Gold Prices Ride Inflation Fears Higher

Fearing the worst, investors are hedging by putting more of their portfolios into gold.
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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 doesn't address the fundamental structural problems that cause Greece, Portugal, Spain and other less prosperous European Union states to spend too much. Namely, over the last 40 or 50 years, economic integration in Europe has increased public expectations that social safety nets -- health care, retirement benefits, job security and unemployment assistance -- would be as strong and generous in poorer EU states as in rich ones.

Unlike the United States, the EU doesn't 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 don't have this option. Instead, they borrow to the point of default, and pose the veiled threat of leaving the eurozone if aid isn't forthcoming.

The Greek bailout doesn't address the underlying fiscal problem -- the absence of an EU taxing and spending authority. The $750 billion fund is merely a down payment on even bigger future bailouts.

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

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In the United States, President Obama's budget projections are much more optimistic than economists or investors believe. The Congressional Budget Office has just concluded, for example, that 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 making over $250,000 and the interest and dividend tax. The president's pledge not to raise taxes on families making under $250,000 puts Washington in a fiscal box.

Also, the banking legislation moving through Congress doesn't fix fundamental problems in the securitization market, and it doesn't fix "too big to fail" for the largest U.S. banks. In the current crisis, the Federal Deposit Insurance Corp. had resolution authority with regard to

Citigroup

(C) - Get Report

and

Bank of America

(BAC) - Get Report

, and Treasury has the same regarding

AIG

(AIG) - Get Report

, but it proved impossible to sell off the 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.

Professor Peter Morici, of the Robert H. Smith School of Business at the University of Maryland, is a recognized expert on economic policy and international economics. Prior to joining the university, he served as director of the Office of Economics at the U.S. International Trade Commission. He is the author of 18 books and monographs and has published widely in leading public policy and business journals, including the Harvard Business Review and Foreign Policy. Morici has lectured and offered executive programs at more than 100 institutions, including Columbia University, the Harvard Business School and Oxford University. His views are frequently featured on CNN, CBS, BBC, FOX, ABC, CNBC, NPR, NPB and national broadcast networks around the world.