Pedal to the Metal

“The power to determine the quantity of money… is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power… Any system which gives so much power and so much discretion to a few men, [so] that mistakes – excusable or not – can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic – this is the key political argument against an independent central bank.”
—Milton Friedman

Keeping the Pedal to the Metal

As we’ve listened this year to past comments on the Federal Reserve Bank’s plans to withdraw stimulus at some point in time – we can’t help but remain skeptical. It’s been our long-standing belief despite its strong-Dollar tough talk – the Fed will keep rates low out of its fear that to do otherwise would cause the credit dependent economy to tank. After decades of easy monetary policy it would seem natural to us for asset prices to experience a large-scale regression to the mean. In other words – what goes up, typically must come down. In our opinion, without Fed stimulus the money and credit supply would likely contract – and asset prices would drop. If that occurred, savers would be rewarded as their cash gained in purchasing power. However, debtors would be punished as the value/cost of their outstanding debt (to be paid back in stronger dollars) would be higher. And there lies the rub. Paying its debt back in more valuable Dollars gaining in purchasing power would be quite painful to a massively indebted U.S. government. And that’s why we maintain our belief the U.S. will continue to employ the printing press to water down the Dollar it must pay its $trillions of unfunded liabilities and debts back with.

On November 18th James Bullard, President of the Federal Reserve Bank of St. Louis stated that interest rates may be held low until early 2012.[1] That, along with Fed Chairman Ben Bernanke’s recent statements that “significant economic challenges remain”[2]… “Jobs are likely to remain scarce for some time, keeping households cautious about spending”[3]… and the job market is an “area of great concern”[4] – strengthens our belief the money printing pedal will remain firmly planted to the metal.

Global Response

As a result, President Obama is catching heat from the leaders of Asian countries – many of which peg their currency to the Dollar in some way.[5] These nations are benefitting from the the Dollar carry trade – where investors borrow greenbacks at low interest rates and invest them in foreign markets seeking higher returns.[6] This has resulted in Asian stock markets substantially outperforming those in the U.S. and Europe.[7] However, these same nations are growing increasingly concerned over asset bubbles created by easy money. On November 13th, Donald Tsang, Hong Kong’s Chief Executive stated about U.S. money printing:

“Where is the money going—it’s where the problem’s going to be: Asia… You can see asset prices going up, not only in Korea, in Taiwan, in Singapore, and in Hong Kong, going up to levels that are incompatible or inconsistent with the economic fundamentals.”[8]

President Obama response was to call for “balanced trade” which may be interpreted as continued support for a weaker Dollar.[9]

And we believe European Central Bank President Jean-Claude Trichet was being diplomatic when he said on November 17th:

“I believe that the strength of the dollar within the set of floating currencies is in the interest not only of the United States, but of the entire international community.”[10]

Mr. Trichet sounds like a man with not much leverage.

On the Other Hand

While the U.S. is certainly printing a lot of money – China, in our eyes, is also responsible for global monetary inflation which may lead to substantial economic problems in the future. By pegging the Yuan to the Dollar to increase exports, it can be argued China is exporting plant shut-downs and job losses over the globe.[11] It can also be argued that American businesses which export labor to China – and American consumers who buy the more cheaply made goods are also to blame. The ultimate question to us is – how long can this all continue? When – in a country where 332,000 homes were foreclosed on in October[12] – where more homes have been lost in 2009 than during the roughly 10 year stretch of the Great Depression[13] – with 7 million more homes potentially to be repossessed by lenders[14] – do increasingly unemployed U.S. workers simply become incapable of buying?[15] And if the goods China produces can no longer be absorbed by the world – we doubt China has the internal demand to make up the difference. At such a point, we believe more Chinese reserves would have to be spent on internal economic stimulus – and less on the purchasing of U.S. Treasuries. And then who’d finance our government debt? (We think the printing press). The potential domino effects are intriguing to say the least. It’s our opinion understanding them could point the way to opportunity.

Does China truly have the advantage over the U.S.? It certainly does provide cheap exports and cheap credit to America. But what if the U.S. raises tariffs – increasing the cost of Chinese goods and reducing demand for them? Would the resulting higher prices paid by American consumers be offset by increased U.S. jobs and wages in such a scenario? Or, would increased U.S. tariffs result in retaliatory tariffs by our trading partners – resulting in declining U.S. exports and economic hardship? Would American corporations with political clout even stand for such U.S. protectionism in the first place?

This is the world we live in as a large-scale game of economic “chicken” seemingly unfolds. With government manipulation of interest rates, money supply, and intervention in trade policies – along with a strong connection between large corporations and legislature (bailouts and tax-policies included) – the free market does not seem so free.

It appears to us that such a shackled market is having a harder time being efficient. And in such an environment come the gross imbalances with their unpredictable consequences we’re referring to.

Stay tuned.

While there is a lot of tough reality going on out there – we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time – now, more than ever – we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group
www.ernharth.com

Go to www.ernharth.com/economic-commentaries to read past articles from our Economic Commentary series.

1.Bloomberg; “Fed May Not Increase Rates Until 2012, Bullard Says”; November 18, 2009
2.Bloomberg; “Bernanke Signals ‘Extended’ Low-Rate Period May Become Longer”; November 17, 2009
3.Ibid.
4.Ibid.
5.Wall Street Journal; “Wall Street Journal: A Dollar Warning From Asia”; November 17, 2009
6.Ibid.
7.Ibid.
8.Ibid.
9.Ibid.
10.Reuters; “ECB’s Trichet: Strong Dollar in Interests of Whole World”; November 17, 2009
11.Telegraph.co.uk; “China has now Become the Biggest Risk to the World Economy”; November 15, 2009
12.Ibid.
13.Ibid.
14.Ibid.
15.Ibid.