Wednesday, July 30, 2008

The Mortgage Market and Incentives

This post is a follow-up to my post of July 27, 2008, “It’s All a Matter of Incentives.” The major concern I was trying to express in that post was that “Incentives are the cornerstone of modern life” (Freakonomics, p. 13) and that Congress and the Administration need to be careful with the incentives they set up because people will not only respond directly to the incentives they set up, but will also attempt to circumvent these incentives if there is economic justification to do so. It is a reality of the situation that this latter behavior may produce results that are contrary to what Congress and the Administration hopes to achieve.

I stated that “The subprime mortgage market is the premier current example” of this type of situation where good intentions have gone awry. These good intentions are captured in the first type of incentive that contributed to the creation of this market: “There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home.”

For a long time, owning one’s own home has been the ultimate hope of the American middle class. This dream has been pictured in stories, novels, radio shows, movies, and TV. Supporting this dream has been a foundation stone to the community of politicians. Throughout most of the 20th century politicians have created programs that encouraged and fostered home ownership from the creation of Savings and Loan Associations, dedicated to home finance for the middle classes, to the Federal Housing Authority and other programs developed in the 1930s, to the programs to help GIs after World War II attain their own homes. Helping Americans obtain their own home has been the bedrock of politics for a long, long time.

The effort to create a derivative security that would allow more funds to get into the housing market came about in the late 1960s and early 1970s. This move to create a derivative security with mortgages as the underlying asset was politically driven. The issue was this: insurance companies and pension funds have lots of money to invest in longer term assets. Mortgages are a longer term asset. But, mortgages are held on the balance sheets of depository institutions and when these institutions are fully lent up there are no more funds to support housing ownership and housing construction. How, the question was asked, can mortgages become acceptable assets for insurance companies and pension funds to invest in? At this point investment bankers were brought into the process to help the politicians in Washington, D. C. create an instrument that depository institutions could use to sell the mortgages they previously had held and sell these instruments to those that had so much money available for investment in longer term assets. This would thereby free up funds for the depository institutions so that they could go out and lend more to the housing market spurring on home ownership and home construction. This would result in an economic and social environment in which elected politicians could get re-elected.

We don’t need to go into the details of the construction of the mortgage-backed security because that is not the thrust of this post. All that needs to be said is that over the next fifteen years, the market for mortgage-backed securities became the largest part of world capital markets and the dull-as-can-be mortgage became one of the stars of the speculative universe. This latter point is most memorably captured in the book by Michael Lewis, “Liar’s Poker”.

The point: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people clever and otherwise, who will inevitably spend even more time trying to beat it…” (Freakonomics, p. 25) The politicians saw to it that the incentive scheme was created…and then human nature took over. And, as they say…the rest is history.

The creation of the subprime market (and others) is just an add-on to this story. The political desirability of such a market is that funds for home ownership could be pushed down below the middle class into segments of society that had not, previously, had access to mortgage funding. With this innovation more and more Americans could live the dream and politicians could walk away knowing that they had contributed to building a better America…and, the best thing was that it cost the taxpayer nothing…or, at least, as originally conceived it cost the taxpayer nothing. Now the incentives spread from mortgage brokers, to depository institutions, to other financial institutions and to the rest of the world. This scheme really worked…and more and more people wanted to get their piece of what they saw as an expanding pie. This ‘new world’ of finance was different from what existed before. This ‘new world’ would continue to grow and grow.

The problem is that the subprime mortgage worked only in periods when there was inflation in housing prices. The scenario is described in an article in the New York Times about IndyMac, the failed mortgage lender. “Executives at IndyMac, like many other people on both Wall Street and Main Street, apparently never dreamed that home prices might fall. To the contrary, IndyMac made many loans on terms that implicitly assumed prices would keep rising.” The bank lent to people that were below standard in terms of credit quality and did not require “documentation to verify their income and assets.”

“As long as home prices continued to go up, the company’s strategy was very lucrative for executive, employees and shareholders…the boom perpetuated an insatiable hunger for mortgages and…the sales culture took over, and the sales division really drove the company. (See, But, if the market provided positive returns at the beginning, the positive returns drew more and more people into the practice and the added competition drove away the returns and resulted in the participants taking on more and more risk in an effort to make their efforts work.

This was the intended focus of my earlier post, to show how incentives can create further incentives and lead people to chase positive returns by seeking an edge over their competitors. In addition, it is important to document how politicians, chasing a particular outcome, can create incentives that end up resulting in behavior just the opposite of what they desire to achieve.

And, the beat goes on. Splattered all over the July 29 newspapers, we see the news that politicians are still attempting to shore up the housing and mortgage markets. (New York Times:; Wall Street Journal:; Financial Times: Hank Paulson, US Treasury Secretary issued guidelines on the development of a covered bond market. Covered bonds are a form of secured bank debt that gives investors recourse to an issuing bank’s balance sheet and a pool of collateral, usually high-quality mortgages or public-sector loans, if the bank is unable to repay its debt. The reason for this…”to increase the availability of affordable mortgages.”

The role or roles of the Federal Reserve? First and foremost, the Federal Reserve is responsible for the amount of inflation in an economy. Inflation is everywhere and at every time a monetary phenomenon. I believe this. Where is the measure of inflation or potential inflation captured? I believe that Paul Volcker is right when he says that the most important price in an economy is the price of a country’s currency in foreign exchange markets and this captures market expectations of inflation, both current and in the future. The Federal Reserve must not have a bifurcated policy directive…price stability and economic growth. It cannot serve two masters. We see this particularly in the behavior of the Fed over the past seven years as it relinquished its independence and under wrote the inflation in the housing sector so as to support the administration’s economic policy. A central bank cannot do this.

