The Natural Advantages of the U.S.

The Geography of Recession

By Peter Zeihan

The global recession is the biggest development in the global system in the year to date. In the United States, it has become almost dogma that the recession is the worst since the Great Depression. But this is only one of a wealth of misperceptions about whom the downturn is hurting most, and why.

Let's begin with some simple numbers.

As one can see in the chart, the U.S. recession at this point is only the worst since 1982, not the 1930s, and it pales in comparison to what is occurring in the rest of the world. (Figures for China have not been included, in part because of the unreliability of Chinese statistics, but also because the country's financial system is so radically different from the rest of the world as to make such comparisons misleading. For more, read the China section below.)

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But didn't the recessionbegin in the United States? That it did, butthe American system is far more stable, durable and flexible than most of the other global economies, in large part thanks to the country's geography. To understand how place shapes economics, we need to take a giant step back from the gloom and doom of the current moment and examine the long-term picture of why different regions follow different economic paths.

The United States and the Free Market

The most important aspect of the United States is not simply its sheer size, but the size of its usable land. Russia and China may both be similar-sized in absolute terms, but the vast majority of Russian and Chinese land is useless for agriculture, habitation or development. In contrast, courtesy of the Midwest, the United States boasts the world's largest contiguous mass of arable land — and that mass does not include the hardly inconsequential chunks of usable territory on both the West and East coasts.

Second is the American maritime transport system. The Mississippi River, linked as it is to the Red, Missouri, Ohio and Tennessee rivers, comprises the largest interconnected network of navigable rivers in the world. In the San Francisco Bay, Chesapeake Bay and Long Island Sound/New York Bay, the United States has three of the world's largest and best natural harbors. The series of barrier islands a few miles off the shores of Texas and the East Coast form a water-based highway — an Intercoastal Waterway — that shields American coastal shipping from all but the worst that the elements can throw at ships and ports.

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The real beauty is that the two overlap with near perfect symmetry. The Intercoastal Waterway and most of the bays link up with agricultural regions and their own local river systems (such as the series of rivers that descend from the Appalachians to the East Coast), while the Greater Mississippi river network is the circulatory system of the Midwest. Even without the addition of canals, it is possible for ships to reach nearly any part of the Midwest from nearly any part of the Gulf or East coasts. The result is not just a massive ability to grow a massive amount of crops — and not just the ability to easily and cheaply move the crops to local, regional and global markets — but also the ability to use that same transport network for any other economic purpose without having to worry about food supplies.

The implications of such a confluence are deep and sustained. Where most countries need to scrape together capital to build roads and rail to establish the very foundation of an economy, transport capability, geography granted the United States a near-perfect system at no cost. That frees up U.S. capital for other pursuits and almost condemns the United States to be capital-rich. Any additional infrastructure the United States constructs is icing on the cake. (The cake itself is free — and, incidentally, the United States had so much free capital that it was able to go on to build one of the best road-and-rail networks anyway, resulting in even greater economic advantages over competitors.)

Third, geography has also ensured that the United States has very little local competition. To the north, Canada is both much colder and much more mountainous than the United States. Canada's only navigable maritime network — the Great Lakes-St. Lawrence Seaway —is shared with the United States, and most of its usable land is hard by the American border. Often this makes it more economically advantageous for Canadian provinces to integrate with their neighbor to the south than with their co-nationals to the east and west.

Similarly, Mexico has only small chunks of land, separated by deserts and mountains, that are useful for much more than subsistence agriculture; most of Mexican territory is either too dry, too tropical or too mountainous. And Mexico completely lacks any meaningful river system for maritime transport. Add in a largely desert border, and Mexicoas a countryis not a meaningful threat to American security (which hardly means that there are not serious and ongoing concerns in the American-Mexican relationship).

