Thursday, May 28, 2009

"Problem" Banks and the Economic Recovery

Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, released the latest information on “problem” banks on Wednesday. The list now includes 305 institutions, up from 252 at the end of 2008. We have had 36 bank failures this year and if no more than a quarter of the “problem” institutions fail, we will be over 110 bank failures for the year. This is nowhere near a record and the cumulative number of failures since the beginning of the recession in December 2007 is minimal compared with what happened in the 1988 to 1991 period.

This raises a question about how many more financial institutions are going to merge or close in the next two to three years. If the historical record is any indication, one could argue that a minimum of 100 banks or thrift institutions will close each year for the next two years. Bank closures are not a leading indicator of economic health and can continue for some time even after the economy begins to recover.

The basic scenario that we are looking at for the next two to three years or so is a stagnant economy for much of the time. Economic growth is supposed to be tepid for an extended period of time. Mohamed El-Erian of the bond fund PIMCO stated the other day that PIMCO was expecting the United States economy to grow by no more than 2% or less in the near term. Given that potential real GDP will only be growing at a crawl during this time, unemployment will stay around 8% or above, something similar to the period from January 1975 through to February 1977 where the unemployment rate was at 7.5% or above and the period from October 1981 through to January 1984 where the unemployment rate was above 8.0%. Thus, from January 1975 through to January 1984, unemployment averaged more than 8%.

Within such an environment, foreclosures and bankruptcies will continue to increase and more and more personal loans and mortgages will have to be charged off bank balance sheets. Furthermore, this environment will not be a good one for non-financial business and many more businesses will close their doors. The restructuring of industry will continue as businesses attempt to align themselves with the markets and technologies of the future. This will impact commercial and industrial loans and more of these will have to be charged off going forward.

There is great concern in the F. D. I. C. and beyond about the adequacy of current loan loss reserves in financial institutions. The underlying fear is that a lot of banks have not sufficiently reserved for the loan losses they will be facing in the near future. Bankers have a tendency to be slow in accepting the fact that so much of their loan portfolio is severely challenged. It is a historical fact that reserving for loan losses tends to lag behind the need to build up bank coffers for future charge offs. The present time is not an exception.

This is not a scenario that contains a lot of enthusiasm for producing loan growth. For one, the focus of the bankers should be upon cleaning up their balance sheets. Therefore, they should not be looking for new loans or new sources of loans. These bankers should be focused internally on what they already have on their books. They need to be focused on the performance of existing loans, on working out existing loans, and on charging off loans that are no longer performing.

As many analysts have stated, we still are anticipating increasing charge offs connected with credit cards, consumer loans and commercial real estate. Furthermore, we still have not reached the end of the problems connected with residential mortgages. And then there are the business loans to keep small and medium sized businesses going. The point of all this is that “we are not out of the words yet” in the banking sector.

Secondly, there is not going to be a lot of acceptable loan demand coming into the banks. Credit standards are higher now than they have been for a long time. Bankers are getting back to the idea that you don’t deserve a loan from them unless you are so well off that you don’t really need a loan from them. This has recently been referred to as “boring” banking. Boring, yes, but also prudent.

Some analysts are arguing that the trouble in the smaller banks is not as big a problem as that for the larger banks. Stuart Plesser, a banking analyst at Standard & Poor’s in New York has been quoted as saying that smaller banks were more vulnerable to a souring economy than larger institutions because they were more specialized or focused on a particular region. “But,” he continued, “the repercussions of the failures among the smaller institutions were not as severe for the overall economy as they would be if a larger bank stumbled because the big banks are more important to the economy. It’s not as big a hit if the small fail.”

This may be true in terms of the “systemic” risk in the banking system, but it is not true in terms of the impact of bank failures on “Main Street.” Because the small and medium sized banks are “more specialized or focused on a particular region,” their failure can contribute to the weakness in the local or regional areas they serve and, hence, can slow down any turnaround or recovery that might take place there.

For the past year or so, we have been focusing on big banks and the problem of systemic risk. Now we need to turn our attention to the rest of the banking sector for there is still much work to be done there. Bank failures are going to rise and remain at a relatively high level for an extended period of time. This is an adjustment process that the economic and financial system must go through. It will be a painful process, but there is little that the government could or should do to accelerate the restructuring.

One comment on recent discussions of the government’s P-PIP. Enthusiasm for this program is waning. As I have written, the problem with the toxic bank assets the government has been worrying about is not a “liquidity” problem. The problem is not that certain “legacy” loans or securities cannot be sold within a reasonable period of time. The problem has been that the value of the loans and securities has been in question because of the quality of the assets. The government has been trying to “force” a sale of these assets. But, this is not the problem. The problem is one of working out the value of the assets and the solvency of the banks themselves. An effort to “force” the sale of bank assets is only a program to “socialize” bank losses so that the government can transfer the losses from the banks to the tax payer and does not resolve the ultimate problem. As the banks are attempting to re-capitalize the solvency issue becomes less pressing and so the interest in the program drops off. Except in the case where the government allows the banking system to make a risk-free re-purchase of their own assets at a profit!

