Wednesday, November 28, 2012

Axel Merk: Is the Yen Doomed?

In his latest Merk Insight letter, Axel Merk explains the Yen may not be the safe heaven it once was , as the Country has just starting posting current account deficit, which coupled with the stratospheric Japanese debt (>200% of GDP) could see the demise the Yen.

Here's the full analysis:

So many foreign exchange (“FX”) speculators have lost money shorting the yen that the currency earned the nickname the widow maker. Indeed, as the yen has had a weak patch as of late, some are already cautioning the trade might be crowded. But we don’t talk about a trade; we talk about a fundamental shift in the dynamics that might finally be unfolding.

To understand the yen, consider the earthquakes that hit New Zealand and Japan in early 2011: New Zealand’s shaker caused the New Zealand dollar to fall; Japan’s earthquake, in contrast, pushed the yen higher. In the short-term, earthquakes disrupt economic growth; conventional wisdom suggests less growth leads to a weaker currency. However, economic growth and currencies do not correlate as highly as one might expect. Indeed, everything appears backwards in Japan, and there’s a reason: historically, Japan has enjoyed a current account surplus. As a result, Japan does not rely on inflows from abroad to finance its budget deficit. Despite conventional wisdom, note that when there’s a shock to the economy, consumers save more/spend less, a positive to a currency all else being equal (i.e., in the absence of a current account deficit). In contrast, countries like the United States, or New Zealand for that matter, have a current account deficit; in the absence of growth, foreigners are less inclined to invest in the country, potentially depriving the country of inflows needed to finance budget deficits and, in the process, putting downward pressure on the currency. One reason why U.S. policy makers favor growth over austerity is to encourage inflows to finance the deficit. On that note, the lack of growth in the Eurozone, where the current account is roughly in balance, may be bad for employment, but the euro has managed to hold up reasonably well despite the crisis.

In some ways, when a country has a current account surplus, currency dynamics may be counter-intuitive: the more dysfunctional the Japanese government, the stronger the yen appears to have been in recent years. Since 2005, Japan has had seven prime ministers, with another change likely soon. A government with rotating heads suggests a government that doesn’t get anything done. Usually a government that “gets things done” is one that spends money, but Japan could not even get an expeditious rebuilding effort under way after the earthquake struck.

However, Japan's current account has been deteriorating in recent years. Japan is doing its part to accelerate the demise of its current account:
  • With one of the world’s highest life expectancies, almost no net immigration and falling birth rates, Japan’s aging population is often cited as the key-long term driver of the country’s deteriorating current account balance. The Japanese retire later than others in developed countries, cushioning the impact somewhat.
  • The main “achievement” after the earthquake was announcing to abandon nuclear energy. Increasingly relying on imported energy is bad news for Japan's current account balance.
  • Rising tensions with China don't bode we'll for trade. Shinzo Abe, Japan's likely prime minister to be is said to potentially escalate tensions further. If correct, we expect Japan's current account balance to suffer as a result.
Why does this all matter? After all, the US has had a massive current account deficit for years. The size of the current account deficit represents the amount foreigners need to buy in assets (local financial assets or real assets) to keep a currency from falling. With a current account deficit, Japan's debt to GDP ratio of over 200% may suddenly matter, as Japan may need to offer higher rates to attract foreigners to buy local assets (e.g., Japanese government bonds). The trouble is that Japan’s debt might be unsustainable at higher interest rates. To the extent that Japan has a current account surplus, it doesn't matter whether foreigners buy the yen, but those surpluses have fallen to deficits recently and that trend looks set to continue.

Some will argue that it still doesn't matter, as Japan is currently more concerned with negative rates. Our analysis, however, shows that the market does care: in recent years, the yen often appreciated when there was a "flight to safety;" if we use the VIX index, a popular measure of implied volatility of S&P 500 index options, as a proxy for the amount of fear in the market, then the yen should show a high correlation with the index. What the chart shows is that the yen isn't the safe haven it used to be. The yen no longer is the "go to" place when fear is elevated. There might be many reasons for this, but we like to look at it in the context of the current account balance, shown in the previous chart: as the current account has deteriorated, the yen's safe haven status appears to be eroding.

The one thing still going for the yen is that Japanese policy makers often don't execute on their talk. For example, Abe's election rhetoric suggests that the Bank of Japan (BOJ) will lose its independence as the government may force it to increase its inflation target of 1% (which it has failed to achieve) to 2 or 3 percent. But the BOJ has failed over and over again to live up to its promises. A side effect of that is that in recent years the BOJ's balance sheet has barely grown (the BOJ has "printed" very little money as one might colloquially say); Japan did its money printing in the 90s.

