Thursday, October 29, 2009

More Talk About Credit Bubbles

Bloomberg put up a headline this morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says”, Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”

We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.

“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”

“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”

According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.

Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.

How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?

In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: has also questioned current values in stock markets.

Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co,, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”,

Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.

According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.

A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha:

Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.

Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”

This is exactly the problem that I presented in my posts of October 26,, and October 27, The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.

Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.

Tuesday, October 27, 2009

Ecomonic Stimulus: Do We Need More?

When the history of the recent financial crisis and Great Recession is written, the basic conclusion that will be presented is that a financial crisis can be ended and a major recession turned around if the government throws massive amounts of money at the economy.

And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.

Spending is addictive. Once you start, it is hard to stop.

Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.

Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.

So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?

And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, The conclusion of the author of the article is not encouraging.

Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!

And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!

Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.

However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.

Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”

The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.

Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?

For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”

More! That’s the answer!

And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!

But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?

Should we stop talking about the deficit?

Or should be consider that maybe, just maybe, more is not the answer.

Monday, October 26, 2009

The State of the Economy and Supply Side Concerns

Several of the aggregate economic indicators are indicating that the economy has bottomed out. Industrial Production seems to have hit a bottom in June 2009 as the year-over-year rate of decline on a seasonally adjusted basis was -13.3%. Since then the negative rates of growth have fallen: in August the rate of decline was -10.4% and in September this rate dropped to -6.1%. The index has actually increased, month-over-month, beginning in July.

The decline in real Gross Domestic Product (GDP) lessened in the third quarter this year on a seasonally adjusted year-over-year basis. The greatest year-over-year decline came in the second quarter of 2009 when real GDP fell at a 3.8% annual rate over the second quarter of 2008. The first look at the third quarter number is to be released on Thursday. According to the Wall Street Journal, estimates for the third quarter over the second quarter annual rate of increase stand at a positive 3.1%. If this quarter-over-quarter rise takes place, the year-over-year rate of decline for the third quarter of 2009 will be -2.4%.

On the surface, it does look at this time as if the third quarter of 2009 will be declared the beginning of the economic recovery in the United States.

That is the good news.

The not-so-good news, to me, is the extent of the recovery. There are some areas we need to keep our eyes on in order to help us understand what is going on in the economy. These are the “supply side” conditions that indicate something else is happening in the economy other than just an economic recovery. They are conditions that tell us that some economic dislocations exist that will have to be resolved in the future if the United States economy is going to become robust once more.

The first of these areas has to do with our manufacturing capacity. Capacity utilization in September of this year stands at 70.5%, up from the trough of about 68% in June. So, capacity utilization has begun to increase.

The problem is that this capacity utilization is at a post-World War II low! But, even more important is that the previous peak in capacity utilization came in the 2005-2006 period but was just over 80% at that time. And, this peak was down from the 85% capacity utilization of the 1995-1997 period and the 1988 period. And, these peaks were down from the 87% capacity utilization of the 1978 period, which was down from the 89% rate of the 1974 period and the 90+% of the middle 1960s.

The United States has seen over the past forty years or so a deterioration of its industrial base. There is a lot of idle capacity that is in place but, for various and sundry reasons, is not being used. We can address some of these reasons in forthcoming posts. The important concern to me is that in the economic recovery we will not even us get back to the 80% range of capacity utilization. The implication of this is that unemployment will not fall as much as we would like and that business investment spending would not be very robust because firms won’t need manufacturing capacity, they already have it.

This would lead one to the conclusion that business spending will not be too strong in the recovery. But, it is a supply side problem, not a demand side problem.

And, speaking of employment, there is an unused capacity problem as far as the labor market is concerned. The official unemployment rate, the total unemployed as a percent of the civilian labor force, stood at 9.8% in September 2009. The rise over the last year is from 6.0% in September 2008.

The total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers is 17.0% in September 2009 up from 10.6% in September 2008. That is, there has been a substantial increase in persons who are neither working, nor looking for work but indicate that they want a job and are available, discouraged workers and people working part time who would like to work full time.

There is a lot of unused capacity in the population as a whole. From everything we are hearing, the marginally attached and the discouraged do not have too much to hope for in the upcoming economic recovery and this doesn’t even consider the expected rise in the official unemployment rate.

The conclusion one can reach from these data is that whatever has been going on in the United States for the past 40 or 50 years has not been totally healthy for the supply side of the economy. Basically, the past 40 or 50 years has seen a lot of inflation. Since January 1961, Consumer Prices in the United States have risen by 625%, or, in other words, the real value of a dollar has decline by 86% since then.

One could easily make the argument that whatever went on in the United States over this period, it was a period of extended inflation and that such an environment was not the most productive one for economic resources. This environment resulted in a lot of unused productive capacity, in terms of physical resources but also in terms of human resources.

