How People are using their Money

It is instructive to take a closer look at how people seem to be handling their money. Obviously, people are not spending much, although the Federal Reserve sure cannot be faulted for not trying to jump start consumer and business spending. The monetary base, the sum of all bank reserves and money that can serve as bank reserves has gone from a year-over-year rate of increase of about one percent at the end of 2007, to a 101%, year-over-year, rate of increase at the end of 2008, to a 102%, year-over-year, rate of increase through the third quarter of 2009.

The unwillingness of banks to lend and/or the unwillingness of people to borrow shows up in how fast this base money turns over in the economy, that is, in the velocity of use of this base money. Whereas, velocity was increasing by about 4% through 2007, it declined by 101% in 2008, and was declining at a 104% rate through the third quarter of 2009.

The consequence of this was a build-up in excess reserves in the banking system. For a current review of this result see the column of Peter Eavis, “The U. S. Economy’s $1 Trillion Question”, in the Wall Street Journal (http://online.wsj.com/article/SB20001424052748703300504574565991276510968.html#mod=todays_us_money_and_investing).
If we look at broader measures of the money stock, we see similar results, but with some interesting shifts between money stock measures. The year-over-year rate of growth in the M1 measure of the money stock was roughly flat through the end of 2007, about 16% at the end of 2008, and approximately 19% through the third quarter of 2009. The turn-over, or, velocity, of the M1 money stock increased by about 5% in the earlier period, but fell by 16% through the year of 2008 and by 20% through the first three quarters of 2009.

The M2 measure of the money stock grew at a 6% year-over-year rate of increase in 2007, a 10% growth in 2008 and an 8% rise through the first three quarters of 2009. The velocity of the M2 money stock was roughly constant in 2007, but fell at annual rates of about 10% in both 2008 and through the first three quarters of 2009.

The difference in the performance of the M1 and M2 money stock measures tell of something very interesting in terms of how people are handling their money, but, it does not tell us much about how banks are lending because all measures of bank lending have been declining throughout the summer and fall months of 2009.

First of all, people have demanded more and more currency, a symbol of not only a move to security, but also an indication that people are paying for more of the things that they are buying with cash. The year-over-year rate of increase in currency outside of the banks was relatively flat through all of 2007 and through August 2008. In September 2008, however, the currency component of the money stock began to increase and was rising in the range of 10% to 11% by the end of 2008 through the September of 2009.
The other interesting thing about the growth of the M1 measure of the money stock was the rise in demand deposits at commercial banks. These are primarily “transactions” balances and serve much the same purpose as currency, reflecting the need to keep funds available for cash purposes. Also, people seem to feel more secure with funds in checking accounts than in other forms of bank accounts.

Demand deposits at commercial banks were actually decreasing all through 2007 and through the summer of 2008. In September 2008, the year-over-year the growth rate dramatically turned positive (16%) and then rose to a 54% rate of increase by December of that year. Demand deposits continued to grow at a 30% to 40% annual rate through most of 2009, falling off to about a 20% rate of increase in September and October 2009.

The interesting thing about this movement is where it is coming from. Primarily the movement into currency and demand deposits is coming from thrift institutions and retail money funds. The growth in savings deposits and small time deposits at thrift institutions turned negative in 2008, although the latter actually started to decline in late 2007. Since October 2008, the year-over-year rate of change of savings deposits at thrift institutions decline in the 7% to 9% range and the rate of decline in small time deposits at thrift institutions was in the teens for most of late 2008 before reaching 20% in the fall of 2009.

The biggest turnaround came in retail money funds. In late 2007 and through July 2008, the year-over-year rate of growth of money in retail money funds was in the 25% range. However, by the end of 2008, the increase was less than 10% and in March 2009, money was actually leaving these funds! In September 2009, the year-over-year rate of decline in these funds was over 16% and dropped further to -22% in October.

The bottom line of all this activity is that people have moved a massive amount of funds from time and savings accounts to demand deposits and currency. They have also moved massive amounts of funds from thrift institutions and retail money funds into commercial banks. There appear to be two main motives for this movement. The first is for people to have access to their funds for spending and to avoid the use of credit, if possible. The second is for people to feel that their funds are safer.

The consequences of this movement of funds are that the growth rate of the M1 money stock rapidly accelerated while the rate of increase of the M2 money stock only increased modestly. In recent weeks, however, the growth rates of both measures of the money stock have been slowing. Hopefully, this is a sign that fewer and fewer people are moving their funds into assets for use in transactions.

The next thing we need to look for in this area is a movement out of these “transaction” assets and back into time and savings accounts. It may take several more months for this to happen. When this movement begins we can gain greater confidence that people are feeling better about their financial circumstances and that the economy is, in fact, recovering.