There are two secondary roles that the Federal Reserve plays. The first of these is to help the financial markets avoid a liquidity crisis. This function the Fed performed admirably in March and April of this year. But, once the crises period has been passed, the Fed needs to back off. The second role is to see that the banking sector remains solvent. This responsibility has to do with the capital requirements in effect in the banking system. All other roles that can be assigned to the Federal Reserve must be carefully weighed and considered before they are implemented. I hope this clarifies where I position myself on some of these issues.

Tuesday, July 29, 2008

Interpreting the Economy

It is very important to understand the state of the economy and the possibilities for the direction of the economy in the future. This understanding is important, not only for policy makers, but also for businesses and investors. It is my view that many analysts are still trapped in a way of thinking that does not really reflect what we are facing at the current time.

The basic tendency is for people to look at the aggregate demand side of the economy to discern what is going on and what should be done to improve economic conditions. This is because the basic paradigm of modern macroeconomics is based upon the work of John Maynard Keynes and this model focuses primarily upon the demand side of the economy. This model was developed for two practical reasons. The first was to create a model that would allow nations to conduct their economic policies independently of one another. The impetus for such a model grew out of the situation that existed in the world at the end of the First World War and the Paris Peace Conference of 1919. There was great concern at that time about the success of the Russian Revolution and the growing fear that revolution might spread to other nations through labor unrest if workers were not kept gainfully employed. This fear along with the dysfunctional efforts at the national level to handle reparations and achieve peace highlighted the need, to Keynes, to focus on full employment and to allow a nation to act independently of all the chaos being experienced in international relationships. (For a reference to this view see Donald Markwell, “John Maynard Keynes and International Relations,” Oxford University Press, 2006.)

The second reason was the need to find a way for a government to act to achieve high levels of employment and thus avoid labor unrest. Keynes grew cynical about the ability of a central bank to impact output and employment when it was really needed. The only way he saw out of this problem was to develop a model that could explain how the fiscal policy of a nation could produce the aggregate demand that was necessary to spur a nation on to high levels of employment. Keynes gave very little attention to aggregate supply assuming that businesses would respond to demand: if demand were low, output would be constrained and workers would not be hired; if demand were high, output would be expanded and workers would find employment available.

The model that focuses primarily on aggregate demand came to predominate economic thinking in the post World War II period and continues to permeate the culture of macroeconomic policy making. If a problem seemed to be one of inflation, policy makers could concentrate on slowing down aggregate demand and take the pressure off of prices. If the problem seemed to be one of slow economic growth then policy makers could stimulate aggregate demand and create greater economic growth in the future. Right now when we seem to be faced with both an inflationary situation and slow economic growth we see that policy makers are talking about the monetary authorities raising interest rates, to ward off inflationary pressures, and further tax rebates (to follow the first round of tax rebates) to stimulate the economy.

Ask yourself this question: what are the conditions of demand and supply that result in rising prices and a slowdown in the rate of growth of the economy. Take a two dimensional graph and place the rate of growth of the economy on the X-axis and the rate of increase of prices on the Y-axis. Then draw a demand curve that is negatively sloped from left-to-right on the chart and a supply curve that is positively sloped from left-to-right on the chart. Now, you are only going to move one of the curves. Which curve, when you shift it, can result in a decrease in the rate of growth of output and an rise in the rate of increase in the price level? Only a shift backwards and to the left of the supply curve can give you this latter result!

Could it be that the shock to the economy is coming from aggregate supply and not from aggregated demand? It sure could. I believe that more and more data analysis is pointing to the conclusion that maybe fluctuations in economic growth are not necessarily coming from the demand side of the economy but are coming from the supply side instead.

What are some pieces of evidence that seem to show that movements in the supply side of the economy might dominate what happens to an economy in the short run? Real consumption expenditures, for example, tend to move in a procyclical fashion with real Gross Domestic Product over the business cycle. Real gross investment is also moves with real GDP as do real wages and the real price of rental capital. Interest rates also tend to move in the same way. If aggregate demand dominated economic activity then one would not expect these variables to move in a procyclical fashion. Furthermore, inflation tends to move in a countercyclical way: actual inflation tends to be above the trend rate of inflation when the actual growth rate of real GDP tends to be below the trend rate of economic growth. All these results support the conclusion that shocks to the economy come from the supply side, not from the demand side!

Given how comfortable we have become with the models in which shocks come from the demand side of the economy, these results seem to be counter-intuitive. However, we need to look at these results very carefully because how we interpret them is very, very important for not only the governmental policies that we support, but also for the economic and financial decisions we make given the choices that government policy makers implement.

If the government acts to stimulate the demand side of the economy as a result of a negative supply shock then the basic result will be more pressure on prices with very little of the stimulus being transferred to increasing output and employment. In fact, there can be a second round effect of such inflationary stimulus. We saw in the 1970s that increasing inflation resulted in people and businesses investing so as to hedge against inflation. Most of this hedging turns out to be counter productive to the productivity of the economy. When people begin to focus on protecting themselves against rising prices, it inevitably causes them to lose their focus on good business practices, practices that include increasing the productivity of capital. Thus, this secondary effect can further slow down economic growth by causing an additional backwards shift of the supply curve. This is exactly what happened in the 1970 period of stagflation.

There are a lot of things that can produce a backwards shift in aggregate supply. We don’t have time in this post to go into them, but I will devote some time to this analysis in future posts. However, the efforts to stimulate economic growth without putting pressure on prices are dependent upon whether or not we can identify the factors that have caused the shift and the incentives that can be set up to encourage people and businesses to increase output and further stimulate economic growth. Thus, in order to create more economic growth without setting off further inflationary pressures, care must be taken to identify what has caused the shift in supply. This will allow policy makers to devise policies that will get business, once again, to focus on what they do best.

The problem…supply side policies tend to be those that create enhanced incentives for businesses. Creating such policies without taking into consideration the problems that people have in finding work, in paying their debts, and in holding their heads up, is a sensitive issue. Policy makers must find the right balance of programs to stimulate business activity while not creating too much aggregate demand that will only exacerbate inflation. This is not an easy task!

