Saturday, October 09, 2010

Monetary Mess, the Dollar, Gold--and You, Part I

For years the Greek government has been spending beyond its means and borrowing to make up the difference. Just like the U.S. government. There is, however, an important difference. The U.S. dollar is the world's reserve currency, meaning the U.S. is the only country in the world that can pay back its borrowings by simply printing more of its own money.

Greece does not have that option. It can no longer manipulate (inflate) its own currency, as the U.S. does. Greece and other members of the euro zone now share a common currency whose supply is determined by the European Central Bank (ECB), which has a single mandate: to preserve the value of its currency, the euro. Membership in this monetary pact requires the individual countries to limit their budget deficits to 3 percent of gross domestic product and their government debt-to-GDP ratio to 60 percent.

Having a common standard of value has certainly benefited commerce among member countries. It eliminated the necessity and inefficiencies of constant exchanges of fluctuating currencies. It also was seen as promoting monetary stability by inhibiting profligate public spending by individual countries, financed by inflation, which historically led to great volatility among European currencies. In addition, it was seen as an alternative to the dollar, whose usefulness as a store of value was declining with a decades-long trend of increased U.S. government spending.

The Greek financial crisis arose when the government increased its initial estimated 2009 budget deficit of 3.7 percent of GDP to 12.7 percent, with the debt-to-GDP ratio going to 113.4 percent. Even the earlier 3.7 estimate failed the euro zone requirement, but this was ignored because Greece was above 3 percent every year except 2006, and several other countries had sometimes been above the 3 percent limit. But Greece's latest figures were shocking, leaving bond investors worried the country couldn't pay them off. The pact among the euro countries was supposed to prevent a single free-spending country from undermining the common currency, but that now seemed to be happening. Since Greece could not inflate its way out of debt, the alternative proposed was economic reform to significantly reduce the deficit by cutting spending, increasing taxes, and freeing up the economy. Many doubted that could or would be done under Prime Minister George Papandreou's Socialist Party government. Argentina, in a similar predicament in 2000, tried a fiscal austerity program similar to that proposed for Greece but ultimately defaulted in 2001. As a result, Argentine bond holders lost 70 percent of their money, according to Moody's Investors Service.

Mr. Papandreou warned that his country risked bankruptcy if it could not find lenders to cover its massive 300 euro ($411 billion) debt. “Every year, we have to borrow about half of what we spend,” he said. “And every year we spend more, and every year we collect less as a percentage of GDP.” In other words, the country has been piling more debt on top of debt by spending more than it is taking in. The interest rate it must pay to borrow is higher than the economy's growth rate, and the interest rate rises as the likelihood of debt default increases. The government projects its total debt will rise from its current 113.4 percent of GDP to 123 percent by the end of the 2010 and reach 148 percent in 2013.

If Greece were to fail, that might well spell the end of the euro. Germany's Finance Minister Wolfgang Schauble stated: “We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers.” French president Sarkozy said, “We cannot let a country fall that is in the euro zone. Otherwise, there was no point in creating the euro.”

But there is great fear that a Greek bailout will lead to other countries demanding similar rescue from similar monetary sins, which will further undermine the value of the euro. On May 3, 2010, a week after Standard & Poor's cut the Greek bond rating to “junk” status, European Central Bank president Jean-Claude Trichet said the the bank would accept as collateral any current or future Greek government bonds regardless of how much the rating companies downgraded them. Trichet had explicitly stated only a few days earlier that this would not be done; the ECB's rule had been to accept only bonds above a certain minimum rating. The new looser policy was widely interpreted as evidence of inflationary danger, detrimental to ECB's credibility and its mandate to preserve the value of the euro. In recent years the euro had strengthened against the dollar because of U.S. deficit spending, but the Greek crisis from the very start undermined confidence in the euro, whose value declined steadily since.

The problem is that there is no enforcement mechanism to ensure compliance with euro limits on budget deficits and debt-to-GDP ratio. When Helmut Kohl was the German chancellor, he wanted stiff fines for violators. That idea was rejected because it would have made the euro treaty a tough sell to European nations whose membership was regarded as essential for success of the new currency.

To save the euro now, it was deemed necessary to prevent Greek bankruptcy. German Chancellor Angela Merkel and French President Nicolas Sarkozy took the lead in arranging a bailout to save Greece from defaulting on its bonds, thus buying time for Greece to achieve the reforms necessary for economic recovery.

Governments, banks, hedge funds, and other investors use credit-default swaps to protect themselves against the risks of default on sovereign bonds such as Greece's. These insurance-like contracts pay out if the bond issuer defaults. Their prices rise when credit worthiness deteriorates. These markets work because other investors and speculators are willing to assume the risks involved, in return for possible gains, by taking the opposite position in the swaps from those seeking protection. The market in swaps and related financial derivatives is due largely to the monetary instability created by irresponsible government policies. As a result, vast sums of money are diverted to betting on future monetary policy or exchange-rate movements.

