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In a rare interview with Western
media, Wen Jiabao, the Chinese premier, told the Financial Times (see http://www.ft.com/wen),
‘Confidence is the most
important thing, more important than gold or currency’
Why is it that such wisdom comes
from the leader of China, but is absent from the leaders of other countries? Do
other presidents and prime ministers intentionally play a backstage role,
letting their Treasury secretaries or finance ministers communicate with the
public to avert blame when policies fail? That suggests that the leadership
may not have all that much confidence in the programs they are promoting; or
more likely, the leadership does not understand the issues.
Investors and entrepreneurs take
risks in search of profit opportunities. In contrast, in times of crisis,
many avoid risks and hoard cash in an effort not to lose money. Except, of
course, if your bank or the currency you hold the cash in goes down the
drain. When confidence even in cash erodes, gold thrives. The slogan for
crisis investing so dreaded by governments is:
‘Gold is the most
important thing, more important than confidence or currency’
Governments dread investors
flocking to gold because it shows a lack of confidence in riskier
alternatives available. Gold’s attraction is that its value cannot go
to zero; that it has no counter-party risk; gold over the millennia has shown
to be a store of value. But economies do not grow when gold is hoarded:
capitalism requires risk seekers.
What do rational market
participants, what do entrepreneurs, what do investors need? Do they need
bailouts? Do they need stimulus packages? Do they need low interest rates? No.
The top priority for any reasonable person to put capital at risk is
confidence. It’s the confidence that the market will provide fair
prices and that one has a fair chance to be fairly compensated for the risks
one takes. Capitalism does not require low prices, low interest rates, easy
access to credit; capitalism requires fair prices, fair interest rates and
fair access to credit.
In a rational market, the cost
of borrowing skyrockets for those who borrow too much. Consumers, businesses
and governments are all subject to the same forces. However, policy makers
seem to want none of that; they argue that requiring homeowners to pay 5%-6%
on a mortgage is too much, that the government must intervene to lower the
cost of borrowing. 5% is too much for someone who cannot make a large down
payment and may lose his or her job; 5% is too much for someone who has maxed
out his or her credit card. But historically, 5% for a mortgage is a
fantastic deal. Confidence does not come back to markets because the
government subsidizes mortgages. Confidence comes back when private lenders
and borrowers agree on the terms of a mortgage; this may take some time as a
lot of confidence has been destroyed by both irresponsible lenders and
borrowers. The government may provide a temporary “feel-good”
effect by buying agency securities of Fannie Mae and Freddie Mac, lowering
the cost for subsidized mortgages. However, by buying these securities, they
will have a label on them: “agency securities are intentionally
overpriced.” – What rational buyer would want to buy such
securities if they are not fairly compensated for the risks they are taking
on? Never mind private buyers, so the government thinks, as the Fed will step
in to buy them. When we have the Fed, who needs the private sector? The Fed
is so much more efficient at printing money. To name just three problems with this approach:
- First, the government
replaces rather than encourages private sector participation.
- Second, the government is
increasingly engaged in specific credit allocation. Picking specific
industries or firms to subsidize is something better left to planned
economies. When governments start picking industries and companies to
subsidize, inefficiencies are created, leading to higher costs, lower
competitiveness and ultimately a loss of jobs.
- Third, given that the U.S. is dependent on foreigners buying U.S. debt, it may be rather hazardous to the value of the U.S. dollar when the
government intentionally overprices U.S. debt. The Chinese especially must be excused for
ramping down their appetite of U.S. debt: the securities they purchase are artificially inflated through Fed
purchase programs; the Chinese need their foreign currency reserves to
prop up their domestic economy; and ironically, the U.S. can’t think of anything better than to insult
the Chinese by labeling them currency manipulators! Contrast that with
Wen Jiabao, who holds out an olive branch, telling the world they will
use their reserves to buy technology in Europe and the U.S.
The concept that
devaluing your currency will jump-start economic growth is simply a baffling
one. Say you own $90,000, worth 100 ounces of gold; or let it be the value of
a piece of land. You devalue your currency, so now the $90,000 will only buy
50 ounces of gold or a fraction of the land. The economy may now be
“jump started” as people feverishly work to make up the loss
again; it will take years of economic growth to be able to afford the missing
50 ounces of gold or the remainder of the piece of land yet again. Somehow
policy makers have it backward. Many of us like our jobs, but not so much
that we love to give up half our net worth for the opportunity to go back to
work.
But what about all those folks
who need to have a bailout? Something obviously went wrong as individuals and
businesses took on too much credit. The solution, however, is not to prop up
a broken system by stuffing even more credit down the throat of those who
couldn’t handle the credit in the first place. The solution is to allow
an orderly write off of investments and loans that have gone wrong. Most
mortgages are non-recourse loans, meaning homeowners could simply hand over
the keys to their homes and walk away from their debt. As a result, financial
institutions would think twice before making a loan to such borrowers in the
future.