Tuesday, May 26, 2009

Known Unknowns

It is still too early to think that we are near or past the bottom of this economic downturn. However, in my mind, we are in the “working out” stage of the downturn, especially in the current economic restructuring we are going through, and we cannot expect this stage to be a short one.

The problem with many analysts and policy makers is that they continue to see our economic problems in Keynesian terms and think that the difficulties being experienced in banking and financial markets as a liquidity issue. Hence the search for evidence pointing to “green shoots” and for an “easing of credit.” Every day we hear when new statistics are released that the numbers just presented are “less bad” than before and this indicates that the economy is getting worse at a slower pace. An obvious sign that we are near the bottom!

In my mind, the two major issues facing the United States (and the world) are the structural problems in industry and finance and the debt problem. I have said all along that the basic cause of the financial collapse and the following economic dislocations comes more from the supply side of the economy than from the demand side as assumed by the Keynesians. And, because our problems are primarily supply side problems, governmental stimulus plans and deficit financing are not the incentives needed for restructuring the economy and putting people back to work.

In fact, demand side stimulus can even exacerbate the problems and slow down the changes that need to be made. Furthermore, treating the debt problem as a liquidity problem, as the Federal Reserve and the Treasury seem to be doing, can do the very same thing.

The “good news” is that most organizations and institutions have identified the major problems they will be facing in the near future. However, the “bad news” is that no one knows the depth or breath of the problems. The difficulty facing these organizations and institutions going forward is that these problems must be “worked through” and “worked out”. This “working through” and “working out” will take time and, since the problems are related and interconnected, the outcomes will be dependent on just how systemic and cumulative they are.

For example, greater unemployment due to structural reductions in the workforce who were employed making cars, producing parts, or selling cars will lead to more foreclosures on “prime” loans. (See “Job Losses Force Safer Mortgages to Foreclosure” in New York Times, This will have further ramifications for the financial sector, housing construction and so on. The repercussions will continue on throughout the economy.

In the area of foreign trade, declining incomes lead to reductions in imports, but these imports are the exports of other countries. Countries that have built their economic growth and prosperity on their export trade face worsening times because of the decline in their exports. And, with the slowdown in these countries world trade declines. (See “Trade and Hard Times” in the New York Times, There are more and more calls to prevent, if possible, further reductions in foreign trade in the world, especially relate to tariffs and other means of protectionism.

These are just two examples of situations where problems exist but where there is no real understanding of how far the cumulative interactions will take us. Many more situations like these exist at the present time. They are not problems that will be resolved through fiscal stimulus and the creation of government debt. There are three major problems with this response.

First, fiscal stimulus does not eliminate structural dislocations in the economy. The government (or no one else for that matter) does not know what the future structure of the economy will look like. Existing organizations, including financial institutions, can “re-tool” themselves, but this takes time and the exploration of different models for companies to find what works best. In terms of innovation, governmental funds can be made available for the next generation of energy sources and transportation systems and so forth, but no one knows exactly how these sources and systems should be put together. Restructuring and creative innovation take time and experimentation. One cannot “will” the right structure or the best innovation.

Furthermore, who wants to invest in something the government is the driving force in? Current events attest to emerging problems related to governance, decision making, and “the rule of law” when the government gets involved with a company or an industry.

Second, when the solvency problem is treated as a liquidity problem, the issue of solvency does not go away. The “toxic asset” program (P-PIP) developed by the Treasury and the efforts by the Federal Reserve to shore up various segments of the financial markets is just a “round-about” way of allowing the federal government to pay for the bad debts that are on the balance sheets of financial institutions. That is, the programs just allow the financial system to transfer financial losses to the government so that the tax payer will eventually end up with the bill for any insolvency that exists. Still, the question of the solvency does not go away.

Third, the government assumption that both problems, those related to economic restructuring and the amount of debt outstanding, can be solved by creating more and more debt is laughable if it were not so potentially tragic. International financial markets understand that in one way or another and at some time in the future, excessive amounts of government debt will end up being monetized. How this monetization works out in each particular case cannot be foretold. History has shown, over and over again, that at some time this connection between large amounts of debt and money creation becomes a reality. It cannot be avoided; it is just the timing that is uncertain.

The conclusions that can be drawn from this analysis are very straight forward. First, economic growth, even when it becomes positive again, will stay low for an extended period of time. My reading of the 1930s has lead me to believe that this decade was a time of industrial and financial restructuring (not helped very much by the government) and technological change. It was not a time that demand-side stimulus could help very much. The restructuring had to take place and World War II did not contribute to the recovery because of the added spending but because of the re-focus and restructuring of industry it forced on the nation. I believe that, like the 1930s, we may be facing an extended period of time in which we need to re-focus and restructure industry. One hopes that we do not need a world war in order to finally achieve this re-structuring.

Second, the continued creation of debt is not going to help. The government debt is going to be monetized at some time. The realization of this, I believe, has become a reality to the bond markets and the foreign exchange markets. To me, the yield on long term U. S. Treasury securities will continue to trend upwards in the foreseeable future and the value of the U. S. dollar will continue to trend downwards. The trends will continue unless some financial “miracle” takes place that eliminates the projected upcoming deficits in the government budget—perhaps an amazing recovering in tax receipts or massive savings discovered in the health care industry.

