If the global economy could be described as a three ring circus, then the center attraction would definitely be the currency and debt exchanges between the United States and China. But for the past month the world's attention has been distracted by an entertaining sideshow in which Greece and the European Union are jostling over a potential bailout for Greek debt and whether the European Union, and the euro itself, will exist for much longer. I believe the short-term problems in Europe are being overblown and the potential demise of the euro highly exaggerated. For those who can connect the dots however, the drama throws some much needed light on the far more daunting problems unfolding within our own fiscal house.

The scenario that is eliciting the greatest fears is that resentment from the more solvent EU members will prevent a bailout for Greece. If the Greek government then fails to adopt austerity measures that will bring it back in line with EU debt requirements, then an expulsion, or withdrawal, from the Union becomes a possibility. This could set off a domino effect that will bring down larger European political or monetary union. On the other hand, if Greece does receive a bailout, a moral hazard will be created that will encourage other indebted countries (Portugal, Spain, etc.) to press for equal benefits. The fear is that either scenario would destroy confidence in the euro, remove the biggest rival of the U.S. dollar, and give a shot in the arm to the dollar's global status.

However, there is a third more likely alternative that few are considering. My gut is that Greek politicians will find the prospect of being forced out of the union and re-creating their own currency, formerly called the drachma, even more unpalatable then swallowing the bitter pill of fiscal austerity. Even if defying the EU might seem like good politics now for Greek leaders, the risks associated with economic independence could be so daunting that politicians will refuse to roll the dice. Their better political choice would be to talk tough against draconian spending cuts but vote for them anyway. By playing the role of callous bullies, politicians in Berlin, Paris, and Brussels can provide Greek politicians with the political cover necessary for them to make the unpopular decisions. That way Greek politicians could have their cake and eat it too.

The best case for Europe would be a solution that is all stick and no carrot. This would mean that Greece would have to get its fiscal house in order with no help from the EU. However, even a solution that involved some help from Brussels, but still forced real reforms in Athens, would be seen as a positive for the euro.

Rather than being the beginning of the end for the euro, the Greek drama may well become the euro's first major victory. If the EU forces Greek politicians to act more responsibly, the Union will show that it cares about the value of its currency and that it has the political will to keep its members in line.

On the other hand, the negative consequences for the EU, and the euro, of an outright Greek bailout would be devastating. Central to the euro's viability is the limit it places on the ability of member nations to run deficits. The moral hazard associated with a Greek bailout would create a situation that would actually encourage all EU nations to run larger deficits because the costs of doing so would be borne by the more responsible members.

Contrary to conventional wisdom, Greek bankruptcy is actually preferable to a bailout, and while the initial reaction might be perceived as euro negative, sentiment will quickly turn in the currency’s favor. A solution that involves a restructuring of Greek debt, that imposes some losses on creditors, would be the most honest way out. Not only would this be positive for the euro, but it would have the added benefit of reminding lenders that loaning money to heavily indebted nations is risky. Governments of such nations would then find it more difficult to borrow money, forcing greater fiscal discipline around the world.

While I still have my doubts about the long-term viability of the euro, I feel that there will be many short-term successes before the experiment ultimately fails. In the meantime, if the euro can survive its current trial, its health could be bad news for the dollar. A battle tested euro, backed by a disciplined union, will have greater credibility as the currency capable of dethroning the dollar. This will eventually refocus attention back on the United States and will highlight the significant distinctions between the two economic powers.

First, while the European Union may have several member nations with fiscal problems, the same situation exists in the U.S. where many of our most populous States are currently navigating similarly dire financial straits. Like Greece, California cannot print money. So if leaders in Sacramento can't find the will to raise taxes or cut spending, absent federal bailouts, default will be their only option.

However, my guess is that the political pressure in the U.S. to bailout State governments, or to avoid the huge cuts in State spending that would be required to avoid default, will be too great to resist. While Germans are vehemently opposed to bailing out Greeks, I do not foresee the same level of opposition on the part of New Yorkers to bailing out Californians, especially since New York will likely need its own bailout in the not too distant future.

This is especially true since most voters will not be asked to pay higher federal taxes to finance State bailouts. We will simply "pay" for State bailouts the same way we "pay" for all the others, we will borrow from abroad or print money.

As a result, none of the States will be forced to make the necessary spending cuts, and many will actually increase spending even faster, even as their tax bases continue to shrink. Those States that may have otherwise acted responsibility will likewise be incentivized to run large deficits themselves to get their fair slice of the bailout pie.

Of course, on a Federal level, there will be no one to force Uncle Sam's hand, because unlike Greece, our government can print money. Since printing money is far more politically popular than cutting spending, raising taxes on the middle class, or honest default, it is the most likely option our leaders will choose.