What it comes down to is that
just about all policies proposed deal with propping up a broken system rather
than initiating the reforms necessary. Credit plays an important role in
modern economies, but throwing more credit at those who are over-extended is
not the solution. Quite the contrary: by not allowing consumers to reduce
their debt levels, allowing them to “de-leverage” as we prefer to
say, it will make the exit strategy all but impossible. Assuming that some of
the money from the stimulus and the easy money will stick at some point, what
happens when interest rates will need to be raised to fight the inflation
that’s being firmly implanted into the pipeline? The Fed thinks it
knows how to fight inflation, but raising interest rates to anything close to
what we saw in the early 1980s is simply not realistic unless one wants to
cause a revolution. Similarly, the spending programs initiated will likely
ramp up by the time the economy shows signs of recovering; how on earth will
one be able to scale them back again? It may not be possible for the dollar
to remain the world’s reserve currency; ultimately, those wishing for a
weaker dollar to boost economic growth may get much more than they are
bargaining for as far as the dollar is concerned. No country has ever
depreciated itself into prosperity and the U.S. is unlikely to be the first.
The optimistic scenario is that
the U.S. will emerge from the crisis through inflationary
growth. While confidence in business will come back in this scenario, the
confidence in the dollar may be shattered.
Present government policies are
aimed at coercing the public into taking risky investments so that they
don’t lose the purchasing power of their hard earned cash. The reason
that’s done is so that all the debt can be served. We can do better
than that. If we had less debt, we would be more concerned about preservation
of purchasing power. But because the government also has tremendous debt, the
interests of governments and savers are not aligned.
Governments should provide a
fair playing field that fosters savings and investments. In China, it’s not that consumers want to save so much,
but that there are not enough investment opportunities available. A healthy
level of spending will result when consumers have strong balance sheets. Spending
driven by excessively low interest rates is not the approach. China has understood much of this, but, in our assessment, could play a greater
role in fostering entrepreneurial activity; there’s a tremendous
opportunity to build a more balanced economy in China, not by encouraging private spending, but by
encouraging private investment. Infrastructure projects play a role in that,
but China should go far beyond that, providing its people a
vision that depends less on export, but more on building a strong domestic
economy.
Europe has chosen a more
modest path where a deep recession may weed out the weak players. Europe can afford to take this approach as consumers have less debt. The
European Central Bank, in our assessment, prefers this path over the U.S. approach that may lead to inflation, possibly even
hyperinflation down the road.
The U.S. economy has attracted investment for so long because
it has been a fair place to conduct business in. Gaining the confidence of
investors takes decades to build, but is easily destroyed. The U.S. must focus on reform to avoid some of the excesses
from happening again; not simply prop up a broken system. So far, all we see
is governments throwing money at the problem. We may be able to sum up our
current policies as
‘We don’t know what
we are doing, but we are doing a lot of it…’
We manage the Merk Hard and
Asian Currency Funds, no-load mutual funds seeking to protect against a
decline in the dollar by investing in baskets of hard and Asian currencies,
respectively. To learn more about the Funds, or to subscribe to our free
newsletter, please visit www.merkfund.com.
Axel Merk
Manager, Merk Hard Currency Fund
The Merk Hard Currency Fund is a
no-load mutual fund that invests in a basket of hard currencies from
countries with strong monetary policies assembled to protect against the depreciation
of the U.S. dollar relative to other currencies. The Fund may serve as a
valuable diversification component as it seeks to protect against a decline
in the dollar while potentially mitigating stock market, credit and interest
risks - with the ease of investing in a mutual fund.
The Fund may be appropriate for you
if you are pursuing a long-term goal with a hard currency component to your
portfolio; are willing to tolerate the risks associated with investments in
foreign currencies; or are looking for a way to potentially mitigate downside
risk in or profit from a secular bear market. For more information on the
Fund and to download a prospectus, please visit www.merkfund.com.
Investors should consider the
investment objectives, risks and charges and expenses of the Merk Hard
Currency Fund carefully before investing. This and other information is in
the prospectus, a copy of which may be obtained by visiting the Funds website
at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus
carefully before you invest.
The Fund primarily invests in
foreign currencies and as such, changes in currency exchange rates will
affect the value of what the Fund owns and the price of the Funds shares.
Investing in foreign instruments bears a greater risk than investing in
domestic instruments for reasons such as volatility of currency exchange
rates and, in some cases, limited geographic focus, political and economic
instability, and relatively illiquid markets. The Fund is subject to interest
rate risk which is the risk that debt securities in the Fund's portfolio will
decline in value because of increases in market interest rates. As a
non-diversified fund, the Fund will be subject to more investment risk and potential
for volatility than a diversified fund because its portfolio may, at times,
focus on a limited number of issuers. The Fund may also invest in derivative
securities which can be volatile and involve various types and degrees of
risk. For a more complete discussion of these and other Fund risks please
refer to the Fund's prospectus. Foreside Fund Services, LLC,
distributor.
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