Current policy is doing what has been done consistently in this period, emphasized a demand side bias. An inflationary policy, created using fiscal and monetary policy to stimulate aggregate demand, has been the response to the economic slowdown. And, the policy attempts to achieve higher rates of employment by putting resources back to work at their old functions. Of course, this cannot be fully achieved as technology and other efficiencies allow new jobs to be created that do not use the old skills, or old jobs to be eliminated and excess capacity to grow. Thus, capacity utilization continues to drop and those in the workforce that are discouraged from seeking a job remain unfulfilled.

Friday, October 23, 2009

Wall Street Smarts

After I posted my comment on “Do we Really Need to Break up the Banks?” yesterday (, I remembered an anecdote from my time in the Finance Department at the Wharton School, University of Pennsylvania. It relates to commercial banks moving from “utilities” to “casinos” in the words of Mervyn King, Governor of the Bank of England.

What brought this incident back to my mind was the recent op-ed piece by Calvin Trillin in the New York Times with the title “Wall Street Smarts.” (See In this piece Trillin runs into a person who reflects on something a speaker who had just been to a college reunion had shared with him.

“One of the speakers at my 25th reunion said that, according to a survey he had done of those attending, income was now precisely in inverse proportion to academic standing in the class, and that was partly because everyone in the lower third of the class had become a Wall Street millionaire.”

He goes on, “Don’t get me wrong: the guys from the lower third of the class who went to Wall Street had a lot of nice qualities. Most of them were pleasant enough. They made a good impression. And now we realize that by the standards that came later, they weren’t really greedy. They just wanted a nice house in Greenwich and maybe a sailboat. A lot of them were from families that had always been on Wall Street, so they were accustomed to nice houses in Greenwich. They didn’t feel the need to leverage the entire business so they could make the sort of money that easily supports the second oceangoing yacht.”

I joined the Finance Department at the Wharton School in the fall of 1972. At the time they had one course related to commercial banking, but the course was structured to discuss banking structure and regulation.

I was interested in running banks so I made the suggestion that we offer a course in bank management that was similar to the courses in the financial management of corporations, only make it specifically related to the issues and concerns of the banking industry.

The response I received from some of the administration was that they were unsure that a course like that would attract many students, particularly at the MBA level. The reason being, that except for hiring several people that were interested in running bond portfolios, the large money center banks did not recruit from the Finance Department at Wharton.

Well, I knew that there were a lot of people from the University of Pennsylvania that worked at the large money center banks so I asked a stupid question: “Where did these banks recruit Penn grads?”

The response: “Oh, they recruit from the History Department, or the English Department or areas like that. What the banks really want are people that get along with others, enjoy social drinking, playing golf or playing tennis, who belong to social clubs and things like that. They don’t want someone that is mathematically trained or otherwise quantitatively orientated. They want someone to help establish or build relationships.”

Well, not that there weren’t smart people that graduated from History, or English, or areas other than math, statistics, physics, and finance. It’s just that, at the time, banks didn’t consider that these were the people they wanted working with their customers. I guess there is a bit of truth to Trillin’s op-ed piece.

Anyway, we did create the course in the financial management of commercial banks. In my last semester at Wharton the graduate class was held in a large auditorium and was completely filled. The textbook written for the course, The Financial Management of Commercial Banks can still be found on (See

Breaking up the Banks?

Mervyn King, Governor of the Bank of England, gave a speech the other night and set off somewhat of a storm…at least across the pond. It is a discussion that needs to be heard here in America. (For a full text of the speech:

Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see

Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.

I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.

In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.

The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.

In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.

The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.

Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.

What changed?

Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.

This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!

Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.

Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.

Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.

As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.

The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!

Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.

Thursday, October 22, 2009

A Quick Look at Profits

So far, two facts stand out to me in many of the current earnings releases. First, for many large financial firms, trading profits have provided almost all of the positive results that we have seen. Second, for many large non-financial firms, cost cutting has resulted in better-than-expected earnings.

Both of these lead me to the conclusion that the basic or fundamental businesses of the companies reporting are showing little or no life. In other words, the demand for the basic products or services they provide is listless, at best. And, results like these are not sustainable.

Yes, the results are encouraging. Profits are always better than losses. But, these profits are not connected with the core business of these companies and hence give no indication that either the financial firms or the non-financial firms have established some kind of competitive advantage that will last into an economic recovery.

In terms of the large financial firms, like Goldman Sachs and JPMorgan Chase, the trading profits have allowed them to post substantial earnings and get the government off their backs. Getting the government off their backs is important and will become more so in the future because these companies can pay to keep their top-flite executives or pay to attract other major talent to their organizations. They can buy time as their core businesses improve. However, trading profits are not sustainable and should not be counted over an extended period of time.

