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The US Federal Reserve has gone
beyond playing with fire, and may have indeed set the house on fire. It's one
thing to push interest rates to near zero to stimulate the economy; it's
another to monetize the debt by printing money to
buy government debt.
In recent weeks, the Fed has broken outside even those boundaries and become
actively engaged in managing the private sector beyond the core banking
system. Worse still, the steps taken may be difficult to reverse and as such
may shape the US economy for a long time.
These steps are taken with the best of intentions, to "save" the
economy. The only trouble is that we may be on a slippery slope
to destroying capitalism on the way. In "doing whatever it takes"
to get the economy back on its feet, the Fed risks destroying the foundation
of why the US has been able to establish itself as the world's leading
economic force.
Actively participating in credit allocation within the private sector, the
Fed jeopardizes the capitalist foundation the US economy is built on. As a
result of these actions, the US may be on its way to becoming a modern
incarnation of a planned economy.
To understand what is so frightening with recent Fed activity, consider that
most central banks focus on interest rates, inflation and money supply to
promote price stability (and maximum employment in the Fed's case).
Generally, they all influence credit creation by managing the cost of
borrowing. Central banks may employ slightly different levers and targets;
and while some central banks are better than others at achieving their goals,
what they have in common is that they traditionally focus on government debt,
mostly short-term Treasuries, to achieve their goals.
This is very much by design as good central bank policy leads to an
environment of price stability fostering long-term economic prosperity. On
the other hand, bad central bank policy may lead to inflation, wide swings in
economic activity or unnecessarily high unemployment. However, free market
forces will push the private sector to make the best of it.
It's when policymakers start subsidizing ailing sectors of the economy that
distortions are created that will come back to haunt us. Traditionally, for
better or worse, elected officials decide on the socio-economic fabric of
society. Now, the Fed decides which areas of the economy need to be propped
up.
The hysteria that has been created by policymakers and the media has allowed
the Fed to pursue its recent unorthodox policies. In late September, the
world financial system looked rather dire; the government was able to play a
role to avoid a disorderly collapse; but the government's role should have
been limited to allowing an orderly adjustment of the excesses of the credit
bubble. Instead, the latest salvo to promote the bailouts is that payrolls
have dropped by the largest amount since World War II.
This may be the case in absolute numbers as the population has grown, but
more jobs were lost as a percentage of the workforce in a 12-month period in
each of 1982, 1961, 1958, 1954, 1948/49; in many of the cases more than twice
as many.
Recessions are no fun, neither are personal or corporate bankruptcies; but they may be the
cure needed to weed out the excesses of the boom. In contrast, today, hedge
fund managers that ran their
funds into the ground are raising hundreds of millions of dollars to start
anew. Some of the folks that ran Long Term Capital Management into the ground
in 1998 started fresh only to have another massive failure in the current
credit crisis. We don't expect the new breed of second chances to be any
better.
And while the blame lies with the managers, excessively low interest rates
contribute to irrational risk-taking: all of the bailouts focus on those who
have been over-leveraged. What about the group of responsible savers that
rely on income? With interest rates near zero, many are tempted to engage in
highly leveraged strategies to meet their required income objectives. Pension
funds "must" return 6% per year, leaving them little leeway but to
give money to hedge fund managers to magically turn 1% yields into 20%
returns; the way to achieve this is with leverage.
Actually, there is another way: the Swiss public pension fund system just
announced that it will scale down its long-term return objective to 4% from
its current 6% per annum.
Giving credit where none is due
In late December, the Fed board of governors approved the application by
General Motors' finance arm, GMAC, to become a bank. The vote was 4-1, and
the one board member with experience as a bank regulator, Elizabeth Duke,
dissented. There was another hurdle: GMAC did not have sufficient capital to
be a bank. That problem was solved in early January as the Treasury injected
US$5 billion into GMAC; the Treasury also gave General Motors $1 billion so
that the auto company could inject that money into GMAC. Equipped now with a
minimum capital base, GMAC is able to operate as a bank and go to the Fed to
access the Troubled Assets Relief Program (TARP) as well as other regular and
emergency Fed windows.