However, it may matter little what the BOJ is up to once the current account deteriorates further. We don't look at these trends as academic exercises, but rather consider the risk of acting versus not acting. At this stage, we assess the risk of not acting to be high and are putting our money where our mouth is.

Thursday, November 8, 2012

6 Ways To Invest in Gold

Merk Investments LLC has published a report entitled "How to Invest in Gold: Six Options to Consider" (PDF) which provides 6 ways to invest in Gold:
  • Gold Mining Stocks - They describe Junior and Majors mining including the different risks profile, and the need to clearly understand to company before investing
  • Gold Mining Funds - Easier to invest than Gold Mining Stocks, but fund managers charge a management fee. Neither Gold Mining stocks and funds give direct exposure to Gold.
  • Paper Gold - ETN are a convenient way to get exposure to Gold, but the risk comes with the issuer creditworthiness. Leverage ETN are risky investment which should only be used by speculators.
  • Open-End Gold Trusts - GLD, IAU, and SGOL are part of this category. This type of investment gives you fractional ownership of Gold and expenses are low. However, make sure to read the funds prospectus to check it does not use derivatives and see if it allows physical delivery.
  • Closed-End Gold Trusts - You get physical gold exposure, but it can be costly. There may be tax advantages to using this kind of investment.
  • Physical Gold - Namely Gold bars and coins.Pain attention to the premium paid (including shipping and insurance costs) . You'll have to find a way to store it safely, and there is the risk of purchasing counterfeit bars and gold. Buying from reputable dealers might help, but it's not a 100% guarantee.
You can read the PDF file for complete details.

Tuesday, August 28, 2012

Bernanke: To Print or Not to Print…?

In his latest Merk Insight letter, Axel Merk discusses the possible policy actions the federal reserver, via Ben Bernanke, make take, and although unlikely for now, one of the latest tool would be to lower the interest rate the Fed pays on bank reserves to possibly 10 basis points or zero.

Here's the full letter:

Official portrait of Federal Reserve Chairman ...
Official portrait of Federal Reserve Chairman Ben Bernanke. (Photo credit: Wikipedia)
To print or not to print? Odds are that Fed Chairman Bernanke has been contemplating this question while drafting his upcoming Jackson Hole speech. The one good thing about policy makers worldwide is that they may be fairly predictable. As such, we present our crystal ball as to what the Fed might be up to next, and what the implications may be for the U.S. dollar and gold.