With geography empowering the United States and hindering Canada and Mexico, the United States does not need to maintain a large standing military force to counter either. The Canadian border is almost completely unguarded, and the Mexican border is no more than a fence in most locations — a far cry from the sort of military standoffs that have marked more adversarial borders in human history. Not only are Canada and Mexico not major threats, but the U.S. transport network allows the United States the luxury of being able to quickly move a smaller force to deal with occasional problems rather than requiring it to station large static forces on its borders.

Like the transport network, this also helps the U.S. focus its resources on other things.

Taken together, the integrated transport network, large tracts of usable land and lack of a need for a standing military have one critical implication: The U.S. government tends to take a hands-off approach to economic management, because geography has not cursed the United States with any endemic problems. This may mean that the United States — and especially its government — comes across as disorganized, but it shifts massive amounts of labor and capital to the private sector, which for the most part allows resources to flow to wherever they will achieve the most efficient and productive results.

Laissez-faire capitalism has its flaws. Inequality and social stress are just two of many less-than-desirable side effects. The side effects most relevant to the current situation are, of course, the speculative bubbles that cause recessions when they pop. But in terms oflong-termeconomic efficiency and growth, a free capital system is unrivaled. For the United States, the end result has proved clear: The United States has exited each decade since post-Civil War Reconstruction more powerful than it was when it entered it. While there are many forces in the modern world that threaten various aspects of U.S. economic standing, there is not one that actually threatens the U.S. base geographic advantages.

Is the United States in recession? Of course. Will it be forever? Of course not. So long as U.S. geographic advantages remain intact, it takes no small amount of paranoia and pessimism to envision anything but long-term economic expansion for such a chunk of territory. In fact, there are a number of factors hinting thatthe United States may even be on the cusp of recovery.

Russia and the State

If in economic terms the United States has everything going for it geographically, thenRussia is just the opposite. The Russian steppe lies deep in the interior of the Eurasian landmass, and as such is subject to climatic conditions much more hostile to human habitation and agriculture than is the American Midwest. Even in those blessed good years when crops are abundant in Russia, it has no river network to allow for easy transport of products.

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Russia has no good warm-water ports to facilitate international trade (and has spent much of its history seeking access to one). Russia does have long rivers, but they are not interconnected as the Mississippi is with its tributaries, instead flowing north to the Arctic Ocean, which can support no more than a token population. The one exception is the Volga, which is critical to Western Russian commerce but flows to the Caspian, a storm-wracked and landlocked sea whose delta freezes in the winter (along with the entire Volga itself). Developing such unforgiving lands requires a massive outlay of funds simply to build the road and rail networks necessary to achieve the most basic of economic development. The cost is so extreme that Russia's firsteverintercontinental road was not completed until the 21st century, and it is little more than a two-lane path for much of its length. Between the lack of ports and the relatively low population densities, little of Russia's transport system beyond the St. Petersburg/Moscow corridor approaches anything that hints of economic rationality.

Russia also has no meaningful external borders. It sits on the eastern end of the North European Plain, which stretches all the way to Normandy, France, and Russia's connections to the Asian steppe flow deep into China. Because Russia lacks a decent internal transport network that can rapidly move armies from place to place, geography forces Russia to defend itself following two strategies. First, it requires massive standing armies on all of its borders. Second, it dictates that Russia continually push its boundaries outward to buffer its core against external threats.

Both strategies compromise Russian economic development even further. The large standing armies are a continual drain on state coffers and the country's labor pool; their cost was a critical economic factor in the Soviet fall. The expansionist strategy not only absorbs large populations that do not wish to be part of the Russian state and so must constantly be policed — the core rationale for Russia's robust security services — but also inflates Russia's infrastructure development costs by increasing the amount of relatively useless territory Moscow is responsible for.

Russia's labor and capital resources are woefully inadequate to overcome the state's needs and vulnerabilities, which are legion. These endemic problems force Russia toward central planning; the full harnessing of all economic resources available is required if Russia is to achieve even a modicum of security and stability. One of the many results of this is severe economic inefficiency and a general dearth of an internal consumer market. Because capital and other resources can be flung forcefully at problems, however, active management can achieve specific national goals more readily than a hands-off, American-style model. This often gives the impression of significant progress in areas the Kremlin chooses to highlight.