The large financial firms that have not produced, like Citigroup and Bank of America, will find themselves at a considerable competitive disadvantage, both in the United States and worldwide, as their competition can apply their strengths to continue to grow and increase market share. Plus, these non-producers are having to sell off assets like BOA’s sale of First Republic and Citigroup’s sale of Phibro even though both were profitable operations.

The last thing these organizations need is to have their pay the top officers receive drastically cut. Not only do troubled firms have problems hiring top talent, but to have the onus of the government hanging over the companies and controlling what top executives get paid is doubly bad. These financial institutions were too big to fail—immediately. But, they are not too big to fail a slow death. Certainly the government’s effort to impact the remuneration of the top executives at firms still receiving government help will skew the playing field to the Goldman’s and the JPMorgan’s.

One can understand in today’s environment that a lot of people are angry about big salaries and bonuses, especially to those that have been bailed out by the government. Certainly, the forthcoming big bonuses to be received by the executives at Goldman and JPMorgan do not help stem these populist attitudes about the pay at financial institutions. But, in this case, the response of the public is just helping the competitive position of Goldman and JPMorgan and hurting that of these other large banks because the actions on pay just makes Citi and BOA less competitive! Goldman and JPMorgan are smiling all the way to the bank!

The other banks, the regionals and the locals? They need time to continue to work out their loan and security portfolios. They need to regroup, get back to their core business and they will be fine. But, this is going to take time. Nothing substantial in profits here for a long time.

As far as the non-financial firms are concerned, their cost-cutting efforts are paying off. Their efforts to return to their core businesses are paying off. But, cost cutting alone does not produce sustainable exceptional returns. Cost cutting can be duplicated. And, as long as consumers stay on the sidelines and restructure their balance sheets and keep reducing their debt not increasing it, the final demand for goods and services will not show much bounce.

There is continued hope in one sector after another that sales will pick up. In computers. In retail sales. In food services. There is continued hope that sales will pick up during Thanksgiving, or Christmas, or at some other relevant time. But, these blips of hope seem to pass on as sales continue to disappoint. The hope is transferred to the next holiday.

Companies, for the past four or five months, have posted not-so-good earnings, but they raise their forecasts for the upcoming year.

There is nothing these companies are doing right now that produce sustainable results. Demand for their products and services must be forthcoming and, right now, there is little encouragement that this will happen any time soon.

All of these factors raise two concerns in my mind. First, what is the basis for the continued rise in stock prices. The profit results that have been achieved so far are not sustainable and point to no growth in earnings or cash flows for the time being. Furthermore, the cost cuts are great, they help companies get their focus back onto the right things. But, cost cutting does not result in a continued increase in earnings or cash flows. In addition, trading profits do not contribute to extended growth in earnings or cash flows. This is why I am concerned about the possibility that the rise in stock prices since March might just be a bubble. (See

Second, managements are refocusing their efforts and reducing inventories, labor, and other resources that they had accumulated during the go-go years. This restructuring, given past experience, will continue, even when the economy begins to recover again. These managements are not going to return to the same business practices as before. This will change the supply side of the economy and, as a consequence, full employment of resources will not be the same as it was earlier in this decade.

If this does occur, and I believe that it will, it will just be one more part of the trend that began in the 1970s. Through all the cyclical swings in the economy during the last forty years or so, the economy has never regained the height it had achieved in the previous upswing. That is, the next peak of employment, of capacity utilization, of industrial production, has never as high as it was at the previous peak.

This means that the economic policies of the last forty years or so have left more manufacturing capacity idle, more workers discouraged, and more resources wasted each cycle of the economy. The American economy is changing along with competition in the world. Artificial stimulus on the part of the United States government just tries to put people and other resources back into the jobs that they once held, like in autos and steel for example. And, such an economic policy only exacerbates the longer term trend. Furthermore, this is not helpful to the stock market.

It is easy to build a case that the rise in the stock market in the 1990s and the 2000s were asset bubbles created by easy credit. Given the performance of financial and non-financial firms at the present time could the Federal Reserve just be producing another one?

Tuesday, October 20, 2009

Obama to Tackle Deficit--Next Year!

“This has been the year of coping with the economic mess. Next year will be the year of coping with the deficit mess that follows the economic mess.”
So says Wall Street Journal writer Gerald Seib. (See “Obama Lays Plans to Tackle Deficit,” “The timing is tricky” because next year is an election year, but Obama is going to do it! Yes we can!

The strategy is a two pronged attack with another strong initiative in the wings. The first go at it will be at the president’s State of the Union address. That’s in January.

Following right after there will be the president’s budget proposals. That will be in February.

Then, well, let’s put together a task force—say eight Democrats and eight Republicans and let them address “the nation’s long-term fiscal imbalances.”

