Thursday, May 29, 2008

Finance, Credit Cards, and the Fed: Three Comments

In today’s post, I want to reflect on three different subjects, all of which have some relationship with one another. These three subjects are (1) the loss of respect for the field of finance; (2) the increase in credit card losses and the numbers game; and (3) politics and the Federal Reserve.

The Loss of Respect for the Field of Finance

I am concerned that the field of finance has lost…is losing…respect in the world. As finance has come more and more under the sway of “financial engineering” it has lost its ability to lead. To present a simplistic view of this situation, I would argue that in the past, people controlled the numbers. In the current situation, numbers are controlling people. I am not against the use of numbers and I am not against the use of highly sophisticated mathematical/statistical models. (I have a background in mathematics and statistics.) The problem is that because of the sophistication and complexity of the models, they tend to be allowed to run on their own. The assumptions used to build the models are usually chosen to make mathematical manipulation as easy as possible and are dependent upon the historical record. These models are fallible!

Judgment and leadership are still needed in finance and this means that CEOs and Fund Managers must live up to the responsibilities placed upon them. They are to be held accountable and thus they must exercise their authority over those that build models and make investment decisions. If those in charge continue to fail to “be in charge” we will find that the financial system will continue to be fragile and the need for increased legislation and regulation will become a reality. Control will be exercised…either internally, within the financial firm…or externally from the government.

The Increase in Credit Card Losses

Credit card losses are on the rise. We have information from some of the major issuers so far and the news is not good. J.P. Morgan’s chief executive James Dimon has given us a peak of the future charge offs at his bank and the trend is definitely upwards. In April, J. P. Morgan wrote off 4.5% of its credit card loans and is forecasting losses to rise above 5% this year and 6% next year. This is up from a charge of 3.8% in April 2007.

But this is not so bad…Citigroup wrote off 5.7% in April, up from 4.1% in April 2007 while Bank of America charged off 6.9% last month, up from 5.4% a year earlier.

The credit card industry has always been a numbers game. That is, the more credit cards a bank issues, the more the percentage loss centers around a particular figure. The credit scoring is designed so that, on average, an issuer will achieve an “acceptable” rate of charge offs given the interest rates and fees that they charge their customers. The assumption is that the distribution of actual percentage losses will approximate a normal distribution with a relatively small variance around the expected mean of the percentage charge offs.

This approach works relatively well when there are not major disturbances to financial markets or the economy. However, when a major disturbance comes along…as we are going through right now…there is evidence that the assumption about the potential percentage losses being normally distributed is not the case. The evidence points to the possibility that the distribution tends to be skewed toward greater losses with the tail being relatively “fat”. That is, the probability of more extreme results is higher than is captured in a normal distribution of possible outcomes. The consequence is that the losses during major disturbances are greater than planned for and, hence, the provision for potential losses is less than adequate. This, of course, has implications for the bank’s capital position.

It seems to me that this attitude has prevailed at many of the larger financial institutions recently. The “numbers game” has been applied to other areas of lending, mortgages, student loans, equity lines, small business loans, and so forth, and we are now reaping the results of such an approach to lending. Having a large numbers of loans does not protect you all of the time because the assumptions of the statistical tests tied to the historical data sets do not conform with the way the world seems to work. When you have very few data points that relate to extreme outcomes you are always going to under estimate the probability that these events will occur.

The “numbers game” does not overcome the deficiencies of poor credit underwriting standards.

Politics and the Federal Reserve

Frederic Mishkin has resigned from the Board of Governors of the Federal Reserve System, effective August 31, 2008. It seems to me that this resignation has tremendous implications for the future of the Federal Reserve System and the functions it is to perform!

The United States has just gone through a significant liquidity crisis and the Federal Reserve has stepped in to prevent the collapse of a major investment banking organization, Bear Stearns. There is an ongoing crisis in the mortgage market along with a slowdown in the sales in the housing market coupled with a drastic reduction in housing prices. And, there are still major concerns about the revaluation of assets, both in US financial institutions, but also in many other financial institutions around the world.

There have been calls for bail outs, new legislation pertaining to financial activity, and modernizing the regulatory system. The Federal Reserve is at the center of all of this turmoil.

Thus, who controls the Board of Governors of the Federal Reserve System is going to have a lot of say about the future of the financial system and the role the Federal Reserve is going to play within that future. Most ideas that have been floated around have given the Fed broader scope and greater powers in the reconstructed financial network. Who controls the Board of Governors is very, very important!

Christopher Dodd, a Democrat from Connecticut, is the chairman of the Senate Banking Committee. This committee is charged with reviewing the nominations for Governors of the Fed. With the Mishkin resignation, of the seven positions on the Board, three members will be missing and one current member is unconfirmed. The delays in three of these positions have been for more than one year.

Is politics playing a role in this confirmation process?

With the odds in favor of a Democrat being elected as the next President, these four positions are obviously “in play”. Whereas the Republican chosen nominees tend to be more “free-market” types and hence at odds with the Democratic majority, a Democratic President, it is assumed, would be more likely to nominate persons in favor of greater oversight and firmer control of the financial system. This opportunity to appoint a majority of the Governors at one stroke seems too good to pass up.

Two points here: first, a central bank is supposed to have as its major focus the state of the economy and the inflation rate; second, heaping more and more responsibilities on the Fed just diffuses this focus. Already, participants in international financial markets believe that the Fed is not playing by the same rules as are other nations in terms of its lack of focus on inflation. Making the Fed more attentive to current political mood swings is not the way to help the United States live up to its responsibilities in the world.

