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The consequences of
the troubled asset relief program (TARP) will be felt for a number of years. The
death of the investment-banking model, the transformation of the domestic
system of finance and the coming wave of regulation of what is left of Wall
Street will have far-reaching consequences. This, however, will take much
time to absorb and assess. What is of immediate concern, is how the proposed
$700 billion TARP will impact the budget outlook for fiscal year 2009.
Looking at the -$486
billion deficit throughout the first 11 months of the 2008 fiscal year the
primary catalysts for the sharp increase in federal spending have been the
fiscal stimulus and decline in tax revenues caused by the economic downturn. We
expect that the final month of the fiscal year will see a net surplus for the
month near $46 billion. Thus, the fiscal year, which will come to a close at
the end of September, should see a deficit of -$440 billion in contrast with
the -$162 billion deficit recorded in fiscal year 2007.
Once one begins to
take a look at the staggering problem at hand, the deficit that was
previously projected by the Congressional Budget Office of -$438 billion
could easily double. Our first cut estimate now expects that the deficit
could reach as high as -$585 billion in fiscal year 2009.
We make that
estimate based on the following assumptions.
- Tax revenues will continue
to underperform on the back of a much rougher economic landscape than
the CBO currently has penciled into their model
- We expect an additional
fiscal stimulus of a minimum of $50 billion dollars, with risk to the
upside
- Increased outlays to cover
coming bank failures of a minimum of $30 billion in FY 2009.
- An extension of the
Alternative Minimum Tax fix
- This does not account for
any additional spending that may be put on the books in the first few
months of the new administration in 2009
- It is unclear how much of
the estimated $700 billion TARP will be allocated to FY 2009 spending. We
expect that it will be valued as such that it does not significantly
increase the overall budget.
- This assumes that the
bailout of Fannie and Freddie are not put on the books in FY 2009
- According to the CBO no
decisions have been made regarding how the funds pledged will be
allocated
- CBO Director Peter Orszag
believes that the bailout of Fannie Mae and Freddie Mac “should be
directly incorporated into the federal budget.”
- Our initial estimate of
$300 billion as the price tag for the bailout of Fannie and Freddie was
based on an assumption of a 5% loss in the overall value of the GSE's. This
may be on the light side and the cost could be considerably larger.
- Such a move would be quite
contentious and could raise direct questions regarding the credit
quality of the US.
- Depending on how the U.S.
Treasury proceeds and how the outlays are valued and classified the FY
2008 debt could easily reach $885 billion with considerable risk to the
upside once one adds in any spending during the early portion of the new
administration.
The short-term
consequences of the bailout are quite clear. The fiscal years 2009 and 2010
will see record deficits on a nominal and possible real basis. The debt to
GDP ratio will increase from roughly 3.0% of GDP in 2008 to a possible 6.0%
in 2009. The steps that are about to be taken will crowd out other spending
priorities and may lead to a reassessment of current entitlement obligations,
foreign operations, national healthcare system and levels of taxation.
Long term however,
the consequences are unclear. The major issue that is rightly being discussed
is; will the increase in federal outlays be inflationary? On first look, the
increase in spending and rising public debt is not necessarily inflationary. The
Fed can take steps via the federal funds rate to maintain price stability.
Unlike, in many
developing countries the Congress, outside of printing coins, does not have
access to the printing presses. As long as the Federal Reserve does not make
the decision to monetize the debt, the inflation problem from the increase in
outlays could plausibly be addressed. However, this will require the Fed to
remain focused on price stability and to continue to make the case that
stable prices are a precondition of maximum sustainable employment. This may
require the Fed to impose higher rates on short-term borrowing than our
political and financial classes are currently comfortable. Yet, that is a very
tall order for even an independent central bank to fill.
While, there is
theoretically no direct impact on the rate of inflation due to the increase
in spending, there is the chance that the introduction of political logic
into an otherwise economic process could alter the equation. One does not
need to be able to recall Lyndon Johnson literally pressuring Arthur Burns
into funding his foreign adventures and ambitious domestic spending
initiatives, to imagine that the constellation of political forces inside Washington could begin to bend the will of the Fed.
Should the current
financial crisis lead to significant deterioration in the economy or taxpayer
losses exceed current estimates due to the sheer cost of the financial
bailout, pressure could be brought to bear on the Fed in such a way that it
may be difficult for the central bank to focus on price stability. The
central bank might at some point in the not so distant future decide to
tolerate a far higher rate of inflation than is consistent with a non-inflationary
target rate. The temptation to keep the federal funds rate low and partially
monetize the debt may prove irresistible to the central bankers that may run
the Fed in the aftermath of the Bernanke tenure.
Past episodes of
inflation have often begun under such conditions. Past deterioration in
public finances have often led to unwise monetary policy. Today, the
probability of the printing presses being cranked up to fund current
obligations of the Federal Government remains low. However, for individuals
and institutions engaging in long term investment decisions the risk of
higher inflation over the long term due to the sharp increase in federal
outlays and public levels of debt should receive serious consideration. It cannot be
automatically dismissed out of hand.
Joseph Brusuelas
Chief Economist
VP Global Strategy
Merk Investments LLC
Merk Investments LLC is the manager
of Merk Mutual Funds, including the Merk Asian Currency Fund and the Merk
Hard Currency Fund. The Merk Asian Currency Fund invests in a basket of Asian
currencies. Asian currencies the Fund may invest in include, but are not
limited to, the currencies of China, Hong Kong, Japan, India, Indonesia,
Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
The Merk Hard Currency Fund invests
in a basket of hard currencies. Hard currencies are currencies backed by
sound monetary policy; sound monetary policy focuses on price stability.
The Funds may be appropriate for you
if you are pursuing a long-term goal with a hard or Asian 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 Funds and to download a prospectus, please visit www.merkfund.com.
Investors should consider the
investment objectives, risks and charges and expenses of the Merk Funds
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 Funds primarily invest in
foreign currencies and as such, changes in currency exchange rates will
affect the value of what the Funds own 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 Funds are subject to
interest rate risk which is the risk that debt securities in the Funds'
portfolio will decline in value because of increases in market interest
rates. The Funds may also invest in derivative securities which can be
volatile and involve various types and degrees of risk. As a non-diversified
fund, the Merk Hard Currency 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. For a more complete
discussion of these and other Fund risks please refer to the Funds' prospectuses.
This report was prepared by Merk
Investments LLC, and reflects the current opinion of the authors. It is based
upon sources and data believed to be accurate and reliable. Opinions and
forward-looking statements expressed are subject to change without notice.
This information does not constitute investment advise nor a solicitation or
an offer to buy or sell any products or services. Foreside Fund Services,
LLC, distributor.
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