Axel Merk, Merk Investments
June 17, 2015
We are concerned the Fed causes both economic and political stability to deteriorate. And, no, this is not about discouraging the Fed to hike rates. This analysis is about pointing out that the road to hell may be paved with the best of intentions. For the economy to prosper, we need a re-thinking not just at the Fed, but also with some Fed critics. Let me elaborate...
Central banks have been ever more engaged in the markets. More than seven years after the onset of the financial crisis, we are still arguing whether we can afford interest rates above 0%. Asset prices have been inflated, benefiting those with assets, but doing little for the working man and woman. Governments from the U.S. to Europe and Japan appear to ever more rely on central banks to provide them with cheap money to keep their deficits sustainable (at zero percent interest, at least in theory, any deficit appears sustainable!).
Generally, when asset prices are distorted, we are all but certain to get capital misallocation. This isn’t simply bad for investment managers that chase the Fed rather than invest on fundamentals- it can also be bad for real investments, as it is difficult to discern what real projects are worth investing in.
The easy money can also be bad for the social fabric of nations. Without rambling too much about the socio-economic implications of extraordinarily low interest rates, in our assessment, the rise of the Occupy Wall Street movement; the rise of the Tea Party; the success of Abenomics; as well the success of various populist parties in Europe are all a byproduct of monetary policy that’s gone astray. Central banks may not be solely responsible for all the ills of the world, but they have played and continue to play a catalyst.
Many may be thankful for the Fed to have “saved the day” in 2008, but the Band Aid approach imposes a heavy toll.
The Fed must get out of politics
The Fed ought to focus on monetary, not fiscal policy. That is, the Fed may set interest rates, but shouldn’t be in charge of who gets a loan. The Bernanke-Fed crossed the Rubicon when it first started buying Mortgage-Backed Securities (MBS). By choosing to favor the housing market over other sectors of the economy, the Fed started to meddle on fiscal turf. Fiscal policy is a messy, well politicized affair. In our humble opinion, anything pertaining to fiscal policy shall be left to elected politicians. Once central bankers start veering away from monetary policy, they are asking for trouble. Because politicians want to have a say in how credit is allocated (through tax and regulatory policy), they now want to have a say over what the Fed is up to. It’s no surprise to us that, as a result, there’s been a movement to “audit the Fed.”
The Fed’s role has expanded vastly over time; be that by adding a full employment mandate in the 1970s; be that by adding responsibilities for consumer protection; or a mandate for overall financial stability.
One doesn’t need to be an expert in central banking to have realized that the Fed isn’t particularly good at most, if not all, of these tasks. At the same time, the more dysfunctional a government appears to be, the higher the expectations rise for the central bank; we have seen this in the U.S. since the onset of the financial crisis; in Japan where the Bank of Japan plays a key part of ‘Abenomics’; or the Eurozone where European Central Bank (ECB) President Draghi had to ‘promise to do whatever it takes.’
What about going back to basics. In reverse order of the below list outlines how radical one might want to be. Let me say that by describing them I am not necessarily endorsing any of these initiatives.
Eliminate the Fed (and central banks altogether)
Let’s be honest about money and have the government, not the Fed print money. From today’s perspective, this may sound extreme, but it’s not impossible. To have such a move be viable, one should address one of the main reasons why we used to have many panics and bank runs until the introduction of the Fed: fractional reserve banking.
Eliminate fractional reserve banking
Modern finance is based on fractional reserve banking, but it does not need to be. For those interested in learning more about ‘full-reserve banking,’ the Wikipedia entry on the topic is a good starting point.
Re-introduce a gold standard
Some love it; others hate it. The gold standard takes away the power from policy makers to print money. And that’s the reason why it hasn’t survived. Even if we went back to a gold (or other metallic) standard, odds are that, sooner or later, politicians would once again find ways around it. As such, anyone interested in the gold standard should consider building their personal gold standard, rather than rely on a government to take care of it for them.
Eliminate the Fed’s ability to make fiscal decisions
The Fed should be allowed to hold nothing but Treasuries. If the Fed were to get stuck with something other than Treasuries, for example, when collateral needs to be seized upon the failure of an institution to which collateral was provided, such collateral should be swapped for Treasuries with the Treasury. Any political decisions on how to administer them would then be shifted to a political body.
Have the Fed solely focused on inflation
If one resigns to the likely fact that the Fed is going to be around, let’s have them try to be good at least at one thing: inflation. Let them not try to hide behind 1001 excuses why they can’t raise interest rates.
If the mandate were clear, it would be easier to communicate, easier to implement.
Oh, and should one mention that low inflation when oil prices fall isn’t necessarily bad (Sweden’s central bank has of late been heavily leaning on that excuse to keep rates low).
A sole focus on price stability isn’t perfect, but should go a long way towards allowing price discovery to take place with fewer distortions, if combined with a ban for the Fed to make fiscal decisions.
Hold the Fed accountable
No, this isn’t the #AuditTheFed movement, but this would be a Taylor-type of rule as a benchmark. The Fed wouldn’t be required to set policy according to the benchmark, but would need to elaborate on deviations from it. This may sound boring, but, in our opinion, would be huge progress versus the tea leaf readings that take place now where policy makers appear to be running in circles, looking for clues from the market as to what they may do next.
All of these ideas have one thing in common: simplify monetary policy, realize its limitations.
Why is any of this important?
If central banks don’t reverse course, it’s more than money that is at stake. The Great Depression ended in World War II- we don't think that’s a coincidence. When central banks help to prop up systems that are unsustainable populist leaders come to power. Because if there’s one thing that hasn’t changed in history it is that policy makers rarely ever blame themselves for the challenges they are facing.
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Axel Merk is President & CIO of Merk Investments
Manager of the Merk Funds
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