Monday, May 26, 2008

Federal Reserve Operations: March 12 through May 21

We are in a brave new world of Fed watching. There are line items on the balance sheet of the Federal Reserve that we have never seen before. The item “Nonborrowed Reserves at Depository Institutions” turned negative in January of this year and has remained negative ever since. How can you have negative nonborrowed reserves? There is a lot of ‘stuff’ going on…and we don’t quite know what to make of it.

The bigger concern is about the state of the economy. Given all these changes to the operating procedures of the Federal Reserve and the new items on the balance sheet…is the Fed doing what it needs to do…or more? Is the Fed monetizing the Federal debt, as participants in international financial markets have been betting on for six years or so…or is the Fed just doing what is needed to resolve the liquidity crisis and its attendant problems and no more?

This is my first go at this effort since the change. I waited for two months to see if some sense could be made of the Federal Reserve statistics so as to avoid some of the ‘noise’ of the initial changes. It, necessarily, will be a rough analysis.

Let’s start from the ‘top down’ so to speak. The year-over-year rate of growth of the broader measure of the money stock (M2) has accelerated in the past three months. After staying in the 5.0%-5.5% range for most of 2007, the rate jumped to 6.7% in February, 7.1% in March and returned to around 6.5% in April, where it has stayed. So, money stock growth has accelerated modestly, but the initial move upwards came before the major operating changes which took place in March.

The total reserves in depository institutions, which had been decreasing through 2007 by a little more than 1.0%, increased a bit in February but then jumped to a year-over-year rate of increase of 4.9% in March and 2.3% growth in April. Something was happening. The rate of increase in the Monetary Base, the sum of reserves and things that could become reserves, remained relatively constant during this time at around a 1.0% rate of growth.

The conclusion one can draw so far from looking at these aggregates is that there has been some acceleration but that the changes are not too disturbing at present. We need to examine the basic disaggregated data as presented on the sources and uses statement of the Federal Reserve and see if any patterns can be discerned. But, this is difficult These data are found on the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” The problem now is that we have to deal with things like the Term Auction Facility (TAF), the international swap lines, and the Primary Dealer Credit Facility among other things. And, we need to deal with the fact that whereas these items are increasing, the traditional items used in conducting monetary policy are decreasing…things like Securities Held Outright.

Our first look is at the item Federal Reserve Bank Credit. This is the operating total that shows the changes that take place at the Federal Reserve that can represent monetary policy. Reserve Bank Credit averaged $869.2 billion in the banking week ending March 12, 2008 and averaged $871.2 billion in the banking week ending May 21, 2008. For the whole period Reserve Bank Credit averaged $869.6 billion. The high value for the period was reached in the week of March 19 at $878.8 billion, when all the new changes were introduced. What caused the changes between March 12 and May 21?

The most dramatic change that took place was the reduction in Securities Held Outright. The decline in this item totaled $206.3 billion which is huge. This decline represents almost 30% of the securities that were held by the Federal Reserve in the week ending March 12. What offset this decline?

First off, Repurchase Agreements, a familiar item, rose by $64.3 billion. (Reverse Repurchase Agreements remained roughly constant during this time period.) And, Loans to Depository Institutions rose by $27.7 billion. This latter item seems to be an old familiar item too, but…primary loans…traditional loans from the discount window rose by only $13.4 billion. The rest of the increase came in something new called Primary Dealer Credit Facility which rose $14.2 billion. This item represents loans to the primary security broker/dealers that the Federal Reserve deals with. This facility became available on March 16, 2008.

In terms of the other new facilities that have been added to the Fed’s arsenal, the Term Auction Facility averaged $125.0 billion in the banking week ending May 21 which represented a $65.0 billion increase over the average of the week ending March 12. The Term Auction Facility was begun in December 2007 and has been increased steadily since then. In terms of supporting Bank Reserve Credit, this has been the primary source of funding.

The TAF has not been the only major new source of bank reserve credit. The Federal Reserve set up swap facilities with the European Central Bank and the Swiss National Bank to provide dollars to financial institutions that needed them in Europe. This swap line does not have its own individual line item on the Fed’s statement but is included in the line item “Other Federal Reserve Assets”. Most of the changes in this account since the creation of this facility in December of 2007 have been due to the drawing down of this swap line. Since the week ending March 12 of this year the total has increased from a weekly average of $42.2 billion to a weekly average of $93.1 billion during the week ending May 21, a rise of about $50.7 billion. This facility has been raised in volume, but has also been extended until January of 2009 since its implementation in December 2007.

The net effect of these changes has been a $1.4 billion increase in Reserve Bank Credit…roughly a balance. The conclusion that one can draw from this is that all the new innovations that the Fed has introduced over the past two months or so have changed Reserve Bank Credit very little. In fact, the monetary base has risen by roughly the same amount over this period. So the rise in total reserves, which has been a modest amount has come mostly from this increase in Bank Reserve Credit and a modest movement from Currency outside of depository institutions back into the banks.

It looks as if the Federal Reserve has made all of these adjustments without causing a major inflation of reserves or monetary measures. If this is the case, then well and good. The intended result of the innovations, we were told, was to get liquidity to the right parties on a real time basis and in the large quantities that were needed. The speed and the size of the effort was of crucial importance. And, we were also told that these measures were temporary and will be removed once the problems have receded. Almost everything that has been put in place has an expiration date. The best we can do right now is continue to watch and continue to hope for the best. There is still much concern that there are still adjustments that have to be made, both in financial institutions and in the economy.

