Magazine | July 5, 2010, Issue


On the dollar, hedge funds are hedging

Readers of this fortnightly would not be surprised to hear someone say, “The stimulus failed.” Most would probably nod in agreement. But they might be surprised to learn that the someone who said it is Jeffrey Sachs, the Columbia University economist most famous for writing The End of Poverty (unofficial subtitle: “Yet another book calling for Western governments to increase their foreign-aid budgets”) (foreword by Bono). He also wrote an article for Time last year entitled “The Case for Bigger Government.” He is, in other words, not easily dismissed as just another right-wing crank. For this reason, it was all the more important for stimulus defenders to dismiss him, so economist Paul Krugman — the stimulus lover’s stimulus lover — assumed the role of freelance psychologist for this purpose. “What I think is happening,” Krugman wrote, “is that we’re seeing the deep seductiveness, for many economists (and others), of taking what sounds like a tough-minded position in favor of inflicting pain on the economy.”

In Krugman’s mind, there is no other answer for why a growing number of left-of-center economists are embracing the argument that the stimulus didn’t work. Their reasoning — Americans are worried about the debt, and in the face of this uncertainty are saving rather than spending — doesn’t add up for Krugman. Evidence of such concerns is “absent from the data,” he writes. If people are so worried about the U.S. government’s ability to carry its debt load, then interest rates on government securities should be going up, to compensate for the perceived risk. Instead, they’ve remained relatively flat (and low) over the past year. Nor are we experiencing monetary instability in the form of inflation, Krugman argues, which would be a sign that the stimulators had gone too far. Oddly for such a die-hard liberal, Krugman is telling us to place our faith in the markets, which are saying that the U.S. government deficit is not a problem, and to ignore Sachs and Co., who are just trying to burnish their reputations as the tellers of unwelcome truths.

As is usually the case, however, Krugman’s presentation of the data is a bit . . . selective. There’s another indicator, besides interest rates and price levels, that tells us when people are feeling fearful and uncertain about the future, and lately it has been spiking to record highs: A lot of people are buying gold, including people who don’t fit the profile of your typical gold investor. (By way of illustration, the value of the gold in Krugman’s Nobel medal has increased by 40 percent since he received it in December 2008.)

Democrats and other stimulus defenders have either ignored this trend or tried to portray the gold-price spike as a bubble at best, a conservative-talk-radio-driven conspiracy at worst. But some of the world’s smartest investors — guys who saw the subprime meltdown coming — are also putting their money into what Keynes once called the “barbarous relic.” They are betting that the next “big short” will be the U.S. government, and they aren’t the kind of investors the government should feel comfortable betting against.

In some ways, gold is a better indicator of investor concern about the government’s finances than are interest rates on government bonds, because at least two forces are keeping those rates irrationally low. First, since the crisis began, the Federal Reserve has injected over $1 trillion of new money into the economy, mostly in the form of loans to the nation’s commercial banks at 0 percent interest. Over that same period, these banks have increased their purchases of U.S. government bonds by $500 billion.

#page#David Smick, a financial consultant and author of The World Is Curved, explained the phenomenon in an article for Commentary earlier this year: “The perception now is that Washington has entered a new era of ‘political banking.’ . . . [Banks] can borrow from the central bank for next to nothing [and] use that borrowed money to buy guaranteed government debt, taking the difference in yields as riskless profit.” This is not a bug in the government’s strategy for dealing with weakness in the banking system; it is the strategy’s central feature. The banking sector’s demand for low-risk securities, and the Fed’s willingness to finance that demand at 0 percent, have helped banks repair their damaged balance sheets while so far keeping the government’s interest rates manageable. With virtually no perceived risk and a Fed eager to finance the purchases, banks don’t mind a low return on their investment.

Second, investors still see U.S. Treasury bonds as safe relative to other investments. Look at the alternatives. Europe is burning. Japan, with a debt load equal to nearly 200 percent of GDP, is widely thought to be next. Corporate debt is a gamble, particularly since the Obama administration set the precedent with GM and Chrysler that the government can design bankruptcy plans that shaft secured creditors in favor of labor unions. And the stock market, with its schizoid “flash crashes” and unexplainable rallies, is an even bigger gamble: Charts of its daily movements resemble the handiwork of a drunk with an Etch-a-Sketch. Even cash, in the form of U.S. dollars, is risky: In the event of a debt crisis, dollar devaluation would be a major concern. Under crisis-level pressure, the government would probably pay its debts by printing dollars, thus debasing the currency.

