EYE ON
AMERICA How the Fed lost control of money
supply By Axel Merk
The
world is awash in money. This money has flown into
all asset classes, from stocks to bonds, from real
estate to commodities. In a world priced for
perfection, should we enjoy the boom or prepare
for a bust? Let us listen to Wall Street's adage
and "follow the money".
After the tech
bubble burst in 2000, policymakers in the US and
Asia set a train in motion they have now lost
control over. In an
effort to preserve US
consumer spending, the Federal Reserve lowered
interest rates; the administration of President
George W Bush lowered taxes, and Asian
policymakers kept their currencies artificially
weak to subsidize exports to American consumers.
These policies have led to one of the
longest booms in consumer spending ever - US
consumer growth has not been negative since the
early 1990s. However, it is credit expansion,
rather than increased purchasing power, that has
fueled the growth.
Until about a year ago,
consumers took advantage of abnormally low
interest rates to print their own money by taking
equity out of their homes. This source of money is
drying up as home prices no longer rise and
sub-prime lenders (those providing loans to
financially weak consumers) are facing
difficulties. More prudent homeowners have not yet
been affected as they buy their homes based on
longer-term interest rates; until December these
interest rates stayed abnormally low.
But
in recent weeks, these rates have ticked up
significantly, and we may see the next and more
severe round of pressure being exerted on the US
housing market. In this phase, we will see
monetary contraction: money that has subsidized
not only the real-estate market but also consumer
spending, stocks, bonds and commodities may
dissipate.
Why is it that asset prices
have continued to soar despite the stall in home
prices? Consumers have not been the only source of
money creation. Corporate America is creating its
share of money as cash flow-positive businesses
are piling up cash, but corporate executives
prefer to invest abroad, providing only limited
stimulus to the US money supply.
A massive
source of money-supply growth is purely of a
financial nature; it is volatility, or - better -
the lack thereof. Volatility in major markets was
at or near record lows last year. With volatility
low, risk premiums are low; when risk premiums are
low, investors have an incentive to employ more
leverage and still be within their risk comfort
zone. What may seem an abstract concept has
propelled financial markets to the stratosphere.
Two groups that have been most aggressive
at taking advantage of this are hedge funds and
the issuers of credit derivatives. Take as an
example a report from The Financial Times in
December: the paper reported that Citadel
Investment Group, a manager of hedge funds, had
US$5.5 billion in interest expense on assets of
only $13 billion. The hedge-fund group routinely
borrows as much as $100 billion. Note that this is
only the leverage visible on the financial
reports; the instruments invested in may
themselves carry yet further leverage.
The
world of credit derivatives has also seen
explosive growth. European Central Bank (ECB)
president Jean-Claude Trichet at the World
Economic Forum in Davos, Switzerland, warned that
the explosion of credit derivatives is a risk to
the stability of financial markets. Specifically,
he complained that the market underprices its
inherent risks.
With risk premiums at
record lows, issuers of credit derivatives can
borrow money at or near the Fed Funds rate. And
that in turn means that we do not need the Fed to
print money; anyone can. That is precisely what
has been happening. However, the credit created is
not without risks; more often than not, credit
derivatives contain risks that only the issuer
properly understands.
A year ago, the Fed
stopped publishing M3, a broad measure of money
supply. Just because you lose control of something
doesn't mean you shouldn't monitor it anymore. Of
the major central banks around the world, only the
ECB takes an active interest in the money supply.
Why is it that the Fed doesn't intervene
and try to stem excesses in the credit industry?
We find the answer by circling back to the
consumer. If the Fed were to do something about
the spiraling credit expansion in the derivatives
markets, the imposed tightening would quite likely
hurt the consumer. Typically, a recession would
not scare the Fed, but globalization has put the
fear of deflation on Fed chairman Ben Bernanke's
table. Tight credit could cause a collapse in the
US housing market and in consumer spending; what
has been a great boom would turn into a great
bust.
The fear also spills over to the US
dollar. As a result of the current-account
deficit, foreigners must purchase in excess of $2
billion in dollar-denominated assets every single
day, just to keep the dollar from falling. As the
US economy slows, foreigners may be more inclined
to invest some of their money elsewhere. The
rising price of gold reflects that many investors
believe that the Fed would rather see a
continuation of monetary expansion than allow a
severe contraction. Bernanke has also made it
clear in his publications that he favors monetary
stimulus at the expense of the dollar to mitigate
hardship on the population at large.
Market forces will try to bring this
credit expansion to a halt. While a crisis
scenario with an imploding hedge fund causing
ripple effects through the financial sector is
possible and likely, we don't need a crisis for
the party to end. What we need is increased
volatility, which we have already seen in the
commodities and bond markets. The equity and
currency markets have also indicated that
volatility may be on its way back.
As
volatility increases, speculators are likely to
pare down their leverage. In our assessment, the
economic slowdown induced merely by an increase in
volatility may be sufficient to encourage the Fed
to ease monetary policy once again. Any easing in
this context will, in our assessment, have
negative implications for the dollar.
Axel Merk is manager of the Merk
Hard Currency Fund, www.merkfund.com.
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