Greece Is Just the First to Default

Philip Coggan, aka Buttonwood, writes the financial markets column of The Economist in London. His new book, Paper Promises: Debt, Money, and the New World Order, released in the U.S. on Monday, is a sweeping examination of the relationship between debt and money since antiquity. By the same token, it's an enigma machine for deciphering the rules for investing in the post-crisis world -- rules not even the most stubborn stock picker can afford to ignore. In today's conclusion to this two-part interview series (Part 1 is here), Buttonwood discusses the likely outcome of Europe's debt crisis and whether gold is a suitable choice for investors -- or nation-states.

There is no better illustration today of the tight link between debt and money than Europe's sovereign debt crisis, which threatens the very integrity of the single currency binding 17 European nation-states. I asked Buttonwood for his base case for the way in which the crisis will play out. In a few sentences, he painted a stark scenario:

There is no way that Europe can grow out of its debt crisis given its demography. So the three options are: inflate, stagnate and default. (The second option will be followed by the third eventually.) Greece is already defaulting, although they are trying to call it something else. After that deal is pushed through, the EU will attempt to muddle through with a grand bargain, being support from the northern European nations for the south in return for pledges of austerity and reform. But the voters will not put up with prolonged austerity and will eventually force default.

Hard money advocates -- gold enthusiasts, in particular -- see the European crisis as just one more example of a fiat currency that is doomed to extinction.

The broader question is whether we should go back to a gold standard. While some people point out that all previous paper money systems have collapsed, I would counter that all metallic standards have been abandoned. That is because democracies find it too difficult to keep the value of money fixed and adjust all other prices and wages, not least because debts tend to be fixed in nominal terms.

If nations are unwilling to adopt gold as a currency, is it wise for their citizens to own it to protect their wealth against government actions?

Gold is fixed in supply. So there is some rationality in owning it when the world's central banks are trying to expand the volume of paper/electronic money. But there are other hedges against inflation such as property and index-linked bonds. The civil breakdown/end of the world argument seems unconvincing since in those circumstances you need food, oil and guns to guard them, rather than a metal.

What of the possibility that gold has gone from cheap hedge to asset bubble, in which case it has become a sound vehicle to destroy wealth rather than preserve it?

Is gold a bubble? It is awfully hard to value since it has no yield or earnings. It has risen remarkably in the last 10 years although, of course, to some extent that is remedying a 20-year period when it went backwards. Relative to oil, it is slightly below the long-term average (see this article for a long-term chart.) The main reason to worry about it, I think, is that it has reached the level of popular interest, with adverts to buy and sell gold on TV and the gold exchange traded fund becoming one of the largest holders on the planet. There is thus scope for quite a big fall if fashion changes.

Buttonwood's not wrong: In the 10-year period through last Wednesday, gold has achieved an inflation-adjusted annualized return of 16.3%. That's better than U.S. large-cap stocks' performance in the 1990s (S&P 500 Total Return: 14.8% per year). To be sure, gold still has some room to run before it equals the numbers put up by technology stocks in the 1990s, Japanese shares in the 1980s... or gold in the 1970s. Nevertheless, for those who own the metal -- whether in bullion or through exchange-traded funds such as the SPDR Gold Shares (NYSE: GLD  ) , the iShares Gold Trust (NYSE: IAU  ) or the Central Fund of Canada (AMEX: CEF  ) -- that 10-year return figure is a red flag.

While gold may not be the right hedge, it's clear that investors should be mindful of the long-term risk of inflation resulting from the Fed's policy actions. That represents an extraordinary reversal from earlier times, for as Buttonwood mused in closing the interview:

Central bankers were once fierce guardians of the currency, believing that the money supply should be controlled and the currency fixed. Now they compete to let their currencies depreciate; the countries with floating exchange rates (America, Britain) have lower bond yields than those with fixed. In the Second World War, the Germans printed fake pound notes and dropped them in Britain as a way of sabotaging the British economy; now expanding the money supply is seen as the way to save it.

A different way to capitalize on gold's price strength is owning This Tiny Gold Stock Digging Up Massive Profits.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 15, 2012, at 4:57 PM, litewave wrote:

    I read a tiny article in our local newspaper, tucked in by the obit's, that Romania already defaulted, that is, their little economy went belly up.

  • Report this Comment On February 15, 2012, at 8:15 PM, TMFAleph1 wrote:

    @litewave

    I have seen nothing to that effect. Do you have a source?

  • Report this Comment On February 16, 2012, at 9:35 AM, TMFGortok wrote:

    "While some people point out that all previous paper money systems have collapsed, I would counter that all metallic standards have been abandoned. That is because democracies find it too difficult to keep the value of money fixed and adjust all other prices and wages, not least because debts tend to be fixed in nominal terms."

    Put another way, when the government wants to spend money and people aren't willing to be taxed for it, it needs a way to do so without committing political suicide (by raising taxes). So it simply prints the money. The Federal Reserve is an engine for this.

    "Democracy is two wolves and a lamb voting on what to have for lunch. Liberty is a well-armed lamb contesting the vote." -- Benjamin Franklin

    In this case, the government has decided to abandon the gold standard. FDR did it by confiscating all Americans' gold (an act of brazen theft). Nixon did it by removing the last vestiges of a gold standard by declaring, "We're all Keynesians now." and closing the gold window (Although I wouldn't suggest going back to the Bretton Woods system, it's worth noting it was a little better than what we have now).

