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I’ve spent a great deal of time in the last few months describing why the Greek crisis was much larger, more complex and a greater risk than anyone assumed. As stocks continued to chug higher (and I built short positions) an odd occurrence was brewing. Gold prices were rallying in tandem with the dollar. As the market began to crater and eventually crash 1,000 points in one day the gold market actually continued to rally along with the dollar! For anyone familiar with gold and forex markets this was more than odd. But there is a reasonable explanation for the move. And half of that move is entirely unjustified and incorrect in my opinion.

What if I told you that the Euro’s “inevitable demise” was not a condemnation of fiat money? You’d probably call me crazy. Well, that’s basically what several emailers have done in recent days. I received this friendly note from a reader recently:

“nice work predicting the risk in Greece and the Euro over the last few months, but you’re dead wrong about paper money and the gold standard. The Euro is proving that paper money does not work and gold’s recent price increases prove that the move towards a gold standard is on the horizon”

The irony behind the Euro crisis is that it is not at all a condemnation of fiat money. In fact, it is a condemnation on single currency systems such as the gold standard. I have long argued that the mess the EMU created in 1999 with the inception of the Euro was unlikely to survive a serious global recession in its original format. This was due to one primary argument. The gold standard and single currency systems have all ended in demise for similar reasons. There are several flaws in single currency systems, however, two are most notable:

  • They are inflexible
  • They are susceptible to corruption

The inherent inflexibility and inherent weaknesses imposed on particular trade partners within the currency system is always apparent in single currency systems. As I’ve previously noted in “Reflections on gold as an asset class“:

“the gold standard had a tendency to cause severe strains on countries due to trade imbalances and the inability to provide flexibility to countries with trade deficits.”

The move off the gold standard and convertible currency systems has generally been due to the inherent restraints imposed by such systems. For instance, trade deficit nations are at an inherent weakness when attempting to respond to recession because the trade imbalance results in rising unemployment and falling output and prices – an inherently deflationary environment. With your own currency this imbalance would naturally offset over time, but under a single currency system there is no opportunity for the floating exchange system to reach balance. This is just one very simple example of the types of inherent restrictions a single currency system imposes on a nation, but it’s particularly pertinent as we see this exact event unfolding in Greece – where the single currency system is destroying the country and handcuffing the government from properly defending their economy and thus providing for their citizens. Instead, they are risking default (a risk which does not exist within a sovereign issuing floating exchange system) and forcing their citizens into recession all so the surplus nation of Germany can enjoy price stability and continued high exports.  Such a system is wondrous during the boom, but it can be catastrophic during the bust.

The other critical flaw within the Euro system (and the gold standard) is a very human one and not necessarily unique to single currency systems.  In Europe, it is the unwillingness to accept political failure which ultimately results in a form of political corruption and manipulation in a misguided attempt to right a previous wrong.  In his “Money: Whence it came, where it went”, John K. Galbraith described this flaw in the gold standard:

“It had also a notable flaw. That was in asking, in an age of growing nationalism with a growing tendency to hold governments responsible for economic performance, that both nationalistic instinct and domestic economic management be subordinated to an impersonal, international mechanism, one capable of inflicting considerable hardship and distress. It was a flaw that supporters of gold did not accept. They saw any reluctance of governments as inhering in the lack of moral fibre of politicians – a lack that led them to try to ameliorate the strains that gold imposed. That the morality of politicians is difficult to alter in the short run was not recognized.”

The inefficient market irony within all of this is that the markets are viewing the Euro crisis as a condemnation and failure of fiat money. That couldn’t be farther from the truth. What we are seeing in Europe is in many ways what we would see if the world were living in a gold standard world or a convertible currency world. The same unnecessary restrictions would occur and trade deficit nations would be at risk of recession which would ultimately result in regional and perhaps global recession. The recent rise in gold prices is not based on the true fundamentals of mined gold, but rather on the hope that the Euro’s failure will increase demand for gold via its potential return as a true currency. As we’ve described above, that is entirely misguided thinking and perhaps the greatest real-time example of the inefficient market I have ever witnessed.

Of course, this doesn’t imply that gold prices are set to collapse. In fact, we are likely to see gold prices continue their record move so long as the weakness in the Euro continues. If the Euro collapses misguided governments will clamor for gold as they incorrectly worry over the stability of their own paper currencies. After all, the ignorance with regards to our monetary system extends up to the very highest levels of government and the total lack of understanding is on display in Europe every day as politicians make mistake after mistake and further destroy their economy. The politicians and central bankers have mishandled this crisis at almost every single step and this lack of understanding with regards to the monetary system is the single largest contributing factor. What does this all prove? The inefficient market is alive and well.

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