One final issue…are we in a recession? I am not going to use the standard definition of a recession associated with the National Bureau of Economic Research which focuses major attention on two quarters of negative growth in real GDP. To me the important consideration is the relationship between the trend rate of growth of real GDP and the actual rate of growth of real GDP. To me, the concern is over how far the latter growth rate falls below the former. If the actual growth rate falls below the trend growth rate by 1.5% or more, then this could be defined as a recession. That is, if the trend growth rate of real GDP is 3.0% and the current actual growth rate is 1.4%, then one could argue that the economy is in a recession because actual growth is 1.6% below trend growth. Real GDP has grown at a compound annual rate of 3.0% over the 1977-2007 period. The year over-over-year growth of real GDP from 2007-I to 2008-I was 2.5%. This would indicate the United States economy is not yet in a recession.

Friday, July 25, 2008

It's All a Matter of Incentives

“Economics is, at root, the study of incentives…” (Steven D. Levitt and Stephen J. Dubner, “Freakonomics”, p. 20.) The modern economy is a “thicket of information about jobs and real estate and banking and investment.” (p. 13) And, we respond to that information, respond to the incentives built into that information “from the outset of life.” (p. 20) “There are three basic flavors of incentive: economic, social, and moral. Very often a single incentive scheme will include all three varieties.” (p. 21) In many cases, incentives lead us to cheating and lying. (In the latter case see “Nobel-winning economist who put a premium on truth.”

The reason I am bringing up the issue of incentives today is to put into perspective some of the behavior we have observed in the economy in recent years and the results of such behavior. My major point is the obvious statement that everyone is looking for an edge. That is, people have goals and objectives to achieve, whether or not these are explicitly understood or not. As a consequence, people will respond to the incentives they observe that will move them ahead in their quest to achieve these goals and objectives.

Many of these goals and objectives are couched in relative terms. That is, the result we are looking for is not one of ‘absolute’ performance, but of ‘relative’ performance. We learn very early in life that in games like baseball, it is not important that we score 10 runs in a game, but at least one more run than our competition. In golf, we don’t need to shoot a score of 10 under par…all we need to do is shoot a score that is at least one stoke less than our opponents. And, we see that this objective holds in many other areas of life as well.

And, stating our objectives in relative terms lead us to ‘copy cat’ types of behavior. If another person, or another firm, has found a way to relative success, others will copy that way in order to duplicate that success, or, hopefully, perform at even a higher level. People that move to ‘the new way’ faster than others tend to achieve more success than those that move at a later date, although this is not altogether the case. But, this is the essence of dynamic markets. When there are opportunities for people to achieve returns that are in excess of costs, new participants will be drawn into the market if the costs of entering the market are relatively minor. In the case of financial markets the costs of entry are usually not excessive relative to the potential returns.

Another important factor is that once favorable market situations arise participants and potential participants often develop the attitude that a “new” world has arrived and that this “new” world represents the future. When this attitude develops, the perspective between the long run and the short run disappears. Thus, concern over conventional standards and conservative practices also disappears because the “new” world demands new standards and practices.

Retrospectively, we can look back at various situations over the past 30 years or so and see many examples of how people and organizations responded to market incentives in an effort to get an edge over their competition. Of course, the movement in the area of derivative securities is a prime example of this competitive behavior. The subprime mortgage market is the premier current example of this kind of behavior. There were many incentives hanging around the development of this market. There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home. There were the incentives for financial institutions to acquire these mortgages, package them into securities and sell them to others, thereby earning fees rather than making profits on interest rate spreads. There were the incentives for the brokers to initiate these loans to generate fees for themselves. There were incentives for funds to hold these securities because of the yields they earned and the fact that they could leverage up their portfolios to add basis points to returns. And, there were incentives for individuals and families to go ‘out-on-a-limb’ to get their own home.

Incentives work…for better or worse. Where does one put the blame? When does one go ‘over-the-edge’? The important thing to remember is that it always is a matter of trade-offs. Levitt and Dubner ask the question: “Who cheats?” And, they answer…”just about anyone, if the stakes are right. You might say to yourself, I don’t cheat, regardless of the stakes. And then you might remember the time you cheated on, say, a board game.” (p. 24) Then they go on: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people, clever and otherwise, who will inevitably spend even more time trying to beat it…Cheating is a primordial economic act: getting more for less.” (p. 25)

Thus, certain types of behavior, as they succeed are copied. This is the way markets work. If exceptional returns are being earned, others will be drawn to duplicate the behavior that succeeds. The “new” behavior becomes a social phenomenon. David Brooks, in the New York Times, has recently discussed this “social” behavior. (“The Culture of Debt”, Everyone jumps on the bandwagon.

However, the additional competition tends to drive out the exceptional returns and promotes even more excessive actions to perform. Again, this is the way markets work. For example, in the 1970s and 1980s there was a move to buyout companies, break them up and sell the various parts. Valuation was such that the individual parts were not being valued at their ‘stand alone’ value and consequently this strategy could succeed and generate a lot of wealth. However, as time passed, the valuations of companies came to incorporate these ‘stand alone’ values and hence people that got into this game at a later date did not achieve the rewards that those who got in earlier received. By the start of the 1990s buyouts were actually losing money in the effort to duplicate what had gone on before.

