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Kass: The Sword of Damocles

This commentary originally appeared on Real Money Pro on Nov. 28 at 8:27 a.m. EST.

The eurozone's economic union and banking system, a house built on pillars of sand -- that is, too much sovereign debt, reckless leverage and unmarked-to-market accounting by the banking industry -- are now in jeopardy.

Given the disparate economic, political and legal interests in the E.U., the regimes of some monarchs and prime ministers have been toppled, but the heavy policy lifting lies ahead.

The lesson learned in the American economic crisis and Great Decession of 2008-2009 and now in the eurozone crisis of 2011-???? is that debt cannot grow beyond the ability to service it.

A period of subpar economic growth is the best outcome for the eurozone. At worst, the European economies' downturn will be far deeper, bank credit will be restrained, the euro could vanish, currency and trade wars might erupt, and the European banking system could collapse -- or a combination of these factors could occur.

The only practical solution in Europe appears to be going the route of the U.S. and our Fed three years ago and embarking upon its own brand of massive European-style quantitative easing.

-- Doug Kass, " Easing Won't Be Easy in Europe"

Over the past several months, investors have lived in constant fear as the eurozone's debt crisis hangs over the world's risk markets like the sword of Damocles.

In the tale, Dionysius II of Syracuse offers to exchange places with one of his courtiers, Damocles. Cicero utilizes the title object, which Dionysius II has hung over Damocles' temporary throne, to convey a sense of the constant fear in which (the great) man lives. The theme -- or moral, if you will -- being that virtue is sufficient for living a happy life.

I have long suggested that the fragile, uneven and still not self-sustaining (incapable of independent or unassisted growth without the support of fiscal and monetary encouragement) domestic economic recovery was exposed to exogenous shocks.

And the eurozone's growing contagion and confidence loss is the sort of external shock that has the potential to jeopardize the U.S. recovery if it leads to more restrictive credit conditions.

The eurozone's debt crisis has already upset the U.S. stock market despite continued evidence that our economic recovery is improving moderately and that the muddle-through baseline case remains a reasonable expectation.

Few expected such a rapid deterioration in credit conditions that occurred in the last month: I was blindsided, as I certainly didn't see the loss of confidence (and rise in sovereign debt yields) happening with such swiftness.

Rather, my recently expressed rising market optimism emphasizes and reflects the improving body of evidence and increasing probability that the rate of growth in the domestic economic recovery was about to reaccelerate. Many of those critical of that more sanguine economic view have typically cited ECRI's statistics, which were flashing recession and at odds with my view that domestic growth was reaccelerating in a muddle through backdrop.

Though the eurozone's escalating debt crisis has squashed the markets, thus far my view of a slowly improving domestic economy not moving toward a double-dip has been materially correct. Lakshman Achuthan's well-regarded ECRI Indicator, which signaled recession 45 days ago, has actually turned up in each of the last three weeks, and numerous other high-frequency economic data points (e.g., LEI, regional PMIs, confidence surveys, existing-home sales, jobless claims, income growth, retail sales) point to a continued, though moderate, path of economic growth.
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