In response to Hugo Salinas Price and Michael Pettis on the Trade Imbalance Dilemma; Gold's Honest Discipline Revisited I received a nice email from Michael Pettis.

Thanks Mish.

My only quibble is that you might have explained that by "Germany" and "Spain" I simply meant countries whose trade imbalances were seriously distorted in the form of surplus (Germany) or deficit (Spain). Otherwise, some of the discussion might seem a little weird.

There is no question that specie money has an automatic adjustment mechanism, but I am very far from being a proponent of a return to gold or any other commodity-backed money.

It seems to me that Barry Eichengreen's argument is about to be proven in Europe.

When workers were effectively disenfranchised and there was a weak popular understanding of the transmission from monetary adjustment to employment, he argued, it was possible for deflationary adjustments under the gold standard, but this involved a huge cost to workers and small depositors in the form of high and persistent unemployment and banking collapses (after all it is very hard to guarantee depositors under the gold standard).

In the case of well-functioning democracies it will be too politically difficult to enforce adjustment. Workers and middle class depositors will turn against it as soon as the adjustment becomes serious. We will see this in Spain. Spanish workers will tolerate at most one or two more years of this before the political system will turn virulently against the euro.

Michael

Generic Germany

This is one of the things that happen when you take snips. I left out a section where Pettis was not referring to Germany per se, but rather surplus countries in general. Here is the clarifying section.

Let me again, following my practice from last month's newsletter, simplify matters by calling all surplus countries "Germany" and all deficit countries "Spain". Germany and Spain jointly have put into place policies that ensure that Germany runs a large current account surplus and Spain a large current account deficit for many years. As I argued three weeks ago, I think that it is far more likely that German policies rather than Spanish policies created the huge distortions, but for our purposes we can ignore the direction of causality.

As long as Germany runs current account surpluses for many years and Spain the corresponding deficits, it is by definition true there must have been net capital flows from Germany to Spain as Germany bought Spanish assets (which includes debt obligations) to balance the current account imbalances. The capital and current accounts for any country, and for the world as a whole, must balance to zero.

The article from three weeks ago which Pettis refers is How to become virtuous and save more

Lack of Enforcement Mechanism a Major Problem

Pettis is working on an idea to fix trade imbalances, one not involving a return to the gold standard. I may have some details later on.

Lack of an enforcement mechanism regarding trade is an enormous problem. Debts pile up forever, with no way to pay them back. History suggests there is no better enforcement mechanism than gold, so it will be interesting to see what Pettis comes up with.

Europe Will Blow Sky High, Gold Will Soar

I believe Pettis is correct regarding the Euro. Spain, Italy, Portugal, Greece, and Ireland are all in serious trouble. Worse yet, bankers demand more austerity so they can pay back debts to French, German, UK, and US banks.

Europe will blow sky high. Major defaults will come when the population gets fed up enough with austerity and demands change.

When things do blow, I look for gold to soar. The issue, as always, is timing the event.