Axel Merk: The strength of the euro is no accident
Comment of the Day

October 21 2010

Commentary by David Fuller

Axel Merk: The strength of the euro is no accident

My thanks to a subscriber for this interesting article [may require subscription registration, PDF also provided] published by the Financial Times. Here is a latter section:
In an effort to impose structural reform, the ECB has held the eurozone on a comparatively short leash ever since the introduction of the euro. As a result, most European consumers, particularly German ones, are far less leveraged than their US counterparts. Tightening in the eurozone won't, therefore, automatically derail a eurozone recovery.

In contrast, US consumers remain on life support; most of the support by way of extraordinary monetary policies is aimed at reducing the number of homeowners "under water" in their mortgages. Given that it is politically unacceptable to encourage consumers to downsize, the most realistic alternative is to push up the price level to bail out these homeowners. As free market forces would favour further de-leveraging and lower home prices, such a policy is going to require an extraordinary monetary and fiscal effort; this may not lead to sustainable growth, but will show up in assets with the greatest level of monetary sensitivity, i.e. through a weaker dollar, and higher precious metals and commodities prices.

This story is beginning to unfold before our eyes: the Fed is likely to engage in more quantitative easing, amplified by Bernanke's unequivocal comments that the Fed will resist market pricing of inflation expectations that it deems too low. Those regions that resist this path, such as the eurozone, may experience weak economic growth on the backdrop of relatively strong currencies.

There are many potential pitfalls to the Fed's strategy; we can, however, be reasonably certain, that the strategy poses grave risks to the US dollar. A strong euro is no accident; a temporarily strong dollar was.

David Fuller's view US Fed Chairman Ben Bernanke spent much of his early career lecturing on how the economy could avoid deflation in the future. It was a key factor resulting to his appointment as a governor of the Federal Reserve in ???

He remained outspoken on this subject, most notably with his speech before the National Economist Club, Washington, D.C. on November 21, 2002: Deflation: Making Sure "It" Doesn't Happen Here. It is worth re-reading, and here is a portion of his section on "Curing Deflation":

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

A number of us increased our investments in gold after reading this speech in 2002 and I have never agreed with the majority view, often promoted by bond market investors, that Bernanke cannot prevent widespread deflation from occurring in the USA. In other words, I do not doubt his ability, as Chairman of the Federal Reserve, to create future inflation in preference to deflationary forces unleashed by a credit crisis, leading to a banking collapse and public deleveraging.

We already see the "success" of Bernanke's efforts to keep widespread deflation at bay. Unsurprisingly, this is not apparent in US house prices although the slide following a burst bubble will have been cushioned somewhat, because money flows to where it finds the best return. Consequently we see asset price inflation, not least in Fullermoney investment themes such as the stock markets of emerging (progressing) economies and commodities. Also, property is not immune in the progressing regions, not least for luxury apartments in Hong Kong where the HKD remains pegged to the USD.

My guess is that only the promise of further quantitative easing is delaying a rise in US long-dated government bond yields, which I regard as all but inevitable over the next many years.

Bernanke's printing press has intentionally contributed to a weak USD except in times of market panic such as we saw with the US Dollar Index from 4Q 2008 to 1Q 2009, and in 2H 2010 during the EUR sovereign debt panic. Other countries and regions have also intentionally weakened their currencies, some more successfully than others.

Currently, the USD is temporarily oversold as Eoin last pointed out on Tuesday. I would be inclined to regard a technical rally in the greenback as an additional buying opportunity in commodities which see some mean reversion towards their rising 200-day moving averages.

Lastly, Axel Merk makes some good points in the article above. To paraphrase Mark Twain: Rumours of the Euro's demise have been greatly exaggerated. However, the EUR/USD rally has partially neutralised the currency tailwind behind Euroland's export earnings. Anything above $1.40 would increasingly become another headwind.

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