If a movement continues on for a lengthy enough period of time it becomes more and more difficult for the person operating in a more conservative way to stick to their principles. For example, a friend of mine ran a mutual fund during the 1990s; he had a fair amount of Nobel-prize money in his funds; his funds performed very well for most of the decade; and his funds stayed out of ‘tech’ stocks since he felt that their performance tended to be speculative in nature. However, toward the end of the decade his funds began to lag other funds that were more heavily invested in “technology”. As a consequence, investors began to move money out of his funds. Finally, feeling that he could not stay away from the ‘dot-coms’ he finally began to move into that area of the market. Nine months after he began this move, his performance was recorded in the main article on the front page of the Wall Street Journal. He had moved just before the crash in dot-coms began. The fund recovered, but if he had stayed with his initial principles for just a while longer, he probably would have made the lead article in the Wall Street Journal heralding his adherence to the fundamentals. (For a happier outcome see “PNC’s caution gives it last laugh over rivals”:

The bottom line to this is that this type of behavior is not going to go away. Legislation is not going to change human behavior. “Incentives are the cornerstone of modern life.” (p.13) Congress can try and put a halt to speculation, they can attempt to halt higher leverage, they can move to prevent ‘cannibalistic’ lending behavior. Yet, if the incentives exist, individuals will find a way to get around regulators and legislators. I am not trying to justify this behavior…just accept the reality of it. The only thing I believe that can help the situation is to create greater openness and transparency in transactions and reporting. This will not change behavior but it will provide more information so that we can more fully understand what is going on in the
markets and the positions that people are taking.

Tuesday, July 22, 2008

Prospects for Stagflation

There has been a lot of talk recently about the United States economy entering a period of Stagflation. Stagflation can be defined as a period of time in which economic growth remains below historical averages while significant inflation is present. A period like this is looked on as the worst of two worlds: the low economic growth results in a higher ‘natural’ rate of unemployment than in more normal times; and the economy still has to deal with an inflation rate that erodes earnings and causes an allocation of resources favoring wealth protection and not productivity. A period of Stagflation tends to be self-perpetuating because the lower productivity results in slower growth and the slower growth exacerbates inflation which further stymies productivity, and so on.

Stagflation also puts the Federal Reserve System “in a box”. If the Fed attempts to ease during such a period, the argument goes that its efforts will tend to go into further inflation. If the Fed attempts to restrain inflation, it will only worsen the unemployment situation. The monetary authorities are faced with a real dilemma.

One of the problems in understanding how Stagflation can occur is that people tend to focus on aggregate demand factors when studying economic fluctuations. If economic shocks come from the demand side, a slowdown in demand translates into slower economic growth which is accompanied by higher unemployment and lower inflation. But, this is not how we define Stagflation.

Instead, Stagflation comes about due to a supply side shock which produces both a slowdown in economic growth and higher rates of inflation (for a given amount of aggregate demand). But, how does this come about?

In terms of economic growth I would argue that two things contribute to the possibility of a slower expansion. First, there is the restructuring that most financial and non-financial firms are going through right now. When firms are going through the process of restructuring they lose focus as to what they really should be concentrating on. I know this sounds contradictory, but my business experience points to this very thing happening at a time like this. When you are restructuring you are concentrating on getting back to basics, eliminating those things that you shouldn’t be involved in and retrenching into those things that you should be involved in. (Should you sell businesses, something that takes time and attention?) Also, financials need to be cleaned up. (Perhaps new capital needs to be raised, something that takes time and attention.) Furthermore, expenses need to be trimmed, people let go, and superfluous efforts eliminated (all taking time and attention).

During such times, executives do not focus on creating or sustaining competitive advantages because their focus lies elsewhere. Achieving and sustaining competitive advantages are what produce exceptional returns over time. But, achieving and sustaining competitive advantages takes time and effort since the primary sources of competitive advantage result from things like barriers to entry and from customer captivity. Barriers to entry come from economies of scale and research programs that create a continuous competitive flow of innovation. Customer captivity comes from building customer relationships through product and service quality and support. A firm generally has to restructure first before it is able to concentrate on these paths to better than average performance. And, since building competitive advantage must be very intentional, it must be the primary focus of management.

The second factor that contributes to slower economic expansion is the impact that inflation has on economic performance. As we saw very clearly in the 1970s, an inflationary environment results in managements directing attention away from longer-lived more productive investments and into shorter-term assets that act like an inflation hedge. Such investment slows down improvements in productivity because productivity improvements tend to be more prevalent in longer-term assets than in short-lived ones. The threat of higher inflation results in lower productivity growth.

Both factors, loss of focus and reduced productivity growth (each of which tend to reduce innovation), contribute to slower economic growth and a less vibrant business environment. This re-focus also results in a change in business leadership. As the culture of businesses change due to different economic environments, management leadership tends to change as well. Promotions and hiring’s go to managers that are more risk averse and less dynamic and this contributes to a slower pace of economic expansion.

On the policy side, both monetary and fiscal policies are directed to stimulate aggregate demand. The general prescription for monetary policy is to lower interest rates (or at least not raise them) and speed up monetary growth. On the fiscal side , a general effort is made to cut taxes and/or increase government expenditures. If the above analysis is correct, both efforts will go to produce more inflation rather than stimulate production, and this, as we have seen, will just contribute to making the situation worse.

If we think we are entering a period of Stagflation, then we must be sure that we understand where the economic shock has come from…the demand side or the supply side. If Stagflation results from a supply side shock then pursuing demand side remedies will only make the situation worse. If Stagflation is coming from the supply side then the government must create more appropriate policy responses fit to meet the needs of the times.

If Stagflation is a supply side problem then we must look at the behavior described above in order to come up with appropriate actions. First of all, inflation is an enemy and its fire must not be fanned! (This even ignores the impact that inflation potentially has on the value of the dollar.) Any policy actions that encourage inflation only create a cumulative problem that just adds fuel to the fire and makes the inflationary spiral that much more difficult to stop. It is hard for policy makers to fight inflation at a time like this because voters and politicians are clamoring for more economic growth and less unemployment.

The second part of the problem is not only difficult but slow to unwind. Also, there are two components to this second part. The restructuring of businesses, both financial and non-financial, must take place and it must take place in as orderly a fashion as possible. This takes time. It has taken the American economy quite a few years to get into the situation it is now going through and getting out of it will be painful and time consuming. Adding to the normal adjustment process is the added problem that the United States, as well as the world, is also in need of moving away from fossil related energy sources and moving into an age of cleaner and more efficient energy sources that are not fossil related. So, we are going though an adjustment related to the financial excesses of the past decade or so as well as an adjustment related to the absence of a sound energy policy in the developed world.