Yes, the Obama administration has things under control.

And, the world goes on.

The value of the dollar has declined by about 13% since January 20, 2009. It is possible that it could decline another 5% to 10% over the next six months or so.

Over the last thirty-eight years, since August of 1971, participants in international financial markets have failed to trust governments that ran up huge budget deficits. The general attitude has been that governments that cause their debt to increase substantially through loose or irresponsible budgets will eventually end up having their central bank monetize large portions of their debt.

In the face of such behavior, investors have sold the currencies of these countries until some appropriate response has been forthcoming from the governments running the deficits. More than a few countries have experienced this consequence of their budgeting largesse. Concern has even been expressed about how a group of “unknown bankers” could have such an influence over sovereign nations. (See for example the book “The Vandals’ Crown: How Rebel Currency Traders Overthrew the World’s Central Banks” by Gregory Millman.)

But, the United States government ran massive deficits earlier in this decade and the Federal Reserve supported such debt with extremely low interest rates while it allowed asset bubbles to run their course. During this time period the value of the United States dollar declined by about 40%.

The situation since January 20 has several characteristics in common with this period: large deficits supported by the Federal Reserve with extremely low interest rates. And, as mentioned above the value of the United States dollar has declined by about 13% since that time.

Talk about a strong dollar is a joke at this time. Talk about getting the deficit under control is approaching the same seriousness.

Let’s face it, Obama owns the deficit now.

As is usual in economics, people and markets have a short memory. The past is the past. The current administration has been in office nine months now. It is a “full term” pregnancy! The child, the current deficit and subsequent problems, belong to Obama.

Markets will not wait for additional speeches, even a State of the Union speech. Daily, there is more and more talk about the inability of the Obama administration to make decisions, to act. It only talks and promises.

People and markets don’t want a task force to address “the nation’s long term fiscal imbalances.” How long will that take? Six months, twelve months, or longer?

The markets need some substance. As far as I can see there is no indication that any “substance” is going to be forthcoming soon. Thus, the dollar will remain weak because what reason is there to buy it?

Monday, October 19, 2009

The Stock Market: A Bubble or Not?

Questions are now being asked about the nature of the rise in the stock market. These questions have to do with the reality of the rise, how high the market will go, and when will the economy produce results that are consistent with the optimism captured in the stock market rise.

There is another way to look at the rise in the stock market since March 2009: the rise could be just another asset bubble.

Asset bubbles are a form of inflation. As we have learned over the past fifty years, excessive monetary or credit ease can come out in one of three ways. First, there can be outright inflation. In this case, popular price indices, like the Consumer Price Index, can rise by inflated amounts. Second, prices of assets in one or more sectors of the economy can rise at a pace that exceeds the rate justified by the underlying fundamentals of the sector. Third, when the economy is facing supply side adjustments that constrain the healthy growth of the economy, excessive monetary or credit ease can force economic growth in areas that have declined in productivity. That is, the excessive monetary growth can force resources back into declining industries rather than allow them to adjust into the more productive areas of the economy that are in the process of expanding. In these cases nominal growth of the economy is higher than it would be otherwise and inflation is muted by the re-kindling of industries that needs to change or modernize. This results in a form of “stagflation” where we get the worst of both slow growth and masked inflation.

There is little doubt that the monetary authorities have pumped plenty of liquidity into the banking system. The year-over-year increase in the monetary base (currency in circulation plus bank reserves) has been increasing at a rate of around 100% for the past year. As yet, little of this liquidity has found its way into bank lending.

Still, the two basic measures of the money stock have shown year-over-year rates of increase that, historically, can be considered to be substantial. The M1 measure of the money stock has been rising for months in the range of 15% year-over-year, while the M2 measure of the money stock has been rising in the 8% range over the same span of months. Some of this growth can be attributed to a re-arranging of asset portfolios into more liquid assets. Still, all of this money is not sitting idle even though interest rate levels are historically low.

How might this expansion of the monetary variables be used? In the past, rates of growth like this would be considered to be inflationary. Yet, there is no evidence that spending on final goods has increased appreciably and, hence, the rate of increase of consumer prices has remained just above zero, year-over-year. There has been some growth of the economy and some of this growth can be attributed to areas where resources had been leaving (autos) to move to more productive operations. The government stimulus spending has produced a spike in output here and there but does not seem to have produced any sustained increases in economic growth. The possibility of stagflation seems to lie in the future. Therefore, it seems as if two of the three outlets for monetary ease can be excluded from the present analysis.

That leaves us looking for the existence of an asset bubble. Certainly the movement in the stock market since March is a good place to look for a possible asset bubble.

We certainly have some experience in stock market bubbles having just gone through the stock market bubble of the 1990s. Could we be having a repeat performance?

