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Why is Greece on road to default again? Why is America in a debt crisis again? Why is there Middle-Eastern instability again?

If you learn from history, you can avoid past mistakes, but we never do. When people tell you: “Hey, this situation resembles___. You should be careful.” You never listen. Why? It’s that beautiful dream that everything will work out.

Let’s take a generic example. A friend is in a bad relationship. You tell them they should reconsider, but they don’t listen, for whatever reason. Whether they are blinded by pride, love, sex, money, whatever. It doesn’t go through. And it feels terrible for you to look at the aftermath, and say “I told you so.” And that “I told you so” is very painful, even for those not involved.

A handful of people always shout of danger from the sidelines. Take Robert Shiller for example (one of my favorite economists). Predicts the tech bubble AND the financial crisis. But we did’t listen. Because it is hard to listen. It is sometimes much too easy to believe that the good times will go on forever. Especially when you are in direct exposure to its ecstasy.

There were a lot of people who offered advice from the sidelines. Why didn’t we listen? Fair warnings were definitely given at appropriate timings.

Well, on hindsight, it is easy to laugh at those who stupidly pursued an unreachable goal. But when we step back and think about it, it was all because of the “dream.” As I’ve said before, when you “buy” an investment, you aren’t investing, you’re actually buying a dream. And often times, we don’t want that dream to end. At the height of ecstasy in the midst of a beautiful dream, we don’t want the alarm clock to wake us up.

And then something bad happens. That bad thing has to get a direct bite out of you before you will learn. You have to experience the pain yourself before you are willing to admit that those triggering the alarms on the sidelines are right. Well, they too, have experienced that direct bite out of their flesh and blood. And that is why they sounded the alarm. They’ve lived through the same experience.

Sometimes, we bring ourselves too far. Sometimes, we act childish. But always, we have to learn from it. If you make a mistake, that’s fine. You aren’t a failure. But you are a failure if you learned nothing, and continue in your stupidly advancing ways.

This is true not just in macroeconomics, but in every aspect of life. We’re all the kids, at some point, who don’t want to listen to our parents; kids who want to childishly continue living in our fantasies.

But as the investing advice goes, if you only make each mistake once, soon enough, you will be a billionaire.

The financial markets are facing collapse again, and the stock markets are still responding as though its Christmas. Bad news guys, Christmas has passed, and it is still far off.

The ECB and EFSF will soon run dry. The EU will soon have absolutely no money to save the nations in crisis. Greece will go in default. All of this in 2012. Sure, we anticipated it. Greece, according to it’s CDS basis points, is floating around the region of 99% chance of default. We know what will happen. And if the market expects it, it can’t be that bad, right?

But this isn’t just about the markets. This is about a change. This is a change that could be as dramatic as the falling of the Soviet Union. A change as dramatic as the Civil War and World War II. Except now, the battlefields are in the minds of the people.

During a time of required unity, we have tearing class warfare. Yes. There is a party clearly at fault, and yes, the natural response is for the responsible to pay. But sometimes, we have to realize, in the bigger picture, it’s not about punishment now. It’s about solving the problem and punishing later. I remember when I was a child, I saw another kid punch another kid in the face. So hard, that he started bleeding. The teacher arrived, and started scolding the kid who just punched the now bleeding-profusely-kid. The child then proceeds to faint. Good thing nothing serious happened. But really, though. We are throwing the blame. We are being distracted. We are not solving problems. We are creating more. The teacher, I believe, should’ve helped the hurt, then disciplined. Not attempt discipline, then save the now fainting child. Solve the problem first. Deal with discipline later.

So, I sincerely hope that we could stop proceeding in this brash, unassuming way. We are heading towards the direction of a completely revolutionary change on the world. The financial landscape will never be the same ever again. My bet is, we need to feel the full pain of a full-blown recession before we learn our lesson. We got lucky in the previous one. Unemployment rate did shoot up, but it was not like reform for the Russians after Communism. It was not like finally leaving the oppression of Nazis for the innocent German citizens. It was not like the pain of the Great Depression.

And before you think the European Crisis is the only problem, let’s take a step back. What is happening right now?

Partially Predictable Factors

1) US debt and Political Uncertainty

2) European debt and Political Uncertainty

Note that both of these crisis is already in the showdown stage. All the chips are on the table. We know what is wrong. We know to some extent how wrong they are. Note that U.S. political uncertainty will likely continue in 2012 because neither party is poised to grab a majority in the house, a supermajority in the senate and control executive office. Political uncertainty will persist, and politicians will continue to use brinksmanship to push debt talks to final minutes. I do not predict substantial reform.

In the case of Europe, with political uncertainty in France (Francois Hollande is winning, but what exactly will he do?). I fail to see anyway out of this crisis for the European Union. They are entrenched in a welfare state they cannot exit from under a regular democracy, and we are poised for a final blow as bonds will slowly come due from February to April. Even if Europe weathers the crisis with (I don’t even know where they can come up with the money for another bailout), the political tension will allow the European Union to be no longer united. There is a large probability the Eurozone will eliminate members and allow the default of some, or pursue a fiscal union at the cost of short-term instability. (please see “What’s happening? section for more details)

Almost Unpredictable Factors

3) Arab Spring

4) China’s rough-landing

Arab Springs will continue in the Middle-East and Africa. It is like the domino theory of communism: once one country falls, the rest will follow. U.S. and Europe, the usual mediators, will be unable to help because their debt and political conflict will eliminate all possibilities of an intervention of any sorts. This will spark a possible commodity bubble due to the unstable locations of key energy resources in the Middle-East and Africa.

