Notes From Underground: Sitting on the horns of a dilemma with ash on our faces

We are very sorry for the volcanic activity that has caused so much transportational havoc throughout Europe. It is rumored that the U.N. is looking to begin investigations to study whether or not Iceland set off the volcano in retaliation for the way the Dutch and British authorities treated the sovereign state. Governments seeking to outlaw, or regulate, non-predictable events, we have no doubt that earthquakes and volcanoes are next.

The Europeans were not the only ones with ash on their faces as the domos at Goldman Sachs were said to be ashen faced after the SEC action on Friday. In a very fine article by Frank Partnoy in Monday’s Financial Times, the problem for Goldman and others is the slew of lawsuits that will follow the regulators’ actions. Goldman may be the most fortunate by being named first for there were certainly be more accusations to follow. The Wall Street crowd took another hit on Sunday as former president Bill Clinton pointed his finger at Bob Rubin and Larry Summers for blocking any type of regulatory oversight of the derivatives markets. Clinton’s statements will challenge Obama, as the president has surrounded himself with Robert Rubin proteges. Now it’s about to get interesting.

Some of the players who opposed derivatives regulation under President Bill Clinton are steering economic policy in the Obama administration.

The dilemma that the world financial market is sitting on is, of course, the contagion that will spread from the Greek debt situation. Markets have failed to give any credibility to the bailout plan crafted by the European technocrats and so the Greek fallout is sure to spread to other periphals as we saw the German/Portugese spread widen out all week. Remember that markets are like water and they will seek out the weakest link or “lowest level.”

The dilemma is/will be if the European Union begins another credit crisis like Lehman. Will a default by one, two or three of the PIIGS result is setting off a global deleveraging of sovereign debt? If we were to enter a new cycle of de-leveraging, the world’s central banks and other lending authorities would step in and open the floodgates to a new round of liquidity creation. We have seen the recalcitrant ECB already agree to accepting all types of sovereign debt as collateral, no matter what the rating, and we don’t even have a full blown crisis as of yet.

The markets are aware of this deflationary dilemma and it impact it will have on international liquidity. The commodity markets from  metals, grains and energy will be the tells in the game as global investors demand hard assets in lieu of fiat currencies. We will be monitoring the spreads in the European debt markets (German paper versus all the others) as an indication that the European policymakers are losing control of the bailout tactic. Remember that the German/Greek spreads began to deteriorate after the Chinese decided to not support a €25 billion-based Greek bond offering. If global investors, especially the Russians, begin balking on holding the PIIGS debt, it will set the above scenario into motion. Negative feedback loops are a terrible situation for DEBT-constrained sovereign borrowers. The markets will vote with their money and that is the greatest fear for the European elites.

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