Thursday, November 3, 2011

Europe Unraveling -- but Is That All?

The news from Europe is uniformly disturbing. The trouble that started in Greece has received only a band-aid, and now the Greeks themselves are not even certain that they wish to put it on. Meanwhile, Spain, Portugal, Italy and Ireland are teetering on the brink, as well. Even the incoherent "protesters" who wanted to shut down the London Stock Exchange managed only to shut down St. Paul's Cathedral instead. Can't anyone in Europe do anything right? (The word "ineptocracy" has been coined to describe the phenomenon, which is, in my own phrasing: "A system where those least capable of leading are elected by those least capable of producing. The former then bungle through as long as they can, by taking from those who are producing, until everyone may enjoy being as impoverished as those who are not producing.")

We may finally be witnessing the inevitable consequences of a global system built upon exclusively fiat currencies -- money that consists only of paper promises. When an economy's medium of exchange is transformed from gold into paper, a certain convenience is achieved, to be sure -- but the convenience comes at a huge hidden cost. As I explained in my previous series on money, paper money is based entirely on debt -- on promises to pay in the future. But pay with what? You guessed it -- more paper money, or more promises to pay. An endless and spiraling cycle of debt is the driver of a fiat money economy.

When money is based on gold and silver coins, no debt is involved. The coin itself is both money, and a thing of intrinsic value, because it is relatively scarce and cannot be counterfeited (although it can be debased). New gold is produced only by mining it. The miner brings his raw gold and silver to the mint, and receives already minted gold and silver coins in exchange. So long as debasement does not occur, there is no addition to the money supply without its being backed by the physical gold and silver that is minted.

But when paper money is printed, there is nothing to back it except the promises of the central bank to print more paper money as needed. (Originally, paper notes were promises to pay in specie; now, they are promises only to pay in more paper.) And since it costs the central bank only the value of the paper, ink and labor consumed to print the money, there is theoretically no built-in limitation on the quantity that it can print. Instead the amount in circulation is left to the discretion of the central banks.

Central banks exist to regulate the supply of money in an economy. Without a gold and silver backing for the paper money, someone has to decide how much money there should be in circulation. Because they have to be able to increase the supply when deflation rears its ugly head, central banks have the unique ability to "create" money, with simply (in today's electronic world) a single stroke on a computer keyboard. Then they get to lend that instant money, created at virtually no cost, to governments and other borrowers at interest. It is a crazy system, but one which makes sense to the central bankers and their cronies, who never have to worry about running out of money.

Over the long term, however, printing electronic money is a recipe for the disaster which we now see unfolding in Europe. The unification of Europe under the Euro stopped the currency devaluation wars which had theretofore been that region's hallmark. (A devaluation war occurs when one country declares that it will exchange more of its currency for the currency of a country with whom it trades. The result is to make the prices of goods in that home country appear cheaper to foreign buyers in terms of their own currency, in the hope that they will be motivated to buy even more goods, and boost the home country's economy. But the increased outflow of the foreign country's currency which results causes that country to lower its exchange rate, as well, and a devaluation war ensues.) With Europe's unification under a single currency, no country could devalue its own versus that of others.

(It is therefore significant that some economists are urging Greece to pull out of the EuroZone, and to start printing its own currency [drachmas] again. The reason? So that Greece can devalue its currency against the Euro, and attract trade and tourists because of the resulting cheaper prices in terms of other currencies. There is truly nothing new under the sun.)

Although unification put a stop to individual devaluation wars in Europe, it could not, and did not, change the spending or savings habits of the individual cultures which make up that region. In the north, Germans continued to work six days a week, to save a high proportion of what they earned, and to produce quality goods much desired by other countries. In the south, the Greeks (for instance) cut their workweek to less than five full days, joined the public payroll in record numbers and voted themselves pensions and benefits which could start as early as age 45, and produced goods of inferior quality (due to the more lackadaisical work force). Meanwhile, Greeks used their earnings to purchase Germany's superior goods, instead of putting them into savings. (What's the point of saving much when you've got a "guaranteed" pension of 100%+ of your salary that can start when you are 50 -- and even earlier, if you are a woman?)

But all of the money changing hands in these transactions was paper money (Euros). As a result of the trade imbalances, Germany acquired more Euros from other EZ countries than they acquired from Germany (by selling their goods to Germany). Without a way to earn enough currency and make it flow into its economy, Greece would eventually run out of paper money, because it was producing less (more people retiring on full pay) and spending more. The Greek government could no longer issue paper money of its own to fill the gap, or devalue its currency to make its goods more attractive to foreigners (see the link above). So it borrowed money from European banks, in exchange for bonds (more promises to pay). This money was used to keep Greek spending and pension benefits flowing. Is it any wonder that the Greeks came to like this new arrangement, while it lasted?

Even the European banks, however, could see that it was not wise to keep lending Greece money without any prospect of their being repaid. The European Central Bank stepped in, and used its ability to print money to stave off a Greek default (i.e., buy Greek bonds and lend it more money to keep functioning) for a while, but that process, too, had its limits. The Euro was still a world currency, and if the European Central Bank inflated the Euro too much, Germany would see the value of its savings dwindle, and its cost of living rise -- despite all its citizens' hard work. As the biggest economic partner in the European Union, Germany carried the biggest clout with the Central Bank. So, nix on printing more money to save the profligate Greeks.

