From The Baseline Scenario, Revised Baseline Scenario 02/09/2010

The following material was the basis of testimony to the Senate Budget Committee today by Simon Johnson.

2) But thinking in terms of these headline numbers masks a much more worrying dynamic. A major sovereign debt crisis is gathering steam in Europe, focused for now on the weaker countries in the eurozone, but with the potential to spillover also to the United Kingdom. These further financial market disruptions will not only slow the European economies – we estimate growth in the euro area will fall to around 0.5 percent Q4 on Q4 (the IMF puts this at 1.1 percent, but the January World Economic Outlook update was prepared before the Greek crisis broke in earnest) – it will also cause the euro to weaken and lower growth around the world.

3) There are some European efforts underway to limit debt crisis to Greece and to prevent the further spread of damage. But these efforts are too little and too late. The IMF also cannot be expected to play any meaningful role in the near term. Portugal, Ireland, Italy, Greece, and Spain – a group known to the markets as PIIGS, will all come under severe pressure from speculative attacks on their credit. These attacks are motivated by fiscal weakness and made possible by the reluctance of relatively strong European countries to help out the PIIGS. (Section B below has more detail.)

4) Financial market participants buy and sell insurance for sovereign and bank debt through the credit default swap market. None of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008, so it is hard to know what happens as governments further lose their credit worthiness. Generalized counter-party risk – the fear that an insurer will fail and thus bring down all connected banks – is again on the table, as it was after the collapse of Lehman.

5) Another Lehman/AIG-type situation lurks somewhere on the European continent, and again G7 (and G20) leaders are slow to see the risk. This time, given that they already used almost all their scope for fiscal stimulus, it will be considerably more difficult for governments to respond effectively if the crisis comes.

6) In such a situation, we should expect that investors scramble for the safest assets available – “cash”, which means short-term US government securities. It is not that the US has anything approaching a credible medium-term fiscal framework, but everyone else is in much worse shape.

The entire report is available here:

http://baselinescenario.com/2010/02/09/revised-baseline-scenario-february-9-2010/

We have bought gold coins, are totally out of the stock market with our retirement funds, and even bought Australian dollars as a hedge for emergency. Australia does not have a trade deficit, they export oil and gas to China, and they have raised their interest rates. It seemed like a good idea at the time.

We can partially, even mostly protect ourselves. Sadly, one should retain some presence and exposure to our corrupt and bankrupt system in order to do business. It does provide certain worthwhile conveniences and efficiencies.

For example, maintain your free checking and minimal savings account requirement at your friendly bailed out bank. Move everything else into a sound local, regional bank or credit union.