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The Beginning of the End of Fiat Money

John Browne
Euro Pacific Capital
November 11, 2011

Last week, the G-20 meetings did not produce an expanded bailout fund for the eurozone. While this may bode well for the long-term solvency of the member-states (moral hazard and all), it has also triggered a market reaction that I expect to help destabilize the common currency. Yesterday’s market moves suggested that this development is good for the dollar and bad for gold. Allow me to step back from the stampeding herd to evaluate whether they are, in fact, moving in the right direction.

The argument for the dollar and against gold is simplistic, and I will evaluate it against the four-stage collapse I see ahead for the Western currencies.

Arguing that gold is a hedge only against inflation, and taking current inflation figures at face value, mainstream analysts have concluded that gold is grossly overvalued – that it may, in fact, be the latest asset bubble to arise. However, these analysts fail to account for why gold is a hedge against inflation: it is ultimately an insurance policy against runaway currency collapse. In other words, it’s intended as a longer-term, wealth-preserving purchase. Yes, some pit traders may be trying to make a quick buck shorting gold and going long on dollars, but for individual investors, following suit would leave them vulnerable to what may prove to be ahead. That is, a phased destabilization of the euro, leading to a possible collapse of the US dollar. In such circumstances, even today’s volatile prices for gold and silver would look attractive.

Phase One of the threatened catastrophe is sovereign debt crisis, which is effectively camouflaging a currency crisis. The Greek default is significant as the first crack in the dam. But Greece is a relatively small problem. The bigger threat is Italy, with its $2.4 trillion of debt and a 10-year bond yield having just surpassed the critical 7 percent level. This is the ruinous milestone at which the cost of new debt money surpasses the economic growth rate plus inflation. Italy faces massive debt refunding, falling buyer interest, and no hope of a bailout. If Italy were to default, it could threaten rapid contagion to Portugal, Ireland, Spain, and other larger eurozone countries, including perhaps France. In such an event, most international banks and institutional investors, including those in the US, could suffer severe, possibly total, losses on their holding of certain sovereign bonds. MFGlobal is but one speculative example of a looming secular trend. Worse still, the writers of credit default swap (CDS) derivatives, including many German Landesbanks (state-level banks) and major US banks, could suffer crippling losses.

This would lead to Phase Two of the collapse: a renewed and far larger banking crisis. This, in turn, could bring stock markets tumbling and threaten major institutional investors, including politically sensitive pension and insurance companies. In addition, banks would become extremely wary of lending to each other. Likely, the interbank market would freeze, but far more severely than in 2008. It could result in curtailed lending and even the recall of short-term corporate funding and call-loans. This could cause a dramatic spike in US bank failures. Unwary depositors who have failed to watch their banks closely could find their insured funds frozen, perhaps for months, as the FDIC reorganizes the problem banks – and perhaps even waits for its own bailout. This would add further downward pressure to economic growth.

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