and bullet train building as the case may be) has its limits as a growth strategy. China's growth the last few years amounts to Keynesianism on steroids with credit fueled local government spending leading the charge. With the central government slowly tightening the screws on the credit spigot over the last year, growth is slowing. Or so it appears; Chinese economic statistics give new meaning to the term opaque. Whether China's central planners can manage to engineer a soft landing will be of utmost importance to a long list of countries dependent on the outcome. That would include most of the emerging world in addition to all the countries - Brazil, Chile, Canada and Australia come to mind - selling commodities to the Middle Kingdom.

Here in the US, the economy has so far managed to avoid a new recession but that's the best that can be said about our current condition. Third quarter growth was almost certainly better than the tepid first half but probably only enough to bring the rate so far this year up to crummy. More important is the outlook though and recent rumblings from the Fed are cause for concern. If first half growth was limited by rising prices due to QE 2 - and I think it was - then a resumption would surely not be welcome news for those of us pining for some real growth. With Europe likely to at least partially solve their debt ills via the printing press and the Fed considering its options despite a CPI inflation rate already at the implied limit, the recent improvement in growth may prove short lived.

What we are witnessing now is a very public demonstration of the limits of government led economic growth. Europe's debt crisis may have been accelerated by the US sub-prime debacle but it is a result of a welfare state that has morphed from social safety net into communal hammock. Simply papering over the losses will not solve the deeper issue of how to create growth with a government that consumes over half of GDP. The mandarins in charge of the latest Chinese five year plan face an infinitely more complex economy than their predecessors and their errors are starting to compound. China has produced nominal growth by suppressing their exchange rate and investing nearly 50% of GDP but one can't help but wonder how many Solyndras lurk on the balance sheets of the state banks.

In the US, we face our own fiscal difficulties. Government spending is now over 40% of GDP (all levels of government) and future liabilities are many multiples of current GDP. We have tried spending our way to growth and emulating the Chinese investment model but the public is growing wise to the ways of crony capitalism. We have tried devaluing the dollar and inflating the Fed's balance sheet with little to show for it but rising prices and volatile markets. Along the way we've ignored our moral compass, punishing prudent savers in favor of imprudent debtors. Low interest rates have hurt those who depend on income from their savings for their very livelihood. Pushing Granny into junk bonds to maintain her standard of living cannot be the right answer to the economic problems of a civilized society.

The US economy has proven amazingly resilient considering the shocks to the system delivered by the last two administrations but it isn't a horror movie villain. If we keep hitting it with higher taxes, more complex regulations and more debt it will eventually succumb. It would be nice if the deficit committee now meeting could come up with a long term solution but with an election coming I wouldn't count on it. The economy will probably have to fend for itself until 2013 and luckily there are some reasons to believe growth will continue, assuming the Fed can resist the urge to tinker. Housing appears to finally be on the verge of healing itself - construction will probably add to GDP this year - and corporate investment continues to be strong. Corporate lending continues to pick up with C&I loans rising steadily since late last year. Corporate earnings are once again coming in better than expected and inventories are conservative. The caveat is that a European debt implosion or a Chinese hard landing would probably overwhelm this natural momentum and there is no room for stimulus - monetary or fiscal - if we fall back into recession. Let's hope neither comes to pass before we decide to get serious about solving our budget and growth deficits.


Joe Calhoun is CEO of Alhambra Investment Partners in Miami, Florida. He can be reached at

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