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December 16, 2005

Will Bernanke Create Hyperinflation?
by Axel Merk

What are the lessons from the Great Depression, from stagflation in the 1970s, from deflation in Japan? The bubbles that preceded these challenging times should never have been allowed to happen. Yet even today, the Federal Reserve Bank (Fed) is very reluctant to pop bubbles. Greenspan talked about irrational exuberance in the stock markets, but let the stock market rise to the stratosphere in the late '90s; he has also kept interest rates low for an extended period despite mounting consumer debt and steep home price appreciation.

Central banks allow excessive credit expansion to take place. Partially this may be because central bankers do not recognize a bubble until they are reasonably well developed. Partially this may be out of fear of political repercussions if central bankers were to openly target perceived bubbles in their infancy. To a great extent it is also because some central bankers believe they can mitigate the fallout from the bursting of a bubble.

Richard Koo, author of 'The Balance Sheet Recession', says massive government spending must take the place of corporate spending to keep an economy afloat when corporations do not invest and consumers do not spend. Koo considers himself to be a leading voice for the 'Japanese experiment'. He argues that corporations that come out of a bubble with massive debt are more interested in repairing their balance sheets, i.e. pay down debt, than to invest. He rejects the notion that such companies should be allowed to fail when the problem is systemic such that 95% of banks have a negative net worth and there would not be any buyers in the ensuing shakeout. Consequently, the economy would potentially suffer a meltdown. He has supported the use of public funds to keep the Japanese economy afloat and has encouraged a gradual and cautious disposal of non-performing loans (NPLs) for banks. Theoretically, government spending should be curtailed once the economy is self-sustaining again. We are skeptical that this will succeed, as once the government has authorized spending projects, they take on a life of their own. As a result, we are growing increasingly concerned about the yen as the Japanese economy shows signs of strength.

Policy makers have a choice to bring an economy to its knees to eradicate any excess; or to provide the appropriate stimulus to try to neutralize just about any potential crisis. Ben Bernanke during his confirmation hearing to succeed Greenspan as head of the Fed, emphasized the experience of the Fed governors will help to preserve prosperity. It goes without saying that inducing a depression by choice is something few central bankers are willing to make. When a central bank takes a more active role in promoting structural change before a bubble has evolved, such as the European Central Bank (ECB) has done over the past couple of years, critics are abundant. Europe experienced hyperinflation twice in the 20^th century and is more concerned about the fallout of excess credit than, for example, the Fed or the Bank of Japan.

Bernanke says that "to understand the Great Depression is the Holy Grail of macro-economics." Fed policy makers have also been observing the Japanese experiment very closely. During his nomination hearing to succeed Fed chairman Greenspan, Bernanke praised the depth of experience of the Fed governors. He also said he saw the role of the Fed to provide adequate liquidity during a financial crisis. All of this suggests that when we face a crisis, the Fed under Bernanke's leadership will seek to rectify any imbalance with a stimulus.

We believe there is substantial risk that central bankers will not fully appreciate that the upcoming economic slowdown we foresee is very different in nature. Both in the 1930s in the US and in the 1990s in Japan, the corporate sector was in turmoil. This time around, with some notable exceptions (think automotive sector), corporate America is in reasonable shape. It is the consumer sector that we are most concerned about. There may also be significant fallout to the financial sector should there be a collapse in housing prices. The Fed has to be careful how it applies its stimulus. The traditional stimulus will encourage corporations to invest more. The problem is that corporations are likely to be encouraged to invest overseas in search of greater returns as their traditional customers, the American consumer, is exhausted. Any stimulus will further increase pressures in producer prices as raw material prices are likely to stay elevated. Given the cheap imports from Asia and high consumer debt, pricing power is likely to remain disappointing. As a result, real wage growth is likely to be lackluster at best as corporations must minimize labor cost to remain competitive.

This year, car manufacturers gave "employee discounts" to empty their lots. Right after Thanksgiving, substantial discounts were given to shoppers to lure them out to the stores. As top line growth may be attained, few retailers are likely to be satisfied with their margins. A slowdown in the housing market and high winter heating cost will put further pressure on consumer spending. An already negative savings rate cannot continue forever. As consumers realize that their real wages do not grow, that they cannot rely on extracting equity out of their homes, that competition from Asia may be a threat to their standard of living, the rational reaction will be to spend less. Given the dependence on the world economy on consumer spending, we believe the Fed will interpret the economic data as a warning sign that deflation could set in and a recession or even depression could follow unless the economy is 'saved' before a deflationary spiral is initiated.

So far, inflation has been tame because of Asia's willingness to flood the US markets with cheap goods, subsidized by rigid exchange rates. However, inflation is creeping through the production chain, and it is only a matter of time that it will become more widely spread. Already, we see significant inflation on any goods or services that cannot be imported from Asia (most of us can relate to inflation in the cost of healthcare and education).  As the US economy slows, foreigners may be less inclined to acquire US assets, vital to support the dollar given a current account deficit around 6% of Gross Domestic Product.

What if the Fed applies the perceived lesson from the Great Depression and the Japanese experiment to prop up the American consumer? If Japan is any guide, rather than allowing financial distress to happen amongst households (in Japan it was corporations), policies are likely to be put in place to allow households to make ends meet. But if the consumer knows that the government will come to their rescue, consumers may not have a good incentive to start saving. Whereas it used to be a virtue to leave something for your heirs, the baby boomer generation is likely to make it a virtue to squeeze the last cent out of a reverse mortgage to finance retirement (a reverse mortgage provides a steady income stream from a bank in return for incremental increases in a mortgage)

Inflation cannot be switched off like a light switch. We are concerned that by the time the Fed realizes that preserving the consumer's financial health may be a losing battle, inflationary pressures will no longer be containable. Any effect on the US economy will be amplified should the dollar fall sharply under the weight of the current account deficit.

Axel Merk
Axel Merk is Manager of the 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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