Just a little aside on regulatory issues: A suggestion for restructuring the banking industry and its regulatory agencies would be to completely eliminate thrift institutions and the regulatory agencies overseeing thrift institutions and allow those thrifts that now exist the choice of either becoming a commercial bank or becoming a credit union.

The uncertainty just won't go away!

This from the Financial Times on the morning of Friday, November 20, 2009: “Short-term US interest rates turned negative on Thursday as banks frantically stockpiled government securities in order to polish their balance sheets for the end of the year.” (See: http://www.ft.com/cms/s/0/52e0f72c-d575-11de-81ee-00144feabdc0.html.)

“The development highlighted the continuing distortions in the financial system more than a year after Lehman Brothers’ failure triggered a global crisis.”

“With the Federal Reserve maintaining an overnight target rate of zero to 0.25 per cent, investors are demonstrating a willingness to completely forgo interest income—or even to take a small loss—to own securities that are seen as safe.”

Just how “safe” do these banks have to appear?

The way they are acting indicate that they are not very “safe” at all.

Total reserves at depository institutions for the two weeks ending November 18 averaged $1,106 billion of which $1,068 were reserve balances with Federal Reserve Banks and $38 billion was vault cash used to satisfy required reserves.

The Fed has pumped roughly $350 billion into the banking system over the past 13-weeks primarily through the purchase of open market securities.

The effective Federal Funds rate has fallen steadily through the fall from August and averaged 11 basis points toward the end of the latest banking week.

Putting this information together indicates, to me, a banking system that is still seriously threatened and desirous of all the spare cash that it can attain. This is not a situation of quantitative easing but of bankers that are overly concerned with their solvency. The Federal Reserve is supplying reserves “on demand.” They are not, at this time, initiating the supply.

And, why might this be so?

Well, take a look at some of the headlines of the past week: United States mortgage delinquencies reach a record high; bankruptcies continue to remain near record levels; commercial real estate to remain major problem for years; commercial real estate too complex for government to bail out; unemployment at 25-year high; credit card delinquencies remain at record levels; and bank failures will continue to average about 3 a week for the next 12 to 18 months.

President Obama is even talking about the possibility of a “double-dip” recession.

The distortions in the financial system continue to be enormous. Even given these attitudes within the banking system, as the Financial Times reports, “many” of the leading US banks are “sitting on big trading profits.”

And, why not? When they can borrow for less than 35 basis points and lend out at 350 basis points who cannot make profits. When they can engage in the “carry” trade and profit from the declining dollar as well as earn large spreads, who cannot make profits.

Stock markets have been living off of momentum trading. There are so many unknowns about the future of business and industry, let alone finance that the justification for the rise in stock prices since March can continue to be questioned.

The real problem that exists in the market right now is the huge overhang of uncertainty. Not only are there unknowns about the recovery of industry and finance right now, there are also unknowns related to the huge cloud of government budget deficits that hang over the financial markets for the future and the concern over the ability of the Federal Reserve to “exit” from all the reserves it has put into the banking system.

The risk that is incorporated in this environment shows itself from time-to-time. Of course, the massive rise in the price of gold has been one place that investors have flocked to this year. Another continues to be the world-wide demand for United States Treasury securities. And, like yesterday, enough bad news causes currency traders to move rapidly back into United States dollars for “reasons of safety.”

I know many measures of market risk have declined substantially over the past six months or so. One has to go back to November 2007 to see a spread between Aaa and Baa yields as low as they are now. Likewise, with spreads on high-yield securities. The VIX index has fallen, once again, around its 52-week low. My belief is that these measures are so low because of the Fed’s interest rate policy. Interest rates, in general, are lower than they would be if the Fed was not forcing low rates on the market, and interest rate spreads are low for the same reason.

Still, there is much to be wary of. The only certainty that exists right now is that the Federal Reserve, and other central banks around the world, will keep short term interest rates low for an “extended period.” But, at some point, these rates are going to have to rise. Until they do, the interest arbitrage opportunities will remain and large financial institutions will continue to take away large profits from the financial market. Furthermore, the carry trade will continue to prosper using funds from the United States.

The question here is, when will all the investors that are “making it” through government support and government guarantees head for the doors. It is only logical that when there is an indication that the Federal Reserve is going to start letting interest rates rise that there will be a rush to get out of the market or move to the other side of the market. In such a situation, the financial firms that are big in the trading area cannot afford to be second or third getting to the door to pull their own exit.

How will this leave the banks that are written about in the Financial Times? If these banks, generally the smaller ones, have “stockpiled” government securities, how will they handle the decline in the prices of these securities once interest rates begin to rise? If they are concerned about their solvency now, what will their condition look like under this kind of scenario?

If there is a rush to get out of bonds, will the Federal Reserve back off its exit strategy?

