The gloomy economic situation of Greece has been the topic of many Gold News
Monitors – we wrote recently about it here
and here,
but also in the
February Market Overview dedicated to European turmoil from the beginning of
this year. It is high time to analyze more thoroughly the relationship
between Greece’s debt crisis and gold. But first we must examine the
institutional foundations of the Eurozone and its currency, as they not only
did not prevent, but actually encouraged imprudent Greece’s fiscal policy,
which led to the current crisis.
The Eurozone consists of several independent governments and one common
central bank – a unique structure, since usually there is one government with
its own banking system. But why is it important? Well, normally when the
central bank monetizes government debt, the costs of the deficit monetization
are distributed among one nation, not several countries.
Oh yes, the direct monetization of governments deficit by the European
Central Bank (ECB) is prohibited by law (with exception of quantitative
easing, apparently). It does not matter, though, because the deficits are
monetized indirectly. The governments spend more than they receive in tax
revenues, so they typically issue government bonds, which are bought by the
commercial banks and eventually used by them as collateral for new loans from
the European Central Bank. The effect is practically the same: more government
spending, more sovereign debt… and more inflation, since banks are
purchasing public debts by creating new money thanks to operating under the
fractional reserve system.
Therefore, each Eurozone’s member can externalize part of the costs of its
deficit in the form of higher prices throughout the whole monetary union. The
crucial thing to understand is that the first users of the new money benefit
at the expense of the latecomers (economists call these Cantillon effects). In that way peripheral countries of
the Eurozone profit, because they have more money whilst prices have not yet
been bid up. In particular, the PIIGS
countries can import more goods and services from other Eurozone members,
where prices have not yet risen. The Eurozone allows for the financing of
import surpluses via money creation, so the peripheral countries do not have
to conduct structural reforms, but continue their excessive government
spending and remain uncompetitive.
Additionally, southern countries benefit from the implicit guarantee by
the fiscally sounder countries, like Germany. Therefore, when the Eurozone
was created, interest rates on their bonds converged to the level of Germany
because of the drop of the risk premium and inflation premium (the ECB was
expected to act like the prudent Bundesbank).
The construction of the Eurozone is a classic tragedy
of the commons. According to this economic theory, individuals acting
rationally and independently according to their own self-interest will
deplete a shared resource, even if it is contrary to the best interest of the
group. This theory is usually brought up when people discuss environmental
issues, e.g., in fishing, where the property rights are not well-defined or
defended. The oceans and seas are public; hence each fisher would try to
catch as many fish as possible, even if all the other fishers do the same
thing, resulting in depletion of the shared resource. However, the tragedy of
the commons also applies to monetary issues and the Eurozone’s construction
in particular. Therefore, as Phillip Bagus, the author of The Tragedy of
The Euro, explained, the tragedy of the euro is the incentive to incur
higher deficits faster than other member in order to make the whole euro
group carry the burden of the costs of irresponsible policies and profit from
the resulting redistribution.
Please notice that the Eurozone designers were completely aware of this
misconstruction and this is why they implemented The
Stability and Growth Pact, aimed to curb these flawed incentives. Not
surprisingly, the agreement failed, because Eurozone members were judges in
their own causes. Even Germany ran excessive deficits for some time.
Now, it should be clear that euro is a political project without much
economic sense, implemented to achieve more political integration and to
dethrone the hated conservative Bundesbank (according to Bagus, Germany
agreed to give up the Deutschmark in exchange for the approval of German
reunification after the fall of the Berlin wall). In its current shape it
cannot compete with gold or even the U.S. dollar. The euro is another fiat
currency, just like the greenback, but with a flawed, inflationary
institutional background. The tragedy of the euro makes the common currency
more prone to inflation and to collapse. Indeed, as you can see in the chart
no. 1, the pace of monetary inflation in the Eurozone was higher than in the
U.S. until the outbreak of global financial crisis.
Chart 1: Monetary inflation, measured by the M1 money supply annual growth
percentage rate, in Eurozone (green line) and U.S. (red line) between January
1999 and August 2008
Given the unstable nature of the Eurozone and its currency, the current
Greek debt crisis was inevitable. Either some countries will be bailed out,
or the euro will collapse. The uncertain future of the euro, the
second largest reserve currency and the currency of the second largest
economy in the world, is a fundamentally supportive factor for gold prices,
which should encourage buying gold as a safe-haven.
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Arkadiusz Sieron
Sunshine Profits‘ Gold News
Monitor and Market Overview Editor
Gold News Monitor
Gold Trading Alerts
Gold Market Overview
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