In the meantime there has been some second guessing going on about the Fed’s cut in interest rates. John Authers in his column “The Short View” in the Financial Times last Wednesday argues that “The market is beginning to think that the US Federal Reserve has got it wrong.” The argument is that the Fed should not have cut interest rates so drastically and just concentrated on providing liquidity to the markets. The concern is that, with the rise in oil prices and other commodities, the Fed has “unleashed another bubble.” Authers article can be found at In other words, the Fed over-reacted to the liquidity needs of the market and may have created more problems for itself in the future.

Thursday, May 22, 2008

The World has changed: When will American realize it?

Two recent articles by well-known authors are particularly insightful, yet particularly troubling. These articles are the work of Fred Bergsten, director of the Peterson Institute for International Economics, and Thomas Friedman, on the editorial staff of the New York Times. Bergsten’s article in the May 20 Wall Street Journal: Friedman’s article in the May 21 New York Times: The nature of these articles is troubling because they both deal with what is happening in the world these days and how the United States government, all parts of the government, seems to be missing the boat.

Whereas these articles are not directed toward areas that I generally deal with, they are very important because they paint a picture of how the world has changed and is continuing to change and the failure of those in leadership positions in the United States to recognize the changes and productively deal with them. Both of these articles relate to the rising power of other nations in the world order.

Bergson is interested in world trade and the role that the United States is to play in this world trade. He is particularly concerned with the move in Congress to change the rules relating to congressional action on trade legislation. His concern is specifically in reference to the free trade agreements with Columbia, South Korea and Panama. The move of the Democratic leadership in Congress, Bergson argues, is leading to a collapse in the credibility of the United States and a decline in international trust. It relates to the willingness of the United States to negotiate faithfully with other sovereign nations. The United States has seemingly developed a bi-partisan approach to international relations, from both the Bush administration and Congress, that others in the world community can only label as unilateral.

Bergson contends that this will “remove the U. S. from any significant international trade negotiations for the foreseeable future.” Given the “large and dynamic economies of Asia”, the strength of the European Union, and the wealth amassed in the Middle East, there is a good possibility that trade pacts will be negotiated within and between these trading centers, pacts that will discriminate against rather than include the United States. The world has changed and the United States is going to have to adapt to it.

Friedman approaches the situation from another direction, but he starts off his essay by stating that a new President may not have to worry about who the United States should talk with because, “The real story is how few countries are waiting around for us to call.” Again, the picture is one of an America that has gone off on its own, believing that it can act as the sole super-power in a world in which it can always get its way. The world has changed and we, the Americans, have not been paying attention.

“It is hard to remember a time,” Friedman goes on, “when more shifts in the global balance of power are happening at once—with so few in America’s favor.” He focuses on three of these shifts that he considers to be the major changes that have taken place. First, due to the failure to develop an energy policy large, transfers of wealth have been channeled toward “petro-authoritarians” and from this wealth, power will follow; second, the “rise of the rest”—BRIC and other rapidly growing nations—is resulting in growing “clout and self-assertion” that is being felt throughout the world; and third, the changing nature and location of leadership which is resulting in changing networks of communication and action.

I don’t want to get bogged-down in the negative aspects of this and I believe that there is enough blame to go around so that finger-pointing will not get us anywhere. The crucial issue, to me, is that the world is different from the one most of us believed existed and something needs to be done about it.

The United States is still a superpower, the only superpower. Yet within the globalized world that it desired and fostered, this power has become diffused. A lesson that has been learned in other areas is that a true monopoly is only local. Businesses have seen that they can dominate a geographic region because of the barriers to enter a market and the economies of scale that they can achieve within this area. However, when the local monopoly places an emphasis on growth and expansion into larger and larger areas it often finds that the expansion does not always produce the results it had anticipated. The larger market area contains more competitors that are not prevented from fiercely competing with the former monopoly and, due to the larger size of the market, the economies of scale that the firm relied on in the past are now not sufficient to differentiate the former monopoly from these other organizations.

The United States, rightly, I believe, pursued a policy of globalization. The success of this globalization can be observed throughout much of the world with many rapidly growing dynamic economies providing evidence that open trade can benefit many, many people and reduce poverty in major ways. But, as the rising level of economic performance has spread throughout the world, this globalization has rebounded back on the United States. As the rising levels of wealth and power among these nations has resulted in increasing self-confidence and authority, these nations have begun to talk with one another and have become more self-assertive. And their success has fostered a rising self-respect and willingness to stand up for themselves. Most believe that this trend will not end any time soon.

The economic policies of the United States in the last seven years have also contributed to the growing independence connected with the “rise of the rest.” Because of the monetary, fiscal, and regulatory policies followed by the United States during this time, the trends that were already in place, but that were unrecognized by the leadership, were stimulated and even encouraged. Whereas other nations around the world had come to the conclusion that they could not run their economic policies independent of the rest of the world, the United States acted as if this knowledge did not apply to them. The result was that the United States, economically and financially, got further and further into a hole. The leadership did not seem to realize that more of the same was not the answer. As Friedman concludes his essay, “The first rule of holes is when you’re in one, stop digging.” But, it still remains to be seen when we in the United States will understand this.