Uncertainty continues to rule the markets. And, on top of the basic market insecurity, there seems to be a growing insecurity about our governmental leaders (Geithner and Bernanke to start with), and about the institutions of our government (see House attack on secrecy in the Federal Reserve). Uncertainty is bad enough but if people have little or no confidence in our leaders and our institutions where are they to turn?

Excess Capacity and the Slow Economic Recovery

Ben Bernanke spoke in New York yesterday and, depending upon which paper you read this morning, he basically said one of two things. First, he said that the Fed was interested in a strong dollar and would continue to keep the value of the dollar in mind in deliberations concerning monetary policy.

Chuckle, chuckle.

Second, Bernanke said that the pain in the labor market was going to last for a long time and that we shouldn’t expect the unemployment rate to fall anytime soon.

That is, don’t expect interest rates to begin to rise in the near future.

Remember, the number one policy goal of the Federal Reserve (and the federal government) is full employment and don’t you forget it. Put inflation, commodity prices, and the value of the United States dollar on the back burner.

So much for an independent Fed!

But, we knew that.

The problem with the economic recovery and unemployment is captured by an article in the Wall Street Journal, “Auto Industry Has Room to Shrink Further,” (see http://online.wsj.com/article/SB125832250680149395.html?mg=com-wsj.) Although the article focuses upon the auto industry, the situation that is described can be extended to many other major (and minor) industries throughout the world.

“Over the past two years, the global auto industry has endured one of the worst downturns in its century-plus history. Auto makers around the world have consolidated, restructured and slimmed down—and yet they still have too much of just about everything, especially too many brands and too many plants.”

“According to CSM Worldwide, the auto industry has enough capacity to make 85.9 million cars and light trucks a year—about 30 million more than it is on track to sell this year, the equivalent of more than 120 assembly plants.”

Furthermore, an auto analyst is quoted as saying, “government intervention to save auto-related jobs has forestalled the inevitable—broad and deep restructuring that would shut down unneeded plants and close loss-making enterprises. Not as much capacity has come out that should have.”

This is just talking about the auto industry. But, it is true of industry in general. The United States and the global economy have become leaner due to the current contraction: still, much excess capacity remains.

Even though capacity utilization for all industry is up in the United States (note that capacity utilization for manufacturing in October did not change from September), giving further indication that the recession is over, the problem of too much capacity lingers. As I have mentioned many times before, every economic recovery since the 1960s has seen a pickup in capacity utilization as economic growth increased, but the peak reached in each cycle was no higher, and was generally lower, than the peak reached in the previous cycle.

That is, capacity utilization rose during the expansion phase of each economic cycle since the 1960s but the trend in the United States was for more and more plant and equipment to remain idle.

In addition, this contributed to the under-utilization of labor as is evidenced by the rising trend in those of the population that are labeled underemployed .

Also, as the federal government, and the independent Federal Reserve System, tried to pump up the economy so that fuller employment could be achieved, the pressure was always on for inflation to rise. Since January 1961, the purchasing power of the dollar has fallen by about 85%. This is not a coincidence!

Furthermore, these policy efforts just put people back to work in the jobs they had been in and reduced the incentive for companies to innovate and change moderating productivity growth.

The performance of industrial production in the United States carries with it the same story. (Industrial production is up in October, but at an anemic 0.1% rate.) The growth rate of industrial production rises and falls through the swings in the economic cycle, but each rebound does not bring with it the same expansion as was achieved in previous cycles. This is just another indication that although recovery takes place, the overall trend in the productive utilization of resources in the United States continues to wane.

This fundamental weakness resource utilization is resulting in changing attitudes throughout the world. David Brooks writes in the New York Times about the underlying optimism that seems to be present in China these days, an optimism that used to be present in the United States. Simon Shama writes in the Financial Times about how China is now “wagging its finger at the United States about it wayward monetary and fiscal policies, as yet, still unaccustomed “to being the strong party in the relationship.” Clive Crook, also in the Financial Times, writes about the looming political battle in the United States concerning the “big questions” that voters have to answer “about the entitlements they demand and the taxes they are willing to pay.”

The United States is strong and will continue to stay strong. But, its relative position is changing. And, the way its leaders go about attempting to resolve problems is missing the point.

The United States economy is recovering. But, unless policy prescriptions change, there will continue to be an under-utilization of capacity, a weakness to productivity growth, a bias towards inflation, further declines in the United States dollar, and the threat of protectionism.

It is said that people and a nation do not change their habits until there is a real crisis. Right now it looks as if we have wasted a pretty significant financial crisis in returning to our old ways and old policy prescriptions and will just have to be content with an economy that produces mediocre results. No one seems anxious to change how we attack our problems.

A Critique of Quantitative Easing

Yesterday, I posted a report on the strategy of the Federal Reserve to exit its position of excessive monetary ease. (See http://seekingalpha.com/article/173556-federal-reserve-exit-watch-part-4.) In that report I mentioned that since August, the total reserves in the banking system had shown a substantial increase.

Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)

The Monetary Base rose by $352 billion during this period of time. (This was both on a
seasonally adjusted bases as well as a nonseasonally adjusted basis.)

What I am interested in reporting on is the total amount of reserves available to the commercial banking system.

Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.

This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.

Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat!

The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008 while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.

Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about 5 times as many reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!

However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.

While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.

The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing. My understanding of Quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.

I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.

This, to my mind, is not Quantitative Easing. It is just a continuation of the strategy the Fed has been following since September 2008: in policy actions, do not err on the side of providing too little stimulus.

This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks to the wall is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy but the problem is that you have a big mess to clean up afterward.

And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.

Federal Reserve Exit Watch: Part 4

This is the fourth month that I have posted something about the performance of the Federal Reserve with respect to their exit strategy, the strategy it is following to remove the massive amount of reserves it put into the banking system in 2008 and beyond. On November 11, 2009, the Fed was supplying $2,176 billion in reserve funds to the banking system. (This is from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.)

This was down slightly from the $2,233 billion total on October 14, 2009, but up from the $2,055 billion on August 12, 2009.

Commercial banks had $1,041 billion in Reserve Balances at Federal Reserve Banks on November 11 and the banking system averaged $1,059 in Excess Reserves for the two week period ending November 4, 2009. On October 14, Reserve Balances were $1,049 billion, but on August 12 this number was only $772 billion. Excess Reserves in the banking system averaged $918 billion in the two weeks ending October 7, and averaged $766 in the month of August.

Thus over the last 13-week period and over the past 4-week period total assets remained form around $2.1 trillion and $2.2 trillion.

However, Total Reserves in the banking system rose from $829 billion in August to $981 in the two week period ending October 7, to $1,124 billion in the two week period ending November 4.

This is an increase of over 35% in the total reserves of the banking system!

Of this $295 billion increase in total reserves, a total of $293 billion went into excess reserves!

Just a side note, Required Reserves rose by only $2 billion over the same time period!

No lending going on here!

The composition of the Fed’s balance sheet is changing, however. Securities held outright by the Federal Reserve has risen from $1,556 on August 12, 2009 to $1,673 billion on October 14 and $1,702 on November 11.

As reported in early editions of the Exit Watch, the Fed is letting the special assets it created run off as the need for them retreats and is replacing these reserves by marketable securities. Not all of these will run off in the near term as the credit and value issues surrounding assets at AIG and other institutions may take some time to disappear. However, these special assets have declined from somewhere in the neighborhood of $550-$500 billion on August 12, to $420-$380 on October 14 to around $340-$300 billion on November 11.

The largest decrease came from the reduction in the use of the Term Auction Credit which was instituted in December 2007 as a part of the dislocations in the financial markets that surrounded the problems at Bear Stearns. On August 12, this facility totaled $233 billion. The total dropped to $155 billion on October 14 and $109 billion on November 11.

Thus, the Fed is reducing the special assets portion of its balance sheet and is substituting for these asset, ownership of securities--Treasuries, Federal Agency issues, and Mortgage Backed securities.

In pursuing this path, the Fed is taking securities out of the open market, from banks and other financial institutions, but the funds it is using to pay for these securities is just going, so to speak, into bank vaults.

Commercial banks are basically saying, “If we don’t make any loans with this money, then the loans we don’t make cannot turn into bad loans!”

Another way of saying this is that the banks have enough bad assets on their books now and they don’t need to add any more. They’ll sell securities, but they won’t do anything with the money they receive back from the sale.

This seems to be creating a very uncomfortable situation. As the Fed reduced special facility assets over the last 13-week period and increased its holdings of open-market securities, it forced $300 billion reserves on the banking system.

Note that in August 2008, Total Reserves in the banking system amounted to $45 billion.

In 13 weeks the Fed forced 6.67 times more reserves into the banking system than the banking system had accumulated in all its history in the United States! And the banks did nothing with the reserves! And, the recession ended in the third quarter!

This is not a liquidity problem!

And the Federal Reserve says that it will continue to keep its target interest rates at its current level for an extended period of time. This is “QUANTATIVE EASING”!

Interest rates are going to start rising at some time. What is the Fed going to do with all the open-market securities it has on its balance sheet? What kinds of losses will the Fed have to take to eventually reduce reserves to reasonable levels once the economy begins to pick up steam?

Well, we really don’t need to worry about the Fed because the can just print money at a cost of zero in order to cover any losses they take.

But, what about those investors, what about the Chinese, what about anyone, who purchased United States Treasury securities during this summer and fall? How are they going to cover their losses when interest rates finally begin to rise?

The Federal Reserve got us here. There is no painless way to get us out of the situation they put us in…at least as far as I can see.

Thanks, Ben!

A Strong Dollar?

