In shades of Mark Twain, history doesn’t repeat but sometimes it rhymes – and sometimes the rhyme has a twist. In that light, the “exploding debt dynamics” shoe could wind up on a Western foot this time.

A few weeks ago we revisited the concept of “exploding debt dynamics” – the IMF term for what happens when a country’s debt-to-GDP ratio spirals out of control.

In Part I of this revisitation we discussed the mind-boggling cost of the U.S. bailouts. TARP official Neil Barofsky’s $24 trillion price tag estimate was so outrageous, it could be cut down by a half or two-thirds or three-quarters and still be outrageous.

Then via two other pieces, “This Ain’t 1982” and “Continental Illinois and the Bailout Snowball,” we covered how all of these events are part and parcel of one giant cycle... a cycle that is still playing out.

For a quarter-century or more, total leverage levels and bailout costs marched skyward. And so, rather than quietly resetting the clock and heading back to 1982, we instead seem headed for a grand, explosive boom-bust finale of epic proportions.

Will another big bank bust mark the end of the cycle? The idea is certainly appealing. Take one of the lumbering giants (like, say, BAC or Citi) out into the back forty and shoot it in the back of the head... absorb one last wave of pain... and then off to the races again.

But your humble editor suspects that won’t be enough. This time, the volcano gods will not be appeased by such a tainted sacrifice. Something far bigger, far grander, feels in order.

As noted to Macro Trader members this week in shades of Mark Twain, “History does not repeat, but sometimes it rhymes.” And sometimes the rhyme comes with a surprise plot twist.

The twist we could see here – a possibility at least worth considering – is that the “exploding debt dynamics” shoe winds up on a Western foot.

Note that the original IMF term was all but invented for emerging market countries... basket-case nations where finances were a joke and the leaders simply couldn’t get a handle on things. From the historical perspective, EDD happens in places like Argentina or Mexico or Iceland. It could never happen to a filthy-rich Western power center. Or could it?

There is a certain compelling logic to the idea...

Basement Windows and Western Catharsis

Few would dispute that emerging market growth is set to be the “big story” of the 21st century. The long-term rise of 3 billion new capitalists, all seeking to emulate Western middle-class consumption levels, is a truly awesome thing to behold.

The emerging market case is also summed up in a cheeky saying: “You can’t commit suicide by jumping out a basement window.” Point being, many emerging markets are coming off such a low consumption base that spending and credit levels are guaranteed to rise. In countries like Brazil and India, hundreds of millions of hardworking poor are starting out so far down, the only direction they can go is up.

But there is a catch. Just as the emerging market outlook has taken on a healthy glow, the Western economic outlook has become pallid and sick. If emerging market countries are starting on the ground floor, rich Western nations occupy the opposite end of the spectrum. We peer down from the observation deck of a leverage-and-credit skyscraper. We have gorged on excess for decades... and now the wind whistles beneath our feet.

The Western world and the developing world are still linked by way of the classic customer-vendor relationship. Emerging market countries like China (especially China) cannot yet stand on their own two feet without the help of substantial export revenues. The Western consumer is still a lynchpin of emerging market growth.

One day this will change. Emerging market economies will stand tall and independent, free of deep Western trade linkage, once they have ginned up enough internal domestic demand.

We have not yet reached that point, though, regardless of Mr. Market’s giddy gyrations. Instead, the world is still dependent on Western spending – and still in need of catharsis.

According to Wikipedia, catharsis is “a Greek word meaning ‘purification’, ‘cleansing’ or ‘clarification.’” In reference to Wall Street and Washington – and London and Brussels too – those three things are exactly what we need.

Simply put, we have not seen true catharsis in the rotten Western financial system. Instead we have seen fudging, denial and delay, with hundreds of billions (if not trillions) thrown into ratholes. In multiple countries and on multiple continents, connected insiders have been content to feather their nests with bundles of taxpayer cash, while government dithers and the underlying reality just gets worse.

Fittingly, a good old-fashioned outbreak of exploding debt dynamics might be just what the world needs. An Argentina- or Iceland-style blowup, happening to an entire Western country this time, could be the catharsis instance that helps the global economy break free.

But What About Mr. Market?

Ah, but some will say, what about the bubbly optimism that is so hard to miss these days? Surely rising stock markets are a clear sign that the worst is behind us, not yet ahead of us? Surely we’ve gotten the all clear to bypass this “catharsis” you speak of, like the Monopoly card that says “Advance Directly to Go, Collect $200?”

With all due respect to Mr. Market... the man can sometimes be an idiot. This is born out through simple and repeated observations of market history. Again and again we have seen investors do their best Icarus imitation – soaring on the giddy wings of optimism, then plummeting like a stone as the wax case melts under reality’s withering gaze.

“The triumph of hope over experience” is practically an institutionalized phenomenon on Wall Street. But then, so too is the contrarian practice of exploiting the hell out of it when reality comes barging in. The crash of 1929, the crash of 1987, the Nikkei crash of 1990, the 1997 Asian contagion, the dot-com bubble and bust, the subprime meltdown... all these, and many others, were pegged in advance by men with foresight – many of whom made fortunes (or added to already sizable fortunes) in result. And now we are working through a run-up that bears uncanny resemblance to the first great hope jag post-1929 (which did not end well, as you might have guessed).

If “the market is always right,” then this recurring pattern of violently resolved extremes makes no sense. If markets are more irrational than rational, however – dominated by myopic vested interests with objectivity and common sense merely an afterthought – then the extremes make perfect sense.

As geopolitical intelligence analyst George Friedman noted earlier this month, “the perception on the part of financial people that the political shattering is reparable is one of the most amazing things to notice, until you look at history. Then you realize it takes a two by four to catch the attention of the markets... eventually the markets catch up.”

Next week, we’ll take a closer look at the leading Western candidates for the Big Kaboom.

Other Related Topics: China Investments , Emerging Markets , Justice Litle , Macro Trader

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