First off, we may be exaggerating: on process rather than substance, though. That is, Bernanke isn’t just thinking about whether to print or not to print as he is sitting down to draft his speech. Instead, he considers himself a student of the Great Depression and has been pondering policy responses to a credit bust for some time. Consider the following:
  • Bernanke has argued that going off the gold standard during the Great Depression helped the U.S. recover faster from the Great Depression than countries that held on to the gold standard for longer.
    • Bernanke is correct: subject to many risks, debasing a currency (which going off the gold standard was) can boost nominal growth. Think of it this way: if the government takes your purchasing power away, you have a greater incentive to work. Not exactly the mandate of a central bank, though.
    • Note by the way that by implication, countries that hold on to the gold standard invite a lot of pain, but have stronger currencies. Fast forward to today and compare the U.S. to Europe. While neither country is on the gold standard, the Federal Reserve’s balance sheet has increased more in percentage terms than that of the European Central Bank since the onset of the financial crisis. Using a central bank’s balance sheet as a proxy for the amount of money that has been “printed”, it shouldn’t be all that surprising that the Eurozone experiences substantial pain, but the Euro has been comparatively resilient.
    • Possibly the most important implication: Bernanke considers the value of the U.S. dollar a monetary policy tool. When we have argued in the past that Bernanke might be actively working to weaken the U.S. dollar, it is because of comments such as this one. This is obviously our interpretation of his comments; a central banker rarely says that their currency is too strong, although such comments have increasingly been made by central bankers around the world as those pursuing sounder monetary policy have their economies suffer from competitive devaluations elsewhere.
  • Bernanke has argued that one of the biggest mistakes during the Great Depression was that monetary policy was tightened too early. Here’s the problem: in a credit bust, central banks try to stem against the flow. If market forces were to play out, the washout would be severe and swift. Those in favor of central bank intervention argue that it would be too painful and that more businesses than needed would fail, the hardship imposed on the people is too much. Those against central bank intervention point out that creative destruction is what makes capitalism work; the faster the adjustment is, even if extremely painful, the better, as the recovery is healthier and stronger.
    • If the policy choice is to react to a credit bust with accommodative monetary policy, fighting market forces, and then such accommodation is removed too early, the “progress” achieved may be rapidly undone.
    • We are faced with the same challenge today: if monetary accommodation were removed at this stage (interest rates raised, liquidity mopped up), there’s a risk that the economy plunges right back down into recession, if not a deflationary spiral. As such, when Bernanke claimed the Fed could raise rates in 15 minutes, we think it is a mere theoretical possibility. In fact, we believe that the framework in which the Fed is thinking, it must err on the side of inflation.
Of course no central banker in office would likely ever agree with the assessment that the Fed might want to err on the side of inflation. But consider the most recent FOMC minutes that read:
  • An extension [of a commitment to keep interest rates low] might be particularly effective if done in conjunction with a statement indicating that a highly accommodative stance of monetary policy was likely to be maintained even as the recovery progressed
As the FOMC minutes were released three weeks after the FOMC meeting, many pundits dismissed them as “stale”; after all, the economy had somewhat improved since the meeting. Indeed, it wasn’t just pundits: some more hawkish Fed officials promoted that view as well. But to make clear who is calling the shots, Bernanke wrote in a letter dated August 22 (the same date the FOMC minutes were released) to California Republican Darrell Issa, the chairman of the House Oversight and Government Reform Committee: “There is scope for further action by the Federal Reserve to ease financial conditions and strengthen the recovery.” Various news organizations credited the faltering of an incipient U.S. dollar rally on August 24 with the publication of this Bernanke letter.
For good order’s sake, we should clarify that the Fed doesn’t actually print money. Indeed, printing physical currency is not considered very effective; instead, liquidity is injected into the banking system: the Fed increases the credit balances of financial institutions in accounts held with the Fed in return for buying securities from them. Because of fractional reserve banking rules, the ‘liquidity’ provided through this action can lead to a high multiple in loans. In practice, one of the frustrations of the Fed has been that loan growth has not been boosted as much as the Fed would have hoped. When we, and Bernanke himself for that matter, have referred to the Fed’s “printing press” in this context, referring to money that has been “printed”, it’s the growth in the balance sheet at the Federal Reserve. That’s because the Fed’s resources are not constrained; it’s simply an accounting entry to pay for a security purchased; that security is now on the Fed’s balance sheet, hence the ‘growth’ in the Fed’s balance sheet.
Frankly, we are not too concerned about the environment we are in. At least not as concerned as we are about the environment we might be in down the road: that’s because we simply don’t see how all the liquidity can be mopped up in a timely manner when needed. At some point, some of this money is going to ‘stick’. Even if Bernanke wanted to, we very much doubt he could raise rates in 15 minutes. To us, it means the time for investors to act may be now. However, talking with both existing and former Fed officials, they don’t seem terribly concerned about this risk. Then again Fed officials have rarely been accused of being too far sighted. We are concerned because just a little bit of tightening has a much bigger effect in an economy that is highly leveraged. Importantly, we don’t need the Fed to tighten: as the sharp selloff in the bond market earlier this year (and the recent more benign selloff) have shown, as soon as the market prices in a recovery, headwinds to economic activity increase as bond yields are rising. That’s why Bernanke emphasizes “communication strategy”, amongst others, to tell investors not to worry, rates will stay low for an extended period. This dance might get ever more challenging.
In some ways, Bernanke is an open book. In his ‘helicopter Ben’ speech a decade ago, he laid out the tools he would employ when faced with a collapse in aggregate demand (the credit bust we have had). He has deployed just about all tools from his toolbox, except for the purchase of foreign government bonds; recently, he shed cold water on that politically dicey option. Then two years ago, in Jackson Hole, Bernanke provided an update, specifying three options:
  • To expand the Fed’s holdings of longer-term securities
  • To ease financial conditions through communications
  • To lower the interest rate the Fed pays on bank reserves to possibly 10 basis points or zero.
We have not seen the third option implemented, but the Fed might be discouraged from the experience at the European Central Bank: cutting rates too close to zero might discourage intra-bank lending and cause havoc in the money markets.

