The sovereign debt crisis will soon morph into a currency crisis

Summary

As indebted governments around the world seek to avoid the pain associated with a long, drawn out period of economic contraction, they will continue to expand their balance sheets by larger and larger amounts. In doing so they will turn a sovereign debt crisis into a currency crisis.

The artificial boom

The economic boom that was experienced in Britain and much of the rest of the world between 1988 and 2007 was achieved to a large extent through the creation of debt. During this period, total debt in Britain, that is the debt of households, corporations, financial institutions, and government, increased from around 220% of GDP to over 460%, and we were by no means alone.

Chart: Total debt of the ten largest developed economiesSource: McKinsey Global Institute (MGI)

As the chart above shows, thanks to the abolition of financial regulation and low interest rates, the total debt of the ten largest developed economies increased markedly.

From boom to bust

In 2007 home prices in the US began to fall and the resulting subprime mortgage crisis became the pin that burst the global credit bubble.

As credit contracted and asset prices fell, and faced with the certainty of a global recession or even depression, policy makers responded with unprecedented money printing (Quantitative Easing), huge bailouts and by reducing the cost of borrowing to near zero.

Rather than stomach the painful downturn and risk being thrown from political office, G20 governments spent more than $5 trillion (£3.14 trillion) in an attempt to prevent the meltdown. Sadly however, true prosperity cannot be created simply by printing money and building bridges to nowhere, or by buying toxic assets from troubled banks. As a result we now have stubbornly high unemployment, record public liabilities and a failing economy.

All the printing of trillions of pounds, dollars, euros and yen has achieved is a temporary postponement of the debt repayment process. In fact, we are already facing another credit squeeze and a possible global recession.

The path of least resistance 

I am confident, having studied history and the actions of indebted governments, that those in power will do everything they can to prevent an economic collapse. What this means is that we can expect more money printing, more bailouts and high inflation for years to come – something which will have serious consequences. 

From debt crisis to currency crisis 

As governments create new money and push it out into the economy, they debase, or devalue, the money that’s already in existence. At some point this process results in soaring inflation (the result of a falling currency) which triggers a capital flight, something which further depresses the currency. 

The currency crisis will likely move first to Japan, then the UK, and the US. Of course, putting a timeframe on this development is extremely difficult, but market cycles specialist, Gary Savage, predicts that the US Dollar is likely to experience severe distress around late 2014.

Conclusion

By dismantling regulatory oversight governments helped create an asset bubble that eventually burst triggering a banking crisis. Then, by bailing out the banks they turned a banking crisis into a sovereign debt crisis. Next, by printing money in order to postpone the natural process of debt deleveraging, they will turn the sovereign debt crisis into a currency crisis.

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