June 1, 2010

Inching closer to the end of fiat money

The near one-trillion dollar package announced by the European Union brought animal spirits back to financial markets only temporarily. US stocks surged massively in the aftermath of the rescue package. India’s Sensex index zoomed more than 500 points and the US 10-year Treasury yield went back up. Investors judged that the risk of a  European and global meltdown had passed. They took comfort too easily. But, that has become familiar to us in the last decade or so. One day, they may learn to look under the hood.

The reasonable questions to ask the European Union are: who would pay for this bailout, how and why. The Maastricht criteria for Eurozone deficit is 3 percent of GDP. Currently, the average for the Eurozone is above 6 percent. Even Germany runs a budget deficit of around 5 percent of GDP. Most European societies are ageing—some more rapidly than others. In this context, it makes sense to ask about the sustainability of the bailout package that has been announced.

Such questions, however, are avoided as the market focuses on the size of the bailout and commentators are satisfied harking back to clichéd expressions such as ‘shock and awe’.

EU buys time for crisis countries. Will they use it?
Barry Eichengreen, professor at University of California at Berkeley, is correct to state that this bailout buys time for the EU governments. But the question is whether the time will be used to do the right thing in the right magnitude. If recent history is any guide, the omens are not encouraging. The financial industry has not done much to put  compensation practices under the microscope. It has not supported reforms to separate proprietary trading from its financial intermediation activities. Furthermore, it has resisted attempts to raise capital adequacy requirements and has sought to scuttle the formation of a consumer protection agency in the United States.

Before the EU-wide bailout package was announced, Arvind Subramanian, senior fellow at the Peterson Institute for International Economics, wrote that the bailout package for Greece did not involve any restructuring of the debt currently held mostly by European banks. However, if the Eurozone governments have decided that banks would take haircuts on the Eurozone sovereign debt that they own, then banks would be queuing up for additional bailouts. We would be back at the starting point.

In any event, Mr Subramanian need not have worried for if Kenneth Rogoff, professor of economics at Harvard University is right, debt restructuring is inevitable. If the kind of deficit reduction that is now expected of the southern European nations is achieved, it would cause considerable economic and social pain. It is doubtful if these countries would stay the course in the face of a social backlash. Debt restructuring would be back on the agenda.

So, Europe will have bought time just for the sake of it and not to do the right thing.

The ECB’s credibility takes a beating
The challenge is to determine how long this would last. In the meantime, given the unprecedented co-opting of the European Central Bank (ECB) into this bailout process, the future trajectory of the euro-dollar exchange rate is now up for discussion. The ECB had offered to buy in the secondary market both sovereign and private debt securities without regard to any credit rating of the bonds in question. This is the co-opting of monetary policy authorities into the fiscal policy domain.

The ECB has said that it would sterilise its bond purchases. That does not sound very convincing because peripheral Europe does need monetary policy to support growth via low interest rates. Hence, in the Eurozone and in the Unite States, interest rates would remain exceptionally low for an extended period. The Bank of England too had signalled its intent to stay on hold by pointing to growth and inflation risks on the downside. The eventual debasement of all paper currencies is unfolding.

Short-term positive for Asia
In the meantime, the decline in commodity prices—if sustained—would be good news for Asia. Most of Asia
imports commodities. Countries to benefit would include India, South Korea, Thailand and Singapore. Of course, crude oil contracts are rebounding, as are copper and aluminium forwards. Yet, the international price of the West Texas Intermediate crude oil is down by more than 20 percent from early May. The Indian crude oil basket fell from $87.37 per barrel on May 3rd, to just over $74 per barrel by May 19th, a drop of nearly 15 percent.

At the same time, it is also likely that capital inflows into Asia would surge if the developed world continues with its bailout policies. At some stage, Asian governments have to either let their currencies rise significantly, put up gates and walls, or use a combination of the two. That drama awaits screening.

However, in the near-term, the crisis is beneficial for Asia for it places in perspective the cyclical problems that the region is facing compared to the intractable structural problems that Europe (including the United Kingdom) and the United States face.

Whither fiat money?
At this time, the world economy must avoid both overheating and deflationary slump. But the use of ‘overwhelming force’ and ‘shock and awe’ risk plunging the world precisely into one of those two risks—overheating. The more the market lurches from one extreme to another from one week to next, the more difficult it becomes for policymakers to undertake structural and painful reforms—assuming they are inclined to in the first place.

That is why it was both surprising and unsurprising to see the movement in gold prices as the European turmoil unfolded and then retreated. Earlier, gold used to rally on easy liquidity. After the announcement of the EU bailout package, as risk assets rallied, the price of gold retreated. It means that gold, the risk-insurance, has arrived. In this framework, gold prices would rise and fall as risk appetite wanes and waxes, respectively.

It is surprising at another level because investors are not reading much beyond the immediate impact of the extraordinary measures coming from Europe. If anything, they should be asking questions of the package of measures and loading up even more on gold since each massive bailout package takes us closer to the eventual and inevitable end of the fiat-money world.

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