James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

To judge by equity markets, central banks have all the credibility in the world, but their reputation just may exceed their actual power.

Markets rallied furiously on Wednesday after six leading central banks acted to give banks access to easy money, a coordinated bid to unblock funding markets which threatened to seize up due to fears over European debts.

The group — the Federal Reserve, the European Central Bank and the central banks of Japan, Britain, Canada and Switzerland — agreed to offer dollar swap lines at a half a percent less interest than previously and pledged to keep these lines in place until early 2013.

In some ways the jubilant market reaction makes sense, though we should be careful about concluding that the outcome of the European crisis has improved by 4 percent simply because shares went up by about that much. Over the long term, central banks have a very hard time affecting the value of anything, though they are excellent at changing the price of things.

What the moves — which are similar to steps taken in 2008 after the collapse of Lehman Brothers — do accomplish is to lessen the chances that a bank gets caught short and collapses because it can’t access dollar funding. The very understandable unwillingness of U.S. banks and money market funds to provide dollars to European banks, many of which are full to the gills with now doubtful European government bonds, had raised this as a real possibility, and a move to mitigate that is welcome. The very existence of the central bank backstop will somewhat ease funding markets, though the days of money market funds lending money cheaply to European banks may well have ended.

What the moves are not is sufficient in and of themselves to resolve the crisis and remove the risk to the global economy. Central banks are intended to provide liquidity to solvent institutions so that they do not get brought down by short-term market crunches. At the extreme edges of central bank actions — and that is where we find ourselves, that distinction between solvent and insolvent actually ceases to matter.

After all an “insolvent” bank with an unlimited (in time and size) liquidity line is, in the long term, solvent once again. What that bank is unable to do, unfortunately, is play its role as an inter-mediator of capital, making loans and priming economic growth.

THE LONG CREDIT CRUNCH

So, in lessening the chances of a self-fulfilling crisis, the central banks are to be praised.

The rest of the account ledger is a lot less encouraging. One of the principal global threats coming out of the European situation is the possibility of a new credit crunch, something that is arguably already taking place in Europe. European banks need to recapitalize to protect themselves from losses they have and will suffer on euro zone government debt, as well as on losses yet to come from corporate and consumer loans in the region.

That recapitalization still has to happen and until it does, economic growth, globally but especially in the euro zone, will be slowed. The experience of Japan shows clearly that keeping zombie banks alive only extends the pain out over a longer period, and very possibly makes things worse by cutting off the opportunities of new and fitter banks and businesses which won’t get funding because we pour our resources into the banks and businesses we already have.

And of course the move does nothing to solve the thicket of problems facing the euro zone. Europe still needs to come to some understanding about how it is going to proceed and knit itself more tightly together through a fiscal union, or how it will extricate itself from its current mutual death grip.

That really comes down to what Germany and the ECB do. To preserve the union as it stands, Germany is probably going to have to sign on for several years of chunky transfers southward. Unlike the banking crisis, there is really no way to do this with smoke and mirrors, the flow of funds is going to require more than a pledge.

Secondly the ECB has to become far more aggressive and far less stiff necked, all at the same time, perhaps an impossible task given its history and bylaws. That means more rate cuts, of course, as their decision to hike in the spring must be one of the largest mistakes in recent financial history, but also somehow make available funds, perhaps to the EFSF or IMF, that somehow are used to purchase bonds directly from Italy and whoever needs money next.

It’s a tall order.

The central banks have bought time, but at a certain point the meter won’t take any more coins, even freshly minted ones.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article.)

In investing, extreme behavior is becoming more mainstream every day.

How else can we interpret the extraordinary moves by the University of Texas’ endowment fund to not only buy nearly $1 billion of gold, equal to about 5 percent of its assets, but to insist on taking physical delivery of the precious metal.

Things really have come to an interesting juncture when the second-largest academic endowment in the U.S., managed and advised by sober, rational people, decides that what they need is insurance against getting, in essence, robbed, via inflation, by fiscal and monetary policy.

Little wonder that gold futures went above $1,500 per ounce for the first time on Wednesday, driven by a laundry list of concerns starting with a falling dollar and not ending with the growing chance of “debt restructuring” (well, default, if you insist) by Greece.

“The role gold plays in our portfolio is as a hedge against currencies. The concern is that we have excess monetary and fiscal stimulus,” Bruce Zimmerman, chief executive officer of The University of Texas Investment Management Company told CNBC television.

While Zimmerman said it was easier and more economical for the fund to physically accept the gold, which it is paying to store in a vault presumably deep below the sidewalks of New York, rather than the more usual route of buying a derivative contract, the move also must reflect concern about the risk of those contracts not being honored. To that extent the investment is not only protection against inflation and currency risk, but against market failure as well.

Zimmerman has described gold as an “anti-currency,” as,  being in limited supply, its value can’t be degraded by central bank-engineered inflation and devaluation. You can’t turn on the printing presses and make more gold, a slender but apparently important virtue.

That’s a legitimate concern, though the kind of scenario that would only have been raised on the most feverish message boards until a couple of years ago. Since the second round of quantitative easing was signaled last August the dollar has fallen about 11 percent against a trade-weighted basket of currencies.

The dollar has fallen particularly hard in recent days, even against the beleaguered euro, after Standard & Poor’s put the U.S. on warning that it has a one-in-three chance of losing its AAA debt rating. Some of the same fears that drove S&P’s move are driving the gold market; the idea that the U.S. will not get its act together to agree budget reform and, in becoming a worse credit, sees the dollar weaken precipitously.

THE ANTI-INVESTMENT
Rather than being an anti-currency, gold is really an anti-investment, not because it can’t pay off, but because it is the one asset that not only protects you against the bad actions of others but actually rewards you for them.

If central bankers and politicians bring on massive inflation, gold goes up. If the U.S. threatens to slouch or leap towards default, gold goes up.

The opposite of buying gold perhaps is to buy equities, because you are betting on creating products, jobs and wealth rather than just protecting yourself. On the other hand, a bar of gold has no executives that can loot the company or accountants that can aid in fraud.  Really the world in which an investment in gold makes you rich is not a very appealing place.

In some ways you can look on capital flowing into gold as a kind of unexpected cost of current monetary policy, just as putting bars on your windows is a cost of living in a dangerous neighborhood. Both divert money away from more productive causes in service to security.

It is really hard to say which is more remarkable; that people are behaving in ways that might have been labeled as paranoid a few years ago or the rise of things that plausibly might make them worried.

The lack of safe alternatives to the dollar is also doubtless driving money to gold. While the euro has rallied against the dollar on expectations of further interest rate rises, its policies towards its ailing member states are in a shambles. There is a real risk that a restructuring by Greece and continued problems in Ireland and Portugal cause contagion to Spain, an economy big enough to call the whole project into question. Electoral gains by a nationalist party in Finland that rejects bailouts only adds to the potential difficulties.

China, though supposedly keen to promote the yuan as an alternative to the dollar, is still partly a closed economy for outside investors. Japan, recovering from disaster and facing huge demographic challenges, is also, though open and big, hardly appetizing.

Gold, then, is a profoundly pessimistic and depressing investment. In current circumstances it also, unfortunately, has a heck of an elevator pitch.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?

In the end, as with all banks, even central banks, it boils down to trust.

Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:

“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”

So, because he intends to undo it later, he’s not doing it now.

This is both demonstrably false and deeply, at least for now, true.

False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.

Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.

You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.

Daniel Thornton, a vice president at the St Louis Fed,  suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.

NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.

Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.

That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.

While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.

“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.

In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.

Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.

For now, the controls are still in Bernanke’s hands, but keep watching the bond market.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)