12  Eurozone Downgrade Shock Waves Could Slam Into US Economy

By Daniel R. Amerman, CFA

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Subscriber One Page Version

8. Federal Reserve & Monetization

Federal Reserve responses to the events of late 2008 and beyond may serve as a guide to some of the strategies that could be deployed in a new crisis.  There are likely to be multiple key stages in a developing crisis, where the Federal Reserve will use its unique powers to create and give out trillions of dollars - with little public attention - either in asset purchases (at non-market prices), or in actual and contingent lines of credit, or in dollar swaps, or in hidden bailouts that are only limited by the imagination of the Federal Reserve.  

The Fed will again want to move quickly and without Congressional approval, and will particularly seek to avoid openly including the bailouts in the federal budget.  Beneficiaries are likely to include US banks, foreign banks, and major US and foreign corporations.

There may also be massive monetary-creation events for the dual purposes of funding radically increased US deficit borrowing, while still keeping borrowing rates below the rate of inflation.

Rather than another TARP-type program for troubled assets that have not actually defaulted, look for the Federal Reserve to take to all new levels its program of directly creating money and using that to purchase investments from banks at non-market prices. This is likely to contribute to the "hollowing out" of financial institutions on a global basis, as performing economic assets are increasingly replaced by central bank reserve balances which have no inherent economic value.

Primer On Monetary Creation & Hollowing Out Banks

9. US Dollar, Long Term

After the immediate crisis and panic-induced global dash for safety is over, then the United States will be in a highly unstable and precarious position, with an effectively artificial economy that is not putting out the goods needed to pay for what it consumes. There will be massive paper money creation as the US engages in currency warfare to bring down the value of the dollar, even as artificially-funded jobs are created all across the country.  Something will have to give - as historically, it always eventually does. 

From one source or another there will be a push.  That push could have a domestic origin, or more likely an international origin.  Either way, because the underlying fundamentals will have already collapsed, and all that will be holding up the value of the dollar is a collective belief system, then once the fall of the US dollar gets going and the rest of the globe heads for the exits, it could be very rapid and near impossible to stop.

We could see a whipsaw in import costs if this scenario occurs. There will be a soaring cost of energy and gasoline as the dollar implodes and oil-exporting countries no longer want US dollars that are plunging in value. We could see a sudden spike in the cost of virtually all the imports that are consumed by the US, with that external supply shock inflation rapidly becoming internalized, and domestically produced goods and services soaring in price as well.

This very high rate of inflation would be economically devastating, and ultimately the only way to stop the damage will be to stop the monetary creation and stop the stimulus spending. Which means that more millions of people would become unemployed as the economic damage that was done to the corporations, banks, and state and local governments must finally be recognized.

10. State & Local Governments

State and local governments are likely to face a deadly combination of soaring unemployment which increases expenditures, even while income and sales tax revenues are falling with employment and consumption. This may be compounded by highly adverse results in pension investment portfolios, thereby pushing highly stressed states and cities into insolvency across the nation.  What is more likely than this scenario of nationwide state and local government bankruptcies, however, is a massive Federal government bailout, that would likely be financed through the Federal Reserve creating still more money out of thin air.

Expanded Analysis

11. Standard & Poor's Business Model

In the process of hastening along a potential "extinction event" for the euro, Standard & Poor's Corporation may also be creating an "extinction event" for its own business model.  The US federal government's response to S&P's August downgrade came in the form of a Justice Department investigation of S&P.  This message is far from subtle, when it comes to the consequences of angering those in power.

The European governments were already quite unhappy about having only US-based rating agencies.  They were displeased about the influence of these foreign corporations upon the European financial system, and there has already been discussion of a European credit rating agency. 

The fact that New York-based Standard & Poor's used its power in the midst of crisis to increase the problems faced by Eurozone governments is likely to be viewed as unforgivable, and an acceleration of the process of creating a more compliant European credit rating agency should be anticipated, regardless of whether there is a near-term S&P credit downgrade or not.

If the European governments view Standard & Poor's Corporation as having helped to create a catastrophic financial crisis, then in the search for scapegoats, do not be surprised if there are not only civil but potentially criminal implications at some point for Standard & Poor's and its employees.

Ultimately, European law is what European governments say it is, they are likely to be mighty angry, and the payments received by rating agencies for their role in the sale of defaulted subprime mortgage-backed securities within Europe may yet constitute a rich hunting ground for highly motivated European prosecutors.

12. Long-Term Investment

Even a partial euro zone currency and economic collapse would have serious negative implications in multiple categories for US investments.  Corporate earnings growth rates could turn negative on a global basis as a result of the new global depression, thereby slashing stock market values.

As discussed previously, the likely US response of trying to cover over negative short-term economic developments by simply creating more money, has highly negative implications for the long-term value of the US dollar.  Quite simply, the more money that is created in the attempt to prop up an artificial economy, the greater the long-term damage to the US dollar, and the higher the likely future rate of inflation. 

This would mean that both bonds and stocks - the two cornerstones of conventional long-term investment strategies - could face devastating and sustained losses, which might never be recovered.

As discussed in the article linked below, the eventual US response to a new unemployment crisis is likely to effectively be currency warfare, which may have particularly unfortunate consequences for retirees and retirement investors.

Expanded Analysis

While these twelve "shock wave" explorations are "US-centric", the article link below explores the rapid redistribution of wealth that may occur within Europe itself.

European Redistribution Of Wealth