In terms of assessing this possibility I am going to turn to two measures of stock market valuation that were discussed in a book I recently reviewed. The book is titled “Wall Street Revalued” and was written by Arthur Smithers. The review can be found at The two measures are Tobin’s Q ratio and the Cyclically Adjusted Price/Earnings (CAPE) ratio developed by Robert Shiller. In mid-September, these ratios were already showing that the U. S. stock markets were 35% to 40% overvalued, and that was before the run-up that took the Dow above 10,000. (For a report on these numbers see

Is the rise in U. S. stock markets a bubble?

Bubbles, of course, are easier to define after-the-fact than when they are occurring. But, the “Q” ratio and the CAPE have done a pretty good job historically of indentifying times when the stock market is overvalued.

If the stock market is overvalued right now because the Federal Reserve has created another asset bubble--it’s third in about 15 years—then the economic and financial situation in the United States is quite tenuous. The economy sucks, the banking system is still faced with major credit problems, and the dollar has fallen close to 15% since January 20, 2009. What kind of a policy can the government throw at this dilemma?

Any tightening to brake the expansion of the bubble and/or combat the decline in the value of the dollar threatens the solvency of the banking system and the fragility of the economic recovery. But, as we have seen over the past 15 years, bubbles eventually collapse on their own. Are there any “good” ways out of this situation?

This is not a pretty sight, but it is one we must take into consideration. As we continue to learn, though, once we lose our discipline, all the good choices in policy seem to disappear!

Sunday, October 18, 2009

Federal Reserve Exit Watch Part 3

This is the third post in a series designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet. (The first two posts in this series appeared on August 21 and September 18.) Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

The fear of many others is that the Fed will withdraw these funds too quickly thereby causing the banking industry further problems and the experience of a second financial collapse.

Bottom line: Reserve Balances with Federal Reserve Banks rose by $190 billion in the four weeks ending October 14, 2009. The rise over the last thirteen-week period was $244 billion. These Reserve Balances totaled $1,049 billion on October 14, a new record high! These data are taken from the Federal Reserve Statistical Release H.4.1.

Required reserves in the banking system averaged about $63 billion in the two banking weeks ending October 7. Excess reserves in the banking system, as reported in the Federal Reserve Statistical Release H.3 were $918 billion for the same period of time. Reserve Balances with Federal Reserve Banks were $963 billion on October 7.

Obviously, there are plenty of reserves in the banking system and the banks still do not seem to be in any mood to begin lending again. See my post on the lending activity in the banking system to support this conclusion:

Where did this $190 billion of new reserve balances come from?

Well, about $52 billion came from factors supplying reserves to the banking system and another $137 billion came from a reduction in factors that were absorbing reserve funds. For the thirteen week period, factors supplying reserves contributed $121 billion to the $244 billion increase and there was a $123 reduction in factors absorbing reserves. Let’s look at both in turn.

As was highlighted in the previous two reports on the exit strategy of the Fed, the monetary authorities continued to allow accounts associated with the special facilities created to deal with the financial crisis to run off. These reductions were offset by purchases of financial assets. This seems to be the first move strategy of the Fed to achieve its exit from the big buildup.

Over the past four weeks, there was a $61 billion decline in three asset categories connected with the new facilities that were created. The Term Auction Facility (TAF) declined by almost $41 billion, the portfolio holdings of Commercial Paper declined by $3 billion and the line item associated with Central Bank Liquidity Swaps fell by a little more than $17 billion.

Over the last thirteen weeks these three items declined by almost $260 billion: TAF dropped by $118 billion; the commercial paper facility by $71 billion; Central Bank swaps fell by $68 billion.

The Fed replaced these run-offs by open market purchases that more than covered the outflow, hence the overall increase in bank reserves. For example, Securities Held Outright by the Fed jumped $103 billion in the last four weeks and by over $360 billion in the last thirteen weeks.

The Fed is therefore allowing the special facilities to decline where possible and is then maintaining the liquidity of the banking system by purchasing securities in the Open Market!

In purchasing securities in the open market the Fed is buffing up the liquidity in these markets and helping to keep interest rates low. Of particular note, the Fed has added $78 billion in Mortgage-Backed Securities to its portfolio over the last four weeks and $237 billion over the last thirteen. The Fed has purchased Federal Agency Securities in recent weeks: this portfolio has increased by $11 billion and $35 billion in the last four and thirteen weeks, respectively.

Two other items of note: first, something called Other Federal Reserve Assets rose by $6 billion over the last four weeks and by $13 billion over the last thirteen weeks. What is in this account? Well, the Federal Reserve states that this account includes Federal Reserve assets and non-float-related “as-of” adjustments. These may include Assets Denominated in Foreign Currencies or Premiums Paid on Securities Bought. We don’t really have any information on the totals, but these amounts are relatively substantial amounts, especially when the required reserves in the banking system only total $63 billion.