But such achievements are largely limited to wherever the state happens to be directing its attention. In all other sectors, the lack of attention results in atrophy or criminalization. This is particularly true in modern Russia, where the ruling elite comprises just ahandful of people, starkly limiting the amount of planning and oversight possible. And unless management is perfect in perception and execution, any mistakes are quickly magnified into national catastrophes. It is therefore no surprise to STRATFOR that the Russian economy has now fallen the furthest of any major economy during the current recession.

China and Separatism

China also faces significant hurdles, albeit none as daunting as Russia's challenges. China's core is the farmland of the Yellow River basin in the north of the country, a river that is not readily navigable and is remarkably flood prone. Simply avoiding periodic starvation requires a high level of state planning and coordination. (Wrestling a large river is not the easiest thing one can do.) Additionally, the southern half of the country has a subtropical climate, riddling it with diseases that the southerners are resistant to but the northerners are not. This compromises the north's political control of the south.

Central control is also threatened by China's maritime geography. China boasts two other rivers, but they do not link to each other or the Yellow naturally. And China's best ports are at the mouths of these two rivers: Shanghai at the mouth of the Yangtze and Hong Kong/Macau/Guangzhou at the mouth of the Pearl. The Yellow boasts no significant ocean port. The end result is that other regional centers can and do develop economic means independent of Beijing.

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With geography complicating northern rule and supporting southern economic independence, Beijing's age-old problem has been trying to keep China in one piece. Beijing has to underwrite massive (and expensive) development programs to stitch the country together with a common infrastructure, the most visible of which is the Grand Canal that links the Yellow and Yangtze rivers. The cost of such linkages instantly guarantees that while China may have a shot at being unified, it will always be capital-poor.

Beijing also has to provide its autonomy-minded regions with an economic incentive to remain part of Greater China, and "simple" infrastructure will not cut it. Modern China has turned to a state-centered finance model for this. Under the model, all of the scarce capital that is available is funneled to the state, which divvies it out via a handful of large state banks. These state banks then grant loans to various firms and local governments at below the cost of raising the capital. This provides a powerful economic stimulus that achieves maximum employment and growth — think of what you could do with a near-endless supply of loans at below 0 percent interest — but comes at the cost of encouraging projects that are loss-making, as no one is ever called to account for failures. (They can just get a new loan.) The resultant growth is rapid, but it is also unsustainable. It is no wonder, then, that the central government has chosen to keep its $2 trillion of currency reserves in dollar-based assets; the rate of return is greater, the value holds over a long period, and Beijing doesn't have to worry about the United States seceding.

Because the domestic market is considerably limited by the poor-capital nature of the country, most producers choose to tap export markets to generate income. In times of plenty this works fairly well, but when Chinese goods are not needed, the entire Chinese system can seize up. Lack of exports reduces capital availability, which constrains loan availability. This in turn not only damages the ability of firms to employ China's legions of citizens, but it also removes the primary reason the disparate Chinese regions pay homage to Beijing. China's geography hardwires in a series of economic challenges that weaken the coherence of the state and make China dependent upon uninterrupted access to foreign markets to maintain state unity. As a result, China hasnotbeen a unified entity for the vast majority of its history, but instead a cauldron of competing regions that cleave along many different fault lines: coastal versus interior, Han versus minority, north versus south.

China's survival technique for the current recessionis simple. Because exports, which account for roughly half of China's economic activity, have sunk by half, Beijing is throwing the equivalent of the financial kitchen sink at the problem. China has force-fed more loans through the banks in the first four months of 2009 than it did in the entirety of 2008. The long-term result could well bury China beneath a mountain of bad loans — a similar strategy resulted in Japan's 1991 crash, from which Tokyo has yet to recover. But for now it is holding the country together. The bottom line remains, however: China's recovery is completely dependent upon external demand for its production, and the most it can do on its own is tread water.

Discordant Europe

Europe faces an imbroglio somewhat similar to China's.

