Tuesday, March 27, 2012

Axel Merk Answers to Bernanke: The Gold Standard is not the Problem, Leverage is.

Ben Bernanke, Vampire Chairman
Ben Bernanke, Vampire Chairman (Photo credit: DonkeyHotey)
Axel Merk has just published another edition of Merk Insights entitled "Bernanke's Problem with the Gold Standard, where he gives a counterargument to Ben Bernanke's take on the Gold standard and explains leverage is the real issue, not the Gold standard.

Here's the article:
In his new lecture series, Federal Reserve (Fed) Chairman Ben Bernanke is going out of his way to discuss the "problems with the gold standard." To a central banker, the gold standard may be considered "competition," as their power would likely be greatly diminished if the U.S. were on a gold standard. The Fed, Bernanke argues, is the answer to the problems of the gold standard. We respectfully disagree. We disagree because the Fed ought to look at a different problem.

Bernanke lists price stability and financial stability as key objectives of the Fed. Focusing on the latter one first, the Fed was established to reduce the risk of financial panics. Bernanke points out:

"A financial panic is possible in any situation where longer-term, illiquid assets are financed by short-term, liquid liabilities; and in which short-term lenders or depositors may lose confidence in the institution(s) they are financing or become worried that others may lose confidence."

Bernanke goes on to blame the gold standard for the panics. While he is certainly not alone in his view – indeed, his very lecture to students at George Washington University is promoting that view to a new generation of economists -, we beg to differ.

Banks - by definition - have a maturity mismatch, making long-term loans, taking short-term deposits. As such, banks are prone to financial panics as described by Bernanke. To mitigate the risk of financial panics, central banks can do what the Fed is doing, namely to be a lender of last resort. Alternatively, central banks can focus on the core issue, the structural "problem of banking." Following the Fed's approach, there are inherent moral hazard issues – incentives for financial institutions to increase leverage, to become too-big-to-fail. To address a panic that might happen anyway, the Fed would double down (provide more liquidity), potentially exacerbating future banking panics. After yet another crisis, new rules are introduced to regulate banks. The resulting financial system may not be safer, but it will increase barriers to entry, further bolstering the leadership position of existing, too-big-to-fail banks. With all the government guarantees and too-big-to-fail concerns, banks might then be regulated in an attempt to have them act more like utilities. Ultimately, that might make the financial system more stable, but will stifle economic growth. Financial institutions, as much as we have mixed feelings about their conduct, are vital to finance economic growth, as they facilitate risk taking and investment.

The problem of all financial panics is not the gold standard - otherwise, the panic of 2008 would not have happened. The problem of financial panics is - again - that "longer-term, illiquid assets are financed by short-term, liquid liabilities." Missing from Bernanke's definition is a key additional attribute, leverage. A maturity mismatch without leverage might cause a lender to go bust, but - in our interpretation - does not qualify as a panic when a limited number of depositors are affected. The "panic" and the "contagion" may occur when leverage is employed, as it creates a disproportionate number of creditors (including consumers with cash deposits).

There's a better way. To avoid having financial institutions serve as “panic” incubators, regulation should address the core of the issue. Bernanke shouldn’t use gold, as a scapegoat for all that was wrong with the U.S. economy previously, to justify a license to print money. First, failure must be an option; individuals and businesses must be allowed to make mistakes and suffer the consequences. The role of the regulator, in our opinion, is to avoid an event where someone's mistake wrecks the entire system.

The easiest way to achieve a more stable financial system is to reduce incentives for leverage. A straightforward method is through mark-to-market accounting and a requirement to post collateral for leveraged transactions. The financial industry lobbies against this, arguing that holding a position to maturity renders mark-to-market accounting redundant. Consider the following example, which highlights the implication: assume a speculator before the financial crisis took a leveraged bet that oil prices - at the time trading at $80 a barrel - would go down to $40 a barrel. In the “ideal world” according to the banks, this speculator would not have been required to post collateral and would have been proven right when oil (briefly) dropped to $40 a barrel after the financial crisis. In reality however, as oil prices soared to $140 a barrel before declining, the typical speculator would have been forced to post an ever larger amount of collateral; likely, the speculator's brokerage firm would have closed out the position, as the speculator ran out of money. The speculator lost money because he was unable to meet a margin call; importantly, though, the system remained intact. The speculator might complain: the price ultimately fell to $40! But such whining is futile because the rules of engagement were known ahead of time. As such, the speculator had an incentive to use less (or no) leverage. The bank's attitude, in contrast, incubates panics. In this example, regulated exchanges exist. But even without regulated exchanges or easily priced securities, similar concepts can be developed.

