A generation of reckless debt accumulation has left us at a diffi cult crossroads. Markets have grown entirely dependent upon an extraordinary degree of government stimulus to remain afloat. But that stimulus is not without cost and is ulti- mately dependent on investor confidence and willingness tofinance careless spending. History suggests that there is a limit to such defi cit spending and the cost of abusing this privilege will end tragically. As a percentage of total global defaults, sovereign debt defaults remain at a generationally low level. That can change, especially when one considers the record amount of sovereign debt issuance by governments in mature economies. Indeed, the database compiled by economists Carmen M. Reinhart and Kenneth Rogoff spanning eight centuries of government debt and default, suggest as much.

It took time for investors to realize the magnitude of the mortgage meltdown and ensuing credit crisis. As late as 2007, Fed Chairman Ben Bernanke assured investors that the subprime problem was “contained.” One year later in 2008, Lehman Brother’s CEO Dick Fuld blamed ruthless short-sellers for the collapse of Lehman’s stock and confi rmed the strength of the company’s balance sheet just days beforefi ling for bankruptcy. So excuse us if we are tempted to chuckle when

George Papandreou, Greece’s Socialist prime minister, blames “speculators” for the “unprecedented attack” resulting in the strangulation of the Greek economy,” does not leave us par- ticularly confi dent. Neither does Joaquin Almunia’s assurance (EU Commissioner for Economic and Monetary Affairs) that, “There is no bailout problem. In the euro area, default does not exist.” In fact, we’d politely suggest that Mr. Almunnia consult his history records – our count has European nations defaulting on their debt a stunning 73 times since 1800, with Greece in default more than 50% of the time!

crisis. Butfi nancial rescue packages come with diffi cultfi scal demands at a time when Greece is already facing a backlash from unions and civil servants. Importantly, any assistance must be signifi cant in size, as well as quick and effi cient in or- der to prove successful. Unfortunately, history suggests poli- cymakers will miss at least one of these targets atfirst blush and initial attempts will likely prove too little, too late. We consider the EU’s ringing endorsement of Greece’sfi scal plan as strike one. Strike two will likely be an insuffi cient response aimed at calming investors’ nerves and reducing volatility.

Any subsequent market reaction would thus be short term in nature, ultimately leading to increased risk of contagion as sovereign balance sheets become a growing theme across the globe. Let’s briefl y review a few of the other usual suspects across the investment landscape.

The Maastricht Treaty, which laid the foundation for the creation of the Euro, states that no country within the EU shall have an annual budget defi cit in excess of 3% of GDP to ensure that the region’s strength is not undermined by a member nation’s excessive spending. A great concept in theory, however, execution has proved more diffi cult in practice, as shown below. Every one of these PIIGS (the acronym Wall Street has lovingly granted to Portugal, Italy, Ireland, Greece and Spain) has blown right through this spending limit, resulting in ballooning defi cits and excessive levels of debt.

In our opinion, Spain poses an even greater threat to the strength of the Eurozone and the Euro given the country’s much larger economy, much larger housing bubble, and much greater levels of leverage than most of the developed world. Spain is still wrestling with the collapse of a decade-long housing boom that has hurled the broader economy into a deep recession, sent tax revenues plummeting and social wel- fare costs soaring. Spanish housing indices reached greater heights than most other global housing bubbles, yet have declined only single digits from their peak. The bubble looks even more extreme when viewed as a ratio to rent, where The Economist puts the market 55% above fair value.

Capital Economics warns that the share of state debt maturing this year is even higher in Spain (17%) than in Greece (12%), heightening the Spanish government’s sense of urgency. While Debt/GDP levels do not appear as stretched here as some of the neighboring piglets, it doesn’t take a stretch of the imagination to see Spanish debt ratios climbing steadily higher as the government is again forced to come to the rescue of still-overleveragedfi nancial institutions facing additional losses from still-overvalued housing markets. Oddly enough, Spanish Development Minister Jose Blanco, is on the tape as we write this, label- ing the current downward pressure on the Euro and on their sovereign debt as a conspiracy or attack. What’s that smell, you ask? There ap- pears to be a whiff of contagion in the air. Or perhaps it’s just Club Med’s version of the Tequila Crisis – The Paella Panic!! Gluskin Sheff economist David Rosenberg summarizes the risk quite succinctly:

“The bottom line is that even if thefiscally-challenged countries of Europe do not end up defaulting, or leaving the Union, the reality is that they will have to take draconian measures to meet theirfi nancial obligations. Devaluation was the answer in the past in Greece but it cannot rely on that quickfix this time around without leaving EMU and if it did, then that could make it even harder to service its Euro-denominated debts — at least not without a restructuring. And, if Greece did attempt at a debt restructuring, rest assured that Italy, Spain, Portugal and Ireland would be next — we are talking about a combined $2 trillion of potential sovereign debt restructuring that would more than triple the $600 billion direct cost of the Lehman bankruptcy.”

Beyond the PIIG pen, Britain is at risk of becoming an “earlier adopter” of sovereign debt crises within the G7. Standard & Poor’s placed the UK’s triple-A credit rating on negative outlook last year, adding that a downgrade could follow if a credible debt- reduction plan wasn’t put in place. The world’s largest bond manager, PIMCO, has been somewhat more direct, putting the odds of a downgrade at 80% based on the country’s debt tra- jectory and inability to adjust. This “inability to adjust” is best showcased by the Brit’s “inability to budget” – amazingly, the UK even failed to put aside money in the fat years. It ran a