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Bernanke's Math - Does It Add Up?

Currencies / US Dollar Jun 04, 2009 - 02:18 AM GMT

By: Axel_Merk

Currencies 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.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.

By Axel Merk

Chief Investment Officer and Manager of the Merk Hard and Asian Currency Funds, www.merkfund.com

Mr. Merk predicted the credit crisis early. As early as 2003 , he outlined the looming battle of inflationary and deflationary forces. In 2005 , Mr. Merk predicted Ben Bernanke would succeed Greenspan as Federal Reserve Chairman months before his nomination. In early 2007 , Mr. Merk warned volatility would surge and cause a painful global credit contraction affecting all asset classes. In the fall of 2007 , he was an early critic of inefficient government reaction to the credit crisis. In 2008 , Mr. Merk was one of the first to urge the recapitalization of financial institutions. Mr. Merk typically puts his money where his mouth is. He became a global investor in the 1990s when diversification within the U.S. became less effective; as of 2000, he has shifted towards a more macro-oriented investment approach with substantial cash and precious metals holdings.

© 2009 Merk Investments® LLC

The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds owns and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard and Asian Currency Funds. Foreside Fund Services, LLC, distributor.

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