Another way to make financial firms more panic prone is to require them to issue staggered subordinated debt. Rather than relying heavily on short-term funding (retail deposits or inter-bank funding markets), banks should be required to stagger the maturities of their own funding over years. If, say, each year 10% of their loan portfolio needs to be refinanced, then - in times of financial turmoil - it might become exorbitantly expensive for a bank to finance that 10% of their loan portfolio. A bank should be able to shrink its loan portfolio by 10% in a year in an orderly fashion, without jeopardizing the survival of the firm or spreading excessive risks throughout the financial system. Note that this is a market-based mechanism to police the financial system.

These concepts reduce leverage in the system. And that's the point, as leverage is the mother of all panics. The concepts presented above will not solve all the challenges of banking, but blaming "the problem of the gold standard" for financial panics is - in our analysis - premature.

Modern central banking is not the answer to mitigate the risk of financial panics because the cost for this perceived safety is enormous. As a result of responding to each potential panic with ever more "liquidity", entire governments are now put at risk when a crisis flares up.
Beyond that, central banks have done a horrible job in containing inflation. The wisdom of central banking is that 2% inflation is considered an environment of stable prices. At 2%, a level often touted as a “price stable environment”, the purchasing power of $100 is reduced to $55 over a 30-year period. It's a cruel tax on the public. What’s more, in practice, countries with a fiat currency system have generally been unable to keep long-term inflation below 2%.
Bernanke warns of deflation. To the saver, deflation is a gift. Not to the debtor. In a debt driven world, deflation strangles the economy. Governments don't like deflation as income taxes and capital gains taxes are eroded. In a deflationary world, governments would need to rely more on sales taxes (or value added taxes): gradually reduced revenue in a deflationary environment would be okay as the purchasing power of those tax revenues would increase. That assumes, of course, that the government carries a low debt burden -- deflation would be a good incentive to limit spending. Get the picture why governments don't like deflation?

With inflation, people have an "incentive" to work harder, to take on risks, just to retain their purchasing power, the status quo. What about the pursuit of happiness? The idea that if you earn money and save, you can retire and live off your savings? We consider it quite an imposition that unelected officials have such sway over our standard of living.
Bernanke also attacks the gold standard for causing havoc in the currency markets.

Monday, March 19, 2012

John Embry: Global Debt Saturation Ensures Much Higher Gold & Silver Prices

Presentation by John Embry, Chief Investment Strategist at Sprott Asset Management, at the 2012 California Resource Investment Conference.

 He explains that due to high level of debts and current policies, currency debasements are inevitable and forecasts a complete breakdown of the current monetary system in the US, in Europe, in Japan and possibly in China.  This will likely lead to Gold and Silver prices higher than the most bullish forecasts.

Tuesday, March 13, 2012

Axel Merk: Euro Crisis: Hope for the Best, Plan for the Worst

Deutsch: Deutsches Logo der EZB. English: Germ...

Yet another edition of Merk Insights entitled "Eurozone Crisis - Hope for the Best, Plan for the Worst", by Axel Merk of Merk Funds where he discusses the different scenario that may occur in the Eurozone amd the consequence for the Euo exchange rate (He expects the Euro to strengthen as short position are unwind).

