The situation in Europe is getting worse than ever but stock markets around the world are shrugging this off. The debt super-cycle has reached a point in Europe where there are no good solutions. Austerity measures to cut budget deficits will back fire because they will cause the European economy and tax revenues to fall faster than the savings that they produce. Allowing countries to default on their debt will ripple through the European banking system and cause banks which are already teetering on the edge of insolvency to go bust. Devaluation or essentially default by inflation also does not work because of the common currency. Sure it will make all of Europe more competitive against the rest of the world but glaring trade imbalances internally will remain as German exports will get cheaper to the same degree as exports from the periphery. They only way to adjust these imbalances with a common currency is for laborers in the periphery to take massive pay cuts (like this will ever happen voluntarily.)

Soon Greece will be front page news again as they try to persuade hedge funds and other private investors to take a “voluntary” 50% hair cut to avoid triggering credit default swaps. If you are a hedge fund manager, why would you ever voluntarily agree to do this? You can hold out and if everyone else agrees to take a hair cut Greece will be in a better position to pay you and you will make out like a bandit, getting paid at par. If nobody else agrees to the hair cuts, Greece will default and trigger the credit default swaps that you bought (you did buy CDS didn’t you) and you will get paid at par. The alternative is that you are the whipping boy and you “voluntarily” take a haircut while the ECB, IMF and other favored entities are paid off at par and end up laughing all the way to the bank.

So with all of this going on: how do Greece and the rest of Europe avoid a financial implosion?

You really owe it to yourself to read the full piece by John Mauldin.