An Open Letter from Axiom Strategy Advisors, LLC

Nearly a century ago, much of the continent of Europe remained ravaged from a great war, and its nations were saddled with massive amounts of debt. It seemed like an impossible task for many leaders of those countries-servicing the debts racked up during the war, while also pitching proposals for the new debt necessary to rebuild cities and infrastructure, as well as to finance public services. In fact, so daunting was the effort for some--like the Germans and, shortly thereafter, the Brits--that they decided to do the unthinkable: they cranked up their printing presses and began churning out piles of fresh currency. That, of course, is an oversimplification of the circumstances, but needless to say, the net results of their actions were detrimental, as the macroeconomic law of supply-and-demand took effect. Each successive, new bill eroded the value of the total supply of money used by a given country, as well as by its creditors and investors, and as that value eroded, the domestic prices for everything soared. In fact, so perilous were these currency devaluations that they actually helped to bring about the end of the Roaring Twenties and, in its stead, ushered in a darker, more depressed economic time.

No matter how wrong their decisions were, perhaps the leaders of post-WWI Europe can still hold their heads up, for no one ever accused those politicians and their technocratic legions of being wise beyond their years, or of being above the capacity to make dangerous mistakes in their efforts to be expedient. Perhaps knowing this fact, those leaders should be forgiven for their round of missteps, only for the fact that they just might not have known any better. They were working through a situation that lacked many empirical references, and they had to wing. Their mistakes, in hindsight, were to be expected. After all, to err with the noblest of intentions is only human--or so some would say.

Unfortunately, few of our present-day leaders can be afforded the same degree of patience and clemency--the least among them, the Federal Reserve. Ben Bernanke, the chairman of the Fed, was an expert on the Great Depression and the systemic faults that led to it. He even wrote an insightful book about that moment in history, aptly titled Essays on the Great Depression. So well-versed and informed are the men and women at the Fed, it would seem odd that they could mishandle the dual crises facing our country. But they are doing just that--and yesterday took us one more step closer to repeating history.

Of course, it should be noted that it may be impossible to repair the broken financial system and reinvigorate the real economy without spending some inordinate amount of money. However, that spending must be targeted and not recklessly fired off, concise and not widespread, and ultimately therapeutic and not just conveniently suppressive. It will do us no good to bandage a bullet wound when we have neither removed the bullet nor disinfected the wound. What's more, you cannot treat one bullet wound with another. Simply printing currency to mitigate unmanageable debts will only make matters worse.

Perhaps the Fed and Mr. Bernanke, in particular, would have been well served to understand this fact before their latest course of action. Wednesday's announcement that the Fed would buy billions in governmental debt, as well as over an additional trillion in mortgage debt, simply to allow certain entities to expunge these assets from their books, actually harkens back to the similar actions taken in post-WWI era, when money was just printed without much consideration of the full implications. Hence, the markets do right to cry foul over the announcement. They know it is not just wrong; it is downright dangerous and contrary to everything that the Bernanke Federal Reserve truly knows to be prudent in these times.

The reactions to the Fed announcement were clear to many. Gold prices, for example, rose by 5.7% to $940.10 in after-hours trading, as investors sought a hedge against the prospect of a weakening dollar. And to compliment that fear, the Asian Times dubbed our situation "a dollar crisis in the making". One would hope that they are not right, but these actions and words do speak volumes about the challenges that we face. Our leaders, particularly those at the Fed today, should take heed, for, while we may need to smartly finance our way out of these dual crises, it can surely not be through the debasement of our dollar and the possible invocation of intense inflationary pressure. There has to be another way.

Gary C. Harrell
Managing Principal
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HEARD ON THE STREET
MARCH 19, 2009

Federal Reserve Slaps Paper Over the Cracks

By PETER EAVIS

The problem with desperate measures: They can end up stoking fear, not confidence.

That is the main risk with the Federal Reserve's tactic of buying $300 billion in long-term Treasurys and up to $1.25 trillion of mortgage-backed securities issued by Fannie Mae and Freddie Mac.

The 10-year Treasury price jumped, causing the yield to fall almost half a percentage point to 2.533%. But two fear indicators flashed red after the announcement: Gold soared 6% and the dollar weakened.

It is unusual for a central bank to print money to buy large amounts of financial assets. Such unorthodoxy succeeds only if its purchases are temporary, and sufficient to kick-start credit markets and the economy.

Any sign their impact is fleeting would raise expectations of further buying. If the Fed responds and balloons its balance sheet, inflation fears intensify, hurting the dollar and pushing gold higher.

The Fed's $300 billion would account for about 28% of government issuance in the next six months, according to Barclays Capital. To keep yields low beyond that might mean heavier spending. The Fed's decision to expand the purchase of mortgage-backed securities underscores its willingness to keep spending.

Investors should track the relationship between the dollar and Treasury yields. Ultraloose monetary policy can debase the currency. That means foreigners, with about half outstanding Treasurys, could demand higher returns.

Yields are now artificially low because of proposed Fed intervention. That might push investors into riskier assets, which the Fed wants. It also could scare foreign investors, who are needed to fund the ballooning fiscal deficit.