If authorities cannot convince bondholders to stop the eurozone rot, the problem could spread to all regions and conventional assets.
Without coordinated realism from policymakers, a rational, unconstrained investor would be unlikely to touch the debt of Spain, Portugal, Ireland or Greece in the short term.
But circumstances dictate that same investor should take a sceptical medium-term view on bonds, equities, commodities and property.
Owing to their deficits, Spain and Portugal have to supply more of their bonds to the market. A big natural source of demand, their domestic banks, have little money to invest. If eurozone bondholders flee, yields will widen.
Both countries are likely to have to increase fiscal austerity without a real stimulus plan to boost the private sector. Given the political circumstances, an orderly exit from the single currency is unlikely.
“Bailing out these four economies would place an intolerable burden on the rest of the eurozone and the EU”
This short-term strategy did not work in Ireland, and is even less likely to work in Spain, where unemployment is more than 20%, and in Portugal, whose private sector is relatively inflexible.
Bailing out these four economies would place an intolerable burden on the rest of the eurozone and the EU. It would in effect have to arrange a shot-gun fiscal union. Even if only Greece and Ireland are bailed out, the debt cut-backs elsewhere in the eurozone would have to be ferocious.
Such problems would not be confined to Europe. Under the surface, America is also trying to prevent a crisis in its state finances, as well as in its ailing mortgage market.
In an extensive report, Meredith Whitney, the independent analyst who predicted the banking crisis in 2007, says the American states will probably need a bailout in the next 12 months.
At the end of 2007, overt and covert problems on a similar scale in America and the EU caused emerging markets to falter. (article continues below)
Investors realised problems in the developed world would hit their imports from emerging market manufacturers, particularly in China.
According to the World Bank, China is more dependent on exports than ever.
The emerging markets that supplied China and other manufacturing nations with raw materials were the next domino to fall, in particular Brazil and Russia.
Emerging markets were able to sell their considerable savings to smooth over the problem. Growth was still strong in China, for instance.
But to take China as an example, doing the same thing this time could have terrible consequences.
Other than in cash, savings in China now seem to be held in two bubbles.
In the case of the private sector, the bubble is Chinese property. Although accurate figures are hard to find, anecdotal evidence would suggest retail investors are using property as a savings instrument, much like equities during the crash of 2008.
In the case of the public sector, the bubble is the American treasury market. Unlike the Japanese government bond market, the treasury market does not have a robust domestic market to underpin it.
On an international level, it is being undermined by the decline in the dollar and yields which cannot keep up with most countries’ inflation.
The federal government is also unwilling to decrease supply, despite protests from emerging markets.
The Federal Reserve is exacerbating the first two problems through quantitative easing (QE), although in the very short-term QE provides extra demand for treasuries.
At the peak of such uncertainty about major nations and currencies, only gold would thrive as an asset class. But as soon as governments took radical action to restore certainty, even gold would probably slip.
By that time, the eurozone bondholders would rule the world no longer. Governments would need to spend to restore confidence. Reserve-rich entities – the sovereign wealth funds, the large multinationals – would be able to impose special conditions on their investments.
Cash, as at the end of 2008, would be king.