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New York: September 26, 2011
By John Stephenson

The global economy and the stock market sit at a precipice of another financial crisis that could easily rival the global financial crisis of 2008/2009. European officials have been scrambling to find a solution to the growing likelihood of a Greek debt default. On Friday, Oli Rehn, the European Union's head of monetary affairs, signalled that Europe was open to using “leverage” to help boost the scope of the €440 billion European Financial Stability Facility (EFSF), a temporary bailout facility put in place in May, 2010.

Over the weekend, U.S. Treasury Secretary, Timothy Geithner, set the tone for the International Monetary Fund's (IMF) annual meeting in Washington , by warning that a European failure to deal with Greece risked “cascading default, bank runs and catastrophic risk.” But while politicians dicker over the how and when of bailouts, a debt-laden Europe and a jobs-starved United States are pushing the world toward the precipice of recession and a massive stock market sell off.

For more than a year and a half, European officials have scrambled to prevent an insolvent Greece from defaulting on its debt. In exchange for a €110 billion bailout package, European and IMF lenders hoped Greece would implement an austerity program that would nurse its economy back to health. But with its economy shrinking and with a private sector still retrenching from the 2008/2009 financial collapse, Greece has shown little capacity to implement the austerity measures demanded by its lenders. In fact, the Greek government has spent more in the first eight months of this year than they did during all of 2010, causing many to speculate that the Greek government lacks the will to address the problem head on.

Austerity programs are nothing more than tax hikes and spending cuts, which yank stimulus out of an economy. And for the moribund Greek economy, which shrank by 4.5 percent in 2010 and is likely to shrink by more than 5 percent this year, a reduction in stimulus is making a bad situation worse. Unemployment has skyrocketed and Greeks have taken to the streets with strikes, riots and protests, some of which have turned deadly.

With Greece on the brink of default, a European recession a likely proposition and with a growing debt crisis in Italy, a country too big to save, European officials are scrambling for a solution that could quickly metastasize into a broader banking crisis that quickly crosses the Atlantic to form a global banking crisis, taking down banks and markets in the process. At the centre of the anxiety over Europe is whether the euro zone's bailout fund, the EFSF, is big enough to handle a worst-case scenario. Italy , the second-most indebted country in the euro zone, has $2.2 trillion of government debt outstanding. German banks have just €70 billion in capital to backstop Italian, Irish, Portuguese, Greek and Spanish bonds with a face value of more than €500 billion—much of that worth considerably less than it has been carried on the banks' balance sheets.

Last week, the International Monetary Fund warned that the European debt crisis has generated more than 300 billion euros in credit risk for European banks, increasing the need for banks to recapitalize. Investors are deeply concerned that European financial institutions will potentially show losses on their government bond holdings and increasingly, European banks are becoming reliant on the European Central Bank (ECB) for liquidity. The usual way that banking crises are resolved is through a state-led bailout, but in much of Europe, the state is so deeply indebted and the cause of the European banking sector woes, are such that ad-hoc bailouts may not be coming.

That has ratcheted up the heat on squabbling European politicians to act and act fast. The dire situation in Europe has only been heightened by the U.S. Federal Reserve's warning last week of “significant downside risks” to its outlook for modest growth. Adding to the concerns has been U.S. domestic political discourse where Democrats and Republican lawmakers seem unwilling to co-operate on any substantive measures.

But for politicians and officials on both sides of the Atlantic , time is quickly running out. The markets which have always been several steps ahead of the politicians in the euro zone debacle are signalling at least a 94 percent probability of a Greek default. To be bullish on this market, investors need to believe that European policymakers can decide upon and implement a dramatic bailout package big enough to lap up Greek, Irish, Portuguese and Italian bonds and to backstop the region's banks before the markets sell short European banks. This seems an unlikely proposition.

With another global financial crisis brewing, investors should adopt the most defensive posture possible. Investors should raise their cash balance, exit their position in junior resource explorers and high-grade their investment portfolios. Gold will once again glisten, but for now, the bloom is clearly off the rose as investors' fears have turned from inflation worries to deflation concerns, sending the price of gold on a $100-an-ounce swan dive on Friday. Politicians in Europe may yet find a solutions to what ails Europe , but I wouldn't bet on it and would rather play it safe than to risk being sorry.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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