Third, whereas paper assets from the United States will not be that desirable internationally, physical assets will. For much of the two years or so ending in August 2008, the weak dollar allowed foreign countries and investors to buy U. S. companies at a record pace. With the rising strength of China, India, and Brazil, I believe that with the continued slide in the United States dollar, more and more U. S. companies and their physical assets will come into foreign hands. That is, until the U. S. Congress bans such transactions.

Thursday, May 21, 2009

The Future of the Dollar

We live in a global economy. And, unless we destroy the global economy that now exists the way the world destroyed the first global economy starting with the 1914 conflict and proceeding through the next fifty-five years or so, we will continue to face the duties and responsibilities of operating within a world economy. And, those duties and responsibilities begin with the currency of the country.

It is hard to have confidence that the United States accepts this fact.

I know that we are in a recession (depression?). I know that the immediate pressure on the Obama Administration is to “get the economy going again.” I know that the Treasury Department and the Federal Reserve, both dependent partners in the effort to get the financial system functioning, must provide whatever means it takes to avoid further deterioration of financial markets.

Still, there is a need to listen to what markets are saying about what the government is doing. And, the financial markets are saying that the United States dollar is in trouble. And, consequently, the United State government is in trouble.

The value of the Euro relative to the United States dollar climbed to 1.3768 at the close of business yesterday. This represents an 11.7% decline in the value of the dollar since Ben Bernanke became Chairman of the Board of Governors of the Federal Reserve System on January 31, 2006. It represents a 23.0% decline in the value of the dollar since Bush 43 became President on January 20, 2001 when Alan Greenspan was the Chairman of the Board of Governors of the Federal Reserve System.

The numbers are about the same if you look at a trade weighted series. The trade weighted value of the dollar versus major currencies has declined by 23.6% since Bush 43 was inaugurated, and, has declined 5.4% since Ben Bernanke became Chairman.

Of course, the figures look even worse if one focuses upon the lows in the value of the dollar which came about in March, 2008. Using this as the standard we find that the trade weighted value of the dollar declined 33.4% from the beginning of Bush 43 and 17.5% since Bernanke was sworn in. The current numbers look great compared with these, but the current figures benefit from the ‘flight to quality’ that took place following the September 2008 meltdown of the United States financial system.

All during the Bush 43 Administration, both the United States Treasury Secretary, whoever that was, and the Fed Chairmen gave lip service to the importance of the value of the United States dollar, yet no one did anything about it. And, the dollar continued to decline. Certainly someone should have understood that the decline in the value of the currency indicated something was wrong with the way the finances of the United States government were being run.

It is very apparent that the Federal Reserve System is NOT independent of the federal government of the United States. One has to go back to Paul Volcker and then back to William McChesney Martin to find Fed Chairmen that acted independently of the Executive Branch of the government. President Carter knew that Volcker would be independent of his administration if Volcker became the Fed Chairman but believed that he had to appoint him anyway. Certainly Arthur Burns and Bill Miller (remember him?), were not independent of the Presidents they served. And, people are realizing more and more that Alan Greenspan was nothing short of a water-carrier for the Presidents he served.

Not being independent of the Executive Branch means that the Federal Reserve is very subject to the position of the federal budget. Even Paul Volcker was eventually tainted with the huge (at the time) budget deficits run up by the Reagan Administration. Still, during his tenure as Fed Chairman, Volcker saw the trade weighted value of the dollar against major currencies rise by 6.4%.

Overall, during the time that Greenspan was Chairman of the Fed, the trade weighted value of the dollar against major currencies declined by only 16.7%. Greenspan’s grade improved in the 1990s due to the movement of the federal budget from a substantial deficit when the Clinton Administration took over in 1993 to a surplus by the time Bush 43 assumed office. In fact, this measure of the value of the dollar rose 13.9% during the Clinton administration.

The important thing to remember is that in the last half of the twentieth century world financial markets came to realize that substantial government budget deficits often got financed, one way or another, by the central bank of that country. As a consequence of this realization, participants in these world markets moved against the currencies of countries that began running large deficits if they believed that the central bank’s of that country were not fully independent of the government. The result was that governments became much more conservative in controlling budget deficits and central banks became much more independent of their governments.

The United States, in the latter half of the twentieth century, except for the early years that Paul Volcker was the Fed Chairman and during the 1993-2001 period, seemed to feel that they were exempt from this constraint. Yet, international financial markets responded to United States deficits and the possibility that they could be monetized in the same way that they responded to the “loose living” of other governments. They sold the dollar and the value of the dollar, for the most part, declined.

As participants in world financial markets perceive that things are beginning to settle down and that financial institutions are not going to completely self-destruct, they will continue to move out of United States Treasury securities and will continue to move out of the United States dollar. The foundational belief behind this movement is that the United States government is just putting too much debt out into the world. First, there were the huge budget deficits created by Bush 43 and now there are the huge budget deficits being created by the Obama administration. To people in the world financial markets, the lessons of the last fifty years still apply.