“It is very important to the United States that we have a strong dollar.”
So said the United States Secretary of the Treasury.

Yes, Paul O’Neill said that.

Oh, yes, John Snow said that.

And, Hank Paulson.

Oh, you say, that the quote is attributed to Tim Geithner, who made the statement yesterday at a news conference of Asia-Pacific finance ministers.

As my good friends would say, “you have to walk the walk, not just talk the talk!” Or, in the case of those looking on, “watch the hips, not the lips!”

The only public person alive today that, in my mind, has any credibility on this issue is Paul Volcker. And, it is Paul Volcker that has written, “A nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate…” (This quote is found on page 232 in the book “Changing Fortunes: The World’s Money and the Threat to American Leadership” by Paul Volcker and Toyoo Gyohten, Times Books, 1992.)

The United States government has no credibility left when it comes to the value of the United States dollar.

During the administration of Bush 43, the value of the United States dollar fell by 37% against an index of major currencies from February 2002 to March 2008 while the dollar fell in value by 45% against the Euro from February 2002 to July 2008.

The United States dollar did rebound at the time of the financial crisis: up 19% against the index of major currencies and up 23% against the Euro.

However, since February of this year the United States dollar fell back by about 13% against the index of major currencies and by about 15% against the Euro.

In watching the hips, not the lips, we see, for the United States government, potential cumulative fiscal deficits of $15 to $20 trillion over the next 10 years. We have a banking system with almost $1.1 trillion in excess reserves during the two week period ending November 4, 2009. We are faced with an unknown “exit strategy” to remove these excess reserves on the part of the Federal Reserve System.

And all this with several other “shocks” on the horizon. Obama “owns” Afghanistan now and it is totally unknown what his “new strategy” for that country will mean in terms of more government spending. Then there is the health care initiative. Obama has said that the program should not add “one dime” to the deficit, yet all indications are that whatever is passed will add to the deficit, although we don’t know what that amount will be. Then there is the climate change bill along with some other proposals that are setting in the wings.

Oh, yes, people within the administration have suggested that the rest of the TARP money, whatever that amounts to, can be applied to reducing the deficit. Whoopee!

I hear the Obama administration talking the talk. I don’t see them walking the walk.

And what about Bernanke. He is staying particularly silent these days. Oh, yes, we learned from the New York Times earlier this week that he is letting Barney Frank do all his talking for him.

The strong dollar is, at present, a myth!

It will continue to remain weak and its value will continue to trend downward for the foreseeable future.

How far am I looking forward?

I will continue to believe that the dollar will remain weak until someone emerges that has some credibility. Right now, I don’t know where that person is going to come from.

Discipline is Needed for Real Economic Performance

There is an interesting article inside the Wall Street Journal this morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises,” http://online.wsj.com/article/SB125798960525944513.html#mod=todays_us_page_one.) In the article a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”

During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.

Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)

The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.

Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.

Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.

Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)

Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.

The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.

Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.

Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!

Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.

In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.

But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.

In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.

Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!

Fannie, Freddie, and Feddie?

Will the Federal Reserve System join the ranks of other government public supported agencies like Fannie Mae and Freddie Mac?

One could argue that they are on the verge of such ignominy.

Never before has the Federal Reserve been under such attack and from all sides. The attacks have gotten so severe that the subject even made the front page of the New York Times today. (See “Under Attack, Fed Chief Studies Politics,” http://www.nytimes.com/2009/11/11/business/11fed.html?hp.) The legislative attack on the Fed continues with the new proposals on financial regulation coming from the Senate Banking Committee. (See “Senate Democrats Seek Sweeping Curbs on Fed,” http://online.wsj.com/article/SB125786789140341325.html?mod=WSJ_hps_LEFTWhatsNews.)

Certainly the leadership of the Federal Reserve seems to be deserving this scorn. Henry Kaufman states bluntly that “there is the Fed’s legacy of its inability to limit past financial excesses. By failing to be an effective guardian of our financial system, it has lost credibility.” (See, “The Real Threat to Fed Independence,” http://online.wsj.com/article/SB10001424052748703574604574501632123501814.html.)

Of course, Alan Greenspan gets his share of the blame for “keeping interest rates too low for too long in the early years of this decade”; for his failure to understand the changes in the financial markets coming from financial innovation; and for his role in the repeal of the Glass-Steagall Act.

But, Ben Benanke must also bear his share in the decline of Fed credibility. He was Greenspan’s co-conspirator, serving on the Board of Governors of the Federal Reserve System during the 2002 to 2005 period in which the Federal Funds Rate was kept below 2.00% from the time he joined the Board until November 2004. For much of the time this Fed Funds rate was around 1.00%. Bernanke was a strong defender of keeping the rates so low, both in terms of economic analysis and speeches.