Instead, the EU rulers and bureaucrats persuaded the European lenders to Greece that they would have to take a "haircut." They would write off some of their Greek bond holdings -- at first 20% was proposed, but then the figure quickly became 50%. At that point, the European central bureaucrats became alarmed that such a massive reduction in the banks' holdings would jeopardize their stability, so they imposed requirements on the banks to bring in new capital.

But the only capital which the banks can bring in is -- you guessed it -- more paper money! And to obtain it, they have to induce investors with promises of return which are better than those which the investors can obtain elsewhere. Tell me: would you invest your savings in the stock of a European bank which stood to take a huge hit from its faulty lending practices? What would it take to make you do so? So now the bureaucrats are considering a scheme to fund the needed infusions of capital by having the Central Bank buy the worthless bonds from the lenders. To do so, however, the Central Bank will have to come up with more money without "printing" it -- a neat trick.

The current financial crisis boils down to this. Too many promises to pay have been made in the past. In this declining economy, with so many out of work, with so little new loans being made because there are so few creditworthy borrowers willing to borrow on the basis of dim future prospects, there is no way for all those past promises to be paid out of current earnings -- without robbing Peter to pay Paul. Because Paul is a spendthrift, however, the process of robbing Peter to finance Paul's profligacy simply leaves everyone a bit more impoverished than before, and is no recipe for economic recovery.

And hence, because the whole system is built on paper promises, the only solution the bankers, economists and politicians can see is for the ultimate banker of last resort -- the Federal Reserve -- to use its power to print more dollars. (In that way, the Fed could end up with the worthless Greek bonds on its balance sheet.) This would be a short-term fix which could last only so long as the rest of the world is willing to take increasingly worthless dollars in exchange for their own currencies, goods and services.

In the longer run, however, anyone can see that this is a recipe for unbridled inflation -- which seems to be what happens every time the physical backing of money is exchanged for debt, a mere promise to pay. Promises are cheap, but gold is not. Think of that as you watch what happens to the price of gold in the coming years.


  1. Mr. Haley,

    Thank you for this excellent explanation of the current economic predicament. It has been more than eight decades since the onset of the last global disruption on the scale of the likely one now looming on the temporal horizon. We are all likely to be the recipients of the (purportedly Chinese) curse, namely that, in the near future it is likely that we will "live in interesting times."

    Pax et bonum,
    Keith Töpfer

  2. Mr. Haley,

    Good explanation. Somehow, though, it leaves me feeling worse about a situation I thought was already bad. Was this your intention in writing this piece? "Here, Milton, along with the collapse of a once great institutional church, take this right to the stomach!"

    Have a nice day...and God bless your soul.


  3. Hi, Milton Finch -- no, I did not write the above with the idea of ruining your specific day. ;>)

    I wrote it instead just to help me understand the nature of the problem, because I figured that if I could explain it to others, then I could grasp the situation myself.

    There is no way to escape from the current predicament if one does not understand what brought us to this point -- and I think the factors which did that are now crystal clear.

  4. @Milton Finch,

    Just to put things in perspective, consider the public standard index (measure) of the US stock market, the Dow Jones Industiral Average (the DJIA, which was established on May 26, 1896.

    That index value is computed at any point in time on the stocks of 30 major industrial firms and represents the sum of the prices of one share from each of the thirty firms, divided by a number that compensates for the effects of stock splits, etc., which, if not done, would result in the index not representing a consistent measure over time. Therefore, the index represents a measure of what the value of those firms is in the same units, (US dollars).

    But there is the rub: Is the value of the dollar a constant over time? The answer is a very authoritative NO!. There are a number of good articles on the Web which give us a good estimate of how much value the dollar (and the British Pound Sterling) have lost in the past 100 years (it turns out to be almost identical for both currencies, $ and £)—in the vicinity of 96%-98%. Our rightly-esteemed host on this blog gave us an illustrative account of this very fact in reporting on a seven-course Christmas dinner in the past year or three.

    So, the great "positive" business news on the telly each weekday evening that the Dow is above 11,000 yet again is illusory, indeed very, very misleading, because that index is denominated in dollars and the value of the dollar has been continuously shrinking.

    I am sorry to have to be the bearer of such bad news, but there are only two "schools" of economics whose practitioners will publicly state the truth about the world's fiat currencies, the Austrian and the Chicago, and the latter school has some problematic understandings, IMHO, one of which is something of a tendency to view economics as a "hard" (i.e., quantitative) science, rather than the social science which it actually is.

    Pax et bonum,
    Keith Töpfer

  5. It makes one desire to get a cabin in the mountains and live off the land...and pan for gold from a near-by stream!

  6. Margaret Thatcher said it best: "The problem with socialism is that eventually you run out of other people's money."

    So why is it so hard for people to accept just how bad socialism is?

  7. Just my opinion; however, hasn't Europe been in further decline since the formation of the EU? Wouldn't Europe be in somewhat better shape if each country was purely independent, sovereign, own currency, own borders, etc?

  8. Well, Europe might be headed back to those pre-EU days, DDR. But with every country's separate currency backed only by promises of more paper, the inevitable tendency of such a system, as Friedrich Hayek long ago noted, would be to wind up in devaluation wars among them.