Others are moving, even if the United States is not. For example, Friedman reports on the testimony of Gal Luft, an energy expert, before Congress where Luft says that with oil at $200 a barrel, “OPEC could ‘potentially buy Bank of America in one month worth of production, Apple computers in a week and General Motors in just 3 days.” As many know, the purchase of United States assets has already started. With a continuing rise in the price of oil…it will just accelerate if nothing else is done.

Another example pertains to the decline in the value of the dollar. In the Financial Times on Monday, May 19, Harold James writes about the possibility that the Eurodollar will become “the world’s hegemonic currency.” This may result from the weakness in the value of the US dollar and the fact that the eurozone is overtaking the United States as the world’s largest economic area. Unless things change, James surmises, this could result in a passing of the baton. You can read his article at

One final example is the suggestion of France’s finance minister who recently urged action by central bankers to reduce the “misalignment” in the world’s major currencies…especially “the low American dollar":

The world that the new President is going to inherit is not the world that the candidates are now talking about in the campaign for the presidency. In one sense we can be thankful that the political discourse seems to have moved from that dominated by the attitudes of the 1960s. Hopefully, we can move the discussion about economic possibilities, policies, and programs into the 21st century.

Monday, May 19, 2008

Where are we going?

One of the most important lessons that can be learned from probability theory is that the shorter the time horizon one assumes, the more the world appears to be random…even if the odds of a particular outcome are quite high over a longer period of time. This is the reason given for focusing on a process of decision making that derives from a tested model or schema rather than short run outcomes. It is why we need to focus on the underlying situation rather than current headlines that we read daily in the newspaper or hear on the TV monitors.

Currently we are reading about the stabilization of the value of the U. S. dollar, but it depends upon the currency we are talking about. We are hearing that the economy is in a recession…or it is not in a recession. We listen to the speeches and testimony of the Governors of the Federal Reserve System and the Presidents of Federal Reserve district banks and they don’t give us a consistent picture of the economy or of the future of monetary policy. The Secretary of the Treasury puts out frequent optimistic comments, but no action occurs. Furthermore, are commodity prices near their peak…or not? What about inflation? What measures of inflation really provide us with the future direction of prices? The CPI? Housing prices? Oil prices? And, so on, and so on.

All of the above issues relate to short term outcomes. They emphasize what has happened and not what forces are in play that will produce future results. These outcomes distract us from concentrating on the fundamentals of the situation and whether or not anything has changed in these fundamentals.

For example, is there any evidence coming from the current administration that would lead us to think that their economic policies have changed or are going to change? This is an administration that will be out-of-work in eight months…or less. Their options are limited…and they have little or no creditability within the world financial community. All they can do now is to try and talk a good story.

Even in terms of monetary policy, the administration has little room to maneuver. The Federal Reserve responded earlier this year and resolved the liquidity crisis. Financial institutions now seem to be working through the solvency crisis in a relatively orderly way and we can hope that this crisis will continue to lessen in future months.

However, no one really knows what damage has been created on the other side of the equation. The Federal Reserve has produced all sorts of innovations in response to the liquidity and solvency problems and no one has any real idea of how all of this will work out. We are told that the auction facility will go away once things return to normal. Will this really happen and will the Fed return to the traditional form of monetary policy…open market operations in U. S. government securities? What will happen to all of the debt the Fed has taken on in exchange for government securities? How much excess liquidity has the Fed created as a result of all of this activity? Will this liquidity result in more inflation? For example, the broad measure of the money stock has shown some accelerated growth in recent months. Participants in world financial markets continue to be concerned about the Fed monetizing a larger proportion of the government debt that has been created in the past six years.

What has changed? Now that the liquidity crisis has been resolved and the solvency crisis seems to be working itself out, will the Fed begin to raise interest rates to strengthen the dollar? Has the situation altered so much that in the waning days of an administration that already carries with it the legacy of a major financial disruption and possible economic collapse, that the Federal Reserve will start raising interest rates to combat inflation and fight the decline in the value of the dollar? Might the Federal Reserve really reverse itself in the near future?

And what about the basic economic fundamentals? Financial institutions may be working through their balance sheet problems and housing prices and construction may be nearing a trough, but now there are other organizations and industries that must restructure as a result of the change in the economic climate. The auto industry, the retail trades, and others, have only begun their adjustments. How will this round of restructurings change the whole picture?

And what about the events that are taking place in the rest of the world? What about the price of food? What about the price of oil? What about other central banks holding interest rates constant or even raising them to fight their inflation battles?

The obvious point of this discussion is that we may be experiencing some stabilization in some markets…for the present…but, the basic fundamentals have not changed. After a market run, one way or the other, markets may take a breather and consolidate for a while, waiting for new information which points to whether or not the markets should rise or fall. In this short run, however, much of the new information will appear to be random. That is why the question must be asked…has anything fundamentally changed?

In my mind, the players and their messages have not changed. Nothing much is going to change on this front for a while. Therefore, we are pretty much in the same place we have been. Some short run difficulties have been avoided, but this does not resolve the longer run issues. Dislocations exist within the economy and we will not get back to a more stable and productive environment until these dislocations are resolved. We are not out-of-the-woods yet, and there still may be some further shocks. In this respect, I see no reason to become more optimistic about a return to a stable and growing economy in the intermediate term.

Friday, May 16, 2008

BRIC is for real!

The world has changed. The change was coming anyway…the United States just helped it along.
Globalization was going to happen. The United States pushed it along for its own benefit…and now the United States is, itself, seeing what globalization is going to mean...for everyone.