After Bernanke assumed the position of Chairman he was slow responding to the possibility that the bubble was bursting in the subprime market. Then, Bernanke reacted very strongly to the financial collapse, possibly over-reacted, in the week of September 15, 2008. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

Congress certainly saw Bernanke in action that week. According to a Wall Street Journal article, which I quoted in the post, “(Hank) Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and ‘scared the daylights out of everyone.’ Bernanke got his wish in that Congress ultimately passed the TARP bill, although they did not pass the bill by the next Monday as Bernanke had originally pressed for.

I’m not completely convinced that Congress, deep down, has all that much confidence in a Ben Bernanke-led Federal Reserve System going forward even though President Obama seems to.

Then, the Federal Reserve, under Bernanke’s guidance, flooded the banking system with reserves, leading up the current time where excess reserves in the banking system total more than $1.0 trillion. His concern over this time period has been the liquidity of financial markets. (See my recent post, “Dear Fed: the Problem is Solvency, not Liquidity,” http://seekingalpha.com/article/171826-dear-fed-the-problem-is-solvency-not-liquidity.)

As Kaufman points out in his Wall Street Journal article, the Federal Reserve now has another major conundrum: “How will the Fed reduce its bloated balance sheet?” This is a real problem because the Federal Reserve has subsidized the financing of massive amounts of federal debt and has also provided massive support to the markets for mortgage-backed securities and federal agency issues. As of November 4, 2009, the Fed owned outright $777 billion in U. S. Treasury issues, $774 billion in mortgage-backed securities, and $147 billion in Federal agency debt securities, roughly $1.7 trillion.

In supporting these markets, the Federal Reserve has kept the interest rates on these securities below the level they would have attained without the support of the central bank. The first question is, what will happen to these rates once the Fed stops supporting these securities. Will their rates ratchet upwards?

And, then, what will happen once the Federal Reserve finally decides it needs to let interest rates move up as the economy gains strength? If the Federal Reserve pursues its exit policy of removing reserves from the banking system it will have to take a loss on these securities. No matter though, it will just reduce the amount of funds (its profits) it returns to the Treasury Department at the end of the year.

In a sense, this will make the Fed like Fannie and Freddie in that it can absorb losses deemed necessary by the government for good social reasons. However, the Fed will not have to go to the Treasury with its hand out, as Fannie and Freddie has to, in order to cover its losses because the Fed makes so much profits by being able to create money whenever it wants to.

But, there is another problem: how much upward pressure will the liquidation of the mortgage-backed securities put on interest rates. How much will Congress resist this upward movement in interest rates? What will the housing lobby do to counter-act this move in rates because such a move will certainly not be good for a recovering housing market.

There is another concern: billions and billions of dollars of government debt have been purchased at subsidized interest rates. Helping this along was the extremely low short-term rates resulting from the Fed’s “close to zero” interest rate policy. If I can borrow for six months at, say, 50 basis points or so, and lend these funds out at around 3.00% on 7-year Treasuries, with a “guarantee” from the Fed that the 50 basis points will remain for “an extended period” of time, I have a pretty nice deal.

And, making money in this way doesn’t even include the returns that are available on the “cover” trade.

But, what will happen to those that “underwrote” the placing of the federal debt when the Fed begins to let rates start to rise? How extensive and deep will be the capital losses? Not everyone can make it through the “exit door” at the same time. Will Congress hear about this?

There are additional regulatory issues relating to institutions that are “too big to fail”. These, too, get us into the political realm. Congress is going to want to get their hands into this “solution” as well.

Has the current leadership at the Fed (Republican appointed) brought us to the brink of the government making the Fed into another Fannie Mae or Freddie Mac? Printing money is sure an attractive way to try and achieve social goals. It is interesting that the political party (the Republicans) that was supposedly the strongest supporter of free-market capitalism has brought us to the edge of greater government control of industry (like autos and housing) and financial institutions (like large banks and the Fed).

Some Positive Movement in Small Bank Lending?

Could there be a glimmer of life in bank loans at Small Domestically Chartered Commercial Banks?

The latest figures released by the Federal Reserve on the Assets and Liabilities of Commercial Banks in the United States gives some indication that this is happening.
In the latest four weeks for which we have data, all Loans and Leases at commercial banks declined by $22 billion, but loans and leases at the smaller banks actually rose by $50 billion. And, this rise was across the board.

Note that over the last 13-week period, all loans and leases fell by $29 billion so that lending is down for the last quarter’s worth of data we have, but the figures reported above represent a movement in the right direction.

Furthermore, the increase in lending was across the board: commercial and industrial loans at these small banks rose by about $19 billion; real estate loans rose by $18 billion; and consumer loans increased by almost $17 billion. All these figures are down for the last 13-week period except for consumer loans that show an increase of about $14 billion for this longer period.

Are we getting a break in the ice barrier at the smaller banks? We’ll just have to wait and see.

