Home > The Merk Perspective > Merk Insights > January 14th 2004

4th Quarter 2003 - We are responsible for our own Future

Axel Merk, January 14th 2004
This article was written by Merk Investments before the Merk Hard Currency Fund was launched.

FEDERAL RESERVE ACT— Monetary Policy Objectives

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The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Above, you find the Fed’s mission statement. Its various goals are at times in conflict with one another;
depending on economic conditions and political viewpoint by the central bank, the priorities may shift. These days, credit growth is emphasized most, especially as prices and interest rates seem stable, and common theory dictates that an expansionist policy should create employment.

I was recently asked why I criticize Greenspan these days – after all, it’s not a good idea to contradict the
“master”. Greenspan and we represent different interests: Greenspan must look after the macro economy in accordance with the above guidelines. We, on the other hand, are interested in maintaining or increasing the purchasing power of our savings.

Let us first note that the Fed’s objectives do not take influences from abroad into account. That may be
understandable, but it is not appropriate for today’s environment. For the upcoming fiscal year, the Bank of Japan (BoJ) has received permission from its government to buy US Treasuries worth an astronomical $1’300bn to slow the rise of the Yen. After a dramatic amount was spent over the past couple of months, the first 3 trading days of the 2004 have already seen more than $20bn worth of US Treasury purchases by Japan; the BoJ had to borrow from the next fiscal year’s budget that doesn’t start until April. One does not need to be an economist to see that these amounts are not sustainable. These interventions, which are also practiced by China, have a significant stimulating effect on the US and world economy. Job creation in the US and Asia may be the most direct result, which is the highest immediate goal. Negative side effects are likely to be inflation (in particular in Asia) and misallocation of capital (projects are financed that would not be profitable if the market were free to set exchange rates) are likely to make coming recessions more severe.

Please also note that the Fed’s policy objectives mention “savings” only indirectly by referring to “stable
prices”. Indeed, “saving” is a hindrance to an expansionist monetary policy. Then we notice that the topic of debt is not part of the Fed’s prescribed worries. Americans are heavily in debt; that the mountain of debt seems to be growing exponentially. But Americans only look at their monthly expenses that remain constant with decreasing interest rates even as total debts increase. Americans also purchase fewer and fewer goods and services outright, but rent or lease them instead. This trend has evolved so far that the Fed had to redefine some measures of debt last summer as Americans find ever more ways to buy goods and services on credit.

What’s phenomenal about this is that this trend is considered positive as money is used more “efficiently”.
Greenspan likes that this money is not sitting idle as if it were if a car was purchased outright, but that only a small portion of monthly income is used to lease a car. The danger of this trend: the US consumer becomes ever more sensitive to interest rates. But because interest rates are low, Greenspan is not worried. We, on the other hand, are worried, as we believe that interest rates are artificially kept low through foreign intervention buying.

If we further consider that service jobs are moving to Asia and Eastern Europe in great numbers, we have a
problem: will US consumers continue to have the purchasing power to keep up their consumption? Only a consumer with a job can spend money, especially if he is heavily in debt.

The holiday sales in the US had reasonably good sales at the top end of the market, but discounters,
including super-efficient Wal-Mart, had problems. As a side note, Wal-Mart as a company is one of China’s largest trading partners, bigger than many European countries.

Greenspan’s policies push the American consumer into debt. Recently, efforts are under way to encourage
the hispanic population to take on debt, as if to say: once you've got debt, you will work harder, and that’s good for the economy. Many baby-boomers do not have retirement savings, but Greenspan may not be concerned, as working elderly are more productive than idle pensioners. Here in Silicon Valley, the first radio commercials have appeared to promote reverse mortgages – it looks like Greenspan has not exhausted the possible ways to live on credit.

Conversely, our goals are different: we want financial stability, we want to be able to pursue our hobbies
when we grow old; if we are fit, we may want to work at an old age, but we desire a cushion, our goal is the freedom to be able to choose “inefficiency”. We want to invest money efficiently, but preach restraint when it comes to consumption.

Greenspan sees the future in a lower dollar. He argues the US economy is no longer as dependent on
import prices as it was some decades ago. While he is right, note that there are limits to this: OPEC recently refused to increase production despite an agreement they would do so should the oil price remain elevated for an extended period. A weak dollar is a short-term cure against the current account deficit, and most Americans don’t notice a weak dollar anyway. Greenspan may be right, except if Asian central banks decide to invest part of their trade surplus not only in dollar, but also a little more in Euro or gold.

Pursuing a weak currency is not a novel idea – the US has pursued it from time to time in past decades; in
Europe, Italy was famous for it (and is only slowly getting to terms with a strong Euro). But that doesn’t mean we have to sit there and watch. While the US and Asia want to take advantage of weak currencies, we can invest our savings in gold or euro. In this environment, commodities and precious metals should continue to do well.

Our remaining investment approach does not change significantly, either: we continue to avoid firms that
are too exposed to the US consumer, especially the low-income consumer. Efficiently run US companies significantly benefit from the economic recovery. The recovery was caused by a massive stimulus – aside from the purchase of US Treasuries by US and foreign central banks, tax cuts, refinancing activity, and (military) spending programs. A cooling off period is to be expected which could have further negative implications for the dollar. Bush and Greenspan have a strong interest in a continued recovery, as so far job creation has been lackluster at best.

Europe has opted for the more difficult, but more solid path and has to deal with a stronger Euro. It looks as
if a pain threshold has been reached – another reason to hold more gold, in case steps are taken to weaken the Euro. As far as European stocks are concerned, there is no change in our philosophy: minimize exposure to the US consumer and choose investments that suffer least from a strong Euro.

Our conclusion: Do not rely on Greenspan to secure your retirement, we are responsible for our own future.

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