If these two scenarios unfold, the EU holding the line on Greece and Washington caving to California, creditor nations will be presented with a clear message as to where to hold their currency reserves. The stampede out of the dollar will begin, and the greenback's tenure as the world's reserve currency will enter its final act. Such an outcome would also throw light on the solvency of the United States itself, which has its own debt issues which in many ways are far more daunting than those faced by the European Union. The real tragedy will play out not in Greece, but in America.

While virtually all other advanced economies are still struggling to emerge from the ruins of the 2008 financial collapse, Australia is reporting increasing housing pricesⁱ, declining unemploymentⁱⁱ, and rising interest ratesⁱⁱⁱ.

As Charles Schulz once said, "Don't worry about the world coming to an end today. It is already tomorrow in Australia."

His words ring true now more than ever.

Stable Government

Australia boasts a relatively stable socioeconomic and political environment. In 2009, it was ranked second worldwide for political stability in the IMD World Competitiveness Yearbook, and of the 57 economies surveyed, it came in ninth for transparency of government policy. Its government is widely agreed to have a very good working relationship with the business sector.

Furthermore, over the past 30 years, Australia has introduced reforms that have allowed it to become integrated with the global economy, but also has equipped it to withstand external shocks. The reforms have included the introduction of a flexible exchange rate system, deregulation of the financial markets, reduction of tariffs, and reformation of the labor market and taxation policies^[i]. This free market approach has allowed for an extremely business-friendly environment.

Sound Monetary Policy

The primary objective of the Reserve Bank of Australia's monetary policy is to keep its inflation rate controlled at 2-3% on average by keeping interest rates up. Its current interest rate is set at 3.75%^iv, which compares favorably to other developed countries' headline rates (see chart below). It was one of the first economies to raise rates in the wake of the financial crisis – a convincing demonstration of its economic resilience.

(Source: http://www.fxstreet.com/fundamental/interest-rates-table/, Feb 2010)

Due in part to the country's strategically high interest rates, the Australian dollar has risen steadily against the U.S. dollar for almost a year (see chart below).

Export & Resource Driven Economy

Australia's economy is driven by exports. This sector is dominated by mining (41.5%), but also includes manufacturing (29.7%), services (18.9%), and agriculture (4.1%). The country's exports rose 21.9% in the midst of the 2008-09 crisis, to $284.7 billion^v. Rising commodity prices have been a boon to Australia's export earnings, as some of their principal exports include coal, iron ore and gold (see chart below).

(Source: ABS catalogue 5368.0 September 2009^vi)

Australia's major export markets are Japan, China, South Korea, and India. Its largest two-way trading partners are China, Japan, the United States, and South Korea.^vii Australia's strong trading relationship with China and other blossoming Asian markets has given it a distinct advantage in weathering the recession.

The Australian Energy Market

Like much of the Australian economy, the overall energy market has been on a general incline. Here are some key facts and charts from the ABARE Energy Update, 2009^viii:

• Australia's energy production rose 1.6% from 2007 to 2008.
  
• Australia's energy exports rose by almost 4%, reflecting strong growth in uranium oxide and coal exports.
  
• Coal provides over 50% of Australia's energy export trade.
• Total electricity generated in Australia grew by about 2.5%.
• Australia's overall energy consumption rose by about 1.5%.
• Growth in energy consumption was driven by the electricity generation sector, the transport sector and the residential sector.
  
• In energy content terms, in 2007-08, the fuel type to record the strongest consumption growth was gas (up 5%), followed by renewable (up 3%).

Caveats

Although we consider Australia to be a relatively lower-risk foreign investment, there are certain risks inherent to all international investing, including currency, market and political risks.

Currency Risk: Changes in the currency exchange rate can affect your investment. When the exchange rate between the foreign currency of an international investment and the U.S. dollar changes, it will impact your investment return.

Market Risk: Foreign markets, like all markets, can experience dramatic changes in market value.

Political Risk: Political, economic, and social factors influence foreign markets.

Company #1

Company #1 is a dividend-yielding Australian utility trust dealing mainly in electricity and gas transmission and distribution. It is made up of three trusts as well as an investment holding company.

The company's asset portfolio contains interests in the following:

• a conduit that connects natural gas reserves with industrial, commercial, and residential consumers
• a distribution network
• a distribution company

Additionally, Company #1 owns an interest in an energy utility that provides electricity distribution and transmission services to upwards of 500,000 customers, and a firm with distribution licenses for several gas distribution systems. This portfolio offers regulatory and geographic diversity with exposure to regulated assets across Australia and the United States.

