Trust in government is the foundation of our system of nation states. People rely on government to defend the borders and provide a safe place for them to live, work and bring up children. More than that, people rely on government to create the prosperity they desire - either directly, through government spending programmes, or indirectly, through supporting and encouraging private enterprise. And people - especially in the developed world - expect government to provide for them when they are unable to provide for themselves.
Trust in government is also the foundation of our financial system. Currency issued by a trustworthy government is regarded as risk-free. So is debt issued by a trustworthy government. Neither has any value if trust in the government is destroyed.
So what happens when people who want safety - physical, economic or financial - start to lose faith that their government can provide it? They start to look for safer places. This can take a number of forms.
- Obviously, if their fear is that the COUNTRY is unsafe, they leave - if they can. Refugees from war zones pile across borders to countries they believe are safer. People who fear persecution on religious or political grounds seek asylum in countries with a strong rule of law.
- If their fear is that the government cannot be trusted to provide the prosperity they desire, they may also leave. Economic migrants risk life & limb in dangerous sea crossings or conceal themselves in container loads to get to countries that have a reputation for economic strength and freedom. Alternatively, people may try to bring down the government and replace it with one that in their view will espouse policies that will bring them the prosperity they want.
- If their fear is that the government cannot be trusted to maintain the value of money, or will seize more of it than they perceive as reasonable, they move their money elsewhere. They reject the government's money, preferring to use foreign currencies instead: they hoard cash in foreign bank accounts and buy hard assets such as gold: they hide their money in places where they don't have to admit to its existence - tax havens.
At the moment, we are seeing all of these happening in the Western world. The price of gold and precious metals is rising: cash holdings by companies and households are at a record high: tax havens are thriving. In the most troubled countries, which are part of the European Single Currency system so do not have their own currencies, investors are rejecting government debt - this is still rejection of government money, just in a different form (if these countries had their own currencies, those currencies would be falling in value). And people, particularly the young, are leaving economically troubled countries such as Ireland and Greece.
Clearly, people are fearful. What exactly do they fear, and are they justified? Let's look at the possibilities.
- Inflation. The rising gold price suggests that people fear future inflation. There are a number of reasons for this fear, but in my view the principal one is the belief that Quantitative Easing (often wrongly described as "money printing") is inflationary. This is because historically there is a strong association between out-of-control production of fiat currency to extinguish excessive government debt obligations (monetization of debt), and hyperinflation.
Personally I don't think QE is remotely similar to this. Every example of hyperinflation in the 20th century that I have found was a distressed sovereign shut out of debt markets, reeling from a recent severe economic shock and usually suffering a catastrophic collapse of production. The only economies I can think of at the moment that any of this applies to are Greece, Ireland and Portugal, none of which can issue their own currencies anyway. If they were to leave the Euro I think hyperinflation would indeed be a serious risk, especially for Greece which is in deep recession. But nowhere outside the Eurozone is in this kind of mess at the moment (although Hungary might be heading that way). The Bank of Japan has been doing QE for the best part of 20 years and there is no sign of hyperinflation in Japan - in fact Japan's problem is actually persistent deflation, which the Bank of Japan only just manages to keep from spiralling out of control.
There are also suggestions from the weird fringe that Western governments, particularly the US, will at some point soon be forced to monetize debt, leading to massive hyperinflation. The thinking appears to be that other countries (especially China) will dump their holdings of US government bonds on the world market, the price will crash and the US will be forced to print money to fund its fiscal and trade deficits. If this were to happen it would indeed be a big disaster, and it is not completely beyond the bounds of possibility. But to my mind, at the moment they would do better to worry about the Eurozone, which is a real, current disaster, rather than chasing chimeras. While oil and commodities remain priced in dollars, countries will want to hold on to dollar reserves in some form, whether as actual currency or as dollar-denominated risk-free bonds - ie US Treasuries. When the US lost its AAA rating last year, FT Alphaville tried to find an alternative risk-free liquid asset to the US Treasury. They failed.
- Government debt default. High cash holdings suggest that people think this is potentially a problem. But not, it seems, for the countries with the most debt. Cash balances in the UK, US and Japan are at an all-time high. And these are all fiat currency-issuing sovereigns. Investors know perfectly well that in the event of debt default by a fiat currency-issuing sovereign, the currency usually collapses too, which would wipe out their cash holdings. Clearly they aren't lacking confidence in these governments at the moment - and this is borne out by the fact that the debt of these countries is trading at record low yields. So although the UK government appears to be terrified that investors will withdraw their money because of the fear of debt default, investor behaviour suggests that the UK is the least of their worries. It is the Eurozone countries, and in particular Greece, Spain and Italy, that are seeing cash leave at a rate of knots. Evidently people fear the default of these governments far more.
- High taxation. At present governments across the Western world are running budget deficits and their debt levels are high and rising. Concern is being expressed in some quarters that this is storing up an unacceptable tax burden for future generations.
It's actually quite hard to determine whether or not this fear is justified, because whether debt (or currency issuance) is unsustainable depends on the economic performance of the country. It is possible for governments to spend so much that they have to tax their populations practically to extinction. But I don't think that any Western government is anywhere near this disastrous state at present. The bigger risk is unquestionably deflation and economic collapse.
- Bleak future prospects. Youth unemployment is at an all-time high. Countries experiencing high unemployment and youth flight are generally pursuing economic policies, in the name of "structural reforms", that cause their economies to contract, which makes unemployment - especially for the young - even worse. The Eurozone leadership would argue that the structural reforms they are imposing will eventually make the future better for young people. But "eventually" is a long time when you're young. I can't blame them for leaving in search of a better future elsewhere.
Loss of trust in government is a serious matter. The actions that people take when they perceive their government as untrustworthy may themselves be highly risky. Physical flight may involve long and dangerous journeys. Attempting to bring down a government may fail, in which case life or freedom may be forfeit - and lives may be lost even in successful government overthrow. Financial flight involves transferring life savings to another country or putting them out of reach of immediate access. And some types of financial flight are more risky than people realise. Buying gold is all very well, but when food is scarce and people are resorting to barter to get what they need, gold has little value. You can't eat gold.
Irrespective of the system of government, there are always a minority of people who don't trust the government of their country. But as long as the majority do, the government and the economic system remain stable and leaders feel justified in ignoring the discomfort of the minority. It's one of these "tipping point" questions: what percentage of the population have to have reached a position of total distrust of their government for that government and the economic system it maintains to be at risk? And how do you predict whether that tipping point will be reached, and when? What was it, in the Arab Spring, that made distrust turn into unrest and then into revolution? What would it take, in the Eurozone, for minority discomfort and flight to turn into a major exodus sufficient to force the breakup of the Single Currency?
It seems to me that many social and economic phenomena have "tipping points": pressures gradually build up, and eventually release themselves in violent revolution, economic collapse or financial catastrophe. Sometimes, after the event, we can see clearly what the trigger was: so for example, with the Weimar republic of the early 1920s, we know that the trigger for the exponential hyperinflation that Germans still fear to this day was the French seizure of the Ruhr industrial area in a misguided attempt to extract overdue payment of World War I reparations. But more often the exact trigger is hard to distinguish, and anyway it is really only a "last straw"; what we should be looking for is the buildup of pressure that leads to the trigger event. Leaders do not pay sufficient attention to this, and all too often silence the people who seek to warn them. So it was with the financial crisis of 2008: so it is now with the Euro crisis. There are many, many signs saying "Danger ahead". But our leaders ignore them and lead us blindly over the cliff.