Austerity in the West? Not if the generals can be useful

Saturday, May 22, 2010


Avner Mandelman is a director of Venator Capital Management and author of The Sleuth Investor.

A Wall Street wit recently said: if Greece is Europe's Bear Stearns, Britain is its Lehman Brothers. Meaning, the first bankruptcy presages the second.

Well, the International Monetary Fund just bailed out Greece. Is the storm over, then? Should you wade in?

Not without strapping hedges on. Because debt is always repaid, either by the borrower or by the lender; so with Greece's loan money gone, either Greece's citizens will eat less, or its German bankers will. Yet when the first was attempted, Greeks rioted. If the same were attempted in Spain, the result might be similar. Such riots were now shifted a bit to the future, grace of the IMF. But sooner or later Europeans must tighten their belts - the Brits too - and in 2012-13, the Americans as well.

Do you think they'd tighten if an alternative were available? Surely not. But is there one?

Before I go into it, let me tell you a true story.

Somewhere south of San Francisco there's a town where, on the main intersection, there was a grassy hill sprouting flowers where locals picnicked and hiked. So most opposed building on the hill. However, it was known that if a shopping mall was built there, it'd be worth $100-million.

This huge potential acted like a magnet: Every city councillor knew that, were he or she to soft-pedal opposition to re-zoning, re-election money would magically appear. Thus, over time, councillors in favour of rezoning were re-elected, while those opposed were not. So roads around the hill were widened; then a permit was issued for a gardener hut (where trinkets were sold); then the hut was converted into a store, which, a year later, was expanded. It took five years, but the mall was built and the city got a high tax base, at the cost of no more hikes, no more wildflowers, and no more picnics.

So why am I telling you this sad story? Because it's an example of how a huge sum of money, created if a certain action is taken, irresistibly re-shapes politics to bring the bonanza into being - irrespective of ethics, justice, or both.

Which is where the debt crisis comes in: Because the only alternative to Westerners tightening their belts is to have some non-Westerners tighten theirs, by force. And since the West's debts are so enormous, there's only one candidate of sufficient size: OPEC, the Organization of the Petroleum Exporting Countries.

Oil is a huge part of the West's costs. The U.S. alone spends about $800-billion (U.S.) a year on foreign oil, and Europe spends more. So if oil prices plunged by, let's say 50 per cent, in five years the savings would pay the entire $2-trillion subprime debt - and European debt, too.

Can you imagine the economic boom?

Of course, the Western boom would be mirrored by painful slumps in OPEC countries, including those that use their oil revenues to make trouble for the West; for example Iran. So a side benefit would be a cut in the global risk premium. And, the combination of rising economies, lower risk premium, and suddenly manageable debt, would create a bull market that could rival that of the nineties', and turn austerity into prosperity.

Do you see where I am heading?

Just as those California councillors modified their policies to obtain the mall's bonanza, wildflowers notwithstanding, so Western heads of states clearly see the potential debt relief due to low oil prices, and start peeking at their Chiefs of Staff's Mideast plans. Now, mind - I am not being prescriptive, just descriptive: The first Gulf War (January, 1991) ushered in a 10-year-long bull market, and the second one (March, 2003) ushered in five - both built on cheaper oil and lower global risk. Can you see now why I consider "Gulf III" as notionally similar to that mall? Costs and ethics notwithstanding, the benefits for bankrupt Western states must be tempting.

Once again, I'm not advocating, just coldly describing. You may consider North American austerity and European debt riots more equitable than more foreign conflicts, but countries with powerful armies have never tightened their belts if they could force others to tighten theirs instead. It has always been thus and always will be.

Which is why it's been my view that the world will likely enter into escalating military conflicts, which could first hurt the market (as Gulf I and Gulf II first did), but then cause oil prices to plunge and global risk to, eventually, decline. It's the only scenario I know of that can pay the West's debts while sticking others with the costs. Immoral, you say? As Machiavelli said, states have no morality, only interests.

What then are the investment implications?

Until such likely conflicts end, the debt crisis will go on. I'd therefore continue to hedge my longs with shorts, own more gold and income securities, be careful of alternative energy, and wait for the market to eventually hand me great stocks at cheap prices.