    We're a constitutional republic, and Congress is not authorized by the constitution to enact legal tender laws.

    Our founders understood the fact that a fiat currency ultimately fails, even if those in power get a short term pass. In the long run, someone has to pay the price.

    To put another way: If men were angels, we'd have no need of a Constitution to limit the actions of Government. The fact that all metallic standards have been abandoned is simply proof that men are not angels.

  • Report this Comment On February 16, 2012, at 10:44 AM, DJDynamicNC wrote:

    If men were angels, we'd have no need of a government to limit the actions of men.

  • Report this Comment On February 16, 2012, at 11:57 AM, TMFGortok wrote:

    @DJ There's a fundamental difference in our views:

    A government is not meant to 'limit the actions of men', it is mean to preserve the rights of its citizens (including their life, liberty, and property rights). This means that it enforces contracts, enforces laws that would take away any of these rights (by enacting laws against murder, robbery, assault, etc). It does not exist to limit what its citizens can do, rather to protect those citizens when someone wants to take away their natural rights. There's a subtle but important difference there.

  • Report this Comment On February 16, 2012, at 1:56 PM, portefeuille wrote:

    European 19 nation-states

    -------------

    The eurozone is an economic and monetary union (EMU) of 17 European Union (EU) member states that have adopted the euro (€) as their common currency and sole legal tender.

    -------------

    from here -> http://en.wikipedia.org/wiki/Eurozone.

    also see -> http://www.ecb.int/euro/intro/html/map.en.html.

  • Report this Comment On February 16, 2012, at 2:14 PM, TMFAleph1 wrote:

    <<Actually gold's ten-year run IS NOT a red flag. The US Monetary policy has not been as i9rresponsibly expansive as it has been under Uncle Ben Bernanke.>>

    This argument is inapplicable to inflation-adjusted returns.

  • Report this Comment On February 16, 2012, at 2:21 PM, TMFAleph1 wrote:

    @portefeuille

    You're quite right -- the Eurozone contains only 17 countries. I'll get that corrected.

  • Report this Comment On February 16, 2012, at 2:22 PM, ejclason2 wrote:

    The gold standard does not always prevent inflation. In the 16th century, Spain was on the gold standard, but it had terrible inflation because of all the gold coming from the new world.

  • Report this Comment On February 16, 2012, at 3:34 PM, hwq1776a wrote:

    >>

    If men were angels, we'd have no need of a government to limit the actions of men.

    <<

    The bill of rights apply to the governed, not the federal government. The only thing the constitution restricts is the actions of federal government.

  • Report this Comment On February 16, 2012, at 4:03 PM, DJDynamicNC wrote:

    @TMFGortok - I think you're splitting some pretty serious semantic hairs here.

    You said: --->"A government is not meant to 'limit the actions of men', it is mean to preserve the rights of its citizens (including their life, liberty, and property rights). This means that it enforces contracts, enforces laws that would take away any of these rights (by enacting laws against murder, robbery, assault, etc). It does not exist to limit what its citizens can do, rather to protect those citizens when someone wants to take away their natural rights. There's a subtle but important difference there."<---

    To summarize - a government's role is not to limit actions, it is to protect the rights of citizens by limiting the actions others can impose upon them.

    I'm not certain how you decided that limiting some behaviors is bad because it's limiting behaviors, but limiting other behaviors is good because it is "protecting rights" and doesn't count as limiting behaviors, but that's what you've done.

    For example - murder is not allowed. That behavior, therefore, is limited. In fact, expressly limited by the government - a limitation we all regard as proper for ethical reasons as well as economic ones, but a limitation nonetheless.

    I'm not sure how that doesn't count as limiting actions.

  • Report this Comment On February 16, 2012, at 4:05 PM, DJDynamicNC wrote:

    @hwq - the Constitution also empowers Congress to pass laws and regulations, and the Executive branch to enforce them.

    It's a little hard to get around that part.

  • Report this Comment On February 16, 2012, at 5:06 PM, TMFGortok wrote:

    @DJ I don't want to derail this thread (any more than it has been), but there is a difference. Maybe it'll help if I reword it:

    Government ought not limit the [legal] actions of men.

    Legal here meaning in keeping with Natural Law, not positive law.

    Government physically can do whatever it likes (which only makes me wonder why people think it's a good idea to give government any leeway whatsoever), but even though it can do something, it is bound (if it is just) by Natural Law to only do those things that protect natural rights, and to do nothing against Natural Law.

  • Report this Comment On February 25, 2012, at 2:21 AM, Rocketbubble wrote:

    A quick thought that, maybe, some other people have thoughts on... With the bailout of greece and their private investors bringing 130 billion, does it seem likely that businesses are attempting to effectively buy the country, help restore it quickly bringing other default countries to the table to let private investors by their own debt and slowly allow companies to own various countries in more than just a mumbled and grumbled about way. It seems to me that this is a turning point where countries will soon turn into a blade runner type society as the companies will be the only entities with the real capital to pull them out of debt. It would allow for open manipulation of wages, import export, and other facets where they couldn't be accurately regulated or even have to follow the accepted relations between two countries doing business.

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