Merk Market Outlook: Budgetary Consequences Of The Financial Crisis

By: Joseph Brusuelas | Fri, Sep 26, 2008
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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.

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

Author: Joseph Brusuelas

Joseph Brusuelas
Chief Economist
VP Global Strategy
Merk Investments LLC

Bridging academic rigor and communications, Joe Brusuelas provides the Merk team with significant experience in advanced research and analysis of macro-economic factors, as well as in identifying how economic trends impact investors. As Chief Economist and Global Strategist, he is responsible for heading Merk research and analysis and communicating the Merk Perspective to the markets.

Mr. Brusuelas holds an M.A and a B.A. in Political Science from San Diego State and is a PhD candidate at the University of Southern California, Los Angeles.

Before joining Merk, Mr. Brusuelas was the chief US Economist at IDEAglobal in New York. Before that he spent 8 years in academia as a researcher and lecturer covering themes spanning macro- and microeconomics, money, banking and financial markets. In addition, he has worked at Citibank/Salomon Smith Barney, First Fidelity Bank and Great Western Investment Management.

Mr. Brusuelas lives in Connecticut with his wife and St. Bernard.

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

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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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