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Germanies Merkel Cautions European Central Bankers on Debt Monetization

Interest-Rates / Euro-Zone Jun 04, 2009 - 02:21 AM GMT

By: Axel_Merk

Interest-Rates

Best Financial Markets Analysis ArticleGerman Chancellor Angela Merkel caused a stir when warning the European Central Bank not to engage in asset purchases. She has received a lot of attention as it is an unwritten rule not to infringe upon the independence of central bankers. While we would typically agree that the independence of central bankers is of paramount importance, we believe it is not only appropriate, but also her duty to speak out. Let us elaborate.


As a backdrop, it is the primary role of central banks to ensure price stability. To achieve price stability, central banks traditionally control money supply or the cost of credit available to the banking system. This is referred to as monetary policy. Part of the role of central banks is to "take away the punch bowl" when the party is getting out of hand. Central banks are given independence so that they can take the tough measures necessary, possibly to induce a recession, to focus on their mandate to promote price stability. In the U.S., the Federal Reserve (Fed) has a dual mandate, namely to also pursue a policy promoting maximum sustainable growth; in Europe, the ECB has a "single needle" as ECB President Trichet likes to call it, to pursue price stability.

When Merkel speaks out, there are two dimensions to consider, one fiscal and one monetary. On the former, central banks throughout the world have veered into fiscal policy by engaging in specific asset purchase programs. That's outside of the mandate of central banks and Merkel is doing the only right thing by warning that such policy must be reversed. The ECB recently announced it may start buying "covered bonds", mortgage backed securities popular in Germany. The purchase of covered bonds ought to be a fiscal, not a monetary decision, as a specific sector of the economy is supported. The reason for central banks to engage in these types of programs is that such "credit easing" as Fed Chairman Bernanke likes to call it, is a targeted stimulus, possibly less costly than trying to provide liquidity to the banking system as a whole. However, we have questioned the value of such programs as they tend to substitute, not encourage, private sector activity as prices are driven to levels where rational players may want to abstain.

More importantly, asset purchase programs are also highly problematic as they are extremely difficult, if not impossible, to unwind. Securities purchased tend to have maturities measured in years, not days. In practice, we do not see how it is possible to ever resell such securities in the market. There are numerous ways that have been proposed to "sterilize" such purchases, but - in our view - all proposals have fundamental flaws. That means, central banks engaged in asset purchases, the Fed in particular, may dig themselves into a corner, unable to mop up liquidity when economic growth resumes. Substantial inflation may be the result.

Just as importantly, when central banks veer into fiscal policy, they invite political backlash. Watch this unfold in the U.S. - Wednesday's testimony by Fed Chairman Bernanke in the House Budget Committee was already far more acrimonious than in the past. It comes with the nature of meddling with fiscal territory - the Fed ought to find a way out from such policies, fast. The ECB should not veer into such territory.

The other is a monetary issue - is too much money being printed? This is open to argument; however, as far as Germany's economy is concerned, it can stomach a recession far better than Anglo-Saxon economies, as Germany's economy has less leverage. It is therefore absolutely in Germany's interest to err on the side of caution. Again, the primary role of a central bank is not to support growth, but to ensure price stability. It is more than appropriate for a politician to speak out when central bankers are at risk of veering from their mandate.

The ECB's policy makers will not be rocked by the comment of the Chancellor, although I very much hope the ECB listens. And it is not so much about the fight between the offices, but in the ECB's interest to stay on track to pursue sound monetary policy. Some say Merkel's comments may drive a transatlantic wedge into policies just when greater coordination is needed. That gives Merkel too much credit - that process started about 6 years ago and is breaking into the open now. The ECB has long showed more restraint; Trichet and his predecessor Wim Duisenberg have long made it clear that they prefer suboptimal growth and possibly a recession over the expansionary policies pursued by the Fed. Giving Merkel credit for the divergence does not give credit to the ECB.

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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