There are a number of reasons to consider investing in energy utilities. Generally, these types of companies have established (sometimes even monopolistic) market positions, durable capital assets, established earnings and cash flows, and stable dividend yields. On the downside, yield-producing utilities may be negatively impacted in a high interest rate environment. We like this company because we believe the improving global economic environment will have a positive impact on the demand for electricity and gas transmission and distribution services. We are impressed with the company's strategic initiatives, as well as its strong cash balance, which is a positive for the company's future expansion plans.

The company's stock is currently down from its peak in June, 2007, although up from the low reached in March, 2009 (Google Finance, Feb, 2010). We believe this may be a good time to consider this company, with its share price at levels which are below its historic average, and currently offering an attractive yield.

Company #1: 6-Month Stock Chart

(Source: Bloomberg, Feb 2010)

Risks

Declining volumes of two of its segments could negatively impact overall revenue growth, as electricity distribution is one of the prime revenue contributors (40.4% in FY09). Further, rising interest rates in Australia could elevate the company's cost structure and negatively impact its ability to maintain its dividend distribution.

Company #2

Company #2 also deals in electricity transmission, electricity distribution, and gas distribution. Its networks provide the following services:

• Electricity transmission network – carries electricity from power stations to electricity distributors via high voltage towers and thousands of kilometres of transmission lines.
• Electricity distribution network – carries electricity from the high voltage transmission grid to over half a million customers.
• Gas distribution network – transports gas to more than 500,000 customers.

We expect a boost to revenue growth due to the company's focus on expanding its network infrastructure due to rising demand for electricity and natural gas. Furthermore, Company #2 will be rolling out smart meters and new initiatives in wind energy that could potentially support top-line growth.

While its stock has fallen from a 2007 peak, the company has a strong history and attractive dividend yield, and we believe it is on track for healthy improvement.

Company #2: 6-Month Stock Chart

(Source: Bloomberg, Feb 2010)

Risks

The primary risk for investors in this security is a substantial change to the regulatory environment. In particular, a change in the estimation of the cost of equity capital could change our view on the stock. Another risk is the possibility of management making value and/or yield dilutive investment decisions. Additionally, adverse weather conditions could impact demand. While high leverage has been a recent cause for concern, extensive hedging by companies may help mitigate the overall risk of indebtedness if the strategy proves correct. Given that the key value driver is the company's dividend yield relative to real interest rates, changes to the one-year forward 90-day bill rate and changes to dividend guidance will have a material impact on our target price. Litigation related to a disaster in the region may impact the company's bottom line in FY10. The electricity distribution segment's EBITDA growth has declined Y/Y in FY10:H1 due to related litigation costs.

ⁱ http://www.bloomberg.com/apps/news?pid=20601081&sid=a2m9sOZ_JwHQ
ⁱⁱ http://news.bbc.co.uk/2/hi/8458636.stm
ⁱⁱⁱ http://seekingalpha.com/article/165688-australia-wins-global-race-to-tighter-monetary-policy
^[i] http://www.business.nsw.gov.au/aboutnsw/climate/A11_govt_efficiency.htm
^iv http://www.rba.gov.au/
^v http://www.dfat.gov.au/publications/stats-pubs/cot_fy_2008_09.pdf
^vi http://www.dfat.gov.au/publications/stats-pubs/cot_fy_2008_09.pdf
^vii http://www.innovation.gov.au/Section/AboutDIISR/FactSheets/Pages/Australia%27sExportsFactSheet.aspx
^viii http://www.abareconomics.com/interactive/energyUPDATE09/

Investing in foreign securities involves additional risks specific to international investing, such as currency fluctuation and political risks. There can be no guarantees of success in pursuing any of the strategies we recommend, or that any of the specific companies will gain in value. Risks include an economic slowdown, or worse, which would adversely impact economic growth, profits, and investment flows; a terrorist attack; any developments impeding globalization (protectionism); and currency volatility/weakness. While every effort has been made to assure that the accuracy of the material contained in this report is correct, Euro Pacific cannot be held liable for errors, omissions or inaccuracies. Euro Pacific has not independently verified the information supplied by the company, and cannot make any representations as to its accuracy. This material is for private use of the subscriber; it may not be reprinted without permission. The opinions provided in these articles are not intended as individual investment advice.
© Euro Pacific Capital Inc. All rights reserved. 1-800-727-7922
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"The Federal Reserve continues to work actively to prepare for the possibility of financial stress." – Ben Bernanke, January 5, 2007

"[Monetary] policy during that period [2002-04]--though certainly accommodative--does not appear to have been inappropriate..." – Ben Bernanke, January 3, 2010

Does the Fed chairman Ben Bernanke know what he's doing? I have my doubts.

