We all know that the U.S has a serious $14 Trillion debt problem that apparently has no end in sight, especially now with this rigged Deficit Commission panel that is comprised of ideologues from both ends of the political spectrum with no true intention of coming to some sort of bipartisan agreement in dealing with our countries perilous debt situation. One party wants to raise taxes on the "evil" rich simply for political class warfare reasons and the other just wants to cut spending, so most likely nothing substantive will come about until the Bond markets forces us to take action. But this isn’t the point of this newsletter, what we are seeing now is that it’s not just the U.S that has a bad debt problem, but pretty much the rest of the developed world such as Japan and Europe (particularly Southern Europe) find themselves in a similar, if not in some cases, a much worse situation.

Remember all the street protests and images coming from Greece when it appeared that the Euro was in danger of breaking up? Greece was on the verge of defaulting and panic hit all the markets, chaos once again was hitting hard investors who’ve been shell shocked over the past couple years. It wasn’t just isolated to Greece, but contagion had hit and all the peripheral nations were getting infected as well. Basically any European economy that was deeply in debt was being targeted by the Bond vigilantes. What this means is that bond investors that owned these southern European bonds deemed these investments as crap, and essentially were panic selling these bonds, forcing yields to go sharply higher. When yields go higher, that means that the interest paid on their debt goes higher, which indicates that it makes it very difficult for these countries to repay their debt.

So the European Union along with the ECB came out with their $1 Trillion bazooka bailout and backstopped these economies. As I indicated in a piece several months ago about this, I stated that this would only buy a certain period of time and that it wouldn’t actually solve the problem. Analysts for the most part agreed, but most believed that it would buy a couple years of time. Hmmm, let’s see here, it has been how long? Yeaah, it’s only been about four to five months. Not good!

So now we are beginning to see the same thing happen again; Irish bond yields are rising sharply, and even worse yet, Spanish bonds are doing the same. So what was the immediate solution? You got it, another Irish bailout fund that totaled $125 Billion. How long do you think this assuaged the fears of the market? Ready for this? A whopping 24 hours as the markets gave a vote of no confidence.

Right now, there are no real solutions that are being offered. Yes, they are imposing austerity measures which are intended to reduce their spending and their debt, and yes that is part of the solution. But I’m afraid we will need more than just austerity to solve these problems. When austerity measures (which means government cutting of spending) takes place, there is a negative effect on growth. Think about it, you slash spending, and this takes away money from the economy which means that growth gets affected, and tax revenues go down even further.

What they really want to avoid is having to bailout Spain. It is estimated that if Spain ends up in the same position, which I believe it eventually will their total bailout cost will be over $350 Billion. You think the Germans want to continue bailing out these countries? It is a political nightmare for Merkel, the PM of Germany. Now some U.S official is talking about allowing U.S funds from the IMF to help with this possible future bailout. Yeah right! We barely can stand U.S bank bailouts; can you imagine the outrage here in the U.S if we bail out the Greeks, Spaniards and Portuguese? Yeah, I’m gonna say that isn’t going to happen.

The problem for everyone is that we are all interconnected. If you allow these economies to default on their debt payments, then we all take a tumble. What makes it tougher for the Germans for this not to happen is that their German private banks are huge investors of these heavily indebted countries through their purchase of bonds. So they can’t have them default because if they do, they will take tremendous losses in the hundreds of billions of dollars and that would create chaos in their economy.

So what is the End Game folks? Do they continue to keep backstopping them with these bailouts with no real solutions or do they attack the problem?

The real solution in my view is a three step process.

1. They have to impose tougher austerity measures.

2. They do have to provide more funding to weather this storm.

3. Last but not least, which they aren’t addressing as of yet, is that they have to reorganize the debt of these bonds with private banks. Meaning that these banks that have been investing in the bonds need to take a haircut on the value of those bonds. In other words take a certain percentage loss and lower the interest rates that these countries have to pay.

The reason why they aren’t doing this last part is because this would mean that the banks would have to take very large write-downs (losses) which of course would affect banking behavior. Lending would go down, and the cost of credit would go higher, which means growth would be affected.

So what do we believe is going to happen? Will they kick the proverbial can down the road or will they actually make the tough decisions and address the problems? My guess is that they will meander around for a while and eventually when all else fails they will begin to address the End Game by restructuring these debt obligations. Until then, you can expect to see the ECB continue with their version of QE (money printing) through massive purchases of European bonds. Of course they would refute my characterization of QE, as they adamantly oppose the notion of this idea, and there is a difference between our motives of QE and the Europeans QE. The U.S Federal Reserve is buying U.S bonds with the intent of stimulating the economy and boosting inflation, where the ECB is buying bonds to support these failing economies and prevent them from defaulting on their bond obligations. But it’s all the same, money printing is money printing, you say TomAto, I say TOmato.

Either way the value of paper currencies is getting debased, no matter what the motives are, and as I always say, as the value of paper currencies goes down, the value of hard assets such as gold goes up.

Matthew Goldfuss

www.gold-observer.com