Whenever there is a financial crisis, investors have been programmed to believe that a central bank or government will step in to bailout anybody that has exposure to the crisis.  It really started in 1998 when the Federal Reserve stepped in to arrange a bailout of the Wall Street firms exposed to Long Term Capital.  Since then every crisis has seen some sort of intervention to prevent losses from occurring.  Human nature is programmed to believe that recent trends can continue, which leaves investors believing that there will always be money available for a bailout.  Nobody seems to be asking, "what if we run out of money?"

We've also discussed how for 30 years the growth in our economy has been fueled by an exponential increase in both household and government debt.  We carried this further as we analyzed the reason all of the government spending and money printing has failed to stimulate a decent recovery.  The Grand Experiment has clearly failed and it is time that our global leaders realize this.

The consequences of using so much debt to fight every crisis and to stimulate the economy is that you have to continue borrowing money from others.  There is only so much money in the world, so the larger countries have turned to each other to borrow money at different times.  What nobody ever considered is what would happen if one of the larger borrowers failed.  What is the impact on the countries that lent money to the failed country?  Could it create a domino effect?

Last week the BBC posted a fascinating interactive tool showing the amount of money some key countries have borrowed and who they borrowed it from.  As I clicked through each country I was astonished at how this looks just like a giant Ponzi Scheme.  Country A borrows from Country B, which turns around and loans money to country C, which turns around and lends it back to Country A. 

I took some time yesterday to chart the data and the relationships.  Note that this data includes money borrowed by both banks and the government, so it shows the total exposure any one country has to the other country.  The arrows on the chart show the lending back and forth between the countries. (click on chart for larger image)

As you can see, the United States is by far the largest borrower, followed by the United Kingdom.  Notice the money they lend back and forth to each other.  One thing that jumps out at me is the amount of exposure France has to Italy.  When you follow the arrows back to the U.S. and U.K., you can see now how Italy's problems could potentially become the U.S. & U.K.'s problems if France runs into problems.  You can also see how even Germany is not excluded from this Ponzi Scheme.  They have quite a bit of exposure to Spain, Italy, and France.  Problems there would filter back to the U.K. and the U.S.  The U.K. also has substantial exposure to Spanish debt, which is likely the next debt shoe to drop in the EU.

Should the U.K. run into problems because of their Spanish, German, and French exposure, that becomes a double problem for the U.S. 

(1.) The U.S., which already would be suffering from their French and Spanish exposure has a great deal of exposure to the U.K.'s debt. 

(2.)  The U.K. is one of the largest purchasers of U.S. debt, which leads to the question, "who will help finance our deficit?"  With the "not so Super Committee" proving that once again the U.S. Congress has no ability to come up with some real spending cuts, this should be a major concern for all involved.

Now you can see why problems in Greece, Italy, Spain, or Portugal are a major concern for U.S. investors.

Knowing that, let's zoom in a little bit and look at just the EU countries (click chart for larger image).

Removing the astronomical U.S. debt levels allows us to see the magnitude of France's problems.  Just focus on the purple boxes -- that is all exposure that France has to Greece, Ireland, Portugal, Spain, and most importantly Italy.  Then look at the final bar that shows who has exposure to French debt.  Is it any wonder why so many people are asking "Where is the bailout money?"  The most recent convoluted EFSF bailout solution that was long on words, short on details may be flawed, but investors were hoping that it would buy some more time.  When a Ponzi Scheme is blowing up, the only thing the perpetrators can hope for is enough time to keep their largest investors happy. 

So overall who has the most exposure to EU debt?  The answer may surprise you (click on image for larger view):

Now it becomes obvious why France is so desperate for the ECB to print more money to start monetizing the debt of the struggling countries inside the EU.  They have the most to lose, especially when compared to Germany's exposure (which is still quite heavy).  Of course Germany does not want to be taking on any more exposure than they already have, which is why they are so against the ECB buying debt directly from the countries with newly created Euros (in the end, all surviving EU countries end up being responsible for the debts the ECB and EFSF take on).  Looking at this chart, it is clear that the Federal Reserve is probably much more concerned about the U.S.'s exposure to EU debt than they are letting on.  It could also mean that they are already providing secret emergency loans to European firms, just as they did in 2007 - 2009 (while they were telling us that everything was fine.)   

Now let's turn it around and take a look at how much funding has come from the EU members.  Here is the same chart from above, only this time we show both how much was lent to EU countries as well as how much was borrowed from them.  Note that the U.S. & the U.K. have tapped the EU countries for over 2 Trillion Euros of funding (click on chart for larger image).