I've met personally with the Fed chief twice now, once in January, 2007, right after he became chairman, and in January, 2010 to assess the mindset of the world's most important financial leader.

In January, 2007, I attended a private luncheon where he spoke on "Central Banking and the Bank Supervision of the United States." After hearing his address, I wrote in my investment newsletter (Forecasts & Strategies, February, 2007):

"Anyone reading between the lines could understand that Bernanke is worried about a financial storm ahead..."

"In his speech, Bernanke used the terms "crisis," "panic," "threats," "stress" and similar words at least 36 times."

"Bernanke said that the Fed has set up a "crisis center" to handle potential global financial problems - to anticipate them, and to deal with them if they occur. What are the possibilities?

• A dollar crisis, like the one Paul Volcker suggested would happen in the next few years.
• A non-dollar currency crisis in Asia, Europe or Latin America (shades of the 1997 Asian currency crisis).
• A housing crash and foreclosure crisis.
• A major terrorist attack on a financial center, such as New York, London or Tokyo.
• A sharp rise in inflation."

I concluded: "I doubt if the Fed will cut rates again unless there is an imminent financial crisis of some sort that will require more liquidity and lower rates."

A year later, his fears became reality, and the financial panic of 2008 forced the Fed to cut rates to nearly zero, inject billions of new money into the system, and run to Congress for help.

Three years later, I approached Bernanke again, this time at a special session at the American Economic Association meetings in Atlanta, Georgia. He was there to give a lecture on "Monetary Policy and the Housing Bubble."

I introduced myself and showed him a copy of the talk he gave three years earlier (January, 2007) at the same AEA meetings.

Then I asked him pointblank: "Did you know in advance that a financial crisis was headed our way?"

He looked nervous and I could tell he was not happy about my question. He stared at me stoically and smiled. He refused to answer. I think he was worried about his job if he said, "Yes."

But there was no doubt in my mind what the correct answer was. He knew there was trouble brewing. As the Wall Street Journal states: "Mr. Bernanke was the intellectual architect of the decision to keep monetary policy exceptionally easy for far too long as the economy grew rapidly from 2003-2005. He imagined a "deflation" that never occurred, ignored the asset bubbles in commodities and housing, dismissed concerns about dollar weakness, and in the process stoked the credit mania that led to the financial panic." (WSJ, December 3, 2009, p. A22)

After our awkward confrontation, I sat down in the front row to listen to his new speech.

Now he was in denial. He rejected the common-sense notion that the Fed's low-interest rate policy in 2002-04 caused the housing bubble or the financial crisis. The housing boom was global, he said, and couldn't be blamed on US monetary policy.

Bernanke did take some responsibility for the lack of proper banking standards that led to the housing crisis. According to Bernanke, the Fed took steps to regulate the subprime mortgage market, but the new regs were "too little too late."

Afterwards, Bernanke took questions, and I asked the final question: "Mr. Bernanke, I see in your speech you talked about interest rates and the price of money, but you said nothing about the supply of money. Will you comment on the fact that the adjusted monetary base [the Fed's checking account] is now growing again at an 80% rate? Does that suggest you fear another financial crisis or credit crunch soon?"

His answer was measured. "No, the rise in the monetary base is due entirely to the Fed's recent purchase of mortgage securities that we agreed to buy."

Then, I had a follow up question: "I note that foreign central banks like Bank of India and Bank of China are now buying tons of gold. Is this a sign that foreigners are losing faith in the dollar-based world monetary system?"

Again, he had a "What, me worry?" response. "The world financial system is sound," he responded. He showed no worries about the consistently low value of the dollar on foreign exchange markets or the dramatic rise in the price of gold since he became chairman.

I came away from my meeting with Bernanke with the following lesson: Don't count on the Fed chairman or any other high government official to admit mistakes or tell us what is really going on.

As long as the Fed's Zero Interest Rate Policy (ZIRP) is in place, the dollar will remain weak, gold will rise, and foreign stocks will do better than US stocks.

Who should take the fall for the financial crisis?

If Ben Bernanke were the CEO of a major US corporation, he would be fired for such dereliction of duty. In 2007, he repeatedly assured Congress and the public that the Fed was alert to any economic problems that might arise. "To make crises less likely," he said in his 2007 AEA speech, "over the years the Federal Reserve has worked effectively with the Congress, other supervisors, and financial market participants to develop statutory, regulatory and other measures."

The Fed has worked "effectively" to prevent crises? Give me a break.

He also said: "With strong private-sector institutions and good public policies in place, episodes of ...financial stress should be relatively infrequent."

Clearly he and the Fed blundered... and the Fed chairman could pay the price. He should not be reappointed.

Mark Skousen and Forecasts & Strategies are not affiliated with Euro Pacific Capital, Inc.

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