Just an interesting side note on this: cash assets held by these same smaller banks actually declined by $17 billion during the last four weeks.

This occurred as the commercial banking system became even more awash with cash during this time period. Cash assets at Large Domestically Chartered banks rose by $88 billion and cash assets held by Foreign-Related Institutions rose by $192 billion. Total cash assets reported in the banking system reached a new high in the weeks of October 21 and October 28 of about $1.3 trillion while Reserve Balances with Federal Reserve Banks rose to $1.08 trillion on this last date and excess reserves averaged $1.06 trillion, a new record, for the two weeks ending November 4.

While the smaller commercial banks were increasing their loan portfolios during the last four weeks, large banks and foreign-related institutions were reducing theirs. For example, in the last four week period, large commercial banks reduced total loans by almost $52 billion. For the last 13-week period these banks have reduced all loans by $139 billion. And the decreases were all over the balance sheet: commercial and industrial loans were down by $27 billion; real estate loans were down by $40 billion; and consumer loans were down by $10 billion.

The only offsetting item on the balance sheets of the larger banks was an increase in securities held. This item rose $29 billion in the latest 4-week period; and was up by $68 billion over the last 13 weeks. This may be related to the fact that the largest reported area for earnings in the larger banks over the last calendar quarter or so came in the area of securities trading.

The securities portfolios of the smaller banks and the foreign-related institutions declined, both for the 4-week period and the 13-week period.

Overall, total assets in the banking system rose by $184 billion in the latest 4-week period, but that can be accounted for by the increase in cash assets. Total bank lending did not increase, and commercial and industrial loans and real estate loans continued to decline.

In this period, when everyone is looking for signs of a recovery, the fact that the lending at smaller commercial banks has shown some positive growth is encouraging. We will have to keep an eye on this area of the economy. Obviously, the lending at the smaller banks needs to pick up if the economy of “Main Street” is going to get started.

Furthermore, there has been great concern over possible solvency problems among the smaller banks. If these smaller banks are beginning to lend again and if they are drawing down their cash balances to do that lending, then that could indicate some increasing confidence within this sector that asset balances are beginning to stabilize. This would really be good news!

I don’t want to be premature on this, but, the increased lending of the smaller banks is a surprise and, possibly, a hopeful sign.

Yet, there are the larger banks. There is no indication that the decline in lending at the larger banks is going to stop. And, in one sense, why should it. Many of the larger banks are making lots of money off of security trading. The ones that are not in as good a shape continue to “down size” and contemplate which assets they want to sell off or which asset they can sell off. Apparently, continuing to stockpile cash assets and excess reserves is a good strategy for them. This, to me, is continuing evidence that the problem in these banks is one of solvency because the value of their assets cannot be determined.

The best news is still that things on the banking front are relatively quiet. Again, this is a sign that the banks are working through their problems. Yes, there is a bankruptcy here and a bank closing there. This news will not stop for another 12 to 18 months. Let’s just hope that things continue to stay quiet and these events proceed peacefully.

Has the Fed (and other central banks) Made a Mistake?

The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.

I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.

I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.

If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.

But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.

Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.

The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.

A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.

First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.

And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.

The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.

To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.

Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.

Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?

And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.

To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.

One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!

Building an Exit Strategy at the Federal Reserve--Part Two

Yesterday, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.

In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?

How about the fiscal deficits that the government is in the process of producing?

The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.

The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.

A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!

The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book “This Time is Different”, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”

Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?

The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.

The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”

Let’s look what seems to happening right now.

Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.

The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)

To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.

If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?

As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”

Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)

Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly”, pain cannot be avoided once financial folly has been committed.

Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.

Building the Exit Strategy at the Federal Reserve

Interest continues to grow about how the Federal Reserve is going to remove all of the reserves that it has injected into the banking system. The articles are getting personal now. See, for example, the article in the Wall Street Journal this morning that actually brings us a name, Brian Sack, who is the head of the markets group at the Federal Reserve Bank of New York and the person responsible for developing the “exit strategy” that the Fed will use to remove the $1.0 trillion, more or less, excess reserves that reside on the balance sheets of the country’s commercial banks. (“Brian Sack Engineers Big Moves at Fed,” http://online.wsj.com/article/SB125720947716624249.html#mod=todays_us_money_and_investing.)
The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.

The first question that arises is exactly what date do we go back to? Do we go back to the week before the week of September 15, 2008 when the financial collapse became paramount? Or, do we go back to the middle of December 2007 when the Bear Sterns deal was cut? Around this latter date we get the creation of the Term Auction Facility (TAF) that was a first innovation of the Fed to meet the financial crisis that was in its early stages. Let’s use both dates to see if there is any substantial difference between the two.