As such, expect Bernanke to give an update on his toolbox in Jackson Hole. The stakes are high as even doves at the Fed believe further easing might not be all that effective and could possibly cause more side effects (read: inflation). As such, we expect him to provide a framework as to why and how the Fed might be acting, and why we should trust the Fed that it won’t allow inflation to become a problem. For investors that aren’t quite as confident that the Fed can pull things off without inducing inflation, they may want to consider adding gold or a managed basket of currencies to mitigate the risk to the purchasing power of the U.S. dollar.
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Tuesday, July 31, 2012

Axel Merk: Gold at ECB: Accident or Strategy?

Axel Merk discusses the relatively constant Gold to Asset ratio at the ECB (15%) in his latest Merk Insight letter and tries to analyze if this is done on purpose.

Here's the full letter:

When the euro was launched, the European Central Bank (ECB) held approximately 15% of its assets in gold. That ratio has remained reasonably stable, giving rise to a variety of chatter, including suggestions that it may displace the U.S. dollar. We pursue the question on whether the ECB’s gold holdings are an accident or strategy.

Let’s look at the numbers. Below is a chart depicting the percentage of gold relative to the ECB’s total assets. As one can see, the percentage has remained reasonably stable despite a significant growth in total assets.
ECB Gold Holdings and Gold Price
Total assets of a central bank may be considered a proxy for the amount of money that has been “printed”; it’s a crude measure as it does not reflect physical money printed; nor does it reflect money in circulation; neither does it reflect sterilization activities that also show a rise in assets. Still, a central bank balance sheet is often referred to as the printing press as money is literally created out of thin air (by the stroke of a keyboard) when assets are purchased. Federal Reserve (Fed) Chairman Bernanke has referred to this fiat money feature as the printing press. We like to think of it as super-money, as central bank purchases provide cash to the banking system, allowing them to lend a multiple of the money that has been “printed”. While banks have been reluctant to lend (the velocity of money has been low), the analogy we like to give is that if you give a baby a gun, just because no one gets hurt does not mean it is not dangerous. That said, let’s look at total assets at the ECB:
ECB Gold Holdings As % Of Total Assets
The interpretation shows that while money can be printed, wealth cannot be created out of thin air: as money is printed, gold has appreciated versus the euro. So while inflation has not shown up in indicators such as the Consumer Price Index, monetary easing is rightfully reflected in the price of gold.
Diving a little deeper to determine how much of this is strategy versus accident, let’s look at the gold holdings at the ECB once more:
ECB Gold Holdings: Value and Volume
The ECB marks its gold holdings to market, i.e. uses market prices for gold. The ECB was selling gold from the inception of the euro until the onset of the financial crisis; since then, the ECB’s gold holdings have remained stable. To understand the motivation, one needs to note that when one refers to ECB gold holdings, one is actually talking about Euro area gold holdings. While the ECB holds some gold, most gold is held by the respective central banks (this is not a discussion of where such gold is physically located):
Eurosystem Gold Holdings
Relevant is that each nation in the Eurozone pursues its own agenda with regard to its gold holdings. Germany has resisted political pressure within Germany to sell gold, as Bundesbank (Buba) profits would need to be transferred to the government; the hawkish Buba has indicated that it would be considered selling gold to help finance the government’s deficit. Italy, as one can see, has not sold any gold. Conversely, as a percentage of their holdings, the Netherlands had been rather eager to sell gold up until the financial crisis; Portugal, too, was an aggressive seller. As one can see, gold sales are not particularly related to the financial health of a Eurozone nation, but more to the cultural attitude in the respective nations towards gold.
Let’s cross the Atlantic to see whether the ECB’s gold strategy is undermining the U.S. dollar. The Fed’s gold stock is valued at $44.22 per fine troy ounce. For purposes of the chart below, we adjust the Fed’s gold holdings to market prices:
Fed Gold Holdings
Note that the chart above starts in 2006, so as to focus on the period of the financial crisis. The Fed has been more aggressive than the ECB in printing money. As such, the percentage of gold in relation to total holdings has declined at the Fed in a more pronounced fashion. There is clearly no perfect relationship between the size of the balance sheet and the price of gold, as other factors also influence the supply and demand of gold; however, increasing the supply of fiat money (dollar, euros) may decrease its value when measured in real assets, such as gold. We have in the past referred to the Fed as the champ in printing money (as measured by the percentage balance sheet growth since August 2008), although the Bank of England has, as of late, taken on that title. But we digress.
From what we see, central banks have been scared into holding gold since the onset of the financial crisis. Beyond that, we don’t see an active strategy at the ECB to keep its gold reserves at 15% of total assets. Instead, the ECB’s comparatively measured approach has simply lead to a reasonably stable percentage of gold reserves. Of course that was before ECB President Draghi said on July 26, 2012, that he shall do “whatever it takes to preserve the euro.” (an interpretation of that may be that more money printing is on the way). For now, the cultural differences in responding to the financial crisis (Europe: think austerity; US: think growth) suggest that the euro should outperform the U.S. dollar over the long term, assuming the not-so-negligible scenario of a more severe fallout from the Eurozone debt crisis won’t materialize.
It may help to keep in mind that historically inflation is the response to a deflationary shock. If market forces were left to themselves, we believe the credit bust of 2008 would have caused a major deflationary shock. It’s the reaction of policy makers that fight market forces that may lead to inflation. Bernanke as of late brushed off such pessimism. As the charts above show, however, gold has been a sensitive – and sensible I might add - indicator to the trigger-friendliness of our central bankers.