The other thing that must be avoided at this time is the move to a more inner-directed management. For the economic growth rate to increase and unemployment to drop, managements must strive to create sustainable competitive advantage by focusing on what they do best and innovating in order to keep ahead of their competition. Costs must be contained, not through cutting back on expenses, but, through economies of scale achieved in the application of core competencies and increases in productivity. This too will take time and the intentional efforts of business leaders and entrepreneurs.

To combat Stagflation we must have monetary policy and fiscal policy working together. Monetary policy must work to keep inflation moderate. Fiscal policy must work to create an environment that encourages the improvement of productivity and risk-taking. Yes, there needs to be a safety-net for Americans that are hurt by unemployment and economic dislocation. But, if Stagflation is a supply side problem, the resolution to the problem must come from stimulus programs that impact the supply side of the economy.

Saturday, July 19, 2008

Federal Reserve Operations: The Last Six Months

A lot has changed over the last six months in terms of how the Federal Reserve conducts its operations. We are still learning how to interpret the data that are available to us in order to discern what it is the Federal Reserve is attempting to do…and whether or not it is succeeding. This post represents my attempt to present some analysis as to what has been achieved.

The three major factors occurring over the past six months, the items that have garnered the most press coverage, are the liquidity crises that peaked in March 2008, the dramatic lowering of the Fed’s target Federal Funds rate, and the dramatic rise in the price of oil. Not getting so much press but of equal importance has been the introduction of new Federal Reserve tools such as the Term Auction Facility (TAF) and the Primary Dealer Credit Facility. The conduct of monetary policy has to be put within the context of these events.

In order to try and put everything into context, let me start out be examining the supply and demand for money. Generally in a liquidity crisis there is a sudden increase in the demand for money. The central bank attempts to ease the strain on the money markets by throwing open its lending window, supplying funds to the market in other ways, and maintaining or lowering interest rates. By doing these things the Fed supplies liquidity to the market and facilitates the selling of securities so that banks and other institutions can meet their obligations. Total reserves in the banking system increase.

We know that the Federal Reserve dramatically lowered, in several successive moves, its target for the Federal Funds rate. But, what happened to bank reserves? In January and February of this year, the year-over-year rate of growth of total reserves in the banking system (not seasonally adjusted) was just above zero. In March the year-over-year rate of growth jumped to 4.7%, dropping off to 2.2% and 2.4% in April and May. Obviously, there was some growth in total reserves to help resolve the liquidity pressures in the money markets. (One can note that the year-over-year rate of growth in total reserves for June dropped back to a 0.7% rate of increase.)

So the Fed was supplying reserves during the March-April-May period, but did this have any effect on money stock growth? If we look at the narrow measure of the money stock, M1, we see that its year-over-year growth rate from January through May varied around didn’t seem to grow at all. However, the broader measure of the money stock, M2, experienced a rise in it’s year-over-year growth rate going from a rate of growth in the fourth quarter of 2007 of about 5.5% to a rate of growth of 6.8% in February 2008, 7.1% in March 2008 before dropping off to 6.5% and 6.4% in April and May, respectively. (One can note that in June the rate of increase had fallen to 6.0%)

One can conclude that during the period of greatest market stress, the Federal Reserve oversaw and increase in the growth rate of total bank reserves that was accompanied by an increase in the growth rate of the M2 money stock. Thus, the Fed underwrote the lowering of its target rate of interest by supplying reserves to the banking system, thereby causing an increase in money stock growth. This is classic central bank behavior.

The question then becomes, how did the Federal Reserve accommodate the problems in the money markets by its operational actions. For this we have to go to the Federal Reserve’s Factors Affecting Reserve Balances, the H.4.1 statistical release. Here is where things get messy. Because of limited space, I am only going to deal with aggregate movements at this time. (If you would like more detail in another post, dates as well as accounts, please let me know.)

From the banking week ending January 2, 2008 through the banking week ending April 2, 2008 the Federal Reserve supplied reserves to the banking system through Repurchase Agreements ($37.8 billion), Other Loans ($39.4 billion) and the Term Auction Facility ($60.0 billion). That is, the Fed supplied the market with $137.2 billion in reserves during the first quarter of the year. But…the Fed’s holdings of securities fell by more than this, removing $156.5 billion in reserves from the banking system. This indicates that the Fed actually allowed reserves to flow out of the banking system during the first quarter of the year…something you would not expect in the period a liquidity crisis was taking place!

What happened? Well on the other side of the sources and uses statement we see that currency in circulation declined by $13.6 billion and other deposits at the Federal Reserve fell by $3.5 billion. These are regular seasonal swings as currency in circulation builds up in the fourth quarter of a year for the holiday season and then declines in the first quarter of the next year as needs for currency are reduced. The swing in other deposits at the Federal Reserve has to do with Treasury deposits and relates to tax dates. So, factors supplying reserves declined by $16.3 billion (incorporating other minor changes in accounts) while factors absorbing funds declined by $15.6 billion (incorporating other minor changes in accounts). Therefore, reserve balances at Federal Reserve banks actually fell during the first quarter of 2008.

But, as indicated above, the growth rate of total bank reserves actually increased throughout the quarter. How can this be explained? Well, the decline in reserve balances actually decreased less this year than it did last year and so total reserves increased, resulting in a year-over-year increase in the rate of growth of total reserves. The Federal Reserve actually eased the pressure on the money markets while seeing reserve balances at the Fed fall. Ah, the problems of these technical factors!

Interpretation…the Fed got $60.0 billion to the banks that needed reserves through the TAF…and a further $39.4 billion to the market through its lending facility. In the first quarter, the major increase in Fed lending came through the Primary Dealer Credit Facility, the borrowing window available to dealers in securities. The Fed continued to supply needed liquidity to the money markets through Repurchase Agreements. Basically, these efforts got funds to the organizations that needed them and did not force them into selling securities at losses…both good results.

