by Axel Merk
This article ran for our enrolled users last week as one in a series from respected guest commentators while Chris was vacationing with his family and working on his new book. Enjoy the fresh perspective.
Will U.S. policymakers cause another financial catastrophe and destroy the U.S. dollar by focusing on their own short-sighted political interests? Or will economic reason prevail? While we wish for the latter, we fear the former is much more likely. Unless real reform of Fannie Mae and its smaller cousin Freddie Mac (together the Government Sponsored Entities, or GSEs) is implemented, the consequences for all of us may be dire. Investors may want to take this into consideration when making investment decisions. Future implications may put downward pressure on the U.S. dollar; investments into more fiscally-stable and prudent countries displaying sound monetary policy may become ever more attractive.
Politicians may be about to embark on an economic mistake of historic proportions. Social subsidies may make good politics, but all too often they make bad economics. When Fannie Mae was created in 1938, the seeds were planted for the biggest housing bust the world has ever seen; the going was good while the party lasted for the first 80 years, but the hangover after it ended in the financial crisis of 2008 still remains. In 2008, in an attempt to prevent financial disaster, the government embarked on the largest bailout in history: The GSEs were put into conservatorship, making the previous implicit government guarantee just about as explicit as is possible.
Now, it appears the proposed “reform” of these entities only has stakeholders in the status quo; we are concerned that this may ultimately open old wounds, and next time the U.S. dollar may suffer as a consequence. While the focus in recent months has been on challenges faced in the eurozone, investors seem to forget that the origin of the crisis was ultimately the U.S. housing market. While the rest of the world may have bought bad securities, and structural deficits may be prevalent elsewhere, it is the U.S. where “Patient Zero” lives. The problem is, there are still millions of them. While financial institutions around the world are recapitalizing and governments are addressing their structural deficits (some better than others), policymakers in the U.S. are fighting the patients’ symptoms without offering a cure. Moreover, the U.S. is not addressing its own structural deficit, increasing the risk that the deficit virus affecting the U.S. dollar will morph into a full-blown disease that includes a tumbling currency and inflation as side effects. Don’t expect to have another 80 years to prepare for this potential crisis.
We have lived with the GSEs for such a long time that we can barely imagine a life without them. How weird for a country that has historically boasted the freest markets in the world: The mere existence of GSEs resembles more of a planned economy approach. Here’s the first problem with subsidizing housing for the masses: Depending on the economic environment and perceived future income potential, rational home buyers allocate a certain percentage of their income to service a mortgage. If the government comes in to subsidize homebuyers, all those receiving the subsidy can afford to pay more. Over time, the subsidy will translate into higher home prices, thus eroding the benefit the policy originally intended to achieve. As a result of these dynamics, it is not all that surprising that the GSEs have gradually increased the mortgage amounts that they are subsidizing. The GSEs are not all that different from a government-run Ponzi scheme, and all existing homeowners have a vested interest in keeping the scheme running. However, that doesn’t make it right.
One only needs to look at the recent home sales data as an example of how government subsidies artificially prop up the housing market: once the homebuyer tax credit was removed, home sales fell precipitously. In fact, the drop in home sales was so weak that not one economist forecast a home sales number as low as the one released.
Important is to acknowledge that GSEs are fundamentally ill conceived. Without subsidies, home prices may fall – that’s correct. But that will make homes more affordable!!! Unfortunately, policy makers don’t seem to be interested in affordable home prices, but in the short-sighted belief that preserving the value of overpriced homes through government interference will get them re-elected.
Some argue that eliminating the GSEs would cause havoc, as the private sector cannot support a market in secondary mortgages; they cite the crisis of 2008 as proof. We would like to point out that not only is there a market for jumbo mortgages, i.e. private sector mortgages too large to qualify for a GSE subsidy, but, when the GSEs were restricted in the amount of mortgages they were allowed to issue due to accounting irregularities during the last decade, the private sector was able to pick up the slack without significant additional increases in mortgage rates.
More importantly, however, and not so surprising, is that the private sector seizes up when a government-sponsored Ponzi scheme continues; rather than unwinding the GSEs, the government opted to keep the scheme running. By all means, when the government competes on terms no private entity can possibly compete with, the private sector simply stops functioning. It has been a hallmark of the bailout era that intervention, whether through fiscal or monetary stimuli, has been able to substitute for, rather than encourage, private sector activity. In that context, it should be noted that the banking sector (AIG, an insurance firm rather than a bank, being an exception) has paid back loans from the government. In contrast, General Motors has not paid back its debt. The GSEs have cost taxpayers over $150 billion since the onset of the crisis, with at least another $150 billion in taxpayer cost in the pipeline, using conservative estimates projecting positive economic growth. We are not suggesting that the banking sector doesn’t share any blame for the financial crisis, but in our opinion, it makes bad economic policy to throw the baby out with the bathwater.
Eliminating the GSEs right away would indeed cause disruptions in the markets. To get the private sector more actively involved, a clear policy should be set to phase the GSEs out over, say, ten years. The U.S. economy will be far healthier when homeowners pay a market-based price for their mortgage, rather than a price heavily influenced by bureaucrats.
In the absence of phasing out the GSEs, government obligations will pile up at an even faster pace, making it ever more difficult to address the major structural deficit challenges that the U.S. is facing. Fixing the GSEs requires political leadership, which is apparently nowhere to be seen on either side of the political aisle. If recent history is any guide, we may get a “reform” after a lot of wrangling – one that’s thousands of pages long, creates new bureaucracies, and does not cure the ills that got us into the mess in the first place. We are also concerned that the Fed may just be all too willing to print money in an effort to keep the party going. The U.S. dollar may be the valve that breaks, suffering as a result of these policies. Investors may want to diversify themselves to take the risk of this scenario into account.
We consider many countries to be better placed both in terms of fiscal health and structural positioning, and many central banks around the world are pursuing sounder monetary policies than those seen in the U.S. As such, we believe attractive opportunities lay outside of the U.S. dollar, and in particular the currencies of countries exhibiting much more attractive fundamentals. More about our specific currency views and investment analysis is available through our website.
Axel Merk is the Founder, President, and Chief Investment Officer of Merk Investments. An authority on currencies, he uses strategic currency investing to seek portfolio diversification.
Axel is the author of “Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption,” released in October 2009. The book provides background into the causes of the current economic breakdown, then transitions to a specific action plan for individual investors to protect & grow their investments. He also authors a free regular newsletter, Merk Insights, which details his outlook on currencies, global imbalances, the trade deficit, the socio-economic impact of the U.S. administration’s policies, and more.