The second item that requires some attention is that the Special Drawing Rights (SDR) account at the Fed increased by $3 billion over the last four weeks. Actually the increase came in the banking weeks ending September 23 and September 30. Thus the Special Drawing Rights certificate account at the Federal Reserve rose from $2.2 billion to $5.2 billion during this period. I am going to have to do more research into this increase and what it means.
In the meantime here is a definition of the SDR: SDRs were originally created to replace Gold and Silver in large international transactions. Being that under a strict (international) gold standard the quantity of gold worldwide is finite, and the economies of all participating IMF members as an aggregate are growing, a purported need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or "paper gold", are credits that nations with balance of trade surpluses can 'draw' upon nations with balance of trade deficits. So-called "paper gold" is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

The other major contributor to the rise in reserve balances at commercial banks was a movement out of federal government accounts at the Federal Reserve. There was a movement of $157 billion out of government accounts in the last four weeks and $149 billion in the last thirteen. A reduction in these accounts takes place when the government disburses money and the funds end up as bank reserves. In terms of the governments’ general account, the movement of funds, in and out of this account, is usually connected with seasonal tax collections and disbursements.

There is another account that saw a large reduction, $100 billion, over the last four weeks. This was in an account called the U. S. Treasury Supplementary Financing Account. The Fed defines this account in this way: “With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.” Thus, a movement out of the Fed injects deposits into depository institutions.” We need more information on this decline.

To conclude: The Fed continues to reduce dollars associated with the new facilities created to combat the financial crises. It is replacing these dollars with open market purchases that keep the banking system liquid. Other transactions have also taken place related to federal government disbursements that add reserves to the banking system. In restructuring its balance sheet the Fed is being sure to err on the side of being too loose in supplying bank reserves. Obviously, the leadership at the Fed does not feel that any type of constraint should be imposed upon the banking system at this time.

Wednesday, October 14, 2009

A Word on the Dollar from Mr. Wolf

Another commentary on the state of the dollar, well worth reading, is that written by Martin Wolf and presented by the Financial Times this morning (see “The Rumours of the Dollar’s Death are Much Exaggerated”:

Wolf begins by stating that “It is the season of dollar panic.” He then specifically lists two, gold bugs and fiscal hawks that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”

I presume that Mr. Wolf would classify me as a “fiscal hawk”, but I do not believe that “Hyperinflationary collapse is in store.”

I do believe that the dollar will remain weak as long as the fiscal stance of the United States government remains as it is, so that the trend in the value of the dollar will continue to be downward. I do not believe that a “hyperinflationary collapse” is imminent.

The reason I believe that this will be the case is that the international investment community will continue to be on the sell side of the dollar as long as the United States government continues to run the size of deficits that it is now running and has no credible plan to bring future deficits under control.

I believe this for the same reason that was stated by Robert Altman, former deputy US Treasury secretary, in his commentary in the Financial Times yesterday (see “How to Avoid Greenback Grief”: Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies.

And, this response on the part of international investors was a common thread in the latter part of the 20th century. France, as well as a dozen or more other countries can provide similar stories.

And Altman argues that “the dismal (US) deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”

I support Wolf’s reading of the recent decline in the value of the dollar. He states: “In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar's fall is a symptom of success, not of failure.”

Note, however, Wolf’s statement, I believe, that the mother, the United States, “did so much to cause the crisis” through “her mistakes” needs to be clarified. What he doesn’t say is that United States monetary and fiscal policy contributed a decline in the value of the United States dollar of about 40 per cent ending in July 2008! I agree with Wolf that the jump of 20 percent came about due to the fact that “In the recent panic the children ran to their mother.”

The subsequent decline in the value of the dollar, in a perverse way, is therefore “a symptom of success” because through the actions of the United States government (as well as many other governments throughout the world) the financial panic ended and so “failure” was avoided.

To me, the return to a declining value for the dollar is nothing more than a return to the pre-crisis situation in which the world investment community is concerned with the huge deficits being produced by the United States government and the fact that there is really no credible scenario being presented by the leaders of the government that these will be in any way reduced in the future. The connected concern with this fact is that, historically, governments cannot contain the underwriting of these deficits by the nation’s central bank over the longer haul. It’s not the fact that the international investment community sees hyperinflation coming down the path, just that historically the evidence is not in place to have a strong belief that an independent monetary authority will be able to offset the substantial increases in debt that are forecast.

I also agree with Mr. Wolf’s assessment that nothing, at the present, can replace the dollar. Whereas I don’t have the space in this post to go into the very cogent discussions that are presented by Mr. Wolf on this issue, I can come out where he does, without having travelled exactly the same road that he has followed.