The path the economy and the financial markets follow relating to how the deficit problem works out is anyone’s guess right now. Who would have ever written the script for how the 2000s have evolved up until now? The historical evidence points to the fact that huge amounts of debt issued by governments cause dislocations. These dislocations have to work themselves out. How these dislocations work themselves out is different in every case. The general consequence of large budget deficits, however, is that large amounts of government debt are not good for the value of a country’s currency. I believe that this is as true for the United States as it is for any other country. The value of the dollar will continue to decline over the next several years.

My grades for the past three Fed Chairmen? Paul Volcker gets the best grade. I am assigning him a grade of plus 6.4. Ben Bernanke is second highest with a grade of negative 5.4 and Alan Greenspan comes in last with a grade of a minus 16.7. Unfortunately, when the grade is negative, we all have to pay for it!

Monday, May 18, 2009

The Fed's Quantitative Easing Goes Forward

Lots of transactions went on in central banking over the past month or so, not only in the United States but in the UK and Europe. Quantitative easing is the game and, at least, the central bankers are getting more and more comfortable with this.

Credit is given to quantitative easing for the drop in the dollar LIBOR rate. The three month LIBOR now ranges between 50 and 60 basis points over the target Federal Funds rate chosen by the Federal Reserve. This is the lowest this spread has been in a long time. For the five years previous to September 2008, the time the financial markets collapsed, this spread averaged between 20 and 30 basis points.

This move reflects the efforts of the Bank of England and the European Central Bank to push short term interest rates lower and to engage in monetary actions that pump more liquidity into the banking systems even though the interest rates do not show a proportional response. The drop is given as evidence that perhaps interbank lending is increasing in these nations and that this is possible evidence of a thaw in credit extension.

In the United States the Federal Reserve was particularly active in April although the total factors supplying bank reserves has increased only modestly in the last four banking weeks, rising just $21.2 billion. All of the action has happened within the balance sheet.

The interesting movement has come in excess reserves in the banking system, a series that is not seasonally adjusted. Excess reserves showed a huge rise, $100.0 billion, in April 2009 from March. I reported earlier that excess reserves in the banking system in April averaged $824.4 billion, almost the entire size of the Federal Reserve’s balance sheet one year earlier.

The combination of these two factors, basically the small increase in Federal Reserve sources funding the monetary base and the huge increase in excess reserves in the banking system, indicates that much of the activity was internal to the Fed’s balance sheet and not a source monetary expansion. Let me highlight the major changes.

Within the banking system itself, excess reserves averaged $771.3 billion in the two weeks ending March 25. This figure jumped to $804.8 billion in the two weeks ending April 8 and then rose to $862.4 billion in the two weeks ending April 22. This was tax time when funds flow into government accounts in the banking system but there were apparently other things going on as well in government accounts. In the two weeks ending May 6, excess reserves dropped back to $777.5 billion, roughly equal to the level they were at in the two weeks ending March 25.

One could argue that the April bulge was just “temporary”. However, a $100.0 billion increase in the excess reserves in the banking system is “eye-catching” when this measure only averaged around $2.0 billion for the eight months of 2008 before September of that year.

What was going on in the Federal Reserve? I can only describe the Fed’s activity as a part of its efforts to provide liquidity to different sectors of the financial markets and this is a part of the plan to provide quantitative easing to the financial system. Specifically, the amount of securities that the Fed holds outright jumped by $166.1 billion between the banking week ending April 15 and the banking week ending May 13. United States Treasury securities increased by $54.8 billion during this time, the largest increase in these holdings since the Term Auction Facility (TAF) was established in December 2007.

TAF was introduced to help allocate reserves into the banking system faster and more directly to the banks that needed the reserves at the time. It was an effort to increase the liquidity in the banking system to facilitate bank portfolio adjustments in the face of the “liquidity crisis” that occurred in December 2007. The Fed continued to use Term Auction Credit over the next 15 months or so to facilitate bank portfolio adjustment.

The “new” liquidity problem, however, seems to be connected with the Treasury bond market. Now, the Fed has entered into a program to supply funds to the Treasury market to help keep long term interest rates down, a goal it has not yet achieved. However, we see this shift in the quantitative easing strategy as the Fed is increasing its holdings of United States Treasury securities while at the same time letting the amount of funds allocated to the banking system through Term Auction Credit decline by $27.0 billion, the first substantial decrease in this total since the program began.

There is another sign of quantitative easing and this is in terms of the amount of Mortgage Backed Securities the Federal Reserve holds. During the four weeks ending May 13, 2009, the Fed’s holdings of these securities increased by $96.9 billion to $384.1 billion. Obviously, the policy makers at the Fed believed that there was serious liquidity problems in this segment of the capital market that needed their attention.

This huge increase brings the holdings of Mortgage Backed Securities up to two-thirds, 67%, of the Fed’s holdings of United States Treasury securities. Who would have ever imagined that this would have happened?