Brazil is now riding high…like other emerging countries, commodities are driving the engine. But, Brazil is just one among several.
· BRIC…Brazil, Russia, India, and China...a group of dynamically emerging countries.
· Sovereign wealth funds; Brazil is joining China and Middle Eastern oil states.
· Canada and a few other countries are being recognized as the ‘next wave’ of countries that are emerging economically.

This is the world of the future. It is a world in which the United States is still the super power, but it is a world that cannot be dominated by the one and only super power. And, these people are talking with one another. For example, the countries that make up BRIC are meeting this weekend in Russia. They are “taking awareness of (their) own influence in world affairs.” And, it is expected that this talking will continue and spread.

But, this is a world in which the United States cannot just do as it wants as it pretty much has tried to do over the past seven and one-half years, economically as well as in foreign affairs. The United States is going to have to consider itself as a member of the world community and learn to work with others as well as encourage and help others if it is going to be respected and listened to.

The United Nations is outdated and unrepresentative; the leadership of the World Bank and the International Monetary Fund is too ‘Western’; and the G-7 or whatever does not contain some important players. The world is in transition and the United States is going to have to be an integral partner in the transition. In the past seven and one-half years, in too many areas, the United States has taken the position that if it didn’t like what was going on, it just removed itself from the picture. As a consequence of such action, the United States lost any ability it might have had to influence outcomes. Also, in the process, other countries learned how to ‘go it alone’ and work out the best solution they could. The United States lost respect while other nations gained in wealth and confidence and the knowledge that they did not need the ‘big guy’ around. They would like the ‘big guy’ there, but their work continued without that input.

Economically and financially, the United States is going to have to become a full member of the world community once again. This administration will not do it…they have neither the time nor the will to do it…but the next administration should. Most of all, the United States must start talking with these nations, not as their superior but as their partner. The United States must not be selfish in this partnership, it must help the emerging powers to become strong, but it must do so while strongly advocating its own position.

Where does this process start? The United States must begin the process by bringing under control its monetary and fiscal policy. It must play by the same rules that the rest of the world plays by.

Why is Brazil considered a part of BRIC? It paid the price of bringing its inflation and its economy under control. Brazilian president da Silva ‘bit the bullet’ and made the central bank independent and let it bring inflation under control. Its economy improved, productivity increased, and, financially, Brazilian debt has been rewarded with an “investment grade” rating. It was not easy, but it was done. Now Brazil is riding the crest of the commodities boom and is trying to make good use of the funds coming into the country: hence the formation of a Sovereign Wealth Fund. And, in the last two years or so, the Real, the Brazilian currency, has even outperformed the Euro relative to the dollar. But, Brazil needs the United States to be strong financially…it needs the United States to be a partner.

Brazil is not the only country that has gone through this cycle. Most major nations, as well as many of the emerging nations have made their central banks’ independent and allowed them to contain inflation. And, this does not help the value of the dollar, given the current stance of the United States with respect to its monetary and fiscal policy.

Hear the stern words of Mervyn King, the governor of the Bank of England, at a news conference on Wednesday: England is “traveling along a bumpy road as the economy rebalances. Monetary policy shouldn’t try to prevent that adjustment.” He further stated that inflation is expected to accelerate and the central bank must continue to combat this inflation and this means that the Bank of England will not make further cuts in interest rates. This, of course, does not help the position of the United States and the value of the dollar. But, the Bank of England does not stand alone in taking this stance.

The world has gotten to where it is faster than it otherwise would have. The United States has contributed to this accelerated pace by creating large fiscal deficits underwritten by extremely low interest rates. The mountains of debt, both public debt as well as private debt, that have resulted have been spread throughout the world. The fact that the United States has no energy policy has also played its part in the changing world and has helped along the explosion in commodity prices. Before these events, the world was globalizing…these events just sped the effort along.

Where does this leave the United States economically and financially? It leaves us in a position in which we must stop pointing at others and placing the blame on them. As Steven Covey wrote…”if you think the problem is out there…that is the problem!”

When there is dislocation and dysfunction, behavior must be adjusted to re-establish some form of unity and wholeness. Most often, dislocation and dysfunction come about due to the strict adherence of ‘ideology’. The United States, once one of the more realistically pragmatic countries in the world, has been compromised by a rigid pursuit of an ideology that has had little connection with the real world. It cannot afford to continue behaving in this way.

BRIC is real. The wealth and power of a dozen other countries is real. And, this change is going to continue. If the United States doesn’t accept this fact, and what it means for its own behavior, disruption and volatility will continue in world markets and may even increase. How one constructs an investment strategy for the future depends upon how one sees this situation working itself out.

Monday, May 12, 2008

Defenses of the Current U. S. dollar policy.

Defenders of the current economic policy of the Bush administration are now surfacing. Apparently, enough concern has been raised to cause a need to defend the status quo. There are two arguments for not changing policy at the present time. First, there is the argument that the value of the dollar has bottomed out along with signs that there could be an upturn. The second argument is that the United States is still too important in the world for the dollar to have to play by the same rules as all other nations. We will present these two defenses in turn.

The argument for the strengthening of the dollar is the growing attention that has been given to the weakness in the dollar over the past six years or so. Some analysts have discerned such concern being expressed in recent speeches of Ben Bernanke. The feeling is that the ‘balance is shifting’ from the emphasis on financial market crisis to greater emphasis being placed on what has been happening in the foreign exchange markets. Just the added attention on the foreign exchange market has given people hope.