So the question becomes if the EU debt crisis continues, who will be left for the U.S. to borrow from?  Since 2000 we have seen an explosion in debt issuance across the world, especially by 'AAA' rated countries.  This chart through 2009 shows how much debt has been issued by those countries since 1990 (click on chart for larger image).

Like in the 2003-2007 "recovery", the 2009-2011 "recovery" has once again been fueled by debt.  In 2010 sovereign debt increased by $4.4 Trillion and total worldwide debt increased by $5.5 Trillion.  This is down from the $6.1 Trillion issued in 2009, but still well above the prior peak in 2006.  There is only so much money available in the world.  In 2008 Global Debt to GDP was 55%.  By the end of 2010 that number had jumped to 69%.  For those that believe China will be able to save the world, it is estimated that they added $1.2 Trillion to their debt in 2010 (source).

Speaking of China, where do they play into this picture?  Despite some people's opinions to the contrary, China remains a communist country so they closely guard their economic data unless it paints them in a positive light.  China could not be included in the data analyzed by the BBC because China does not report their transactions through the Bank for International Settlements.  So nobody knows how much money has been borrowed by Chinese companies or how much the Chinese government or their businesses have invested in U.S., U.K., or EU debt. 

What we do know is that China held $1.1 Trillion of Treasury bonds as of October of this year, but they have been selling their holdings in recent months.  The fact is nobody knows for sure how much debt China has.  Northwestern University professor, Victor Shih estimates that when you add up the liabilities of all of the state owned entities, their national debt is in excess of 150% of their GDP.  China NEEDS the U.S., U.K., and EU to survive so they can continue selling their products to those countries.  This is why they continue to look for ways to prop up those economies.  In the grand scheme of thing they are a big part of the Ponzi Scheme and cannot be counted on to "save" the EU from the crisis.

Some of the other data inside the BBC graphic was interesting and helped frame the level of foreign debt each country issued. (click on the charts for larger images)

We know that Ireland, the country in the worst position has already needed bailed out.  Greece, Portugal, & Spain are all in about the same fiscal condition.  Two of the three have already received some bailout money and Spain is next on the list.  Italy is actually a little bit better off than France and Germany when you look at debt to GDP.  The thing to consider is that as each country needs bailed out, their debts become debts of the countries that are bailing them out, which increases the likelihood that they too will run out of money.

Outside of the EU, I continue to be surprised that more is not being made about the poor fiscal condition of the U.K.  An article from last week pointed out to the desperation they must be feeling over there.  Apparently the London Stock Exchange has become a lender of last resort for Italian banks that are struggling to meet their liquidity needs.  As we learned in 2008, problems that may appear to be minor are probably an indication of severe problems lurking beneath the surface.

How much longer can this Ponzi Scheme continue?  That is anybody's guess, but the thing I remind everybody about is the fact that the problems behind the 2008 financial crisis were never solved.  The banks were not forced to take the losses on their bad investments.  Instead they were able to either sell those investments to the Federal Reserve or use those investments as collateral for loans from the Fed.  In other words, the debt still sits on somebody's balance sheet.  The only difference is that there is now LESS money out there to help fight the next crisis.  The more I look at the Ponzi Scheme that is our global economy, the more I am convinced that we cannot not get out of this by hoping for more time.

Some may argue that the stronger countries like the U.S. & the U.K. can print more money to help fund the debt fueled spending.  That may be true, but there is no such thing as free money.  If they were to continue devaluing their currency so they can spend more money the countries that lent them the money would eventually begin to step away because they'd be paid back in money that is worth less than the original loan.  This would also cause a continued widening in the gap between the upper and lower class as a weaker currency causes inflation, which hurts those that spend most of their income.  The Social Uprising has already started around the world.  Choosing to print money in order to fund deficit spending will only make the situation worse.

The only way out of this is for SOMEBODY to take the losses on all of these bad investments.  If the banks are forced to take the bad investments, many will fail.  That may be a short-term problem for the markets, but if the governments step in and guarantee the deposits inside of those banks and assist a stronger bank to take over the banking operations, the pain can be quickly solved.  This cleansing would allow the stronger companies to begin rebuilding our country and give everyone confidence that there are no more weak institutions out there. 

If instead, the governments decide to continue to step in and take on the bad debts and allowing the banks that made the bad investments to continue doing business (like they did in 2008) we are destined to continue asking, "how much longer can the Ponzi scheme continue?"  That will lead to years of volatility as the uncertainty will keep long-term investors away from the market, leaving it to the speculators.

I fully expect the central banks and governments to attempt the latter because they are too afraid of the former.  I keep trying to see another way out of this, but I honestly can't think of one.  Plan accordingly.

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