Again, reflecting the shift taking place in where the quantitative easing is being applied, the Commercial Paper funding facility at the Federal Reserve fell by $83.3 billion from the banking week of April 15 to the banking week of May 13. This decline can be interpreted as an indication that some easing is taking place in short term money markets, allowing the Fed to focus more upon the longer term end. The Fed, at its peak, had supplied over $250.0 billion to the financial system through this facility.

Furthermore, there was a drop in Central Bank Liquidity Swaps during this time period of $47.0 billion. Currency markets were apparently stable enough during this time so that these borrowings could be reduced. However, there are still about $250.0 billion in swaps still outstanding to other central banks.

This last month gives us a good picture of how quantitative easing seems to work. There was very little change in the total amount of funds that the Federal Reserve supplied the banking system, but there was substantial Federal Reserve activity within its balance sheet as it readjusted its focus upon which markets it believed needed the greatest amount of assistance with regards to the supply of liquidity. The crucial factor in this exercise seems to be that once the liquidity needs of a market are satisfied by the market itself, then the market participants that used the Fed’s facility pay back the funds that they have used. This allows the Fed to address other segments of the financial markets and, hopefully, satisfy the liquidity needs in these other areas.

Overall, the dream is that all the funds will be paid back to the Fed as the financial system and the economy turn around and begin to function effectively again. Not only will this allow the Fed to cease being the “fireman” that must run from fire-to-fire putting out the latest blaze, but will also get out of the “fire-fighting” business itself and allow its balance sheet to shrink back to an appropriate size. We are not there yet, but it does provide some comfort to see that the Fed can move from one current fire to another without another massive expansion of its balance sheet. However, whether this can really be accomplished remains to be seen.

Thursday, May 14, 2009

Prices Continue to Rise

"The Labor Department reported that prices received by producers of finished goods rose 0.3 percent last month, further blunting the prospect that the economy was veering into a vicious cycle of lower prices and lower wages known as deflation.” (See Analysts continue to be amazed that we have not yet moved into a deflationary spiral, given the weakness in the economy.

The amazement is due to the fact that most analysts still perceive the decline in the United States economy as one of a collapse in aggregate demand.

The amazement would disappear if these analysts considered that maybe the decline in economic activity was, at least, partially caused by a reduction in aggregate supply. However, most economists are still locked in their retreat to a fundamental Keynesian interpretation.

The banking industry has shrunk. The automobile industry has shrunk. Many retail chains have fallen by the wayside. The housing industry has suffered a massive decline in activity. And, there are many other structural shifts taking place in output and production. These are supply side shifts that are resulting in a major reconstruction of American commerce.

Yes, demand has fallen as the collapse in these industries has resulted in layoffs, firings, and reductions in force. However, the reductions in demand coming from the consumer have been the result of the structural shift in how the United States produces goods and services. Aggregate demand has fallen, but it has followed the decline in aggregate supply and not led it.

The consequence of this? A double whammy! Employment and output have declined due to the shift in both aggregate supply and aggregate demand, yet price increases have not declined as might have been predicted if the reduced output were just a result of a fall in aggregate demand as in the Keynesian case.

What evidence do we have to support this shift? First, there is the massive drop in capacity utilization. Since the start of the recession in December 2007, capacity utilization in the United States has dropped from about 80% to about 65%, a huge decline. Of course, capacity is defined in terms of the current industrial structure and does not take into account that a goodly portion of this capacity is redundant given the changes that are going on in the economy. This is why the auto industry is closing plants.

Furthermore, capacity utilization always lags the recovery of the economy, but in this case the response will be just that much slower because of the structural shift that needs to take place in how we produce and deliver goods and services.

Second, industrial production has nose-dived since the recession began. This is another indication of the structural shift that has taken place in the economy, a shift that will not be recovered just because aggregate demand increases. There has not been a decrease like this in Post World War II history, even in the 1981-1982 period. The year-over-year rate of change in industrial production has dropped from about a 2% rate of increase in December 2007 to a 13% rate of decrease in March 2009 with no let up expected.

Third, civilian unemployed has increased tremendously and the rate of increase of those unemployed has not yet slowed down on a year-over-year basis. This too is a reflection of the structural shifts that have taken place in employment patterns. Furthermore, these numbers include those that are discouraged from the work force and those that are partially employed but would like to be fully employed. Year-over-year, the civilian population that is unemployed has increased from around 10% in December 2007 to about 80% in March 2009. We have not seen such an increase in the Post World War II period!

So, the United States economy has been seeing a tremendous shift in its productive base. Yet, inflationary pressures seem to have remained relatively steady. This is captured in the year-over-year rate of increase in the consumer price index, when energy costs are excluded, which is increasing at a 2.2% rate in March 2009 which is down only slightly from a 2.8% rate of increase in December 2007. In terms of a broader measure of inflation, that recorded by the year-over-year rate of increase in the deflator of real GDP, inflation was at 2.1% in the first quarter of 2009, down modestly from 2.5% in the fourth quarter of 2007.

