(07/15/11) Place Your Bets, Bernanke vs. Paul

To QE3 or not to QE3, that was the question Congress put to Bernanke this week, but Ron Paul and the Fed chairman had a very insightful colloquy, notes Axel Merk of Merk Funds.

Federal Reserve Chairman Ben Bernanke, in a verbal duel with Representative Ron Paul, provided insult to injury to hard money-attuned investors.

When asked whether gold should be considered money, Bernanke replied “no.” When further quizzed why central banks then hold gold reserves, Bernanke brushed the question off, suggesting gold is simply held because of tradition.

This occurred after Bernanke claimed that Fed policy has been profitable, as manifested by the billions in profits paid to the Treasury as a result of these policies. To make it clear: when a central bank prints trillions of dollars to buy securities, those securities will of course pay record amounts in interest.

However, it is misleading to conclude that such operations are profitable. The money that gets printed dilutes the very value of the currency those profits are paid in.

Claiming that Fed operations are profitable, while ignoring the fact that the currency itself may be debased, is rather irritating to those that believe that a central bank’s role is to pursue sound monetary policy. Sound monetary policy is a pursuit of price stability, not one of generating paper profits on printed money.

Bernanke firmly embraces the US dollar as a monetary policy tool. In our analysis, he has worked on weakening the dollar in both word and action.

In the past, Bernanke has testified that going off the gold standard helped the US recover faster from the Great Depression than other countries that held on to the standard for longer.

Bernanke has argued that a weak dollar is not inflationary. We disagree.

The action of buying government securities by a central bank causes such securities to be intentionally overvalued. Rational investors may look overseas for less manipulated returns.

Not surprisingly, the US dollar moved sharply downward as Bernanke started testifying to the House of Representatives, where the above exchange between Ron Paul and Bernanke took place.

One of the US economy’s greatest attributes has been its flexibility—in large part because we allow free-market forces. While massive monetary and fiscal efforts in the US and globally may have compromised these free-market forces, we believe they will play out over the long term.

In our opinion, the US dollar is a natural valve to allow the US economy to adapt to global market dynamics; we consider both free-market forces and the unintended consequences of monetary and fiscal policies may push the US dollar lower over the long term.

The recent financial crisis has in many ways exacerbated the global imbalances that concerned us leading up to the crisis. Of grave concern is the unsustainable federal budget deficit, which may have morphed out of control.

More worrying still is that there appears little evidence of government restraint from either political party. With a sluggish economy hampering tax revenues, and further spending on the horizon, we are likely to see continued deterioration in public finances over the near term.

The notion of a balanced budget seems a very distant thought, when overlaying the near-term outlook with the budget implications of long-term obligations such as Medicaid, Social Security, and Medicare.

Put simply, the fiscal position of the US has deteriorated significantly, and we consider the outlook remains bleak. We believe this situation is likely to wear away at the safe-haven status the US has held for so long. Many other countries have been more fiscally prudent, and now find themselves in much healthier fiscal positions relative to the US

The US current account (trade) deficit remains at unsustainable levels, despite recent improvements. The current account balance is what the US earns from other countries (exports, services, investments abroad) minus what the US pays to other countries (imports, services, loans).

The balance on trade (the difference between exports and imports of goods and services) is the largest driver of the US current account deficit. In our assessment, the recent narrowing of the deficit can be attributed to a weak US economy and consumer, rather than the strength of the US export sector.

In fact, the economic downturn caused both exports and imports to fall—it's just that the rate of decline was more pronounced for imports, given the weakness of the US consumer.

While we see considerable risks domestically, we believe there are attractive international investment opportunities.

On a long-term view, we anticipate that Asia may outpace most Western economies, including the US, attracting global investment and putting upward pressure on the value of many Asian currencies.

Many Asian nations have substantial surpluses and much healthier fiscal positions than the US. Moreover, most countries in the region have focused on growing their domestic economies...spending on the likes of infrastructure, growing the middle class, and urbanizing the workforce.

A likely side effect of such rapid domestic growth may be increased inflationary pressures. In our view, these inflationary pressures may force the hand of Asian countries following currency-peg policies, such as China, to allow their currencies to appreciate.

Strong, ongoing Asian economic growth will likely increase the demand for commodities and natural resources. Countries rich in such resources may fare well, and ongoing Asian demand will likely benefit the currencies of such nations over the long term.

We consider that countries whose governments display greater fiscal restraint and responsibility will increasingly be viewed as sought after sources of stability. Over time, such countries may supplant the US as safe havens.

Additionally, in our assessment, the monetary policies pursued by central banks globally will have a marked impact on currency valuations long-term. Relative to the Fed, we believe many international central banks are more effectively fostering an environment of price stability. As such, the currencies of such nations may retain significant value relative to the US dollar.

Consequently, on a long-term view, we favor the currencies of nations that are well placed to benefit from ongoing Asian economic growth, display fiscal restraint, and whose central banks’ pursue prudent monetary policies.

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