May 14, 2010

Meanwhile, gold is rising ...

Will the euro bailout work? No, the bailout has slowed the euro’s slip, but it hasn’t solved the problem. That’s what the gold market seems to think, in fact the price of gold is rising against every major currency, not just the embattled euro. This, according to Royal Bank of Scotland foreign exchange strategist Greg Gibbs, is because the market sees the true scale of the sovereign risk problem, the solution and fallout:

If the market won’t buy the government bonds, the central banks have to. There is no other choice. The alternative is just too damaging for the economy to contemplate. If the central banks don’t buy the debt, then governments are forced into a budget surplus (a surplus is required to cover interest payments on existing debt). Imagine the carnage if major economies were forced from double digit deficits to surplus, you are talking Great Depression type scenario or worse.

Even getting close to that outcome is too bad to consider, so when borrowing costs start to rise, as they did recently in the Eurozone periphery, making borrowing difficult, the contagion spreads to equities and global asset markets. This forced the Eurozone governments to promise to throw money at the problem. The US$ 1 trillion bailout package only has some credibility because it involves core countries and the IMF which still have relatively low borrowing costs. However, the package would have little bite if the ECB were not involved. The ECB’s purchase of government bonds (monetization) is critical. It is the most credible source of funds since it creates the money.

It is undoubtedly true that the actions of the ECB this week make it clearer than ever what the real threat of the sovereign debt problem globally is. All countries, not just the Eurozone, when push comes to shove, when bond yields start to rise because of sovereign default risks, will force their central banks to buy the bonds (monetize). You can talk all you like about sterilization, but when the central bank is forced into this path, you can be sure they will not be raising cash rates. They will aim for negative real rates, and until the fiscal house is put back into order, they will aim for nominal GDP growth. Whether this arises from higher inflation or real growth will be of second order importance.

Even though inflation is yet to break out, the price of gold is telling us that this threat is very real over the longer term. People rightly so do not trust fiat money anymore.

Via Chicago Blog.

1 comment:

  1. It could also be maintained that had credit been virtually free in Europe as it has been in the USA and even in Great Britain during the crisis, things wouldn't have become quite so bad in the euro zone.
    For the last four years the euro has been over-valued by pumped up interest rates in order to 'render it credible' and, one also suspects, to promote it as an international alternative to the dollar. This Bundesbank economic policy seems to have caused more harm than good, certainly regarding the European stock-exchanges and the State members whose relied on exports have continually suffered as a result, even before the crisis really set in.
    What measures were taken during the crisis by the ECB were too late and insufficient. The euro zone will be the last continent to painfully drag itself out of the crisis, and it's certainly not there yet.

    Ironically it was/is the Greek disaster with other issues that's finally dragging the value of the euro down to its true level. If it's impossible to cure the debt disease by making it even worse, at least the real, even belated, value of the euro, will be better than nothing (provided the ECB refrain from raising the interest rates again).