France's giant 116-year old bank Credit Agricole SA bought swap insurance against bond defaults by Greece, Italy and Germany. Spain's Banco Santander protected itself against British, German and French government bonds. Barclays bank hedged its exposure to Italy, France, Greece, Germany and Portugal. Goldman Sachs was also a credit default swaps buyer.

As of June 2008, the notional amounts (stipulated principals) of financial derivatives, according to the Bank for International Settlements, totaled $684 trillion—over 12 times the world's nominal gross domestic product! These derivatives included credit default swaps, options, forward-rate agreements, and foreign exchange contracts. All of these make it possible to bet on future monetary policy and exchange rates. And three-quarters of this massive derivatives market, “which has wreaked the most havoc across global financial markets,” says economist Judy Sheldon, “derives from the capricious monetary policies of central banks and the chaotic movement of currencies.”

On April 8, 2010 the Wall Street Journal noted, “Several years ago, when few ever imagined a European Union member could face a default risk, insurance on Greek bonds was dirt cheap—a mere $7,000 a year to insure $10 million of Greek debt for five years.” The cost reached $124,000 at the start of October 2009. Four months later it reached $425,000, compared to just $13,405 to insure $10 million of German bonds for the same period. In April 2010 the cost to insure $10 million of Greek debt was $711,000 per year, and the interest rate Greece had to pay to sell its bonds was 6.1 percentage points higher than those from Germany, a nation whose bonds were much less risky. The cost in May 2010 to insure debt of 10 million euros for five years was 163,789 euros compared to just 90,715 only two months earlier.

In the same way that governments, banks and other investors employ credit default swaps to protect themselves from default on Greek or other sovereign bonds, companies doing business internationally also find it necessary to protect themselves from monetary instability. They employ derivatives as insurance against currency and interest rate fluctuations in the countries in which they do business. Coca-Cola, for example, generates euro income equal to about $3 billion annually, and derivatives provide a way to protect against the loss of value when this revenue is converted into dollars. McDonalds hedges its euro exposure in the same way. So does Dole Foods and countless other corporations.

Derivatives for insuring against the loss of value—due to unreliable currency—impose gigantic costs on the world's economy. What would happen if there were no derivatives? Coca-Cola would have to charge more for Coke, McDonalds more for its hamburgers, and Dole Foods more for its products, in order to offset possible losses from currency fluctuations in countries where their products are sold. And Greece and other countries selling bonds would have to pay even higher interest rates to bond buyers if the latter were unable to offset the risk by purchasing derivatives.

But what if the world had a stable money? Then there would be no need for all those derivatives to protect against money itself losing value. The trillions of dollars spent on them could instead be used more productively to produce prosperity. In fact, this is what happened when the dollar was “as good as gold.” For much of our history, the dollar was exchangeable for gold or silver at fixed rates, and derivatives against monetary instability were unheard of. And before the dollar emerged as the world's currency, the British pound occupied that position because it was fully convertible into gold for roughly a hundred years before World War I, when London was the center of the financial world. Gold-backed currencies controlled inflation, led to strong employment, and fostered rising living standards. Stable money made economic calculation simpler and more accurate, thereby creating efficiencies and optimizing investments. It also preserved the value of people's savings, thereby encouraging them to save, which, in turn, increased investment capital to further enrich the people and the country. It all happened without any need to buy insurance against monetary defaults, fluctuating exchange ratios or variable interest rates.

Money is a measure of value. It must have a standard by which to gage that which it measures. Length, weight, sound, time and temperature all have units that make it possible for people to communicate easily with each other about them. If some people used a foot that contained 13 inches, a pound that contained 11 ounces, or an hour that contained 48 minutes, trade with others for goods or labor would require cumbersome conversions. The same difficulty occurs when people in different nations measure the value of anything in terms of different currencies that lack a common standard.

Over the centuries, many things were used as money, including metals, grains, cattle, furs, salted fish, salt, tobacco, whiskey, nails, fishhooks and seashells. Some worked better than others. Furs could rot or burn, while metals would not. Iron could rust, but not gold or silver. Whiskey could be spilled or evaporate and was not as uniform in quality as many other commodities. Diamonds could be exceedingly valuable, but they were not uniform in size or quality; nor could they be easily divided, another important attribute for money. Countless transactions by billions of people over thousands of years eventually led to gold becoming the preferred money because of its intrinsic characteristics. It simply worked better than anything else. Certainly it has worked better throughout history than fiat paper, which has no intrinsic value.

The advocates of unbacked paper money often argue that money is only a medium of exchange and, therefore, need not have any material value itself. But money is first and foremost a store of value; it must be a store of value before it can be a medium of exchange. If something did not have intrinsic or objective value, it would never have become money in the first place. And taking away the value from extant money—making it irredeemable in the original measure of its worth—will eventually destroy its usefulness as money, leading to replacement of the currency. Because it can no longer be trusted as a store of value.

For Part II of this series, click Monetary Mess, the Dollar, Gold—and You, Part II

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