Monday, July 23, 2012

Axel Merk: Is Spain Jeopardizing the Eurozone?

Axel Merk published his latest Merk Insights entitled "Spain's Molasses Jeopardizing Eurozone?!". He analyzed the debt structure in Spain, and explains that just shuffling debts around won't fix the debt problem, and guarantees must be removed to solve over-indebtedness. Failing to do so will make the global financial system as a whole at risk.

Here's the full commentary:
Spain's regional government debt is in focus again. Spanish 10-year government bond yields are trading near 7.5% as Spain’s central government is expected to bail out its regions – and in return may ask for a bailout itself. Guarantees don’t make a system safer, quite the opposite: everything is safe until the guarantor itself is deemed unsafe. While the failure of any one business of regional government is a tragedy, providing a guarantee puts the system as a whole at risk.

Spain consists of 17 autonomous regions, whose total debt almost doubled in the past three years. Technically, Spanish law forbids the central government from rescuing regional government (in much the same way that the Maastricht Treaty prohibits bailouts of EU countries). The debate on whether the central government should take more control over regional budgets and provide guarantees/bailouts has intensified since January, when the central government implicitly helped Valencia, one of the most indebted regions, with a €123 million loan repayment to Deutsche Bank:
  • Though the central government is prohibited from rescuing regional governments and it denied it has done so, El Pais (Spain's highest-circulation daily newspaper) reported earlier this year that the Spanish Treasury provided implicit guarantee and help to Valencia in repaying the loan to Deutsche Bank. The central government advanced its regular transfers to Valencia by about 10 days to January 3rd. On the next day, Jan. 4th, Valencia was reported to have repaid the loan. It can be viewed as the first implicit bailout from the central government in Spain.
In an effort to impose more control over the spending of regional governments, the Spanish Council of Ministers approved a draft of a Stability and Sustainability Law in late January; one provision is that the central government could oversee the budgets of the 17 autonomous regions and establish penalties for those who do not meet the balanced budget targets (all regions missed the deficit-to-GDP target of 1.5% last year). Not surprisingly, the provision created strong controversy. Socialist-led regions (i.e. Catalonia) criticized the provision harshly, while some conservative-ruled regions (i.e. Valencia) backed the plan. The criticism didn’t stop Catalonia to ask for delays in handing tax payments to the central government.
In May, in a clear sign that troubles for the regions were escalating, Valencia, one of the most troubled regions, was forced to pay what was considered a punitive 6.8% yield to roll over €500 million for six months, more than six times the Spanish Treasury had to pay on the comparable-maturity at the time. By now, the yields have further risen to around 20%.
A highly decentralized budget system
  • Spain is divided into 17 autonomous regions due to historical reasons and cultural differences.
  • Regional governments have historically been granted significant control over spending. They take charge of education, health and social services, which account for 50% of total government expenditures.
  • Regions also have the power to authorize or veto the issuance of public debt.
  • The central government has little ability to interfere regional government spending, but is prohibited by Spanish law to bailout regional governments.
Mismatch in regional fiscal autonomy
  • While regions enjoy high autonomy on spending, the central government retains effective control over regional government revenue.
  • For 15 out of the 17 regions, the central government retains all powers over the collection and regulation of important taxes (i.e. corporate income tax, import duties, payroll taxes). Regional government revenues mainly come from the central government's conditional grants and ceded taxes (set at central level, but collected at regional level). Central grants vary from year to year; they are designed to address regional imbalances. And for some of the ceded taxes, these regions only retain a small share (i.e. 35% for VAT and 50% for personal income tax) after collection.
  • Only two regions are close to the maximum fiscal autonomy. They have full powers over a number of major taxes and retain 100% of ceded taxes.
Regional debt accumulation
  • As a result of the economic recession and housing market collapse, all 17 regions experienced a significant rise in debt. By 2011, the total debt of 17 regional governments rose to €140 billion, accounting for 13.1% of Spain's GDP. This number is up from 6.7% by 2008.
  • 10 out of 17 regions' debt-to-regional-GDP ratio exceeded 10% (versus 2 out 17 by 2008). All regions missed the deficit-to-GDP target of 1.5% last year.
  • The most indebted region, Catalonia, recorded a 20.7% debt-to-regional-GDP ratio and 3.6% deficit-to-GDP ratio in 2011. Catalonia’s 10-year bond yield exceeded 14% at its peak in June.
  • The 2nd indebted region, Valencia, delayed repayment of a €123 million loan to Deutsche Bank in January. Subsequently, the region's credit rating was downgraded by Moody's to junk and it failed to raise €1.8 billion in a bond auction in March. Valencia is a Mediterranean region with many beach-front properties; its economy collapsed after the housing bubble bust.
Last Friday, Valencia was the first region to say it would contribute into a new Spanish government fund to meet its debt-refinancing obligations, as well as to pay suppliers. With that, the Spanish government is now clearly on the hook for the regions’ debt. Not surprisingly, the market is pricing in that reality. Trouble is that Spain’s central government does not have the credibility that it has sufficient influence to turn the regions’ finances around. Unless the Spanish government can assure the markets that it can deliver sustainable budgets – for itself and now the regions as well – it will simply go deeper into the molasses and risks taking the Eurozone with it. And while Spain certainly tries to advance its structural reform, the headlines coming out from the region suggest Spain might be more interested in the European Central Bank (ECB) intervening to help out Spain’s cost of borrowing. As long as debt is merely shuffled around, the Eurozone crisis won’t be solved. And as long as ever more guarantees are provided – from regional to national governments, from supranational issuers such as the European Stability Mechanism (ESM) to the International Monetary Fund, the more the global financial system as a whole may be at risk.