In the second quarter, the Fed directly supplied reserves to the banking system and continued to support the year-over-year growth in total bank reserves but not at the peak rate through March 2008. The Fed’s holdings of securities continued to decline, falling $110.2 during the quarter. Also, Fed lending declined by $28.4 billion in the second quarter as both banks and securities dealers repaid borrowings. These declines were partially offset by an increase of $50.0 billion of TAF funds and an increase of $32.8 billion in Repurchase Agreements. There were new factors supplying reserves to the banking system during this time. Other Federal Reserve Assets increased by $40.9 billion. This increase was due to the drawing down of the Fed’s Currency Swap line established with the European Central Bank, the Bank of Switzerland, and other central banks. In additions, the Fed supplied $29.8 billion in reserves related to the Bear Stearns bailout. (This appears in a line item labeled “Net portfolio holdings of Maiden Lane LLC”.) Factors supplying reserves to the banking system netted out to a +$14.5 billion. Factors absorbing reserves during the second quarter netted out to +$13.1 billion (the largest factor absorbing reserves was the seasonal increase in Currency in Circulation which increased by $11.1 billion.) Taking much of the seasonal swing out of the change in total reserves resulted in a decline in the year-over-year rate of growth of total reserves, dropping to just a 0.7% increase by June.

The conclusion: the Federal Reserve seems to have gotten through the period of the credit crisis in good shape. The crucial thing is that it lubricated the market when if was in the greatest need of liquidity and then seemed to back off as the money markets stabilized. The bottom line to this is that the Fed seems to have backed off in continuing to supply liquidity after the liquidity crisis abated. I would argue that money stock growth (M2) is still too high and under the present circumstances points to a rate of inflation of around 4% per year, but the central bank had to deal with the liquidity crisis first before it could move on to other objectives. I must add, however, that we are just getting used to the new tools and institutional arrangements and so any analysis must be tentative.

Thursday, July 17, 2008


How far the mighty have fallen…

Take a look at the picture of Fed Chairman Ben Bernanke in this Wall Street Journal editorial:

I don’t think anything else needs to be said at this time.

Wednesday, July 16, 2008


It all starts at the top!

How desperate are things? Well, the “Decider” stepped out yesterday to calm the American people’s fears about the financial system and the economy. Here is a person who has no credibility…a person that has been put in front of the American people time-after-time to build up their confidence and encourage them to stay-the-course…a person who is worn out and has no energy…and we hear from him that things are “OK”. Thank goodness he didn’t call us a bunch of whiners!

It is apparent, however, that his leadership permeates his whole executive team. The result was dramatically seen elsewhere in Washington, D. C. yesterday. U. S. Treasury Secretary Henry Paulson carries little or no weight in the current exercises. (See, for example, The testimony of Federal Reserve Chairman Ben Bernanke was weak and muddled. Who can we turn to?

In my experience the Chief Executive sets the tone for the organization…the culture, if you will. Everything the Chief Executive does, or says, or seems, is reflected in his or her team and the performance of the institution he or she leads. The “Buck Stops” with the Chief Executive, whether or not the Chief Executive accepts this fact or not.

How are things going in the world? Mister leader…you are the captain of the ship…responsibility falls to you!

Secretary Paulson and Chairman Bernanke are honorable men. They are also capable men. But, so is Colin Powell. The performance of the team is always, for better or worse, overshadowed by the boss. If the Chief Executive is a capable leader…if the Chief Executive has good people around and facilitates the use of their talents…if the Chief Executive doesn’t fall victim to the flattery and ego-inflation of some of his team…that Chief Executive can produce extraordinary results. However, if the Chief Executive does not possess these talents…even good, capable people perform way below what is possible.

In my estimation we are beyond specifics when attempting to judge where the economy is and the soundness of the financial system. We have a leadership void and as a consequence we face a situation in which things can only deteriorate further until some form of real leadership is re-established within the United States government. The scary thing is that we seem to be facing a minimum of six months before the possibility of a change can become a reality. Not only do we have the “Gang that couldn’t shoot straight” in office, but the “Gang” is also a “lame duck”!
What needs to be done, in my estimation, is greater than just specific responses to market conditions. We need leadership in the following areas.

· International cooperation and coordination in economic advancement. The United States is still the one super power in the world but it needs to be a part of the development taking place in other nations and areas. The United States may be disliked and resented by others but the United States is still needed by these nations and areas and can still be a facilitator in the development and advancement of the rest of the world. (You might also look at the T. Friedman editorial this morning And, the United States cannot close itself off from other parts of the world as “Reverse Globalization” takes place. Conversation and communication needs to be expanded from just the G-8 to the G-20.

· The United States must get it monetary and fiscal policy “in sync” with the rest of the world. The government must cease to believe that it can continue to operate its economic policy independently of the world. The budget of the United States government must be brought under control and managed with a firm discipline. Monetary policy must be directed to focus on the value of the dollar and possibilities of future inflation. The Federal Reserve must not be burdened with more and more responsibilities that can present it with conflicting goals and objectives. We have seen what difficulties can arise by just having two objectives—inflation and economic growth.

· The United States must develop a “real” energy policy! Enough of band aids. Enough of political posturing. Enough of catering to the financial interests of a small segment of the economy. If T. Boone Pickens can move on this issue…surely others can also move! (

These, of course, are longer run concerns, but they pertain to the strategic direction of the United States. If we don’t have a vision of what is needed and if we don’t have leaders that can express a vision we can buy into and trust, then the responses and reactions that happen within the short run result in nothing but a ‘random walk’ and we end up with a hodge-podge of consequences that do not serve us well over the longer run.

Yes, I know…in the long run we are all dead. (Keynes) But, we only become desperate for fixes in the short run when there is an absence of leadership and no one seems to know where we are going.

