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Merk: More Positive on the Eurozone than Most

Paul Justice, CFA

Paul Justice: Hi. I'm Paul Justice, associate director of ETF research at Morningstar. Today, I'm joined by currency guru and macro-economist Axel Merk. Thank you for being here.

Axel Merk: Good to be with you.

Justice: Many folks are concerned today about the U.S. dollar, but they're also concerned about the euro. They're really focusing on the policy differentials between the Fed and the ECB. You have some pretty strong opinions about differences between the two, and I thought it would be good for our viewers to hear some of your thoughts.

Merk: Sure. We have been far more positive on the eurozone than most people have. And it really starts from a structure approach how the European Central Bank approaches monetary policy versus what the Federal Reserve does.

And it also comes down to the fact that we believe that spending money and printing money in the eurozone is structurally more difficult. And as a result, they will inflate their way less so to get out of their problems.

But let's start, maybe, with the Federal Reserve. The Federal Reserve has printed an incredible amount of money to buy mortgage-backed securities. All that money is now available in the banking sector to spread to the economy. The Federal Reserve has bought mortgage-backed securities.

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There are huge challenges with that approach. It makes the balance sheet of the Federal Reserve extremely inflexible. Traditionally, the Federal Reserve acts by buying and selling government bonds to manage the market rates. Now they're stuck with this huge portfolio. The balance sheet of the Federal Reserve is over $2 trillion and it is very difficult to get it out from that.

People are talking about an exit strategy. Well, the only exit that we're seeing is that we are not purchasing additional securities. And now it's very challenging to get out of that.

In the European Central Bank, conversely, they have a very different approach in their refinancing operations. But in their emergency facilities, what they have been doing is that they have been providing unlimited credit, so to speak, to the banking system. And they have done so on a 12-month, 6-month, 3-month, 1-month basis.

They have phased out the 12-month and 6-month programs and they're down to 3-month and 1-month program. Now, for traditional central banking, they're still long, but they're out of these programs. They're back, pretty much, to normal times in many of these things. They still have some issues with collateral that they have to address as far as accepting collateral from a country like Greece and things like that. But still, they're in a position where if and when there is inflation coming in, they can act.

The big fear we have is in the U.S. is that the entire policy is based on the notion that, "Trust us. We will take care of you. We will print as much money as we can." As long as there is confidence in the Federal Reserve, there's not going to be a breakout of inflation.

That policy, in my view, is very dangerous because at some point inflation will break out to the indicators the Federal Reserve is watching. And what is the Federal Reserve going to do then?

At that stage, the Federal Reserve is going to be boxed into a corner. If they were to raise rates, maybe the housing market will come crashing right back down. That is the last thing they want to happen. They think they will be repeating the mistakes of the 1930s. Under the leadership of Bernanke, I don't think that is going to happen.

So the Federal Reserve is going to be in an extremely tough spot in relation to the European Central Bank that has been able to be far more robust throughout the crisis. Sure, there are some issues in Greece and some other spots, but at the same time, the European Central Bank approach, in our view, in the medium term is going to be far less inflationary than the approach of the Federal Reserve.

Justice: Would you argue that it is politically more palatable in the U.S. to adopt inflationary tactics right now to deal with our problems that are known and quantifiable in the short term and exchanging them for these long-term unknowns?

Merk: In the U.S., we have never had fear of inflation. In Europe, there has been hyper-inflation twice in the last century, so there is a very different basic mindset. But the challenge really is that you can either pursue a policy where, by policy, you are not going to get inflation, and that would mean that you trying to not allow money supply growth to go too far.

Now, money supply has been going down recently, but it is the liquidity that's in the system that could potentially break down. Or you say, and it's the currently prevailing view, "Oh, well, there is a slack in the economy. There is high unemployment. It's impossible to get inflation."

Now, that is the majority view, but it's certainly not the only view.

Ultimately, we believe inflation is a factor of inflation expectations. And while that may sound like a circular argument, inflation expectations are driven by the Central Bank itself. And so when the Federal Reserve is printing all this money and just saying, "Trust us," we think that's a very dangerous road to be on.

Justice: So the money-supply side of the equation is clear. We've printed a lot more dollars. What about the velocity side of money? Do you see that changing in the U.S. anytime soon?

Merk: If you look at it, inflation can happen in various ways. We have oil prices at a very high level given how active the economy is. We think it doesn't affect us. Whenever we have the stock prices go up, when we have oil prices go up, it is not inflation. But let one inflation indicator go down and everybody screams deflation.

One of the challenges is that we are, over time, becoming more of a price taker than a price setter. Asia, with all its growth, is now the setter in commodity prices. Of course the U.S. still has a major influence on it, but we are now part of a global world. It is not just the U.S. anymore dictating commodity prices. And so at some point, we do have to worry about these things.

Everybody urges China to revalue. We also believe it's in China's interest to have a stronger currency. Well, we believe it is more inflationary than the statisticians at the Federal Reserve think. At least there's the risk of that happening. And so the Federal Reserve needs to retain its flexibility. And the Federal Reserve, with all the policies it has done, is not flexible.

And then after that, you mentioned the political component. When you veer away from monetary policy as the Federal Reserve has done by engaging and allocating money to specific sectors of the economy, such as mortgage-backed securities, you are stepping on turf that is traditionally the domain of Congress.

And what you would do with that, you are inviting the political backlash. And in doing so, that makes Federal Reserve policy less efficient. Rather than uttering a few words to move the markets, you have to print a trillion dollars or two to try to achieve the same goals. And that is the real danger with the policies we've been pursuing at the Federal Reserve.

Justice: Well, in academic financial theory, I guess they always say, "If there is no risk, there is no return." And I can definitely see how policies have shifted us more to a risky world where we have to make some decisions. Thank you for your commentary. I'm Paul Justice for Morningstar. I appreciate it, Axel Merk.

Merk: My pleasure.