Europe has a number of rivers that are easily navigable, providing a wealth of trade and development opportunities. But none of them interlinks with the others, retarding political unification. Europe has even more good harbors than the United States, but they are not evenly spread throughout the Continent, making some states capital-rich and others capital-poor. Europe boasts one huge piece of arable land on the North European Plain, but it is long and thin, and so occupied by no fewer than seven distinct ethnic groups.

These groups have constantly struggled — as have the various groups up and down Europe's seemingly endless list of river valleys — but none has been able to emerge dominant, due to the webwork of mountains and peninsulas that make it nigh impossible to fully root out any particular group. And Europe's wealth of islands close to the Continent, with Great Britain being only the most obvious, guarantee constant intervention to ensure that mainland Europe never unifies under a single power.

Every part of Europe has a radically different geography than the other parts, and thus the economic models the Europeans have adopted have little in common. The United Kingdom, with few immediate security threats and decent rivers and ports, has an almost American-style laissez-faire system. France, with three unconnected rivers lying wholly in its own territory, is a somewhat self-contained world, making economic nationalism its credo. Not only do the rivers inGermany not connect, but Berlin has to share them with other states. The Jutland Peninsula interrupts the coastline of Germany, which finds its sea access limited by the Danes, the Swedes and the British. Germany must plan in great detail to maximize its resource use to build an infrastructure that can compensate for its geographic deficiencies and link together its good — but disparate — geographic blessings. The result is a state that somewhat favors free enterprise, but within the limits framed by national needs.

And the list of differences goes on: Spain has long coasts and is arid; Austria is landlocked and quite wet; most of Greece is almost too mountainous to build on; it doesn't get flatter than the Netherlands; tiny Estonia faces frozen seas in the winter; mammoth Italy has never even seen an icebreaker. Even if there were a supranational authority in Europe that could tax or regulate the banking sector or plan transnational responses, the propriety of any singular policy would be questionable at best.

Such stark regional differences give rise to such variant policies that many European states have a severe (and understandable) trust deficit when it comes to any hint of anything supranational. We are not simply taking about the European Union here, but rather a general distrust of anything cross-border in nature. One of the many outcomes of this is a preference for usinglocal banks rather than stock exchangesfor raising capital. After all, local banks tend to use local capital and are subject to local regulations, while stock exchanges tend to be internationalized in all respects. Spain, Italy, Sweden, Greece and Austria get more than 90 percent of their financing from banks, the United Kingdom 84 percent and Germany 76 percent — while for the United States it is only 40 percent.

And this has proved unfortunate in the extreme for today's Europe. The current recession has its roots in a financial crisis that has most dramatically impacted banks, andEuropean banks have proved far from immune. Until Europe's banks recover, Europe will remain mired in recession. And since there cannot be a Pan-European solution, Europe's recession could well prove to be the worst of all this time around.

San Antonio...Expanding Global Trade Route?

Forecast In a situation where retail sales are down for an undetermined amount of time, manufacturing and distribution lines are ultimately affected. San Antonio had already begun to reposition itself in the logistics industry prior to the economic slump. Therefore, as companies evaluate cost-effectiveness, the Alamo City may be the answer. The new Union Pacific Intermodal became fully operational in February. Combined with the Port of San Antonio, this will increase the overall capacity of products that can be moved in and out of the Alamo City, which opens the door for future distribution lines. The logistics operations supported by UP will aide in reducing distribution costs for retailers, manufacturers and ultimately consumers. Additional routes from overseas are being explored including Port Lazaro Cardenas, the only port in Mexico with water depths and access channel to accommodate the newest cargo ships. It is also the only protected harbor that can receive ships up to 165 thousand tons of displacement. Trade through the port in Mexico is expected to increase as Lazaro Cardena is only 925 miles from San Antonio versus 1,435 miles to the Long Beach deep water port, making travel time via rail substantially faster as well. In the past, China and other southeast Asia countries manufactured products destined for the United States and the lower labor costs off-set the expenses associated with longer supply lines. Today, the economic prosperity in China has resulted in growing labor costs and more national consumption, which will continue to drive up the cost of imported goods. One of the opportunities to be considered is relocating manufacturing operations to Mexico which could soon provide a lower labor cost alternative, combined with shorter supply lines, potentially better profits and lower costs to consumers. As trade routes continue to expand, San Antonio will be one of the first cities to benefit.

