THE MARKETS HAVE GOOD REASONS TO BE NERVOUS /THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

OPINION

MAY 8, 2010.

The Markets Have Good Reasons To Be Nervous

The euro will probably survive the current scare but nobody will trust it like they used to.

By ANDY KESSLER

Nathan Rothschild famously quipped, "Buy when there is blood in the streets," but he never said anything about firebombs thrown at Greek riot police, a trillion dollar easing of the money supply, or synthetic collateral debt obligations.

And so, after facing turmoil in the sovereign debt markets, the Dow Jones Industrial Average is down 5.7% this week—and slightly down for the year. The FTSE and the DAX are down, while Greece's Athex Composite index is off 12.8% for the week and a whopping 25.5% so far this year.

Is Europe really a problem for the U.S.? Is this a buy signal—or is it more like the bank run of the last two years morphing into a run on debt-laden countries?

We can argue until we are blue in the face what the right level of debt to GDP any country can legitimately carry, but all that matters is that debts get refinanced. I remember in early 1998 sitting across the table from a chain-smoking Korean gentleman who was selling off a portfolio of technology venture investments at pennies on the dollar as the Korean won sank and the International Monetary Fund (IMF) and other sources committed $58 billion to restructure their debts. In times like these, everything is for sale, which is why markets are swooning.

But I doubt it's a buy signal. While $140 billion has been offered the IMF, Germany and other EU members to bail out Greece, the markets are saying that's not enough. Estimates for a bailout of Spain are topping $600 billion. Illinois Congressman Mark Steven Kirk, who is on the committee that oversees the U.S. financing of the IMF, says the fund only has the capacity for maybe $250 billion. So who is going to step up now?

During the 2008/2009 financial crisis, the Federal Reserve and the U.S. Treasury tried everything to fix the financial sector. They guaranteed debt, pumped TARP money onto balance sheets, and even let Lehman fail. What worked was the Federal Reserve printing money, via $1.2 trillion in Treasurys, mortgage-backed securities and agency debt purchases, which helped spur a powerful stock market rally. Banks and Wall Street could sell equity and refinance themselves, buying themselves years to get rid of all their toxic assets.

What do you do when a country starts going belly up? Normally, banks world-wide would jump in and charge usurious rates to countries down on their luck. But not many banks have the capital to take on the task.

In the Asian crisis of 1997, the IMF demanded a series of reforms, tax increases and austerity programs before bailing out Korea, Thailand and Indonesia. Greece and probably other countries have been using derivatives—bought from Goldman Sachs no less—to push out their debt obligations and put off the day of reckoning when they'll have to cut expenditures or raise taxes. Even so, they'll still have obligations under the derivatives contracts for balloon payments to various lenders.

When debt payers default or banks fail, it is deflationary as money disappears. The Federal Reserve learned its lesson to either be the lender of last resort, or if defaults occur, to print enough money by buying bonds to make up for the lost money supply. It has worked so far over the past 14 months. Ben Bernanke, to his credit, knew when to stop printing by not extending the March 31, 2010, deadline for mortgage security purchases. Still, I think he overshot a bit by boosting the stock market past 11,000.

But bank debt and sovereign debt are two different beasts. A rising market won't allow Greece to refinance like it did Bank of America. It's the sell-off that could help.

A down stock market can be a policy maker's best friend. When the first Troubled Asset Relief Program vote in September 2008 failed, the stock market sold off almost 9%, scaring everybody. The next vote on the program, with a few cosmetic amendments, passed a few days later. Can European policy makers point to a brutal stock market to force through cuts and austerity programs? That might be impossible. So either there will be outright defaults and lots of euros printed to make up for the lost money supply, or we'll see huge bailouts and lots of euros printed to pay for them.

Many Germans do remember the days of burning Reichsbanknotes to keep warm, their value less than the paper they were printed on. They will fight printing euros. But when rioters firebomb banks, the trade-off becomes debasing the euro in the hope of political stability, however fleeting.

My guess is that the euro will survive, but no one will trust it like they used to. At the end of the day, it's an entitlement problem. In Greece, the public sector makes up 40% or more of the work force, with short weeks, lots of vacation and lavish retirement benefits. All of that needs to be paid for with real income, not debt, and the markets are anticipating the day of reckoning. One can only hope European policy makers listen to the market. I wonder if California and Medicare are taking notes.

Mr. Kessler, a former hedge fund manager, is the author of "How We Got Here" (Collins, 2005).

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