Debunking Bernanke's Myth
In his interview with "60 Minutes", Federal Reserve (Fed) Chairman Ben Bernanke suggested it is a myth that quantitative easing implies printing money. With all due respect, Mr. Bernanke, if it looks like a duck and quacks like a duck, it is a duck!
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Bernanke argues his policies do not amount to printing money, as neither currency in circulation, nor money supply has increased. This analogy is a bit like giving a loaded gun to a kid, then telling your friends that it's not a deadly weapon because the shots that have been fired haven't killed anyone. Granted, we are exaggerating here because, after all, it's only money we are talking about. Yet, printing money may destroy one's purchasing power and thus one's life's savings.
Indeed, the Fed doesn't only print money, but prints "super money". The money the Fed prints is more powerful than currency in circulation. It's money made available to the banking system. When the Fed buys government bonds, or any other security, from a bank, the Fed credit's the bank's account at the Federal Reserve, with the amount due. That "money", however, is merely an entry on the computer system at the Fed - it's literally created out of thin air. It's not physically, but electronically printed. A bank with cash in its hands can create new loans; those loans may be deposited elsewhere by the person taking the loan; money created by the Fed out of thin air can have a multiplier effect of 1:100 by the time it makes its way through the economy. The loaded guns handed to the kids are not a water pistols, but automatic weapons.
The kids, of course, are the banks. So far, the latest scolding (the 2008 financial crisis) remains fresh in their minds, and they are thus reluctant to pull the guns' safety. But make no mistake about it: the banks are being handed potent weapons. Indeed, the Fed would love to see the banks pull the trigger and hand out more loans. It turns out the banks are not finding enough creditworthy borrowers.
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Truth be told, the money does make it somewhere, but the Fed cannot control where the money flows (have you ever tried to control a little kid? Please do not try this at home). Instead of flowing to where the Fed would like to see all that freshly printed money go, it ends up in assets with the greatest monetary sensitivity: precious metals, commodities, as well as outside of the U.S. dollar. Courtesy of the Fed's "mythical printing", gasoline is as high as $3.50 a gallon at some gas stations in California.
The money doesn't "stick" where the Fed would like it to because the Fed is fighting market forces. Consumers would love to get their house in order - quite literally: without massive fiscal (read: cash-for-clunkers) and monetary (read: credit easing, monetary easing) intervention, over-extended consumers would downsize further. However, "downsizing" implies foreclosures and bankruptcies: promoting such a course of events could well be political suicide for policy makers. Well, it appears Bernanke believes that if you simply throw enough money at the problem - trillions of dollars worth - you might just get some of that money to flow where you want it.
Bernanke brushed off his critics, arguing those critical of his policies are not considering the risks should nothing be done, namely deflation. We are not quite as concerned as Bernanke is about lower wages, as that may well be an answer to reduce the oversupply of the unemployed. But it is not the argument of deflation or inflation we are most concerned about. Let's remember: in the run-up to the financial crisis, bad things happened. This is not the place to argue whether it was the bad banks, bad consumers, bad regulators or bad politicians causing the crisis (in the spirit of the season: let he who is without sin cast the first stone!). No, the real problem is that the massive and ongoing intervention by policy makers led us to believe that there is a magic wand - the Fed's printing press included - that can fix our sorrows. Because the government has come to the rescue with such great force, the financial reform bill may not be worthy of its name; our system is no better than before the crisis; on top of that, we may be setting ourselves up for a much worse crisis further down the road. Beyond regulatory reform, there is also no incentive to engage in fiscal reform as the Fed helps financing the government deficit.
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On that note, the reason we are far more optimistic about the Eurozone than most is because the sense of urgency hasn't gotten lost there. Real reform is implemented as the European Central Bank (ECB) has reduced liquidity (that's the opposite of money printing - just as mystical) by hundreds of billions of euros this year. Yes, there are real problems in Europe, but there's a wonderful dialogue between the markets and policy makers. Policy makers don't like the medicine they are prescribed by those "speculators", but structural reform is greatly expedited. In contrast, in the U.S., we are merrily printing money because - well, in our assessment, U.S. policy makers simply believe they can still get away with it.