Perspective

Tough news....unprecedented? Read on...then check the date at the end!

Not for many years has a Christmas season begun with so many tidings of spreading discomfort and lack of joy about the U.S. economy. Already racked by a devastating double-digit inflation, the nation is now also plunging deeper into a recession that seems sure to be the longest and could be the most severe since World War II. Consumers who a few weeks ago worried mostly about rising prices now fear for their jobs and incomes as well. For many Americans, the Yuletide will be a time of less elaborate meals, infrequent parties, fewer and cheaper presents.

All last week the bad news mounted. The auto industry reeled from a new-model sales rate 35.8% below last November's already somewhat depressed pace. Ford and Chrysler announced massive new layoffs for this month. Automakers now plan to close at least 14 assembly plants and put as many as 230,000 production workers, clerks, accountants and executives out of work before Christmas, and about 20% of General Motors' 500,000 U.S. employees will be idle in January.

But the decline is no longer confined to autos and home building, which is down 33% from early 1973, as it has been for most of this year. In classic fashion, the recession* has begun to work its way through the entire economy. Although demand for home freezers is still high, with housewives stocking up on food to beat rising prices, sales of other major appliances—TV sets, washing machines, dryers, vacuum cleaners—are turning sick, and layoffs are spreading in the plants that make them.

December 9, 1974...read the whole article here:

 

 

Gloomy Holidays--and Worse Ahead -- Printout -- TIME.pdf

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Whereto the Euro?

Europe On the Ropes The Absolute Return Letter March 2009  "Many of today's policy proposals start from the view that "greed" and "incompetence" and "poor risk assessment" are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than "the idiots" who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the "true" probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place." Woody Brock, SED Profile, December 2008 Policy mistakes 'en masse' The last few weeks have had a profound effect on my view of politicians (as if it wasn't already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn't resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister - advocating 'Regulation Light'. Policing must improve If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds' use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers' compensation packages. It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal. So, with that in mind, let's take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don't read any further. What is about to come, will make your heart sink. More leverage in Europe Let's begin our journey by pointing out a regulatory 'anomaly' which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing. That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets. Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don't be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11. Not much of a cushion left Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%1. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity. The wheels are coming off But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe's current account went from +6% to -6% of GDP2. That is a frightening development and is likely to cause all sorts of problems over the next few years. Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region's banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.   The problem is widespread To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe. Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn't look like it can escape the mayhem. Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers' money. US banks are better off US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.    The great mortgage show The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn't anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.   Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don't ask me why Credit Suisse has included South Africa in Eastern Europe!).  Chart 4: Eastern European vs. Asian Crisis   Source: Wall Street Journal Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world's GDP in recession, who are they going to export to anytime soon? Austria is in greatest trouble According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%3. An extra $250bn to the IMF Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF's coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not. Conspiracy or...? On the 11th February the Daily Telegraph's Brussels correspondent Bruno Waterfield wrote an article under the header: "European banks may need £16.3 trillion bail out, EC document warns." In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union's finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article's header was changed to "European bank bail-out could push EU into crisis" and two paragraphs had mysteriously disappeared. Here they are: "European Commission officials have estimated that "impaired assets" may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the 'trading book' total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets. In addition, so-called 'available for sale instruments' worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion." Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don't know and I probably never will. But one thing is certain. If the EU Commission's estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well. Public debt to rise and rise Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers' money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free. BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).   For that very reason, and as pointed out in last month's Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn't work), why wouldn't they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things. Can Germany rescue us? Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea. The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis. Given this outlook, do you really want to be long euros?