Merkel Cautions CBs & Bernanke's Math - Does it Add up?

By Axel Merk

Merk Hard Currency Fund

June 4, 2009

Merkel Cautions Central Bankers

German Chancellor Angela Merkel caused a stir when warning the European Central Bank not to engage in asset purchases. She has received a lot of attention as it is an unwritten rule not to infringe upon the independence of central bankers. While we would typically agree that the independence of central bankers is of paramount importance, we believe it is not only appropriate, but also her duty to speak out. Let us elaborate.

As a backdrop, it is the primary role of central banks to ensure price stability. To achieve price stability, central banks traditionally control money supply or the cost of credit available to the banking system. This is referred to as monetary policy. Part of the role of central banks is to "take away the punch bowl" when the party is getting out of hand. Central banks are given independence so that they can take the tough measures necessary, possibly to induce a recession, to focus on their mandate to promote price stability. In the U.S., the Federal Reserve (Fed) has a dual mandate, namely to also pursue a policy promoting maximum sustainable growth; in Europe, the ECB has a "single needle" as ECB President Trichet likes to call it, to pursue price stability.

When Merkel speaks out, there are two dimensions to consider, one fiscal and one monetary. On the former, central banks throughout the world have veered into fiscal policy by engaging in specific asset purchase programs. That's outside of the mandate of central banks and Merkel is doing the only right thing by warning that such policy must be reversed. The ECB recently announced it may start buying "covered bonds", mortgage backed securities popular in Germany. The purchase of covered bonds ought to be a fiscal, not a monetary decision, as a specific sector of the economy is supported. The reason for central banks to engage in these types of programs is that such "credit easing" as Fed Chairman Bernanke likes to call it, is a targeted stimulus, possibly less costly than trying to provide liquidity to the banking system as a whole. However, we have questioned the value of such programs as they tend to substitute, not encourage, private sector activity as prices are driven to levels where rational players may want to abstain.

More importantly, asset purchase programs are also highly problematic as they are extremely difficult, if not impossible, to unwind. Securities purchased tend to have maturities measured in years, not days. In practice, we do not see how it is possible to ever resell such securities in the market. There are numerous ways that have been proposed to "sterilize" such purchases, but - in our view - all proposals have fundamental flaws. That means, central banks engaged in asset purchases, the Fed in particular, may dig themselves into a corner, unable to mop up liquidity when economic growth resumes. Substantial inflation may be the result.

Just as importantly, when central banks veer into fiscal policy, they invite political backlash. Watch this unfold in the U.S. - Wednesday's testimony by Fed Chairman Bernanke in the House Budget Committee was already far more acrimonious than in the past. It comes with the nature of meddling with fiscal territory - the Fed ought to find a way out from such policies, fast. The ECB should not veer into such territory.

The other is a monetary issue - is too much money being printed? This is open to argument; however, as far as Germany's economy is concerned, it can stomach a recession far better than Anglo-Saxon economies, as Germany's economy has less leverage. It is therefore absolutely in Germany's interest to err on the side of caution. Again, the primary role of a central bank is not to support growth, but to ensure price stability. It is more than appropriate for a politician to speak out when central bankers are at risk of veering from their mandate.

The ECB's policy makers will not be rocked by the comment of the Chancellor, although I very much hope the ECB listens. And it is not so much about the fight between the offices, but in the ECB's interest to stay on track to pursue sound monetary policy. Some say Merkel's comments may drive a transatlantic wedge into policies just when greater coordination is needed. That gives Merkel too much credit - that process started about 6 years ago and is breaking into the open now. The ECB has long showed more restraint; Trichet and his predecessor Wim Duisenberg have long made it clear that they prefer suboptimal growth and possibly a recession over the expansionary policies pursued by the Fed. Giving Merkel credit for the divergence does not give credit to the ECB.

Bernanke's Math - Does it Add Up?

The current account deficit is down as we are less reliant on foreigners to finance our deficits; the government's deficit is increasingly covered by the domestic private sector as private sector borrowing is down. -- These were the approximate words of Fed Chairman Bernanke in testimony to the House Budget Committe. This statement is so troublesome, let's examine it a step at the time.

The current account deficit reflects the amount foreigners need to buy in U.S. dollar denominated assets to keep the currency from falling. As the trade deficit shrinks because of weaker global trade, the current account deficit came down a bit last year. However, external financing is part of the current account and as the U.S. government has to raise trillions in the markets this year, it is difficult to imagine that the current account deficit will be down this year from last. It would imply that over $2 trillion in new U.S. government debt will be financend entirely domestically. Two main ways this may be achieved:

• Money that U.S. government raises is money not available to the private sector, referred to as crowding out the private sector. We have been warning about this for some time, but if Bernanke truly thinks this is going to happen at the scale required to keep the current account deficit down, economists would be well served to revise their growth estimates for private sector growth down sharply.
  


• The Fed could finance the government debt, referred to as debt monetization by economists. The Fed has been monetizing the debt already, but not on the scale that may be required to keep interest rates low or to not rely on foreigners.
  

More realistically, the dip in the current account deficit was temporary as foreigners will continue to play a major role in financing U.S. deficits. However, because there is less trade and foreigners could use the money in their own countries, it will be an uphill battle to attract the massive amounts needed. The task is made more difficult by U.S. policies that are at risk to leading to unsustainable deficits. The reference to unsustainable deficits come from Mr. Bernanke himself who is well aware of the challenges.

In our assessment, the cost of borrowing should increase substantially as the supply of new debt may simply dwarf the demand - in that context, it is not particularly relevant whether the demand is domestic or international; plunging bond prices in recent weeks may be a pre-cursor of what is to come. Lower bond prices imply higher costs of borrowing not just for the government, but everyone. A nascent recovery could easily be stalled in the process. That in turn may tempt the Fed to monetize the debt, although at this stage Mr. Bernanke says the Fed will not pursue this path.

With regard to foreign appetite for U.S. debt, it may be noteworthy that foreigners have indeed continued to buy U.S. debt in recent months; however, foreigners have been bidding for short-term Treasury Bills at unprecedented amounts. That implies foreigners may agree with our assessment that long term bonds are overvalued and shift to shorter maturities to mitigate potential losses should inflationary expectations rise. While this may make sense from investors' point of view, it poses yet another challenge to the government that may struggle to issue longer dated debt. In our view, the government is digging itself into a hole that may not be very different from those of consumers that took out adjustable rate mortgages, only to be caught off guard as interest rates eventually rose.

© 2004-2009 Biiwii.com

Views presented in guest articles are those of the authors and do not represent  those of Biiwii.com.

Biiwii.com does not recommend that any trading or investment positions be taken based on views expressed on this site. If you speculate or invest it is suggested that you consult a financial advisor qualified in your area of interest. For more detailed information and full terms of service, see "About & Terms" here.