It turns out the ECB's divergence from the Fed is not a recent, but a decade old phenomenon. In an effort to impose structural reform, the ECB has kept the Eurozone on a far tighter leash than the Fed has kept the U.S. economy. As a result, European consumers are generally far less leveraged than U.S. consumers (with notable exceptions in some regions). In the U.S., if monetary policy were to be tightened, it may well throw the U.S. economy into a depression; in contrast, those European consumers that stopped spending won't cut back much further. Quite the contrary, German consumers in particular are starting to embrace the holiday spirit after years of holding back. In more mundane terms: the euro may well outperform the U.S. dollar because less money is being printed in the Eurozone.
This leads us to the future: in our assessment, the Fed's worst nightmare may well be that this mythical money makes its way through the economy. Bernanke said he could raise interest rates in "15 minutes" should the economy need to be tamed. That's a cute pun on a TV program called "60 Minutes", but ignores a philosophical and a practical challenge: Bernanke has extensively argued that tightening monetary policy too early after a recovery took place was a key policy mistake of the 1930s; to us, it appears highly unlikely that the Fed will apply any 15 minute policy to the U.S. economy.
Let's give the Fed the benefit of doubt for a moment - after all, we believe the men and women at the Federal Reserve Open Market Committee (FOMC), the group that decides on monetary policy, has the best of intentions. Here's the challenge: by fighting market forces, we keep, or quite possibly expand, the extensive leverage in the economy. As a direct result, the U.S. economy is exceedingly sensitive to monetary policy. Think of it this way: if you have no debt, you couldn't care less about interest rates. If you have loads of credit cards bill, in addition to a large mortgage, the amount of sleep you get every night may be highly correlated to interest rates. So if the Fed gets its wish and we get strong economic growth, how on earth is the Fed going to mop up all the liquidity they are saturating the economy with? The technicalities aside (we have issues with those, too), we have grave concerns that as soon as the Fed would indeed start tightening, it would have a far more amplified effect than they anticipate, causing the economy to plunge rather sharply.
In a "best case" scenario, we may end up with a rather volatile Fed policy in the years to come, bouncing back and forth between full-speed ahead and applying the emergency brakes. As it turns out, very little, if anything, has really worked according to the "best case scenario" in recent years. In this context, please pardon our assessment that the risks of quantitative easing far outweigh the potential "benefits."
What are those "benefits" anyway? At the risk of great simplification, it's all about home prices. Millions of homeowners are under water. To remedy the situation, homeowners can downsize (the healthiest from a macro point of view, but politically not an option); pay down their debt (may happen individually, but real wages haven't gone anywhere in a decade, thus making it an unlikely option); or, alternatively, the Fed can employ its mythical printing press in an effort to push up the price level. The "benefits" thus go to those with too much debt; the pain goes to those who have been savers, including pensioners. The policies are rewarding speculation; not just any, but the type of speculation that chases the next great intervention by policy makers, not the next great business opportunity. Asset classes have become increasingly correlated as a result.
Excessively accommodating monetary policy fosters capital misallocation; those in desperate need of yield may be buying ever longer-dated and riskier securities. The greatest bubble in monetary history may have been in the making, a bond bubble (see our analysis Bond, Junk Bond - Casino Royale).
Talking about myths, there is a myth that Bernanke continues to promote: the myth that the Fed can fight inflation. Even central bank super-hero Paul Volcker, who is credited with "beating inflation" in the early 1980s, merely got the annual inflation rate back down to earth. When central bankers pat themselves on the back for "beating" inflation, we never come back down to the price level before inflation started - monetary super-heroes are those who can stop the bleeding.
To end this on a conciliatory note, we agree with Bernanke that one should never underestimate the determination of the Fed. However, that's because, in our assessment, inflation is not primarily a function of the "slack in the economy", the "output gap" as economists like to call it, but a function of inflation expectations: if consumers and businesses believe we will get inflation, they will push for higher wages and prices. And because the Fed has the power of the printing press, it's the Fed that can control inflation expectations - if it only has the will. When Volcker "beat" inflation, many were skeptical about his determination until proven wrong. Now it's Bernanke that has empathetically called for inflation to rise. Again, some are skeptical; we believe those skeptics will be proven wrong. Indeed, longer-term inflation expectations have been ticking upward ever since Bernanke said in August that the Fed will "strongly resist" inflation expectations falling too low.
In this context, investors may want to consider diversifying beyond the U.S. dollar to mitigate the risks of the Fed's policies. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.