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5. Political confrontation.

There is an underlying resentment that is simmering in the PIIGS and in Germany that portends heightened confrontation.

On the one hand, many Germans feel that they have “paid their dues.” Specifically, many Germans suffered greatly during the reunification. It took about fifteen years of painful austerity for the reunification of Germany to finally be achieved and for the German economy lift off. The Germans feel that they have reached their current state of economic superiority through blood, sweat and tears. Under such circumstances, they are not disposed to give away their hard earned money to PIIGS that have not engaged in similar self-sacrifice on their own behalf. East Germans and working class Germans that suffered the most from reunification feel particularly intensely about this.

On the other hand, a growing number of Greek, Portuguese, Italian and Spanish people are feeling, rightly or wrongly, that much of Germany’s economic success has been achieved at the PIIGS’s expense -- largely by undercutting PIIGS producers and driving them out of business. Under such conditions, many are inclined to believe that it is selfish of the Germans that have benefited the most from the Euro to not show solidarity under current circumstances. Furthermore, many Europeans in “peripheral” nations believe that the Germans are utilizing this crisis to increase their economic and political grip over Europe and EU institutions. When merged with historical memories of German expansionism and aggression, such feelings become particularly explosive.

At the present time, political confrontation at the grass-roots level and the intergovernmental level have been kept under control. The instinct to preserve European unity is exceedingly strong throughout the continent. However, unemployment and crushing poverty are “game changers.” They can create an emotional environment in which old beliefs are abandoned very quickly. In such a milieu, demagogues rise, zero sum thinking gains hold of the mind and bonds of solidarity tend to fray. Furthermore, scapegoats must be found, preferably foreign ones.

Italian Prime Minister Mario Monti, as well as various high ranking officials in Greece, have warned in vivid terms of the prospect of populist uprisings that could bring down their governments and their countries’ links to Europe. History suggests that their warnings should not be taken lightly.

Expect the degree of political confrontation to increase dramatically in 2012.

6. Social unrest and political instability. Massive unemployment amongst young males has been the source of social and political unrest that has consistently brought down governments from ancient times (Greek city-states and Rome) to Argentina and Egypt in the past decade. In the best-case scenarios, the instability will occur within an institutional democratic framework as governments are voted out and replaced in relatively rapid succession. More violent and/or chaotic overthrows cannot be ruled out.

7. Alternative quasi-currencies. I would like to predict the possible introduction of a device that I believe could eventually arise in the European context. It was a device that was used with some short-term success by provinces in Argentina in 2001 in a period called “the festival of bonds.” Unable to finance their own deficits, politically unable to cut spending any further, and prohibited by law from printing currency, provincial governments in Argentina came up with a rather ingenious alternative. They simply made up for deficit shortfalls by issuing interest-bearing bonds and requiring public employees and suppliers to accept them at par in payment for goods and services. The bonds actually traded at par alongside the Peso for many months before Argentina actually devalued the Peso. The details are far too numerous to describe here, but provincial governments were able to induce widespread circulation of the bonds by accepting them as payment of taxes as well by compelling supermarkets and certain sellers of basic goods and services to accept them at par under penalty of sanctions.

To my knowledge, there is nothing in European law that would prevent such an initiative by member states. In other words, if the PIIGS cannot sell their bonds in financial markets, the EFSF or to the ECB, they could force them on average citizens. Such an expedient could be used as a last resort to buy time and avoid a humiliating and costly exit from the Eurozone and the replacement of the euro with a new currency. Under such a scenario, the nation would remain a full member of the Euro Zone and the Euro would remain as the only official currency. This would also be a rather effective tool as a threat in negotiations with international creditors. The proliferation of such bonds would massively dilute the claims of international creditors as well as the ability of governments to repay debt in Euros.

Note that the bonds would not legally be considered a currency. However, they would act as a quasi-currency in practice.

8. Miscellaneous issues. There are so many holes that are and will spring up in the European ship that it will be difficult to keep track of them. Investors will hardly understand what happened with one leak that sprung before their attention is diverted to another. In this regard, we can expect to hear of quite a few ancillary issues that will be far from trivial such as: Possible bank insolvencies, international disputes over multilateral aid packages, international trade and currency disputes, frequent elections and changes of governments. As these issues arise, many investors will be lulled into thinking that these are the main issues. In truth, all of these issues are ultimately derivative of #1 .

9. Euro can survive. When I speak of a crisis in the Euro Zone, I am not necessarily referring to a crisis of the euro as a currency. Some people have misinterpreted me in this way. Thus let me be explicit: It is quite possible for the Euro Zone to undergo a horrific crisis and for the euro to maintain much of its value in international markets. This can occur in much the same way that gold maintained its value as an international currency despite crises of many nations that used it as the basis for their money. If the ECB adopts a policy in which inflation is strictly targeted, confidence in the value of the currency can be maintained. Confidence in the value of sovereign and private debts may collapse; but confidence in the currency is an analytically distinct matter.

Furthermore, the ECB can deviate from “hard money” principles and vastly expand the monetary base without causing a devaluation of the Euro. This is actually occurring right now. This is because the monetary base – which is the only variable that the ECB actually controls directly – is only a small portion of the money supply as a whole. To the extent that the quantity of money matters at all – and contrary to popular belief, it actually matters relatively little – the only thing that matters in this regard is the broad money supply, not the monetary base or the size of the ECB’s balance sheet.

Thus, investors should not construe my bearishness regarding Europe’s economies as bearishness on the euro as a currency. These are distinct issues. As of right now, my assumption is that the euro will survive. It’s value will probably decline, but perhaps not dramatically so. What remains to be seen is what countries will be using it and/or whether they will use it exclusively.

Conclusion

I do not think investors as a whole have an appreciable understanding of what is occurring in Europe. What is occurring in Europe is no less than the closing of an economic era and the destruction of an economic regime. Various European nations will ultimately abandon the Euro, European nations will default on their sovereign debts, European nations will adopt parallel quasi-currencies, the whole of the Euro Zone will undergo a massive inflation, or some permutation of two or more of these alternatives. In sum, an economic catastrophe and transformation is in the works. And at this point, it is extremely unlikely that one or more of these scenarios will not occur.

The exact timing and sequence of specific events is unclear. However, I believe that March of 2012 represents a key test. By this time, it will probably be clear that neither Greece, Portugal, Spain or probably Italy will meet their fiscal targets. At that point, the negotiations to institutionalize a “fiscal union” will increasingly be seen as a farce. At the same, time the Germans are highly unlikely to accede to larger bailout facilities or to monetary financing via the ECB. Political tensions will rise. At that point, a financial market crisis will ensue that will test the desire, will and ability of the Germans to prevent a massive Euro-wide crisis.

I am as of yet unsure of what the response of the Germans and other Europeans will be to this fateful situation. What I am relatively certain of is that when the moment for this choice has arrived, global equity markets including the S&P 500 (SPX) will across the board be at least 20%-25% lower than they are right now. As a result, I would stay away not only from virtually all European equities such as ING (ING) or Siemens (SI), but also from US equities and equity ETFs such as Apple (AAPL), General Electric (GE), Exxon (XOM), SPY and QQQ.

Source: 2012 Europe Outlook: How The Fiasco Will Unfold, Part 2