How long will that Dam Wall hold?

By Greg Canavan at the Daily Reckoning Australia

--The Greek yo-yo continues. Every day is a last ditch chance for Greece to come to an agreement with its creditors. Every day the market rises or falls based on Greek ‘hopes’ or ‘fears’.

--That global financial markets are so concerned about a tiny economy in the corner of Europe may seem bizarre to some, but there is much more at stake than the fate of the Greek economy. After all, the creditors have shown they are not particularly concerned about the welfare of the Greek people.

--It’s the all-encompassing ‘European Project’ that is the main concern. Europe’s elites want European integration to occur at all costs. Ironically, this determination is the product of two devastating wars that ripped through the continent in the 20th century.

--In the elite’s eyes, an economically integrated Europe, sharing the one currency, will never go to war again. So from that perspective, it’s an admirable project. And as I pointed out on Tuesday, the euro is also about having a currency bloc to rival the US dollar.

--But here’s the thing. The US dollar took a long time to get to a position of global dominance. About 150 years, in fact. First, the nation had to unite. In its early stages, the US had state based, or individual bank based currencies. The financial system was all over the shop.

--The country fought a terrible Civil War that was as much about uniting the country (and currency?) as it was about slavery. The ‘Union’ won that war of attrition, which eventually laid the groundwork to ‘unite’ the States.

--Uniting the States allowed greater issuance of Federal Government debt. I’m not saying that this was a good thing but it certainly gave more legitimacy and integrity to the US dollar, which became the common currency of all the states.

--In Europe, the various ‘states’, or nations, are not united. They all issue their own debt and operate under different jurisdictions and political persuasions. Yet every nation’s debt and economy is fixed to the euro.

--This is a problem. ‘Fixing’ anything in economic terms is a recipe for disaster…in the long term at least.

--Greece is only the latest example. Greece’s economy is ‘fixed’ to the euro. The euro fluctuates against other currencies based largely on the economic output of Germany…it doesn’t really care what happens in Greece.

--Prolong the situation long enough and you’re going to get major imbalances, like a massive debt pile that cannot be serviced.

--Going back into the past, the booms and busts and constant banking crises in 19th century US had much to do with the ‘fixing’ of gold and silver to dollars. It led to monetary lurches from one side to the other, causing havoc in between.

--While it’s true that the classical gold standard, from roughly the 1870s to 1914 was a period of great price stability, it did end in the explosion of the First World War. Tensions had been building for years as the great powers in Europe jostled for economic supremacy (colonialism was all the rage back then).

--You could argue that the war was the result of a form of economic imbalances and intensifying pressures, which in turn was the product of fixing the value of national currencies to gold.

--You could also argue against it. I know many people would.

--What about a recent example? There’s the Chinese yuan ‘fix’ to the US dollar. This little policy allowed China to accumulate history’s largest hoard of foreign currency reserves. That’s enabled the US to continue consuming way beyond its means. It also provided the fuel for China’s massive 2009–2011 credit boom, the ramifications of which are still being felt today, particularly in Australia.

--This little fix, which has been in effect since about 2001, with only slight modifications, is probably the largest source of global imbalances in history.

--No, fixing the value of currencies to anything is a recipe for disaster. If you look closely enough, economic history shows that fixing currency values is the source of many economic problems.

--The Bretton Woods system died because it couldn’t sustain the US dollar to gold exchange rate. Back then one ounce of gold equalled US$35. There was too much inflation in the system though. 30 years latter Bretton Woods was dead, and the 1970s was a time of inflation and great currency turmoil.

--Now one ounce of gold equals US$1,175. And there’s plenty more to come in the years ahead as gold eventually recognises the vast inflation washing through the financial system.

--I’m a fan of gold. I own it personally. But I don’t think that returning to a gold standard, with currencies fixed to a specific weight of gold, will solve anything. It will just sow the seeds of the next crisis.

--Nature is constantly changing. Change is a key survival mechanism for all of nature’s creatures. Markets are the same. They are just a reflection of nature, often at its most brutal.

--So if you try to fix values in the market place or economy, nature will slowly chip away at it until it breaks. And when it does break, all the associated pressures that have built up will release at the same time, causing turmoil.

--Which brings us back to Greece. If Greece relieves the pressure by cutting loose from the Eurozone and getting back to a flexible currency arrangement that is suited to its own economy, the floodgates will open.

--The risk of contagion will spread. Maybe Portugal will leave too…and then Spain, and Italy. Once Greece leaves, it sends a signal that the European Project is vulnerable. Greece is the breaking of the dam wall, and all the political willpower of Germany and France won’t be able to hold it back.

--So expect plenty more ‘hope’ and ‘fear’ headlines on Greece in the weeks and months to come. There is a tremendous amount of political will trying to hold the dam wall together. I’m just not sure whether they can hold much longer.

Greg Canavan
For The Daily Reckoning, Australia