Capital Flight in Europe

Even the casual observer in economic matters knows that something is wrong. There is a grave misconception that the average person is surprised when a crisis hits. I think it’s more accurate to say that people are surprised by the magnitude of a crisis. Most people who bought real estate in the bubble years knew they were buying high, they just wanted to sell to a greater fool. The same goes for the internet bubble. No matter what we believe, humans do not act rationally in markets, because if they did, we would hardly see any volatility.

In a free-floating system without any anchors like gold, imbalances persist much longer than they should. The U.S. basically had a free ride and current account deficits actually spurred the economy. Foreign countries essentially recycled their dollars into dollar-denominated assets, which crudely lowered the cost of capital for Americans, which then allowed them to consume more than they should have. This entire system is based on the assumption that foreigners have an unlimited appetite for American assets. There is a school of thought that believes that as long as there are export-driven emerging economies willing to support our current account deficits, these imbalances can last. I tend to disagree, because capital largely resides in developed nations, and they can already move markets.

That being said, capital is already starting to flee Europe. Bank runs are occurring in Greece, and to an extent in Spain, and I see nothing in the horizon that will change these trends. Europe can only react to these capital outflows by a) reducing their consumption, b) devaluing their currency (breakup of the Euro), and c) decreasing their borrowing. All 3 of these things are devastating when your economy is already slowing and you need to stimulate.

The U.S. will be faced with this conundrum soon, but for now capital is finding its way into U.S. Treasuries, which is no surprise. Right now the name of the game is safety, not yield.

In the short run, capital will find its way to the dollar and U.S. Treasuries. I suspect gold is next. As yields go down, so will mortgage rates, so real estate in the U.S. should also get a boost. Real estate prices in the U.S., believe it or not, are cheap on a relative basis.

The crisis in the U.S. will look something like this. Foreign outflows of capital will force us to devalue our currency, because cutting spending is not really an option for our leaders. This will lead to a rise in bond yields and an immediate and substantial rise in our debt servicing costs. This will indicate that the end is near: right when we need to borrow the most, the global market will lose its appetite for our debt. Again, everyone knows we have a debt problem, but people are underestimating its magnitude.

You all have about a 2 year window to diversify out of the dollar. We are coming upon a turning point in history, and it is staring us in the face. Fortunes will be made and lost, and the sophomoric buffoons who run policy in our country will be humbled–again.

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    My view on Europe: The Greeks vote for the conventional
    parties next month and stay in the Euro. The ECB prints to prop-up all the
    banks. Also more printing from the Fed, Chinese, and the BOE. All the drama
    queens end up with a bit of egg on their face!

    The next issue for the press to get into a fluff about will
    no doubt be the US debt ceiling. That should push gold up quite a bit.

    • http://www.expectedreturnsblog.com Moses

      I really don’t think it’s up to the Greeks, it’s up to the market. And the market is pricing in a breakup right now. 

  • http://twitter.com/LongShortTrader Dani El

    “The U.S. will be faced with this conundrum soon, but for now capital is finding its way into U.S. ” – where will capital? Does it begin with a g?

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