My short run concern is that since participants in domestic and international markets have little or no confidence in the leadership that exists within the United States…in the business and financial community as well as in the political sphere…the drift in the financial markets and the economy will continue to be on the downward side. Economists and other pundits can continue to come up with suggestions and schemes to contain the trouble or dreamscapes to resolve the whole problem…but, that is all they will be until leadership is established once again. Unfortunately, the current players seem to lack this skill.

Monday, July 14, 2008

"And, another one bites the dust..."

One more major American company has been acquired by foreign interests. As Anheuser-Busch has agreed to being purchased by InBev, we see the relentless march to foreign ownership proceed. While the turmoil in the financial markets and the ‘bail-out’ of Fannie Mae and Freddie Mac dominate the headlines…reverse globalization takes over the United States.

I call what is happening ‘reverse globalization’ because, for Americans, globalization was a good thing when the United States was dominating the world, spreading into more and more corners of the globe, and investing in more and more foreign companies. Now, the shoe is on the other foot and the question of concern is over American attitudes to world trade…to further globalization.

We see trade agreements are in danger in Congress. We hear Presidential candidates claim that firms that transfer jobs off shore will be punished. And, we see more and more American Companies being purchased or invested in by foreign companies or national wealth pools. The question is how long will the voters in the United States support open trade and world economic evolution?

The problem is that in an inter-dependent world, countries cannot act as if they are isolated from other nations and international financial and economic markets…even if they are the sole remaining superpower. And, as we see in economic affairs, what has been started and supported historically must play itself out. It has taken us a long time to arrive at the situation we are now in and there is plenty of blame that can be passed around to all who have been involved.

The fact is, we are in the situation we are now in and we must deal with it in the best way we can. And, whether we like it or not…we must accept the fact that the current administration in Washington…the “Gang that couldn’t shoot straight”…is going to play a role in how we get to the future. The sad thing to me is that both candidates for the presidency are concentrating on programs that they are going to put into place once they are elected…and fail to recognize that the situation is not one in which they are going to be able to enact any of these programs.

Furthermore, more and more people are beginning to realize that the situation is continuing to unfold…the economy has not felt the full impact of the financial upheavals and the collapse of the housing market…and, that Americans are not just “whiners” who have a mental depression.

The good thing is that things are proceeding and being dealt with. There are going to be more assets written down. There will be more losses. There will be more financial institutions taken over by the regulators. But, situations are being identified and people are moving to resolve the problems. I believe that this will continue, if we can just keep attention-seeking Senators from sending out letters that set off panics at financial institutions.

It seems to me that two major changes in the way the United States does business is needed in the current situation. First, we need to make sure that the world does not dive into a ‘protectionist’ shell. That is, it is best for all to keep trade open, to allow purchases of assets go ‘both ways’, and to facilitate the evolution of world trade integration rather that arrogantly stand above the fray and maintain the superiority of the anyone country.

Unfortunately, this is going to result in some pain because of the policies and programs that have been instituted in the past. The rest of the world owns a lot of America’s financial assets. With the value of the dollar being so low, it makes sense for these wealth interests to convert their financial assets into United States physical assets. This is something we are going to have to live with. The alternative, too, is painful…a protective world where trade is reduced and trust and cooperation is minimized. I believe that it will benefit more people to reach a balance closer to open trade than it will be to ‘close down the shop’.
Second, international communication and cooperation must be promoted on a greater scale. An article in the Financial Times has argued that the G-8 is really inconsequential any more and that the world stage must be broadened to at least the G-20. The point is that there are many more nations that play a significant enough role in the world that they must be included in any discussions taking place. Things just won’t get done if the circle is not widened.

But, even more important, the arrogance of the United States must be minimized. The United States must play by the rules of inter-dependent nations. The United States must become one among many and cannot appear agreeable to what others want when they are together and then go home and undercut the whole process.

This, too, will be painful. The consequences of the monetary and fiscal policies of the last seven to eight years must be reckoned with and this is going to hurt. But, the United States has to bring itself more into line with the rest of the world. Its policies are already hurting enough countries, countries whose currency is tied to the value of the dollar. And, the United States must accept the fact that because it did not play by the rules in the past that the nations and areas that did work hard to establish discipline and market confidence over these years must not now abandon their efforts in order to help out ‘good old America’.

As I have suggested before…the United States is at a ‘tipping point’. The country that we have known over the past forty years or so is rapidly receding. We are struggling to gain the future.

I have gone through another ‘tipping point’ in my life. My children have asked me over the years…”what was the big deal about Viet Nam?” This, I have found, is a difficult question to answer in a simple way. Perhaps the most relevant thing I have said about this period is that life before the 1960s was quite different from life after the 1960s.

I firmly believe that life after the 2000s will be considerably different than life before the 2000s. How so? No one has an answer for that at this time! But, we all must be flexible in our commitments and return to the principles of sound financial and economic programs and policies and cooperation and openness with others in building the world community.

Thursday, July 10, 2008

Yes, Greenspan is to blame!

There has been a lot of discussion recently about who is to blame for the current economic and financial situation. I firmly believe that Alan Greenspan cannot be excluded from those that deserve such blame. There is only one question that needs to be asked: who was the Chairman of the Board of Governors of the Federal Reserve System in the period from 2001 until January 31, 2006? Now look at the chart of the exchange rate between the U. S. Dollar and the Euro during this time. (

Need I say more?

By the end of 2006 things were beginning to unravel in the rest of the economy. The rest is history.

Greenspan was an expert on the minutiae pertaining to business cycles. He cut his teeth during the time when understanding short term movements in the economy, independent of what was going on in the rest of the world, was the fashion in economic forecasting. Times changed. Greenspan didn’t.