Wednesday, June 27, 2012

Axel Merk: The US of E has Arrived!

Axel Merk published his latest Merk Insights entitled "United States of Europe has Arrived!". With lots of talk about a fiscal union, a banking union and a potilical, Merk wonder if we are assiting to the birth of the United States of Europe.

Here's the full letter:

A vision "Towards a Genuine Economic and Monetary Union" has just been published by the European Union. Key components include integrated financial and budgetary frameworks. The goal is to achieve a “strong and stable architecture in the financial, fiscal, economic and political domains.” For a vision to work, it has to be realistic. The budgetary framework calls for “joint decision-making … and … steps towards common debt issuance.” Given that German Chancellor Merkel was quoted as saying Europe will not have shared liability for debt as long as she lives, such goals seem a tad ambitious. Understanding that Merkel is like a mother to the United States of Europe, she should consider nurturing it with vitamins, love and care.

Love has a lot to do with communication. And while it should be so easy, we all know that we sometimes neglect to communicate with our loved ones. Translating that to the Eurozone, take charge, be a leader and communicate! Merkel may not be a Reagan, nor a Thatcher, but it ultimately falls upon her shoulders to frame the discussion. If she does not agree, there is little others can do to move forward. Tough love is okay, too…
Intensive care is what peripheral Eurozone countries are in. Let’s focus on the good news in terms of European integration: those countries that require assistance have yielded sovereign control to the European Commission. Presto! That’s the key element of the union. Those that have proven prudent in managing their budgets don’t need to yield control to Brussels bureaucrats. But those that are not capable do. It may sound like an unbalanced union, where not everyone is ceding control, but given the political realities, policy makers ought to leverage the cards they are dealt.
Regarding the so-called banking union, the same principle applies: countries that have been incapable of cleaning up their own banking system, ought to cede control. Seizing control from national bank regulators, including a European resolution scheme are key; but unlike the proposed vision published by the European Union, such a scheme must start with the more modest goal of first intervening where calls for help have been issued.
The way you leverage on the framework is by providing hope and support to those that succumb to it. Some vitamins, when administered in too high a dose, may be toxic. The European Stability Mechanism, the ESM, has shown such toxic characteristics. Because the ESM subordinates all other debt, it has made such subordinate debt toxic. The ESM is a last resort bailout scheme, not a tool to promote a “strong and stable architecture.” The discussion about the solution must include Eurobonds.
Having said that, vitamins do little good if not accompanied by underlying lifestyle changes. Put another way, as long as policy makers look for evermore creative ways to finance rather than to reduce debt, the underlying disease won’t be cured. Ultimately, debt will need to be reduced. The way it looks, it may be more likely be through default than sustainable fiscal policies.