Shell-shocked consumers are worried about their jobs and have lost a
substantial amount of their net worth in 2008; they simply don't want or need
a car right now. In December, car sales fell off the cliff. But it wasn't
only GM that had problems; even Toyota, which had access to credit and
introduced zero percent financing, recorded a 37% plunge in sales (unlike
other carmakers, Toyota has traditionally not offered zero percent
financing).
Incentive programs prior to the bursting of the credit bubble lured consumers
into six-year loans with zero percent
financing. Policymakers take this as a reason to provide money to GMAC that
pursues a business model proven to be ruinous: it simply doesn't make sense
to offer cars at zero percent if interest rates are above that, even if they
are "close to zero", as they are now. GMAC takes money from the
Treasury to be able to request more from the Fed. And the first course of
business for GMAC is to extend zero percent financing to consumers with lower
credit
ratings than had
traditionally qualified.
The Fed is only ramping up its mission to allocate credit where the Fed -
rather than the free market - deems it appropriate. A major program announced
in the fourth quarter and rolled out in early January consists of a $500
billion program to buy mortgage-backed securities (MBS). The perceived
positive is the plummeting of mortgage
rates. Consumers with
superb credit now qualify for 30-year mortgages at less than 5%.
One problem with such programs is that the Fed intentionally inflates prices
(lowers the yields) on these securities; in turn, rational market
participants may abstain from buying them. As a result, the Fed risks replacing
private sector activity, rather than encouraging it. Furthermore, the Fed
jeopardizes the dollar as foreigners may be discouraged from buying US government and agency security debt; given that the US has become dependent on foreigners to
finance its spending needs as well as the unprecedented debt that will be
financed in 2009. This is a very dangerous road to be on.
The Fed may be able to phase out its commercial paper subsidy program or
drain liquidity from the TARP program over time; however, the $500 billion
MBS program may be difficult, if not impossible, to unwind. Indeed, the
design of the MBS program calls for holding of the securities until maturity.
For practical purposes, this means that the Fed's balance sheet is not just
"temporarily" inflated, but that the Fed will permanently keep more
money in the economy.
Traditionally, the Fed's balance sheet is $900 billion. Therefore, even if
one gives the Fed the benefit of the doubt that the current escalation to
over $2 trillion is temporary, there will be a significant hangover as not
all additions can easily be removed.
This doesn't even consider that, quite likely, the MBS purchase program may
need to be extended beyond the six-month period it was put in place for. Watch
for bond manager Bill Gross this June calling for the Fed to continue buying
MBS, preferably the ones he has on the books, to save the economy from
collapse. Incidentally, his firm, PIMCO, is one of the firms managing the Fed
program.
To counter the effects of this added money in the economy, the Fed would need
to keep interest rates permanently higher. One realistic alternative,
however, is that the additional money will stay in the economy as draining it
would cause too much economic hardship. This may well embed inflation into
the US economy for years to come. Importantly, note that there is little, if
any, accountability at the Fed monitoring its actions; no one is there to
ensure that the Fed will, at some point, phase out its programs or added
powers.
Live free or die
By engaging in credit allocation to specific sectors of the economy, the US is stepping into a territory traditionally left to governments with a socialist or
communist brand. Communism has shown us that planned economies don't work.
New Hampshire in 1945 added the slogan "Live Free or Die" to its
state emblem, a quote stemming from a general in the Revolutionary war. Translated
to the economic crisis, this should mean that a severe recession ought to be
the lesser evil than a planned economy. And to continue the parallel, when
communism swept Eastern Europe, the standard of living for everyone dropped. In
today's world, we already see that the "re-failure" rate of those
who defaulted, then renegotiated their teaser rate loans, is above 50%. Yet
all taxpayers have to pay the price for the bailouts.
To be sure, we are a far cry from communism. But we must keep our eyes open
and not be blinded by the perceived "help" of money printed by the
Fed. Debt is the origin, not the solution to the problems we face. The
Declaration of Independence's "life, liberty and the pursuit of
happiness" may be difficult to achieve when the country is drowned in
debt; building sustainable wealth without the shackles of debt may be the
more appropriate path.
It's not by mistake that the Founding Fathers demanded that the country's
currency be backed by a precious metal that cannot be inflated to give in to
the temptation of the day.
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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