Two central bankers this week, Mario Draghi and Ben Bernanke, started what I hope is a trend of placing blame for our economic troubles where it properly belongs – on the politicians who shirk their public responsibilities. Both bankers were expected to provide hints of future monetary policy accommodation and neither delivered the goods. At the press conference following the ECB’s decision to hold interest rates steady, Draghi, in what may be the understatement of the year, said:

There are some problems in the euro area that have nothing to do with monetary policy. I don’t think it would be right for monetary policy to fill other institution’s lack of action.

Yes, there certainly are some problems in the Euro area and it doesn’t sound like Mr. Draghi is interested in making them any easier for the politicians to solve. The architects of the Euro were warned at its initiation that monetary union without fiscal union was bound to end in tears. Margaret Thatcher kept the UK out of the Euro precisely because she foresaw that monetary union would lead inevitably to a loss of sovereignty. Of course, for many in Europe, the Euro was merely a way to accelerate something they’d worked generations to achieve, the desires of the public be damned. It didn’t matter to them whether Europe was ready for full integration or not; they were ready. The fact that the Euro might one day lead to a crisis that forced a closer, more complete fiscal union was a feature not a bug.

And so now the day of reckoning has come for Europe. There are only a few ways to solve the problems facing Europe and we’ll likely find out fairly soon which path will be taken. Either Europe will achieve a closer union with individual nations ceding some measure of sovereignty to the central authority or it will disintegrate back to its disparate pieces. If the first path is finally chosen, it means a transfer of wealth from Germany to the rest of Europe. Germany is unlikely to choose this path – and it is their choice – without major concessions from the other individual states. If the second is chosen, it means the end of the Euro by one means or another. Either Germany leaves and the Euro sinks to the level of its weakest member or the weaker members return to their old currencies in an attempt to devalue their way to prosperity. The first option, with the rest of Europe becoming more like Germany, is the better long term solution but if I were a betting man, I’d be placing my markers on the second. Neither option is within the ECB’s remit and Draghi was right to put the onus on the politicians to either complete or abandon their unity project.

Ben Bernanke also chose to place the onus on politicians to solve America’s economic difficulties. In his semi-annual testimony to Congress Bernanke spent a good third of his opening remarks on fiscal policy. Fed Chairmen have in the past avoided speaking too publicly about fiscal policy but we have reached a point where monetary policy has been strained to its breaking point. Bernanke, whether he is willing to admit it publicly or not, knows that monetary policy cannot solve our debt and spending problems. Quantitative easing, while accomplishing the stated goal of lowering interest rates, has been a failure in terms of creating economic growth, nominal or real. That isn’t surprising to us here at Alhambra but it must come as a shock to Mr. Bernanke.

Quantitative easing as a growth policy leaves a lot to be desired. Its immediate effect is to raise inflation expectations by lowering the value of the dollar. This has had a positive effect on nominal asset prices but an equally depressing effect on growth enhancing economic activity. Zero percent interest rates have a devastating effect on capital formation anyway but when you add the capital destruction associated with 9% of GDP government deficits and high commodity prices, future real growth prospects become downright depressing. Is it really that surprising that companies are unwilling to invest when the future prospects for growth are so grim and current policies make it grimmer still?

Another problem with QE as a growth policy is that it favors large existing firms over new, startup firms. Large public firms can borrow from public markets at artificially low rates while startups are starved of capital. Fed policy aimed at supporting stock prices of existing firms creates an incentive for investors to favor these large – Fed safe – firms while shunning the risk of deploying capital in startup firms. Unfortunately, jobs are not created by large incumbent firms. They are created by entrepreneurial start up firms and QE limits their attractiveness as investments. Large government also tends to favor large incumbent firms who have the wherewithal to lobby politicians for tax breaks and other crony capitalist devices. Even when government policy does favor smaller startup firms it tends to make investments based on political considerations rather than sound business practices. The results have not been pretty.

Finally, QE to the extent it is “successful” in raising inflation expectations tends to effect commodity prices first and foremost. QE 1 and 2 raised inflation expectations and oil prices rose from a low of $33/barrel in early 2009 to nearly $115 by early 2011. The effect has been a rush of oil drilling in the US in previously unprofitable shale formations. Most of these areas are unprofitable at prices less than $50 and many only at prices north of $70. While this has been positive for those involved in the oil industry, the effect of high oil prices on the rest of the population has been, shall we say, less than desirable. Furthermore, when oil prices eventually fall below the cost of production in these areas, the capital expended in bringing them online will have been wasted, buried as surely as if the Fed hired men to dig holes and fill them with dollar bills.

The answer for monetary policymakers is to allow the market to find its clearing level by allowing the dollar to first rise and then stabilizing it at a level that balances the interests of debtors and creditors. Oil prices have been falling of late along with a variety of other commodity prices and if the Fed can keep its dovish members from doubling down on the losing bet of more QE, they will keep falling. While I feel for those who were fooled into drilling oil wells that should never have been drilled, their ire should be directed at the Fed for creating the high prices that fooled them, not for failing to maintain the illusion. The country as a whole will be better off with lower energy prices and the savings will eventually be invested in more productive activities. In the meantime, it will place pressure on the politicians to craft a fiscal policy that is directed at creating real growth. So, Mr. Bernanke, have courage and stay the course. Keep the pressure on the politicians where it belongs. No more QE.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: or 786-249-3773.

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