Another factor in this glimpse of optimism is what is happening in Europe. Last Thursday, the Bank of England and the European Central Bank left their interest where they were. The concern expressed by these leaders is with inflation and they, the leaders of these banks, stated that ‘their mandate’ is to maintain price stability within their domains. Given the recent rise in the price of oil and other commodities, greater concern is being expressed that inflation could get out-of-hand and the need right now is to keep a lid on price pressures. The underlying theme is that these central banks will do what they have to do in order to fight these inflationary trends...but this could cause an economic slowdown in Europe, taking the pressure off the central banks to further raise rates or even to let them fall.

This, of course, is taken as a hopeful sign by those arguing for the stabilizing of the dollar because it would help to change relative interest rates between Europe and the United States, something that has contributed to the weakness in the dollar. Higher short term interest rates in Europe have drawn investors away from the U. S. during the recent period when the Federal Reserve has been dramatically lowering their target for the Fed Funds rate. In addition, the Federal Reserve Open Market Committee, after their latest meeting, announced that their latest reduction in the Fed Funds target may be the last one…at least for a while. [See the post of May 1, 2008, “Where is the Leadership?”] This has been taken as a hopeful sign that the yield differential between Europe and the United States will become more favorable to the United States.

Finally, although not noticed at the time, the finance ministers of the G-7 nations called attention to the problems, including that of the dollar, in international currency markets and stated that they could not ignore these going forward. [See my post “Finance Ministers Concerned with the U. S. Dollar”, of April 13 at the above website.] Analysts have now gone back to this and claimed this to be another piece of evidence that the concern over the decline in the value of the dollar has risen on the agenda of world bankers. This, they argue is just another sign that maybe the decline in the value of the dollar is over and that some rise might be expected in the future.

In terms of the second argument, analysts are arguing that, yes, the dollar has declined in value but we needn’t be overly concerned with the decline because the United States is too important in the world for nations and other investors to ‘dump’ the dollar. The United States, they argue is still a great place for people to invest and, in this respect, will continue to be a haven to world investors in this age of uncertainty and changing technologies. Also, just the fact that the United States possesses the major military machine in the world gives it the ability to continue to pay off its debts. Even though China and India are becoming major economic powers in the world, the United States and the dollar will maintain its position and prevail over other currencies [including the Euro] in the foreseeable future.

Essentially, the argument here is that it is in the best interest of other nations [China and India included] to see that the role of the dollar is maintained. And, as long as the United States and the U. S. dollar serve as the lubricant for world trade, there is plenty of incentive to see that the current system continues to work. Others, like the G-7, will do what they have to do to keep things as they are.

There are several responses I would like to make to these arguments.

First, people seem to forget that the United States had a budget surplus as recently as 2001. Why do we think that fiscal discipline is not a viable alternative?

Second, most of the first argument is based on wishful thinking. There has been talk before by Treasury Secretaries and Federal Reserve Chairman about a strong dollar…but nothing ever came of this. The situation in England and Europe may require higher interest rates before lower rates are considered…and the Federal Reserve has only suggested a pause in the lowering of interest rates here. And, what is the G-7 going to do for the dollar if United States policymakers do not show a real commitment on their part.

Third, no country in the world has considered itself ‘too’ important to ignore the rules that other nations play by. Although a ‘go-it-alone’ attitude has prevailed in Washington, D. C. over the past 7 ½ years, it has already come back to haunt us in many different areas. In the early 1990s, Robert Rubin convinced Bill Clinton that the United States could not afford to be out-of-step with the rest of the world and needed to bring the Federal budget under control. Clinton listened to him and by the time he left office, the United States was, fiscally, in very god shape and the dollar was doing quite well. This strength was recognized in world financial markets. We are a part of the world and can play by the rules that everyone else plays by. We only hurt and isolate ourselves if we consider that we are above the rules.

Will we continue on the path suggested by those arguing for little or no change in United States economic policy? Yes, for at least the short run.

First, we have a lame duck administration. There is nothing dramatic that will be done before a new administration comes into office. All that we can expect is efforts to protect the legacy of the current administration.

Second, there is a question as to whether a new administration will accept the economic and financial realities that exist or will they try and enact legislation reflecting the promises they are making to get elected. Before confidence can be restored in the U. S. government, there must be real commitment on the part of a new administration that market participants in international markets can trust.

Third, there is still the lingering financial uncertainty. How fragile is the financial system at this time and how will continuing economic weakness contribute to any future dislocations? Banks and others seem to be working out their problems in an orderly fashion, but will this continue?

Fourth, how will United States citizens respond to more and more foreign ownership of their physical assets? Sovereign wealth funds and other investors will keep investing their dollars in U. S. companies. The use of these dollars in this way has recently increased every year and there is no reason that this will stop. How will the electorate respond in the future to seeing U. S. firms coming more and more under the control of foreign nations and other foreign interests? Globalization is coming home to America.

Finally, will the United States enact an effective energy policy? This, sadly, is still in the distant future.

The future...the dollar may fluctuate around the current range for a while...but, it seems to me that unless things change, the longer term picture contains more weakness in the dollar's value.

Monday, May 5, 2008

Regulation Fever

It appears as if we are on the other side of the tidal wave of financial disruption that we have been facing over the past eight or nine months. There are still fairly large charge-offs being reported and earnings are not going to recover for a while…but, these are now taking place in an orderly fashion. The hope is that banks and other financial institutions have gotten their arms around their problems and are working things out day-by-day.

