Managing the Aging Population

Neo-Mercantilism

In the mercantilist era, European governments encouraged businesses via a variety of means to export in exchange for gold. Today, many Asian, and on occasion European, governments concoct policies that favor their exporters, while discriminating against domestic consumption. The prize in this case is not gold, but instead the development of a productive infrastructure that can employ people whose marginal productivity will suffer a big drop in the next-best alternative for their labor.

In the short run, this provides cheap goods and services to the U.S., at a cost of additional debt to be serviced, fortunately in a currency getting increasingly less valuable. (The gold came to the mercantilists at a high cost in goods. Using the gold proved less valuable than previously thought.)

Who funds the debt? In this era, it is the central banks of the neo-mercantilists, which are valuation-insensitive buyers of the debt of the U.S. government and its agencies, and U.S. corporations. Foreign private investors are not a big factor at present. The central banks can ignore depreciation of the U.S. dollar in the short run; the only time there would be a difficulty is when the dollars might be needed to settle a financial claim. The foreign central banks can print additional local currency if they need to make up for the depreciation. Eventually this induces inflation in the economies of the neo-mercantilists, because the balance sheets of the central banks expand, increasing credit but not increasing domestic goods.

This may eventually lead to a crisis in China, because as a leading neo-mercantilist, if inflation becomes great enough that the political pressure from consumers exceeds the political influence of the exporters, there will be pressure for China to revalue the yuan. But if China can avoid it, it will not revalue. Ending the yuan peg will signal a large change globally, because many Asian countries, for competitive reasons, base their own currency policies on Chinese policy. Those currencies, which float subject to government constraints, would be freer to revalue upward following China's policies, and end their own imbalances with the U.S. economy.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.