The use of resources, that is the use of capital and the use of labor, has declined in a major way since December 2007 reflecting not only the weakening economy but also the structural shifts taking place in the production of goods and services. Inflation has decreased only modestly. The combination of these two facts cannot indicate that the changes in the economy have only resulted from a shift in aggregate demand.

There are several reasons why we need to get a consistent interpretation of what is happening to the United States economy. The first is to understand that any stimulus that increases aggregate demand will have a minimal impact on the growth of economic output. The reason for this is that the restructuring of the economy is underway and jobs will just not be forced back into the previous employment patterns. Ironic as it sounds, demand stimulus will have more effect in keeping inflation where it is rather than increasing output. That is what happens when there has been a shift in aggregate supply.

This is, of course, difficult on the consumer because employment and incomes are falling, yet prices are staying constant or increasing, which reduces real incomes.

In addition, this interpretation can also help us to explain why the long term Treasury yields remain high. Everyone agrees that Treasury rates dropped dramatically last fall due to the international rush to quality. As the desire for low risk investments resides, the fact that inflation is not dropping off is being transmitted back into the bond market and Treasury yields are rising once again. In addition, with the massive federal deficits that are now on the horizon, the fear that this new debt will be monetized becomes more and more real to participants in the bond markets.

Furthermore, as Treasury rates rise, upward pressure is also asserted on mortgage rates, which is not helpful to a sagging housing market, and on corporate rates, which will not help stimulate business activity or support corporations in their attempt to restructure their balance sheets.

Finally, as the concern over quality declines, the value of the United States dollar will decline. It seems as if the structural shift in United States economic activity is more supply side than in other parts of the world. Thus, the behavior in prices appears to be different than that in other countries. That is, the price in goods outside the United States will fall relative to the price of goods in the United States. This will put downward pressure on the value of the United States dollar over time, even though interest rates in the United States may stay high relative to those in the rest of the world. This paradox exists because of the change in the relationship between price levels in the various countries.

Sunday, May 10, 2009

When Will the Banks Start Lending Again?

The Federal Reserve, as we know, has been pumping all kinds of reserves into the banking system. For the banking week ended May 2, 2009, Federal Reserve Bank Credit stood at $2.041 trillion. This is up from $0.894 trillion for the banking week ending September 3, 2008, an increase of $1.147 trillion.

Total reserves in the banking system jumped from $44.1 billion in the month of August 2008 to $881.8 billion in the month of April 2009. This is an increase in total reserves in the banking system of $837.7 billion.

Note that the difference between the amount of credit the Federal Reserve extended to the economy and the increase in total reserves in the banking system is $309 billion, the amount of Federal Reserve credit that ended up in coin and currency outside the banking system.

This massive growth in total bank reserves can be picked up in the year-over-year growth in total reserves as represented in the accompanying chart. Note that the year-over-year rate of growth in total reserve for April 2009 is 1,924%.

The crucial point I want to make here, however, is that in the banking week ending September 3, 2008, Federal Reserve credit stood at $894 billion. The increase in total reserves at ALL commercial banks from August 2008 through April 2009 was $838 billion. In eight months the Federal Reserve added just about the same amount of dollars to commercial bank balance sheets that it had accumulated on its own balance sheet in the 94 years beginning in 1913!

And, what did the commercial banks do with the funds the Federal Reserve forced into the banking system. It sat on them. In the next chart we get a picture of the excess reserves of all commercial banks in the United States. We see the commercial banks are holding $824 billion in excess reserves. That is, in August 2008, the commercial banking system held between $1.0 and $2.0 billion in excess reserves. So, almost all of the increase in total reserves in ALL of the commercial banking system between the first of September 2008 and the end of April 2009 went into excess reserves! There was next to no lending going on in the whole banking system.

What happened to loan growth in the United States banking system? Well, in the fall of 2008 the year-over-year rate of growth in the loans and investments held on the balance sheets of all commercial banks was over 10%. In April 2009, the year-over-year rate of growth in loans and investments held on the balances sheets of all commercial banks was just over 2%. Loans in the commercial banking system increased by a little more than this number but, the decline in the loan series was even greater than what took place in loans AND investments.

The bottom line is that the banking system was putting out next to nothing in loans or in investments in securities. The banking system basically has sat on the reserves that the Federal Reserve has pumped into the economy.
There is only one conclusion that I can draw from the analysis of these data. Commercial banks are so petrified at their condition that they are not putting any money out into the business or financial community!

I don’t care what the stress tests show. Behavior speaks louder than stress tests! Commercial banks aren’t lending because they can’t take the risk that they will put any more bad loans onto their books. At least cash holds its nominal value and is not subject to default risk!

When will banks begin to lend again?

Unfortunately, I don’t like any of the answers I come up with that would account for them lending more in the near term.

Thursday, May 7, 2009

A Tipping Point?

Almost everyone is looking for a tipping point. At this time we are looking for signs that the decline in the economy and in the financial markets is lessening and that we might be somewhere near the bottom. If this is the case then can the turn to recovery be far behind?

It seems that every piece of information currently being released carries with it the claim that “this decline was less than expected” or ‘the decline was smaller than the last information released.” These are taken as signs of hope.