This is the way things usually work out during these periods of financial upheaval. There is the shock of realization that things are not as they are thought to be…then there is the sell-off…then there is the intervention of the central bank…and then…people begin working out things in as orderly fashion as possible. Time is what is needed…and the actions of the central bank are aimed at buying time so that the institutions involved will have the time needed to clean up their balance sheets.

It is a scary thing…a liquidity crisis…and a solvency crisis. There is so much uncertainty…because when these events begin there is so little information available. We don’t know what is happening. We don’t know what the problem is. And, we don’t know how severe the problem is.

Markets hate uncertainty!

But, things are being worked out. Institutions seem to be getting their balance sheets under control and are re-constructing themselves for the future. We can only hope that we are not going to be surprised again. We can only hope that all the banks and other financial firms that were impacted have the time they need to regain their strength. The economy is still not ‘out-of-the-woods’ and this, too, will take time. People are aware and are responding to the recession-like environment. The next year or two will not be an easy time.

What is interesting to me is that there are people that are already wringing their hands over the missed opportunity to massively re-regulate the financial system. Paul Krugman writes, in the New York Times of May 5, 2008,

“The bad news is that as markets stabilize, chances for fundamental financial reform may be slipping away. As a result the next crisis will probably be worse than this one.”

I don’t want to concentrate on the ‘fear’ connected with the next crisis. That is just Dramatics 101. Let’s look at the other side of this…introducing ‘fundamental financial reform.’ First of all, when was this reform going to be instituted? Trying to legislate reforms of the financial system at the peak of the liquidity crisis is NOT the time to change the regulations and the regulatory structure! One really doesn’t know what the problems are at that time and the responses to the situation usually are about ‘outcomes’ because outcomes are what catch the attention of the press and the public. People want to legislate ‘results’. Instituting good changes require an understanding of the problem and a focus on ‘processes’, on how organizations do business. This understanding only comes with time and study.

Also, is it wise to implement all new sorts of rules and regulations at a time when the banks and other financial institutions are going through their ‘working out’ efforts? These organizations need to focus on the ‘business at hand’ and not on commenting on, fighting for, or implementing any new legislation with regards to the way they do business. If you want to cause further trouble, get these institutions to focus on things that are not the immediate problem! No, they need to keep their attention on working their way out of the mess…and this cannot be done immediately.

Now, let’s look at the next issue Krugman brings up…

“After the financial crisis that ushered in the Great Depression, New Deal reformers regulated the banking system with the goal of protecting the economy from future crises. The new system worked well for half a century.”

I can’t believe that Krugman feels that for 50 years the ‘new’ system worked and then, all-of-a-sudden, banks and other financial institutions began to innovate and create all of these new financial instruments that resulted in the situation we are now facing. That would mean that we made it into the 1980s before all of this innovation began to take place.

If one looks back to the 1960s one can see the beginnings of the financial innovation. The 1940s saw the world at war and the 1950s was a relatively tranquil period that brought back some ‘normalcy’ to life (whatever ‘normalcy means). In the 1960s we saw some financial innovation or innovative use of financial instruments that had not existed before. These were given names like Federal Funds, negotiable CDs, and Eurodollars. These innovations allowed commercial banks to readily obtain funds from sources that were not limited to the bank’s ‘local’ area, whether a state or a more limited area in ‘unit’ banking states.

My experience in the Federal Reserve System going into the 1970s was that the banking system was about 6-9 months ahead of the regulators with respect to some of these instruments. That is, the banks would do something to get around regulations and it would take the regulators from 6 to 9 months to find out what the banks were trying to do and then close the ‘loop hole’. Then the whole process would begin again.

And, this was just a start. With the new electronic technology, banks could cross regulatory lines and break down the barriers to state banking restrictions. When I was teaching at the Wharton School I wrote articles about the fact that commercial banks were already regional or national in scope because the new information technology allowed them to draw from out of their areas to conduct banking business and the regulators could do little or nothing to stop the ‘innovation.’

Innovation is going to take place! Regulation is always going to be behind the curve! Legislators and regulators are always going to be playing ‘catch up’! That is the way the world works!

What do I suggest? There is not much space to go into this too deeply in this post, but I would like to make one suggestion. I firmly believe in openness and transparency. I believe that trying to open up reporting requirements would help the situation immensely. There are several areas that immediately come to mind that would help. Let me present three. The first has to do with the market value of assets. I can understand why some institutions do not want to regularly adjust balance sheets for the market value of their assets…both securities and loans…but these values, even if estimated, should, at a minimum, be noted in their required releases. My belief is that if the people within these organizations know that these data are going to have to be released it will give them greater incentive to act on their problems earlier rather than later. My experience in turning around banks underscores the behavior of organizations that get into trouble…they keep postponing action thinking that the markets will ‘turnaround.’ In most cases, they don’t!

Second, I believe that assets should not be allowed to exist ‘off’ balance sheet. All assets need to be reported and need to have sufficient capital supporting them. Putting something ‘off’ balance sheet does not eliminate the need to support them…and the investment community needs to know of their existence. The more ‘daylight’, the better these assets will be managed.

Finally, transactions need to be reported. Long Term Capital Management made the point over and over again that the spreads they worked on were so narrow that they couldn’t release the information on them because others could then duplicate their deals. If the spreads are so narrow that the ‘deals’ require massive amounts of leverage to make them work and if the spreads are so narrow that information on the deals cannot be released…I say, let the information be released! Let the spreads go away!