This will also play into China’s potential hard landing. The real question is, what are the systematic risks in China right now? The real-estate market? Nope. The fact that the growth is hard to sustain unless they concentrate their GDP on local consumption? The spectre of inflation? The potential of the commodity shock weakening the economy? Yes to all of those. The Chinese government is switching over to a model that will help make consumption a larger part of GDP, but these changes don’t happen overnight. Inflation setting in could completely cripple any attempts to convince people to consume locally. Add in the potential commodity shock, and China doesn’t look as strong as investors are putting them out to be anymore. The other problem is, how much do we really know about China’s actual financial status? Nothing. China could be broke now for all we know, and their balance sheets still look perfect. Ok, that’s a bit of an exaggeration, but they are definitely not as strong as the street predictions are making them out to be. And this is just the reality of the financial world. You can’t just give the client’s money back. You have to do something with it less you don’t want your service fees. Thus, they have to look for relative strength. That’s currently in China. Unfortunately, if China merely decreases their growth rate to a still-impressive-5%, the markets will panic, and the “strong market” will suddenly have a negative outlook.

Completely Unpredictable Factors

5) Natural Disasters

An Earthquake sure hit Japan at a terrible time. Not that it wouldn’t have been a terrible thing if it hit during Japan’s golden age. It just wouldn’t have been as bad. The Earthquake last March is still taking its toll on Japan’s economy, though they are recovering. Combine that with the other disaster of the “strengthening” (this word doesn’t even make sense here anymore) yen, and that’s already one country sunk by a natural disaster in terms of economic outlook. Maybe they’ll outperform, but definitely nothing extraordinary will come out of Japan’s manufacturing sector.

Japan is just an example. What if more natural disasters were to come? I certainly hope not. On top of all the systematic risks above, the impact on whatever economies it hits, and the commodity risk would send ruptures in the balance sheets of many banks. I have no crystal ball, but be fast to respond to natural disasters in 2012.

The Key Month: April

Real reforms in Greece come when? After the election in April. Note that current reform is impossible because there is an election in April. That means that absolutely no substantial reforms will happen until then. Why? The reality of democracy is the world would only change if there is enough political incentive. In a time when everyone is campaigning for reelection, who would dare go against the benefits that drives in the votes? Substantial short-term reforms in Greece are impossible.

This leads to the problem of how Europe will scrounge up the money to buy more time until April? And buy more time for the reforms to settle in? Europe is out of money, and they don’t have a lifeline. Eurobonds as a temporary lifeline are probably not going to happen until, you guessed it, April, when Francois Hollande enters office. Eurobonds unfortunately will not happen under Sarkozy (unless he gets desperate), but even so, this is only a temporary solution. Just like EFSF bailouts.

Throw in the fact that PIGS debt is coming due en masse in the period of February to April, and we have a true problem that needs to be dealt. Europe needs cash to flow in, but they are unable to muster the political support to do something to instill long-term investment confidence. Sure, they might create a short rally, but will this be permanent?

The only way we can avoid 4/5 of these and minimize the damage for the last one is for us to trust in the diligence of our politicians, and hope that they do the right thing. I’ll be honest here, I have no solution, I just see a lot of problems. Who has the solution? I don’t know. Here’s the heart-breaker: Ask yourself, “Do you trust the world politicians?”

What’s Happening?

Oh yeah, if you didn’t know, the stock market is not a representation of how the economy is doing. Back when people warned of the dangers of starting a monetary union without fiscal integration, no one was listening again. The fantastical prospects of becoming stronger economies together (in the near horizon) was too good to give up. Unfortunately, investors failed to realize that there is no exit strategy for the Euro, and Merkel, Sarkozy, Monti and Papademos will not find a solution to all the problems.

Now, they are in deep water. They have created interdependence in the financial system to make it impossible to dismantle. As Niall Ferguson puts it: “The euro may survive, but the European Union as it is will not.” Given that major change won’t happen until after elections and until people feel enough pain that they have to remove the source of it, fiscal integration (a United States of Europe of some sort, if you will), would never happen.

One of two scenarios will likely follow:

The Good Case (what I hope will happen, though I never get what I want)

The EU fails to meet many financial obligations up until April, markets suffer, but leaders do the right thing and establish a central authority regarding European fiscal policy.

The Bad Case (the one kids who have worked their life to get a job in finance hope won’t happen)

Stock markets rally to new heights as Europe scrounges up the money to bailout more countries. Heights of 14-16k are reached in the Dow, but with little real significance. Painful crash to follow, with a complete change of the global financial landscape.

On the short run, though, ask yourself this: Do you trust the politicians of the world to do the right thing? If your answer is no, here’s my recommendation:

Short all financials at height of rally. Shorting financial ETFS will be particularly beneficial in the upcoming months of February, March and April. Particular banks to watch for include the bulge bracket banks, as well as any bank severely exposed to European debt (Credit Agricole, Societe Generale, UBS, etc.)

There are few things left to long in this economy. I would recommend hedging with a lot of cash/gold (combined hedging with gold and some USD is probably the best option) The only way is to play clean-up crew in late 2012/early 2013.

A strong rebound may be coming, but this is all part of investors pursuing the type of fantasy I outlined at the beginning of the article. But the dream will likely end. Another strong rally may continue for a few weeks, and maybe even a few months. But let’s get real here. We have a lot of problems, and none of them have full solutions. As a cynical economist, I unfortunately will have to side with my instinct that human beings are not made to solve problems by taking short term losses for long term gains. They will wait for the big, painful fall before they see the fleetingness of the dream, and engage in full reform. Just like naive kids when pursuing a terrible relationship.

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