Even the results of the Treasury’s “stress tests” on the banks are accompanied by the assessment that the major banks that have just been examined are better off than was thought. Therefore, the banking system is not in as bad a condition as feared, and, stock prices can now continue moving upwards.

Fed Chairman Bernanke is still the leading spokesperson and “cheer-leader” in the administration and he stated this week that the economy will begin to expand later this year. So we must be at or near the bottom if the administration thinks so. Right?

We still have the nay-sayers out there claiming that things remain in terribly bad shape. Nicolas Taleb, of Black Swan fame, is saying that the economic situation is worse than it was in the 1930s because world markets are much more integrated now than it was then. And, Nouriel Roubini continues to sound alarms about how bad things could get. Part of his argument rests on the fact that the worst case scenario used in the Treasury’s “stress test” is out-of-date due to the recently released estimates issued by the International Monetary Fund that financial sector losses have doubled in the last six months. Yet are their claims sounding awfully shrill these days amidst the hope others are seeing?

Where are we?

To me, the uncertainties still outweigh any real sense of which direction the economy might take. I would tend to lean on the side that we have not seen the bottom yet, but what odds would I place on this possibility? Maybe I would give odds of 2-to-1 that the economy still will decline further. Maybe they should be 3-to-1. Maybe they should be 3-to-2. Somewhere in there.

First off, I am not convinced that the banks are coming out-of-the woods yet. Even if they are able to obtain more capital, I don’t see their lending picking up in any major way. Personal and business bankruptcies are still on the rise and there are still several major “black clouds” on the horizon that threaten that the storm that has hit bank balance sheets is not over. There are still large companies that are going out-of-business on a regular basis, in retail, in commercial real estate, in some areas of manufacturing, and we are waiting for the full ramifications of the collapses in the auto industry. Car dealerships are being closed, parts supply companies are on the edge, and the spread of these closures are affecting many other organizations and geographic regions. If unemployment is going to continue to rise, since it is a lagging economic indicator, then there still are houses that are going to need to be sold if not foreclosed upon and some credit card debt and auto loans that will need repayment.

And, speaking of cars. Last time I looked the price of a barrel of oil was approaching $60. Where is the price of oil going? And, the price of other commodities? The Financial Times has had several articles recently about why the price of commodities, including oil, might be going higher if a trough or bottom has been reached. What would higher commodity prices do to any recovery?

Then there is the level of interest rates. The government held an auction today for $14 billion of 30-year Treasury securities. The result? The yield of the new issue came out at 4.288% higher than the expected 4.192%. This caused a decline in bond prices with the 10-year Treasury note trading around 3.30% up from 3.14% late last week which was above the 3.00% level, reached earlier last week a level that had not been crossed since November 24, 2008.

How high are these interest rates going to go and what impact will these higher rates have on mortgage rates and corporate rates? We are already seeing spreads between Treasuries and corporates reach levels since last October and November. And the interest rate spreads on lesser credits have also been increasing. And, there is still much more Treasury debt to come.

Furthermore, the economic structure of the United States (and the world) has changed. The manufacturing base is going to be different in upcoming years and everything is going to be more connected technologically than before. And, what if the personal savings rate in the United States reverts back to 8% or so as it was before 1992? We are not going to be able to force employment, human or otherwise, back into the same industrial and financial structure with the same employment intensity as existed before this economic collapse.

I am not intentionally trying to stay on the “dark side”. It would be great if things were bottoming out and the economy were about to start on an upward path once again. But, there still seem to be too many “unknowns” out there, unknowns that relate to serious problems, for us to get our hopes up too high at this point. Managements must still re-focus their businesses and must deleverage their balance sheets. Boards of Directors still must make sure they have the right executives in the right places, and if the Boards don’t do this then the shareholders must become more aggressive. Many executives that managed in the pre-2007 period, I believe, are not the executives to lead our companies in the post-2009 period.

Are we at a tipping point? Are we at or near the bottom of the downturn?

The most important questions are still going unanswered: even with the results of the Treasury stress tests. Will a major bank fail? How many regional banks might fail? So far there have been 32 bank failures this year, up from 25 last year and 8 the year before. How will a General Motors bankruptcy impact the economy? What other possibilities are out there?

Other company failures? Bloomberg reports today "Moody’s is forecasting the default rate among high-yield companies globally to soar to 14.8 percent by year-end from 8.3percent in April as companies that financed a record amount of high-yield, high-risk debt leading up to the credit crisis struggle to refinance."

And, I haven’t mentioned the debt overload that exists throughout the country. The list goes on.

It seems to me that what we are seeing a lot of these days is wishful thinking. I really haven’t seen anything yet that one could argue was a “hard” fact pointing to a bottom of the downturn. I really don’t think we are going to see any “hard” facts in the near future, so the stock market and other areas of the economy will just to continue to live off of wishful thinking. This is a situation made for traders. Uncertainty creates volatility and traders feast off of volatility. I guess it is good to know that at least some people profit from this environment.