Thursday, May 1, 2008

Response to "Second Thoughts"

This post is in response to the request of “Second Thoughts” that was posted on April 30. Thank you (and others that have responded to my postings) for the thoughtful points that you made in your post.

With regard to the first point…“I'm not convinced that any of the "new" objectives actually conflict in the ordinary course of conducting policy. I have to add that caveat because, clearly, what has been happening is not "ordinary".” Clearly, the times are not “ordinary”. But, my point relates to what has transpired over the past seven and one half years which has brought us to the times that we are now a part of. The policies of the current administration have created a situation in which the goal of ‘saving’ the financial system is in conflict with our responsibilities of being a part of the world financial system. I have written on this in many of my earlier posts and will not go into them further at this point. The tensions created by this divergence of responsibilities have resulted in rapidly increasing commodity prices and a sharp decline in the value of the United States dollar. Providing more and more liquidity to the U. S. financial system has not been looked on favorably in world markets. Adding more and more responsibilities onto any one specific agency at this time only diverts the focus of the heads of the agency and muddies the water. My experience in managing organizations in crisis is that the leadership of the organization needs to bring on a tighter focus to their decisions rather than adding more and more responsibilities to their agenda. So, my point is that in these times that are not “ordinary” we need to keep focus as much as we can. However, the leadership void in Washington D. C. at the present time does not help us to achieve this goal. We need to try and avoid confusing institutional deficiencies with weak leadership.

In terms of the second point made, “The time is ripe to reconsider the structure of all these multiple agencies, with their different agendas, constituencies and leaders, to assure ourselves that our governmental infrastructure is in some sense "optimally" configured to address the world of finance we live in now.” I don’t disagree that the regulatory structure needs to be reconsidered and we are long overdue in aligning the structure with the modern world of money and finance. However, being a fallible human being among other fallible human beings, the idea of being able to create an “optimal” infrastructure or even approach something that might be considered “optimal” is to me the impossible dream. It is a goal to shoot for, but my experience with trying to construct ‘ideal’ systems is that we expect more from humans than they can possibly deliver. Thus, we need to have checks and balances within the system to protect against human error and incompatible human objectives. I am more comfortable giving different agencies different, clear responsibilities so that they can be held accountable for their piece of the pie than to center everything within one or two agencies where we don’t know what is happening and exactly who is responsible. My example of the latter case is FEMA.

That said let me respond to the author’s concern “that having disparate agencies (Treasury, Fed, SEC, Comptroller, etc.) responsible for the various aspects of monetary policy more broadly characterized has been a source of delay and inadequacy.” My feeling here is that having everything within one agency can cause ‘delay and inadequacy’ as much or more than having separated agencies with specific responsibilities.

Let me be more specific on this. In the current environment in Washington D. C. there seems to be a void of leadership…at the Treasury, the Fed, the SEC, the Comptroller…and so on, and so on! I see little or no leadership at the Fed. Paulson tried to carry the ball on the discussion about regulation, but he seems to be ‘out-in-front’ with no one following him. And so on, and so on. There seems to be very little interagency coordination or discussion. Something comes from here and something comes from there…and we are confused and uncertain.

An alternative example…and, I am not promoting one political party over another, for my experience with both the Reagan administration and the Bush 41 administration was much more like what I am going to reference than Bush 43. Read the book by Robert Rubin, “In An Uncertain World”. He writes about crisis after crisis in which the different agencies within the government got together, talked with one another, and worked together. It can be done…effectively…and relatively efficiently. But, I would argue, that was because they had very talented people, one being Tim Geithner who is now the President and Chief Executive Officer of the Federal Reserve Bank of New York, different agencies with strong, independent leadership, who saw the need to work together to resolve problems. If the power is all centered in just one agency you do not get this kind of dynamic.

I hope that this response helps “Second Thoughts” understand where I am coming from. Since no one is the fount of all wisdom, I am open to the possibility that I am not correct on every point I try to make. However, I hope that the dialogue will continue because in discussion we all learn and maybe we can all do a little better with the additional insight.

Where is the Leadership?

Where is the leadership in the Federal Reserve System? I wonder…the market wonders…and so does the world. Ben Bernanke has been the Chairman of the Board of Governors of the Federal Reserve System since his swearing in on February 1, 2006 and, as yet, we have failed to see any leadership established at this very important institution.

Yesterday, the Federal Reserve cut the target Federal Funds rate by 25 basis points, reducing this target to 2.00%. The statement put out by the System states a little of this and a little of that…and, by the way, don’t expect any more cuts in the near future.

Huh! Is anybody there?

The 25 basis point cut was seemingly done because the market expected it! So we get a scenario of a guy taking a young woman home from a date. She lets him kiss her on the doorstep, but immediately says…you got what you wanted but don’t expect anything more. I mean it…realllllllllllllllly. And, then she smiles.

The last time I can remember leadership like this was when the chairman of the Board of Governors was the only person in the history of the United States who was chairman of the Board of Governors and then became the Secretary of the Treasury. Do you remember who that was?

The head of the central bank needs to provide strong leadership…he (or she) needs to be someone markets can have confidence it. Although he may speak elliptically, market participants must feel that someone is in charge! At present, we are waiting for this person to show up.

By-the-way, the chairman of the Board of Governors I referred to two paragraphs ago was William Miller.