The result:
Substantial dislocation in world and domestic economic and financial markets;

Substantial commodity price inflation; and

The largest sell-off of American assets in the history of the United States. See “Foreign Investors Pile Up More Pieces of Americana,”

Certainly monetary policy is not the sole cause of the present unpleasantness. The irresponsible fiscal policy of the period cannot be passed over and the failure of the United States government to develop a sound energy policy must also be included in the picture. But, Greenspan cannot be excused from events because of what was happening in the housing market or some other market. This just diverts attention.

The most important price in an economy is the price of its currency in foreign exchange markets. In watching over this price…Greenspan failed miserably.

Wednesday, July 2, 2008

The Dollar: the Next Six Months

The last six months was not one of the best for the United States Dollar. The value of the dollar declined by about 7.5% against the Euro; 1.3% against the British Pound; and around 3.5% against an index published by the Federal Reserve System, an index relative to currencies in a broad group of major U. S. trading partners. During this period United States policymakers were focused primarily upon a liquidity crisis that hit full force in March and resulted in an assisted merger transaction and weakness in the domestic economy. The Federal Reserve and the U. S. Treasury Department were continually putting out fires here and there and providing liquidity to securities dealers and investment bankers. The first half of 2008 was not a time these policy makers could pay much attention to the decline in the value of the dollar.

What is the outlook for the next six months?

In my view, the outlook for the value of the United States Dollar over the next six months is not a good one. There are just too many things now in the works that do not favor an emphasis on a strong dollar. The question is, however, whether or not these possibilities are already incorporated in the current value of the dollar? My best guess is that the dollar will remain weak during this time period and will drift lower as more and more information reaches the market concerning the problems the world and the United States are facing.

The first such event on the horizon relates to the possibility that the European Central Bank will raise its base interest rate to combat the inflation that has now spread across Europe and that is twice the level of the ECB’s target rate of inflation. Moving this interest rate will put more pressure on the U. S. Dollar because the Federal Reserve is not expected to raise its target rate of interest due to the weakness of the U. S. economy and it financial institutions. There is also the possibility that central banks throughout the world will be raising their interest rates during the summer or fall months.

This possibility points up a real problem in world financial markets: the ECB, for example, is charged with one objective…to keep inflation under control. Its charter makes it completely independent of the political structure in the European Union. Thus, the ECB can pursue its objective of keeping inflation under control without immediate fear of political consequences.

Due to the independence of the ECB and many other central banks throughout the world, inflation targeting can be the sole focus of these organizations. This contrasts with the goals and objectives of the Federal Reserve System in that the Fed has two objectives it must focus upon…inflation and economic growth. These goals are not always compatible. Furthermore, if nations are “out-of-sync” economically with one another, as the United States seems to be “out-of-sync” with much of the rest of the world, then playing by different rules creates major national conflicts.

The possibility of conflicts, like the current one, is seemingly going to be an issue to be debated in the future. The French president Nicolas Sarkozy has already raised the issue of independent central banks and the problem of focusing on just one goal…inflation. (See the article in the Financial Times, “Elysee attacks ‘misguided’ policy of ECB”, This is the problem that ‘politicians’ always have with independent central banks and it represents the reason why central banks need to be independent of their governments. The current times are going to be ripe for political attacks on this independence. But, any such debate will not be a confidence builder for the support of strong currencies.

There are several other factors that will be hanging over the foreign exchange market over the next six months. Perhaps the most important one is the influence, or, one could argue the lack of influence, the current administration will have on the economy and the financial markets should a crisis arise. There is only one thing, in my view, that the Bush administration can pursue aggressively in the last few months it is in office…it can aggressively move to prevent further financial collapse or economic dislocation. This is the only thing the United States Congress will allow the Bush policy makers to do. Anything of a more positive nature will be postponed…like the efforts of the Treasury Department and the SEC to coordinate and share data collection. The Democratically controlled Congress expects to see a Democratic President seated in January 2009 and also expects to hold greater majorities in both the Senate and the
House. They are not going to allow this administration to initiate anything in its last few months in office.

Administration policymakers are very much in a dilemma. We have recently heard Fed Chairman Bernanke and Treasury Secretary Paulson speak about supporting a strong dollar. Paulson “reaffirmed the importance of a strong dollar” in Europe yesterday. (See “Paulson, in Europe, Finds Misery Loves Company”,
Neither really have the option of doing anything about it at this time except talk. Furthermore, raising interest rates over the next four months and causing greater financial distress and economic misery would only make it more difficult for a Republican to be elected in the fall. So much for central bank independence.

The economy is also going through its adjustments and there are many uncertainties connected with how strong or weak the economy will be. On one hand, the United States economy has stayed stronger than expected through June of this year…but there is plenty of evidence that events over the next six to eighteen months may be rather unpleasant ones, especially for workers and businesses, both large and small. We are only beginning to see the impact that the higher price of oil is going to have on the economy. The auto industry is reeling…airlines are facing huge problems…retail trade is suffering…financial institutions are not out of the clear (there is great concern over the condition of regional and smaller banks for example)…and there is still the housing industry. What this is going to do to labor markets and workers and families is still to be determined. (For an interesting take on this see “Dispelling the Myths of Summer”,

The uncertainty with respect to how the economy is going to evolve connected with the inability of the “lame duck” administration to do much of anything leaves the candidates for president in an awkward position. The state of the economy is certainly going to have an impact on the election, but the issue is, what approach to projected policies should the candidates take? Right now the candidates are presenting programs representing what they would do if they are elected president…and the economy were not a problem. We are hearing nothing about what they would do if the economy is not in very good shape…or if the economy is “in the tank.” We have no idea who they would install as cabinet members or advisors. As a consequence, we have no idea about how either candidate would respond to the issues now facing the financial world over the value of the dollar.

Thus, the outlook for the dollar over the next six months is for little or no support to come from the United States government. And, with no insight as to how a next presidential administration would respond to the dollar situation there can be little or no confidence as to whether the dollar would be supported in the future. I don’t see how one can attach any confidence at this time to a sustained near term recovery in the value of the dollar.