Monday, May 4, 2009

Structural Changes in the Economy, Unemployment, and Inflation

A new concern about the economy has surfaced recently. This new concern has to do with the changing structure of the economy and the impact this change might have on the outcome of government policy.

Specifically, the argument is that the United States economy, and that of the world, is currently going through a transitional change that only occurs once or twice every century. This is the transition that takes place in the productive structure of the economy—a sort of “tipping point”.

There is no doubt that the structure of automobile production is going to be different in the next ten years from what it was over the past fifty years or so. This shift will affect dealers, suppliers, and many other companies that are peripheral to the car-making process. But, changes are also taking place in the way that different forms of energy are going to be provided. Information technology continues to change and we still don’t know what the future looks like in this area. And, these are just a start.

The point is that the world has changed. People that are facing unemployment due to the collapse of the auto industry are not going to find the same employment opportunities in the future that existed in the past, even if the stimulus and bailout packages work. There will be a different focus in energy with new types of jobs becoming available and the old types being less plentiful. Openings in health care are going to be different. And, what about employment in financial services? New jobs might be much more plentiful in government service. And some people are calling for a re-instatement of the military draft.

This changing structure is going to impact many, many people who will need to change jobs, change where they live, and change skills. During times like these, what is called the non-inflationary rate of unemployment tends to increase. This is because the structure of employment has changed and the industry and the economy need to adjust to accommodate this change. Whereas, the non-inflationary rate of unemployment for all workers over the past ten years may have been around 5.0%, this rate, looking forward, may be at 6.0% or more depending upon the restructuring that needs to take place.

What is the problem created by this shift?

The models used by the federal government in determining what monetary and fiscal policies are appropriate for achieving “full employment” contain the lower estimate for the non-inflationary rate of unemployment. These models are based upon historical data and the “historical data” don’t include the adjustments that are now taking place in the actual economy.

The consequence of using an unemployment figure that is too low?

Deficits will be greater than expected because government tax revenues will be lower than initially projected and the choices for monetary policy will be too expansionary for the new structure of the economy. That is, the employment situation will be worse than expected and the pressure on prices will be greater than expected.

What does this mean for the results that we will be seeing? Well, it means that unemployment will remain higher than what is desired and inflation will also remain higher than desired, even though the pressure on wages will be downward. That is, there will be a greater fall in real wages than expected and this will further dampen consumer spending and cause additional foreclosures and personal bankruptcies.

This can have further repercussions in financial markets as increasing federal deficits and rising unemployment puts additional pressures on the Federal Reserve to monetize the debt. Long term interest rates will not fall under these circumstances even though real resources are seemingly under-utilized.

What is happening here?

To me, what is happening is confirmation of what I was writing about last summer and through the fall and winter. First, the shift in economic activity is coming from the supply side of the economy—and not from the demand side! Most economists (and this is especially so with the reincarnation of the Keynesian school of thought) interpret a slowdown in economic activity as a deficiency of demand. Hence the monetary and fiscal policies that are created aim at restoring sufficient demand to return the economy to full or near-full employment levels.

If the slowdown in economic activity is coming from the supply side, different monetary and fiscal policies are needed to confront the state of the economy. A slowdown in economic activity coming from the supply side needs policies that deal with the structural changes in the economy and these require efforts much different from demand side policies.

Demand side stimulus, in cases like this, often exacerbates the problems because all the demand side stimulus seems to do is try and force the unemployed people back into their old jobs which are no longer available. If the structure of production and employment has actually changed, then these old jobs have disappeared and there is no way that demand stimulus will bring them back into existence. Hence, too much money is chasing too few goods—even though unemployment has increased.

The second factor I have discussed before is that there is too much debt outstanding and that this problem must also be dealt with before economic expansion can begin again. But, if there has been a structural shift in the economy, this situation becomes more problematic because a higher rate of non-inflationary unemployment means that previous debt loads are even more out-of-line with what people can handle than at the rate that was being used before. That is, the debt problem is worse than previously anticipated.

The Federal Reserve and the Obama administration still seem to believe that the problem in the financial markets is one of liquidity. However, the problem is one of solvency and this is a structural problem and not one that is temporary and handled by buying more and more different kinds of securities. The focus on the liquidity available in different segments of the financial markets and on the balance sheets of banks is misplaced. Individuals, businesses, and governments have too much debt outstanding relative to the state of the economy. The auto industry is “painfully” shedding some of its debt. The Treasury Department is attempting to help the banking industry shed some of its debt. Still, there too much debt outstanding and the federal government is adding more and more to this total.

The bottom line is that the changes that have taken place in the United States economy are structural in nature and must be dealt with as such. Unfortunately, the policy makers in Washington, D. C. don’t seem to see it that way. As a consequence, the policies that have been forthcoming may only add to the dislocations that exist in the economy and result in a rate of inflation that only adds to these problems.

Even with the substantial decline in real GDP in the first quarter of 2009, the GDP deflator rose at a 2.9% year-over-year rate of increase. This is worrisome. But, when output falls and inflation rises or stays relatively constant, this is an indication that the supply side of the economy has shifted and not the demand side.