I have made three, rough calculations about the “excess” funds that the Fed needs to remove from the banking system if we are to get back to a Fed balance sheet that looks something like either the ones that existed on either December 19, 2007 or the September 10, 2008. I use the actual Wednesday data and not the averages of daily figures for the banking week ending on those dates.

The three rough numbers are $1.3 trillion to get back to the balance sheet of the earlier date and $1.1 trillion to get back to 2008 date. My third estimate is generated by assuming that the Federal Reserve balance sheet would grow from December 19, 2007, at a (generous) 10% annual rate up to the current reported figure for October 28, 2009. This third figure is $1.1 trillion. All these numbers are rounded off so as to produce general targets so that we have a rough idea of the magnitude of the task.

So, given these estimate the Federal Reserve needs to remove approximately $1.1 to $1.3 trillion from its balance sheet.

Now, there are two parts to the removal of these funds from the balance sheet. The first has to do with very specific responses to the crisis, either in terms of particular markets or in terms of particular institutions. In terms of particular institutions, I am referring to the “line items” on the balance sheet that relate to the Bear Sterns and the AIG deals. In terms of particular markets, I am referring to the facilities set up for Primary Dealers and Broker-Dealers, Commercial Paper Funding, Money Market liquidity funding, Central Bank liquidity swaps and so forth.

The current strategy of the Federal Reserve with respect to these specific “line items” is to let the dollar amounts decline at their own speed as the need for them dissipates or as the assets are worked off. This strategy is already reflected in the balance sheet results examined in my series on the Federal Reserve Exit Watch: see http://seekingalpha.com/article/167300-federal-reserve-exit-watch-part-3, and, http://seekingalpha.com/article/162274-federal-reserve-exit-watch-part-2.

The total of these accounts, as of October 28, 2009, is $412 billion. These accounts seem to be declining on a regular basis and there is really little or nothing that the Fed can do to speed this decline along. In fact, you want these accounts to be reduced at their own pace because as the need for the assistance goes away, the accounts will fall to zero. True, some of the accounts could remain on the books for an extended period of time, but these will be minor relative to the whole balance sheet.

If you remove these numbers from the shrinkage that needs to take place on the Federal Reserve balance sheet you are left with numbers in the $700 to $900 billion range. The total of Mortgage-Backed securities on the balance sheet as of October 28, 2009 is $774 billion. Federal Agency securities totaled $142 billion on that date. Thus, the “active” strategy for reducing the Fed’s balance sheet relates to these specific security portfolios.

This is where the proposed program called “reverse repos” comes into the picture. Obviously, the Fed cannot just dump $774 billion in mortgage-backed securities on the financial markets. (There is even some concern that Congress may want the Federal Reserve to hold onto a large portion of these securities so as to continue to support housing in the United States. That, however, raises other issues.)

Furthermore, the Federal Reserve is very cognizant of the events of 1937. The United States economy had recovered from the Great Depression (or Great Contraction) and was experiencing relatively satisfactory growth at that time. The commercial banking system, however, was holding onto a large amount of excess reserves (not unlike the current situation). In order to tighter their control over credit, the Federal Reserve, in all its wisdom, raised reserve requirements.

The result was disastrous! The bankers wanted those excess reserves and the removal of them caused the banking system to contract even more and the amount of credit and money in the economy contracted as well. The 1937-1938 depression was the result.

The Federal Reserve does not want to duplicate such a mistake. Consequently, they are going to try and “ease” the funds out, not “yank” them out. This, seemingly, is the reason why the Fed is looking at the “reverse repos’ program as an alternative. Because “reverse repos” would represent the “temporary” removal of funds from the banking system and because they would be undertaken through market transactions, the Fed would not get “ahead of the curve” in removing reserves from the banks. That way, they would constantly be “in the market” and be able to determine if there was any resistance to the removal of funds. In that way, they could proceed incrementally toward selling the securities and then, as the markets allowed, actually sell them outright from their securities portfolio.

The Federal Reserve is in a delicate position. They know that they will need, at some time, to remove the excess reserves from the banking system. However, they don’t want to move too fast and create another financial crisis, as happened in 1937. But, the Fed knows that at some time it is going to have to remove the excess reserves as quickly as it can.

Let me repeat, the Federal Reserve is in a delicate position! In talking about “exit strategies” in the public domain, Fed officials hope to keep the financial community informed and prepared for what might be done and at the pace it at which it will be done.

The Upcoming Banking/Financial Regulation

New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there is a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.

Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.

From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.

There are three topics that seem to be missing in every discussion about new regulation or re-regulation.

First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?

The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.

Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.

I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.

Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!

Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: http://www.ft.com/cms/s/0/ea9f6964-c57a-11de-9b3b-00144feab49a.html) or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”: http://www.ft.com/cms/s/0/a43d96f0-c74e-11de-bb6f-00144feab49a.html).

Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.

Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?

Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.

Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.

The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.

We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.

My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.