Squaring the circle
The price for living beyond one’s means and failing to regulate one’s banking system should be the loss of sovereign control over budgeting and regulation. This part is already reality, as evidenced by the various bailout schemes in place.
What is not in place is a mechanism to allow those chronically sick children to get back on the right path, for national governments to conduct policy with enough dignity, so that political backlash won’t tear those countries apart.

The solution must include a tough love support mechanism, one where sovereign debt of the country in need is not de facto labeled as toxic. At the same time it is fully understandable that a country such as Finland wants to receive collateral for loans provided to those that have a proven track record of living beyond their means. Once a check is written, it’s rather difficult to decide on where the money is going to be spent. As such, a basis of discussion for the Eurozone should be:
  • Countries that want final control over where bailout money is spent, need to accept the seniority status of IMF and ESM money.
  • Eurobonds (without seniority over outstanding bonds) should be issued to finance projects that are directly supervised by the European Commission.
If Spain wants a bank bailout that doesn’t jeopardize its sovereign bonds, it must yield control over its banking system. It must accept that fact that its banking system may be too big, that institutions may be liquidated and management teams fired.
It’s too early to write off Europe. In the short-term, expectations are so low that policy makers will have a hard time disappointing. In the meantime, central banks around the world appear to be hoping for the best, but planning for the worst. That may mean easy money, a weak U.S. dollar, with money flowing into currencies of countries whose central banks can afford to not join the fray. To us, it is no coincidence our analysis of recent market data suggests biases of major central banks towards easing, whereas central banks of smaller countries shift towards tightening monetary policy

Wednesday, June 20, 2012

Axel Merk: Growth vs Austerity Analysis

Axel Merk, of Merk Funds, analyses both current economic models: Austerity and Growth; he tries to find out which one is more sustainable? Since Merk Funds focus on currency investments, he has a look at the implications on the U.S. dollar.

Here's the full newsletter:

To have budgets sustainable is as simple as matching revenue and expenses. Almost. Politicians have figured out that running a deficit may still yield a stable debt-to-GDP ratio, assuming there is economic growth. When U.S. politicians brag their budget forecasts bring down the absolute level of the deficit, it’s the debt-to-GDP ratio at best that may improve, assuming their rosy projections of economic growth prove correct. In the Eurozone, governments have – theoretically – committed themselves to running no more than 3% deficits, suggesting that such deficits lead to sustainable debt-to-GDP ratios. Not quite. Our research shows that, in order to achieve a long-term debt-to-GDP ratio in the low 50% range, deficits of no more than half of GDP growth may be run. If GDP growth is 3% a year, the deficit ought to be no higher than 1.5%. If 3% deficits are allowed, but GDP growth is only half of that – a more realistic assumption for many countries in today’s environment, the debt-to-GDP ratio will stabilize at above 200%. For a visualization of where the debt-to-GDP ratio will peter out given different growth and deficit scenarios, consider this table:
Average annual deficit Average GDP growth Long-term debt-to-GDP
1.5% 3.0% 51.5%
3.0% 3.0% 103.0%
3.0% 1.5% 202.9%
Why do we care about debt-to-GDP ratio? Allowing a high debt-to-GDP ratio is akin to playing with fire. Just look at the housing bust for an illustration as to what’s so dangerous about piling up too much debt: when interest rates are low, life feels great, the standard of living has gone up. But when interest rates move up, those with a higher debt load have to make disproportionate cuts to their standard of living to service their debt. According to the Congressional Budget Office (CBO), the U.S. paid an average of 2.2% of GDP in interest from 1972 until 2011. In its “Extended Alternative Fiscal Scenario” that assumes current policies, as opposed to current laws, remain in place, net interest payments will soar to 9.5% of GDP in 2037. In 2011, $454.4 billion in interest was paid in a $15 trillion economy; that is, 3% of GDP was spent in servicing interest payments. If the U.S. were to spend 9.5% of GDP to service its debt rather than 3%, it requires a cut of 6.5% of GDP in other services. It dwarfs the fiscal cliff (the reference to Bush era tax cuts running out coupled with spending cuts, absent of Congressional action) that might put a 3% to 5% dent on GDP. 