This brings us back to gold. While the too-big-to-fail banks are buying T-bills in bulk — and when you’re a de facto branch of the government, this is not a risky move — the too-small-to-bail hedge funds are buying metals and shorting other countries’ sovereign debt and, in some cases, our own. Hedge-fund managers have no unofficial partnership with the U.S. government distorting their investment decisions; they are just looking out for their clients and themselves. And, like Jeffrey Sachs, most of them can’t be accused of having an ideological axe to grind: They are by and large donors to Democratic candidates and causes.

Granddaddy Democratic donor George Soros recently doubled the size of his gold holdings; they now make up 7.5 percent of his $8.8 billion fund. Former Goldmanite Eric Mindich, head of the hedge fund Eton Park, has invested over 4 percent of his fund in gold. Mindich doled out around $94,000 in political contributions in 2008, all to Democrats. John Paulson, the investor who became famous for shorting the housing market and, more recently, for being named in the SEC’s lawsuit against Goldman Sachs, started a separate fund devoted just to gold investments. Paulson is another major donor to Democrats.

Perhaps the most trenchant critic of the Obama administration to have made a major investment in gold is David Einhorn, director of Greenlight Capital and another donor to liberal candidates and causes. Einhorn blasted the administration’s fiscal management in a speech before the Value Investing Congress last fall:

When I watch Chairman Bernanke, Secretary Geithner, and Mr. Summers on TV, read speeches written by the Fed governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one [of] these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

#page#In the same speech, Einhorn explained how the low interest rates the U.S. government currently pays — Exhibit A in Krugman’s case against the deficit hawks — could spike suddenly, without much warning. The collapse of Lehman Brothers, which Einhorn predicted, set off a chain reaction when it caused investors to reprice the risk of lending large amounts of money on a short-term basis to investment banks. None of the remaining major Wall Street investment banks survived the fallout. (The only two that remained independent, Goldman Sachs and Morgan Stanley, were forced to convert into commercial banks in order to receive federal assistance.) Einhorn pointed out that a currency crisis in Europe, sparked by the collapse of a eurozone member such as Greece, “could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.” In case you haven’t been paying attention, that’s us.

Some financial thinkers have gone beyond recommending gold and now say investors should bet on a sovereign-debt crisis. Einhorn’s firm has made large wagers that Japan will experience a sudden interest-rate spiral. Nassim Taleb, author of Fooled by Randomness and other books, has argued that the Obama administration’s fiscal management has been so bad that “every single human being” should short U.S. Treasury bonds. And Kyle Bass, another investor who gained fame by betting on a housing collapse, explained in one of his letters to investors that “there is a ‘Keynesian end’ to the policy du jour that governments can solve all their fiscal and economic problems with more debt. . . . In the end (and there will be a reckoning for many countries) nations, including the United States, need to dramatically cut spending and get their fiscal balances in order.” At the end of the letter, Bass noted that his firm had increased its gold holdings and was “taking other steps to position ourselves for the most likely outcome over the next few years” — which, in his view, will be a sovereign-debt crisis.

At this point, Krugman might point out that Bass has given money to the National Republican Congressional Committee and thus can’t be trusted. For all we know, he might even be a fan of Glenn Beck — in which case, according to Rep. Anthony Weiner (D., N.Y.), he has fallen victim to a conspiracy between conservative talk-radio hosts and the gold companies, such as Goldline International, that advertise on their shows. In May, Weiner issued a formal report condemning Goldline, calling on federal agencies to investigate the company. He explicitly accused Beck and others of impropriety in their relations with Goldline, insinuating — never proving, of course — that Beck’s criticism of the administration is at least partially motivated by a desire to scare up business for an advertiser.

One way to look at Weiner’s report is as a typical nanny-state intervention: Busybody Democrat with too much free time wants to tell you what to buy (and what not to buy) — news at eleven. But there is a darker possibility here, one foreshadowed by U.S. government restrictions on short-selling and by officials’ denunciations of the investors who are betting on European fiscal incontinence as “wolf packs.” Weiner’s report is a tinny echo of these broader alarms, an attempt to delegitimize dissent by painting it as self-interested. But Glenn Beck and others are trying to sound, for the nation’s small-dollar savers, the same alarm bell that the nation’s large-dollar money managers have evidently heard loud and clear. That’s not against the law — yet.

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