Bernanke is not heading the central bank of Zimbabwe

All precious metals and most of the base metals, the only exception were lead and zinc, closed last week higher. While base metals also got some support from the Chinese manufacturing PMI, which rose stronger than expected from 51.7 to 53.8, the major driver was a weaker US dollar. Some of the economic data released in the US were also better than the consensus of Wall Street economists predicted, the markets are still convinced that the FOMC would implement a large scale quantitative easing after its November meeting. Even a report in the Wall Street Journal warning that the magnitude of a possible program to buy US Treasury paper would be smaller than the market discounts had no major impact. The outlook for quantitative easing drove the US dollar weaker against the major currencies and this stimulated demand for metals.

 After the announcement of the FOMC it might implement a new round of quantitative easing, the media spends again a lot of attention to so-called investment gurus like Jim Rogers or Mark Faber. Jim Rogers stated in an interview with a German business daily that somebody who prints fresh money would ruin his country. Mark Faber called quantitative easing as monetary policy according to the Zimbabwe school of economics and likened Ben Bernanke as head of the central bank of Zimbabwe. They argue that quantitative easing would lead to a collapse of the trust in paper money and to accelerating inflation. From our point of view, both gurus are totally wrong.

First, quantitative easing had been implemented by the Bank of Japan after hesitating far too long and the Japanese economy was already heading towards deflation. While the BoJ pursues quantitative easing for now around 10 years, the inflation rate in Japan was -1.0% in August. The BoJ would be happy to lift the inflation rate above the zero mark. According to Messrs Rogers and Faber this is not supposed to happen, Japanese inflation should already been sky-high. Also the demand for the yen is contrary to their theory. There are more zeros printed on a yen bill with the smallest denomination than on comparable US dollar bill, nevertheless, the yen is strengthening against the US dollar. Thus, people still trust in paper money despite quantitative easing in Japan.

Second, the first round of quantitative easing by the Federal Reserve, the ECB and the Bank of England were dictated by the turmoil in financial markets in 2008, especially after the collapse of Lehman Brothers. Most economic commentators fearing inflation as a result of the balance sheet extensions by these central banks overlook an important factor. Contrary to widespread economic theory that markets would always be functioning if the government does not intervene, the money markets in the US, the eurozone and the UK ceased to function properly. A vanishing confidence and rising distrust among banks led to a collapse of interbank lending. Banks with excess liquidity preferred to deposit those funds at the central bank. Commercial banks, which needed liquidity, were not able to borrow in the interbank market and had to rely on the lender of last resort. Central banks increased the liquidity facilities and widened access to the various facilities in order to prevent a collapse of the banking sector. The extensions of central banks’ balance sheets reflect to a major extend the replacement of interbank lending by borrowing from the central bank. The focus of many economists on the balance sheet of the central bank has lead to some false conclusions. A look at the aggregate balance sheet of the banking sector (incl. the central bank) would have provided a far better picture as the interbank relationships cancel each other out. Only the provision of liquidity to other sectors could lead to the risk of increasing inflation.

Third, even with increasing lending to the non-banking sector, higher inflation is not an inevitable result. There was much talk about a possible credit crunch. Corporate treasurers might increase borrowing from banks and depositing the funds on accounts with short term notice. The higher borrowing costs could be viewed as an insurance premium to have funds available once they are needed, for example to redeem maturing loans or outstanding corporate bonds. Furthermore, not only banks, but also the corporate and the private household sector had to deleverage their balance sheets. In such an environment, the risk that quantitative easing would lead to inflation is rather small.

In addition, it is not sufficient to look only at the provision of liquidity. The argument that increasing money supply would lead to inflation is based on Irving Fisher’s quantity of money theory and his famous identity equation. One of the assumptions fully in line with the neo-classical theory is that the economy is operating at full employment and capacity utilization. However, with the US unemployment rate at 9.6% and a capacity utilization of 74.7%, the US economy is far away from a situation that increasing demand for goods would lead to rising above the comfort level of 2%.

We would not deny that snake oil salesman like the two gurus (both have a commercial interest in their biased statements) could mislead some investors. “Animal spirits” of retail investors, as Akerlof and Shiller explain in their superb book, could be sufficiently strong to push demand for gold as a supposed store of value and trigger a price rally. However, are the smart money managers at hedge funds also fooled by the argument that quantitative easing would lead ultimately to accelerating Zimbabwean-style inflation rates in the US?

We have our doubts for two reasons. First, George Soros already called gold the next major bubble at the World Economic Forum earlier this year. Nevertheless, his fund (Mr. Soros is not in the active management) invested heavily in gold ETFs. However, this appears to be more exploiting opportunities in markets according to a statement a former CEO of Citigroup made during the financial crisis that as long as the music plays one had to dance.

The second reason relates to what the UN describes in the “World Economic and Social Survey 2010” on page 114 as externalities of the US monetary policy. The provision of liquidity by the Fed does not only lead to lending to the industrial and private household sector or the government, but also to non-bank financial institutions. Hedge funds are among those non-bank financial entities. Hedge Funds could borrow at low US interest rates and invest outside the US in instruments with higher return perspectives. The US dollar serves as a funding currency in carry trades. In addition, Russia and China questioned the status of the US dollar as a reserve currency. Both, carry trades and the fear China might sell US dollars to diversify its foreign reserve holdings, lead to a weaker US dollar. But the investment driven capital flow is not only directed into emerging markets. A depreciation of the US dollar also triggers fund buying of commodities. And it is the impact of Fed quantitative easing on the US dollar, which is relevant for the demand for metals.

Some time ago, there was a report in the media that a taxi driver in New York stopped his cab on the way from JFK airport to Manhattan and asked Mark Faber to leave. Mr. Faber urged the driver intensively to buy gold. The driver was fed up and replied that he has to pay his bills and taxes in US dollars and not in gold. This taxi driver had more economic wisdom than the investment guru. Retail investors buying gold for its supposed store of value should keep this in mind. And journalists better spend less time interviewing Mark Faber on the prospects of the US dollar as he could provide less added-value compared to his taxi driver.