Here's the article:
When Greece’s woes first rattled the markets two years ago, the pundits predicted a collapse of the euro.
The resilience of the euro has been due to a number of factors, not least of which is that the eurozone as a whole has a broadly balanced current account. As such, a misbehaving bond market doesn’t necessarily cause a plunge in the currency, as foreign buyers are not required to fund a deficit or protect against currency weakness.
The euro has also been on the other side of the Bernanke trade: the Fed’s printing of trillions of dollars is a deliberate effort to weaken the US dollar in an attempt to promote economic growth. Conversely, with the European Central Bank showing more restraint, the euro has been stronger, yet that strength has exposed a host of problems.
A similar pattern was evident during the Great Depression, where those countries holding on to the gold standard longer had stronger currencies, but suffered painful fiscal and political consequences of trying to do the right thing.
The focus should be on making the financial system strong enough to stomach potential sovereign defaults. And, as no one else has been able or willing to step up to the plate, the ECB has been forced to take on the task.
By charging only 1 per cent on unlimited 3-year loans, the ECB is allowing banks to reap substantial profits by buying higher yielding securities. This can be extremely profitable. In the US, the Fed brags about handing over $80bn in profit to the Treasury, neglecting to state the fact that the more money a central bank prints, the more securities it can buy and, thus, the greater the interest it earns. The ECB, though, “splits the coupon” with the banking sector, boosting their profitability.
For now, policymakers hope the ECB’s elixir will continue to soothe the markets, but the fear of contagion is still a big concern. With Greece temporarily patched up, the focus may shift again to Portugal, Spain, and Italy. Policymakers in emerging markets have cause for concern, too, as European banks have been a key source of funding for these markets. Emerging market funding is often provided in US dollars, stoking contagion concerns for US markets. Prime US money market funds were all too willing to buy US dollar-denominated commercial paper issued by European banks.
Indeed, central bankers have ramped up their efforts, seemingly planning for the worst. The Fed introduced a currency swap line to alleviate US dollar funding concerns in Europe. The ECB conducted its 3-year long-term refinancing operations (LTROs). The Bank of England provided another dose of quantitative easing. The Bank of Japan pursues its newly anointed inflation target. These are all variations of printing money.
With all major countries printing money, the problems in the eurozone may ease for now. Add to that the large degree of short positions previously built up in the euro that still need to be wound down, and the single currency should do just fine for the time being.
There’s a price to be paid, though: we don’t see how the ECB, in three years’ time, will be able to mop up the trillion-euro liquidity it has provided. The ECB has now introduced a structural rigidity into its monetary policy, akin to what the Fed is faced with. In many respects, central banks have disrupted the natural transition of market-ascribed economic health by imposing their colossal might (balance sheets) onto the markets. This should be alarming. Central bankers are increasingly manipulating rates all along the yield curve.
Such policies take away crucial economic gauges (market-based interest rates across the yield curve) from investors and policymakers. As result, policymakers can no longer rely on these metrics in setting appropriate monetary policy.
Politicians, too, no longer get market feedback to encourage reform. Spain has already indicated it will further soften its budget goals. Yet, without the ECB’s liquidity provisions, the bond market might have responded with its own “encouragement” to run less of a deficit, by selling Spanish debt.
This is not just a European problem. Look at the proposed 2013 US Budget and it becomes clear that, without the encouragement of the bond market, policymakers may have little incentive to pursue fiscally sustainable policies. With its significant current account deficit, the US dollar may be much more vulnerable than the euro should US bond markets act up.
In the meantime, Greece is experimenting with a carrot and stick assortment of incentives. That approach may be doomed to failure as each time a target is missed the ire will be directed at creditors, most notably Germany. To move beyond planning for the worst, Greece and others must learn to own their own problems rather than rely on central banks and other people’s money

Tuesday, March 6, 2012

Axel Merk: Fed Flying Blind and Poses Risk to the US Dollar

Axel Merk, Merk Funds, published a new "Merk Insights" newsletter entitled "Fed Flying Blind" where he explains that the voice of reason (i.e. "the market"), who is supposed to tell the federal reserve to stop printing money, has been silenced and this poses potential risks to economic stability, as well as the U.S. dollar.

Here's the the full Merk Insights letter below:

The entrance to the Federal Reserve Bank of Sa...
Federal Reserve
As the Federal Reserve (Fed) has become ever more engaged in micro-managing the economy, we have moved from rate cuts to emergency rate cuts, to printing billions, then trillions, first to buy mortgage backed securities and more recently, Treasuries. Coming to the realization that talk is cheaper than action, the Fed has since switched gears and “committed” to keeping rates low, initially through mid-2013 and now through the end of 2014. The Fed has a buzzword to describe its policies: “transparency”; instead, you may want to call it the “fear not – we will take care of you” policy. There are reasons the Fed needs to signal that rates will stay low for such an extended period, amongst them: a reasonable person may believe that current monetary policy could be inflationary; a reasonable person may believe that the Fed actually wants to have inflation to bail out homeowners that are under water in their mortgages; finally, a reasonable person may have paid attention to Fed Chair Bernanke when he argued that raising rates too early was one of the biggest policy mistakes during the Great Depression, concluding that erring on the side of inflation is desirable. But “fear not – we will take care of you” is the message: the Fed is introducing an inflation target, providing assurance that inflation won’t be a problem.

