Editor’s note: Lombard Odier Darier Hentsch, the Swiss private bank, is bullish on gold and is negative on the equity market. In this economic commentary, the bank argues that instead of central banks trying to revive flagging markets with another round of money creation, governments should tackle the root of their problems – heavy debt. As ever, the views expressed are not necessarily shared by this publication.

Despite the widely acknowledged failure of QE2, we would not be surprised to see the Fed start another easing programme sooner rather than later, which we could probably label QE3. If this proves to be the case, it would in our view be another major mistake. With $1.7 trillion worth of excess reserves, a number that should normally sit in the area of $2 billion – and the subsequent capacity to generate $11 trillion of additional credit, the US economy is all but liquidity-constrained.

In addition, negative real rates prove that inflation expectations are largely high enough, and the Fed is not by any stretch facing a deflation threat. Therefore, QE3 is not the appropriate policy in this liquidity-flushed and non-deflationary environment. What is desperately needed here is a fundamental restructuring of the debt.

Total credit market debt in the US amounts to $53.5 trillion, which represents 354 per cent of gross domestic product – barely off its 380 per cent March 2009 peak. $11 trillion, or 20 per cent of this debt, is household mortgage debt.

The US household sector sits on $4 trillion of negative equity and – not surprisingly given the total absence of measures taken to address solvency issues – the situation has not improved since the depth of the financial crisis. In an economy where the consumer represents 72 per cent of GDP, such a deep negative household net equity value is a non-negotiable obstacle to economic growth. Whilst QE will only inflate asset prices temporarily and distort resource allocation without doing anything to solve the underlying debt issue, an “equitisation” of the debt would be one step toward a much needed sustainable de-leveraging to revive consumption, growth and employment.

Stabilising the US government debt/GDP ratio near the 100 per cent level would require permanent fiscal policy tightening of around 7 per cent of GDP, which would severely reduce current demand and – barring a compensatory measure to boost private sector demand – send the economy into the sort of unstable downward spiral we are currently seeing in many European countries. In these conditions, debt ratios actually rise and solvency concerns worsen -as shown in research by Alberto Alesina (Fiscal Adjustment: lessons from recent history, Harvard, April 2010), the decline in current government spending induced by fiscal tightening leads to a reduction in the expected future private tax liability, a reduction in default risk probability and a decline in the cost of capital, lifting private demand and reducing debt ratios, only when private agents can "bridge the gap" between lower current and higher future/permanent income through compensatory leverage.

Until the household sector is relieved of the crippling burden of current mortgage debt, it is inconceivable that this gap can be bridged, and measures to address government solvency simply make matters worse: the government is caught in a catch-22 situation. As for Europe, its basic problem is similar to that of the US. Spain, for example, is not much different from the US, and a similar debt/equity swap process is necessary to resolve the unbreakable cycle of tighter policy/slower growth/worsening solvency concerns.

However, in addition to structural solvency issues in most governments, European banks have little buffer in the (unfortunately likely) event of sovereign losses or even defaults. Recapitalisation of European banks seems inevitable under any reasonable policy response.

With our recession “wind-sock” indicating a high probability that the US is in recession, and with the solvency of many (mainly but not exclusively European) governments in question, added to the implementation of failed liquidity policies instead of active solvency policies, we will remain defensive.

In order for our outlook on equity market returns to improve, we would need some tiny hint that the massive overhang of private debt, so far shielded from restructuring pressure by the creeping insolvency of sovereign debt, is going to be restructured. In the meantime, we keep our underweight in equities, overweight in gold, and exposure to long-duration government bonds.