I believe that over time the global role of the dollar will lessen. I believe with Mr. Wolf that “the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong.” I agree that the reason that a different role for the dollar is needed is because the current role “impairs domestic and global stability.”

I would just like us to get to this new system by a different path than that proposed by Mr. Wolf or by his colleague at the Financial Times, Gideon Rachman (see my post of October 6, 2009: “The G20: Time for a US Attitude Adjustment”:

The world has changed and will continue to change. The United States and the United States dollar will continue to be powerful; they just will not be as relatively powerful in the future as they have been in the past. This has to be taken into consideration by the United States government as it goes forward, but the new system must not be negotiated with the United States government reeling and in a defensive position from continued pressure on the value of its currency.

Tuesday, October 13, 2009

The Supply Of and Demand For Loans at Commercial Banks

More and more stories are appearing that exhibit the reasons why the commercial banks below the behemoth size are not seeing their lending growing. And, the evidence appears to be that the slowdown in lending is being affected by the demand for loans from businesses and households as well as by the supply of loans coming from the banking sector.

Yesterday, I touched on the aggregate balance sheet figures published by the Federal Reserve. (See, One can interpret the most current data as showing that the financial difficulties that larger commercial banks have been facing are migrating to the smaller banks and this is affecting bank lending activity.

This morning there were two articles in the New York Times on the front page of the business section that provide additional antidotes and analysis on what the “less-than-huge” commercial banks are facing. The first looks at the situation that some borrowers are facing in attempting to obtain loans from banks. This article, by Peter Goodman, “Clamps on Credit Tighten”,, emphasizes the difficulties small companies are having because they cannot obtain funds from the banking system at this time.

It becomes apparent within the article, however, that the shortfall of lending is not solely coming from the supply side. Raymond Davis, the chief executive of Umpqua Bank, in Portland, Oregon is quoted as saying, “Banks want to lend money. The problem is the effect that the recession is having on us. Some of these businesses are still trying to come out of it. For them to go to a bank, if they are showing weak performance, it is harder to borrow.” The Umpqua Bank is a regional lender.

In other words, businesses know that the banks have tightened their requirements when it comes to lending and they know that their balance sheets and income statements are not up to these new bank standards. Consequently, they are postponing even going to the bank until such time as they are in a position to get a favorable response on a loan application.

These business, of course, are ones that are not in such dire straits that they are desperate for funds and are trying to find any source they can for obtaining the funds that they need. Fortunately for them they can wait out the current state of affairs, at least for the near term. However, this delay means that people don’t get hired and inventories are not purchased and so economic recovery is pushed off longer into the future.

Also, these companies are restructuring in an effort to get their balance sheets in order: “Among small privately held companies, the amount of debt they carry as a portion of their equity has slipped by about 5 percent since 2007” the article reports. “The drop reflects not only how companies have cut their inventories and paid down debt, but also the tightened credit terms they face when they try to borrow.”

The intermediate term problem relates to the cumulative result that if firms can’t borrow, for whatever reason, they can’t conduct their business, they can’t hire people who then don’t have money to spend on things, and the firms can’t make profits to improve their balance sheets. The article contains several narrative stories on how this is playing out in various areas of the country.

Another article in the New York Times, deals with the “pace” of loan losses. See the article by Eric Dash, “Pace Slows on Losses for Banks”, The gist of the article is that although loan losses at commercial banks “are still expected to stay high through most of next year” the speed at which these losses are accumulating is lessening. Loan losses “haven’t peaked, but outside of mortgages, we are getting close,” according to Scott Hoyt. Again the evidence points to the differences in where the difficulties are coming. Larger banks are currently suffering more from delinquencies and defaults from consumers.

The “Less-than-large” banks are facing rising pressure from problems in the commercial real estate area. “Elbowed out of the credit card business and mortgage lending businesses by their larger rivals, (hundreds of small, community banks) began aggressively financing home construction projects as well as office, hotel, and retail development deals. Many of those borrowers are just starting to default, leading the banks to book giant write-offs and set aside more money to cushion future blows.”

That is, these charge offs are just starting to hit the books!

Some businesses are finding one possible source of funds that they have not tapped to any degree in the past. This is the bond market. As reported by Goodman, “As the financial crisis has largely eased in recent months, big companies have found credit increasingly abundant, with bond issues sharply higher.” This movement to bond financing seems to be occurring in companies that are smaller than big and it seems to be a worldwide phenomena. For information on this latter development see the article in the Financial Times, These companies are using funds for the bond markets in ways that they formerly used bank lending for. Plus, they are not faced, in the bond markets, with some of the covenants and restrictions they faced with the banks.