The pessimistic CBO outlook assumes what we judge to be an unrealistically low 2.7% average interest rate on debt payments. Should the market demand more compensation – generally referred to as bond vigilantes holding policy makers accountable – financing the deficits may no longer be feasible. Just ask Greece; or Spain.
With 10 year Treasuries yielding 1.6% in the United States, some argue that higher deficits are warranted. As the discussion above shows, the logic behind the view is fundamentally flawed, if not reckless. In the U.S., we differentiate between discretionary and mandatory spending. Mandatory refers to contractual obligations, the entitlements, most notably regarding Social Security and Medicare. Put simply, it may not be realistic in the long run to finance thirty years of retirement with forty years of work. As interest payments take a bigger chunk of GDP, discretionary spending is squeezed out. Be that an infrastructure project at the federal level; teachers at the state level; or firefighters or animal shelters at the local level.
In real life, there are some added complexities: we all fight for our benefits, take them for granted once granted and will fight vigorously to retain them. Also keep in mind that emergencies, such as natural disasters or wars, are typically not reflected in budget forecasts, as they might be considered “one off” items; even if that were correct, emergency spending adds to the deficit.
As debate rages whether austerity or growth is the solution to the plight of the developed world, keep in mind that there is a history spanning centuries, if not millennia, of governments spending too much money. In the old days, neighboring countries were “taxed” to fill domestic coffers: taxation, as in conquering other countries and taking treasures and slaves. Debt is a modern form of slavery, except that it is voluntary servitude. If history is any guide, don’t get your hopes up too high that these issues will be resolved. But investors may be able to navigate the waters, mitigate some of the risks or even profit from opportunities that arise in this environment.
The growth camp suggests that, with enough growth, a high debt load can be carried. That may be the case if such growth is not financed through debt. In recent years, trillions have been spent to achieve billions in growth – not exactly a recipe for sustainable budgeting.
The austerity camp suggests that, with enough austerity, books can be balanced. Except that, as services are cut, the economy is at risk of entering a downward spiral, increasing, rather than decreasing deficits. 

And while these two ideologies are being discussed, central banks struggle to either keep the banking system afloat (as in the Eurozone) or are helping to finance the government deficit (as in the U.S.). Indeed, the key difference between the U.S. and European model is that U.S. Treasuries appear to be backed by a) the taxing power of Congress and b) a lender of last resort, the Federal Reserve (Fed) with its printing press; whereas European sovereign debt is backed only by the taxing power of the national governments. The European Central Bank (ECB) has made it clear that its role is to support the banking system, not the sovereigns. In contrast, the Federal Reserve (Fed), while not admitting to outright financing of government deficits, has shown a willingness to do so in practice. As such, European sovereign debt is trading more like municipal bonds trade in the U.S., with weak “municipalities” (think Spain) paying a huge premium.
To be fair, the growth camp wants more than deficit spending; and the austerity camp wants more than cost cutting. Indeed, in a recent analysis Saving the Euro, we argued policy makers should instead focus on competitiveness, common sense and communication. Ultimately, both camps believe their philosophies should attract more investment as confidence is increased. In practice, the proverbial can is kicked down the road. By the time the can reaches the end of the road, it may be very beaten up. Indeed, an increasing number of investors are spreading their investments across multiple “cans” – we refer to these “cans” as diversified baskets of currencies, including gold.
What’s different between the U.S. and Europe is that the U.S. has a significant current account deficit. In our experience, countries with current account deficits tend to favor growth oriented strategies as they need to attract money from abroad to finance their deficit and, as such, to support the currency. While a bond market in shambles is a major drag on growth in the Eurozone, the Euro has been able to hold up reasonably well given the fact that the Eurozone’s current account is roughly in balance. A misbehaving bond market might have dire consequences for the U.S. dollar, even if one disregards the odds that the Federal Reserve may make U.S. Treasuries even less attractive by financing government spending (when a central bank buys a country’s own debt by printing money, such securities are intentionally over priced, potentially weakening the currency).