“I am an optimist,” Axel Merk wrote recently. “I’m no conspiracist. I just happen to think the road to hell is paved with good intentions. As a result, I own gold.”
“A government in debt does not have its interests aligned with those of investors,” Merk, president and CIO of Merk Funds, wrote on Wednesday. “As such, an investor interested in a gold-backed currency should create their personal gold standard should they desire one.”
Merk (left) argued that a government with too much debt can try to outgrow it by increasing GDP, thus shrinking the debt-to-GDP ratio; pay it off; restructure; or print more money.
The Eurozone’s austerity experiment is an attempt at the first option. The Eurozone has actually been fairly resilient, even considering weaker countries’ struggle, due to stronger countries’ safe-haven status, Merk wrote. Furthermore, he pointed out that money has been flowing from the core countries to the weaker ones since last August.
Merk described several scenarios where owning gold would be favorable.
Unlike the Eurozone, the United States has been more likely to print more money. Merk noted that in 2008, U.S. Treasuries were the “only asset class that appeared to do well,” but lately have been under pressure. “It begs the question whether the U.S. dollar is the last domino standing,” he said.
Rising interest and entitlement expenses make an impending crisis predictable, Merk wrote, but could be avoided since “comparatively minor changes to entitlements might make the programs sustainable.” Unfortunately, those changes are unlikely to happen due to political gridlock, and increased tax revenue could reduce the “sense of urgency” some people had to make those changes.
Merk said pressure from the bond market was the “only effective tool […] to get policymakers to make the necessary tough decisions.” Unfortunately, with much of our deficit financed by foreigners, if investors abandon bonds, the consequences for the dollar could be severe.
“Gold has been shown to preserve wealth better than the currencies of central banks ramping up their printing presses,” Merk wrote. “So while we might be able to nominally pay off our obligations for some time even in the absence of entitlement reform, there is a risk that the Fed will continue to ‘monetize the debt.’”
Merk predicted that in trying to get ahead of deflation in Japan, leaders there may inadvertently destroy the yen. Japan’s 10-year bond (JGB) market is large and not as liquid as the U.S. Treasury market, he wrote. “For now, the BOJ has said they will not intervene to put a ceiling on JGB yields (while yields have spiked and been volatile, they remain at or below levels from about a year ago). But we believe there’s a good chance that these yields will move above the comfort zone of the BoJ at some point,” he said. In the U.K., stagflation is a persistent problem, and the Bank of England will soon have a new leader, Mark Carney, who “has indicated he might pursue nominal GDP targeting, or raise the BoE’s inflation target,” according to Merk.
Furthermore, British banks tend to operate internationally, and any disparity in currency between assets and liabilities could make them vulnerable.
The problem with these scenarios, Merk wrote, is not “whether I will be right. It’s about the risk of being right.” He owns gold to mitigate that risk.
“Market timing is very difficult, especially when it pertains to the future. This overused phrase should be taken seriously, though,” he wrote, noting that when the credit bubble started to burst, it wasn’t because of Lehman Brothers blowing up, but because of an appreciation of risk. As risk increased, investors deleveraged. “The problem was that when ‘everyone’ deleverages simultaneously, prices tend to plunge rather rapidly, and those not holding liquid collateral may face first a liquidity, then a solvency problem.”
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