The alternative, of course, would be to conduct what we would deem sound monetary policy, so that a reasonable person wouldn’t be concerned about the risks of money printing in the first place. But that’s so yesterday. Instead, the Fed has engaged in Operation Twist, applying the Fed’s firepower to lowering rates further out the yield curve (longer term interest rates). Indeed, the Fed now owns over 30% of all outstanding marketable U.S. Treasuries with maturities of 6-10 years; across the yield curve, from Treasury Bills to 30-year Treasury Bonds, the Fed has accumulated almost 20% of all outstanding securities.1 These days, the Fed owns more U.S. government debt than China.

As long as there is confidence in the Fed, the Fed’s strategy may pan out, right? Maybe. We don’t even question the motives of the Fed. However, we question the Fed’s ability to conduct policy when its policy makers are blindfolded. We fear that some of the Fed’s most important gauges used to set policy have been taken away, by the Fed itself. As if to prove the point himself, Fed Chair Bernanke told Congress last week that he is puzzled about incoming economic data, unable to explain why the unemployment rate has come down quite so rapidly. Consider the yield curve: typically, yields provide a wealth of information about the health of the economy, about inflationary pressures, to name a few. As such, an important feature of the yield curve is that it can sell off, amongst others, should inflationary pressures pick up or should investors be concerned about long-term fiscal sustainability. With the Fed becoming evermore engaged in yield curve management further along the curve, this gauge has been taken away.
Former Fed Governor Kevin Warsh, a critic of active yield curve management, has said the Fed is looking into the mirror in conducting policy. We agree. Luckily, the folks at the Fed are some of the smartest economists around. Unfortunately, though, they are human and should periodically be reminded that the greatest failures in monetary history have also been conducted by some of the smartest economists of the time.

If it weren’t enough that the Fed is blindfolded, the Administration and Congress are no better off. At some point, bondholders might get antsy about unsustainable fiscal policies. Without major policy initiatives, the non-partisan Congressional Budget Office (CBO) estimates that the U.S. deficit will grow by $3.86 trillion (the 2013-2017 adjusted baseline scenario in the 2013 budget). Should the Administration be able to implement all its policy initiatives, the five-year addition to the deficit would “only” be $3.44 trillion. The math includes $560 billion in additional revenue by phasing out the Bush-era tax cuts. Should Congress find a way to extend those tax cuts, the Administration’s proposals actually increase the deficit by $140 billion over the next five years (our special thanks to our Senior Economic Adviser Bill Poole, who helped us understand a budget that is most challenging to understand, even for experts). The tragedy here is that fiscal deficits are not taken seriously. We point this out not to single out the Administration: neither Congress, nor the presidential candidates, have come up with clear initiatives that would actually put the budget on a sustainable path.

Why not? Because the bond market lets policy makers get away with squandering money. Not so in Europe: Thanks to the “motivation” provided by the bond market, European policy makers are engaged in very serious structural reform. In our assessment, the language of the bond market is the only language policy makers understand. With the Fed’s micro-management of the entire yield curve, warning shots by the bond market may come much later than they otherwise would. As we have seen in Europe, the longer policy makers wait before engaging in reform, the more painful the consequences. Ultimately, the Fed may not be strong enough to fight market pressures, but that may be of little consolidation: unlike the Eurozone, the U.S. has a significant current account deficit. Whereas in the Eurozone, notwithstanding significant bond market turmoil causing political havoc and pain, the euro held up relatively well, surprising most pundits to the upside. In contrast, a volatile bond market may have more dire consequences for the U.S. dollar, as it might be increasingly difficult to encourage foreigners to finance U.S. deficits.

It was in the earlier part of last decade when the late Wim Duisenberg, European Central Bank (ECB) President until 2003, said, “We hope and pray that there will be an orderly adjustment to global imbalances.” – in those days, we were concerned that policy makers were overly reliant on hopes and prayers for solutions. Now, hope and prayer has moved to the forefront of Fed policy making, as the Fed has taken away what we deem are some of the most important gauges used to conduct monetary policy. Unfortunately, hope and prayer are no substitute for sound policy making. Prudent investors, as well as investment professionals with fiduciary duty over client accounts, may want to take this risk into account when allocating within their portfolios.