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Why gold prices are soaring

By Peter Morici
web posted May 17, 2010

Gold prices are soaring because of growing inflation fears--both the European Central Bank and the Federal Reserve seem to be on the path to permanently easy money with the Greek bailout and huge U.S. budget deficits.

Neither the reforms attached to the Greek bailout nor banking legislation in Congress get at the structural problems that caused failures in Athens and on Wall Street.

Soft reform is no reform--investors are fearful too much money will undermine the value of euro bonds and U.S. Treasuries--even if those bonds don't outright default.

The bailout for Greece and aid for other debt ridden Mediterranean economies provides hard commitment of assistance but does not address the fundamental structural problems that cause Greece, Portugal, Spain and other less prosperous EU states to spend too much. Namely, over the last forty or fifty years, economic integration in Europe has increased public expectations that social safety nets—health care, retirement benefits, job security, unemployment assistance, etc—would be as strong and generous in poorer EU states as in rich ones.

Unlike the United States, the EU does not have well developed mechanisms for taxing high-income states to provide low-income states with the same level of social expenditures. The EU can't tax Germany to subsidize Greece, as Washington taxes New York to subsidize Mississippi.

Consequently, Mediterranean governments spend too much and push costs on private sectors those can't bear, and higher inflation results. When those countries had their own currencies they could let those slip in value against the mark, over time, but now with the euro as legal tender, governments do not have this option. Instead, they borrow to the point of default, and pose the veiled threat of leaving the euro zone if aid is not forthcoming.

The Greek bailout does not address the underlying fiscal problem—the absence of EU taxing and spending authority. The $750 billion fund is merely a down payment on even bigger future bailouts.

Simply, the European Central Bank will have to print lots more money to buy European government bonds to keep the system afloat and a weak euro, inflation and rising interest rates will follow.

In the United States, President Obama's budget projections are much more optimistic than economists or investors believe. The CBO has just concluded, for example, health care reform will cost the federal government much more than originally projected.

With new health care legislation, U.S. federal deficits will exceed $1 trillion for many years to come, even with repeal of the Bush tax cuts for families over $250,000 and the interest and dividend tax. The President's pledge not to raise taxes on families under $250,000 puts Washington in a fiscal box.

Also, the banking legislation moving through Congress does not fix fundamental problems in the securitization market, and it does not fix too big to fail for the largest U.S. banks. In the current crisis, the FDIC had resolution authority with regard to Citigroup and Bank of America, and Treasury has the same regarding AIG, but it proved impossible to sell off these firms' good businesses in a crisis to save the taxpayer from sinking hundreds of billions in bailout funds. Quick rinse bankruptcy procedures, as proposed in the banking reform legislation, won't fix that.

Hence, large deficits and more bailouts are likely over the next decade, and that will ultimately drive up interest rates on long U.S. bonds, and drive down, five years from now, the prices of 20- and 30-year Treasuries purchased today.

Overall, neither euro denominated assets nor U.S. Treasuries are a good investment in such a potentially explosive inflationary environment.

Investors, fearing the worst, are hedging by putting more of their portfolios into gold, and the price of gold rises. ESR

Peter Morici is a professor at the Smith School of Business, University of Maryland, and former Chief Economist at the U.S. International Trade Commission.

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