This move by companies to obtain bond financing raises an interesting question. The question is this: What if this movement is part of the overall effort to “securitize” everything? That is, what if almost all funding occurs in “financial markets” and not in financial institutions as it mostly has been done in the past? Maybe this slowdown in bank lending will accelerate this movement to market-based financing. Then maybe the commercial banking industry will shrink as has the thrift industry (see my “Have Thrifts Outlived Their Usefulness”,

Certainly commercial lending is not the major part of the balance sheet of the commercial banking industry as it once was. Commercial and Industrial Loans at commercial banks, as of September 30, 2009, represent only about 12 percent of the total assets of the banking system. In January of 2000, this number was about 18 percent. In the 1980s, the number was substantially higher. The makeup of commercial banks is changing. Is the current move to greater use of the bond market just one more step along the path to the remaking of the whole financial system?

Just a thought.

Monday, October 12, 2009

Dollar Weakness: The Debate Continues

Today, the editorial pages are full of discussion over the falling value of the dollar and what to do about it.

As could be expected, the fundamentalist preacher of a rigid, dogmatic Keynesianism, Paul Krugman, has his say in the New York Times this morning (see “Misguided Monetary Mentalities”: As is typical of someone that is locked into a reductionist view of the world, Krugman spends as much time calling people names as he does putting forth his dogma.

In the Financial Times we find two other points of view presented, views that are backed up by experience and historical support.

The first comment is by Roger Altman, who was in the Treasury Department during the Carter administration and was deputy US Treasury secretary in the Clinton administration. He also is an investment banker and private equity investor. Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies. And, as he says, it is not a pretty sight.

In his comments in the Financial Times, Altman recognizes that there are still short term economic ills that need attending to (see “How To Avoid Greenback Grief”, But, he argues, “the dismal deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”

Washington, right now, is in “a nearly impossible fiscal position.” Amen, to this.

And the problem is exacerbated because no one believes what America’s leaders are saying. In the other commentary in the Financial Times by Wolfgang Münchau (see “The Case for a Weaker Dollar”: the author states “I do not buy the strong-dollar pledges by Tim Geithner, Treasury secretary, and Larry Summers, director of the National Economic Council. They have to say that. It is the official policy line. The bond markets would go crazy otherwise”

But, Altman is right. There are two problems, the short run and the longer run. In the short run, attention must be paid to the weaknesses in the economy. What exactly the right policy is for this period of time is something for another post. However, there is a short run problem.

The difficulty is that financial market participants are not convinced that there is a longer-term policy. Altman states “Vague promises will not work.” And, it has been vague promises that we have been getting.

A firmer approach is needed! Altman argues that “for 2011 and beyond, the fiscal challenge is fearsome.” The United States must prepare a credible approach to its fiscal policy and present a unified front to the world that it will, in fact, bring the federal budget under control and live with that promise. Believability is crucial!

“It is true that Mr. Obama inherited the deficit. But, like Afghanistan, it is his responsibility now. Only he can forge a process for solving it.”

Mr. Münchau, in his commentary, goes through much of the argument that Altman makes, but then takes a more Euro-centric plea for a weaker dollar. To him a weaker dollar would allow for a greater balance of economic interests to be reached in the world today. This is consistent with the view that the European community play a stronger role in the Group of Twenty (the G-20) in order to achieve greater world co-operation. (See my post on this subject: A weak dollar, to this author, is desirable because it strengthens the world monetary system. This is a policy coming from the experience of the European Union. It is grounded in the history of that body.

It does not seem, to me, to be in the interest of the United States to adopt a “weak dollar” policy, although that seems to be the one that it has adopted. As Altman states, if Geithner or Summers or Bernanke advocated a weak dollar there would be a run for the exits and the dollar would experience a dramatic decline. No, this does not seem to me to be a realistic alternative.

Thus, we are back to current fiscal (and monetary) policy. I still go back to the statement written by Paul Volcker: “the most important price to a nation is the price of its currency.” The United States cannot afford a “weak dollar” policy.

Yet, almost by default, the Obama administration is taking that path. And, the “true believers”, like Krugman, shout out Amen! Here we have someone that has not even been the chair of the Princeton Economics Department, as Ben Bernanke was before he became the Chairman of the Board of Governors of the Federal Reserve System, preaching the Keynesian gospel to those in his tent and they too, respond, Amen!

There are those that have experienced the response of world financial markets to governments that follow irresponsible fiscal budget policies. Altman is one that was on the firing line. From the past fifty years, we do know that investors will not allow these policies to continue forever.

Now I will introduce my Keynesian argument, a tactic that most commentators do at least once in their articles these days. Keynes, when asked why he changed his mind as often as he did replied: “When the facts change, I change my mind. What do you do?”

It is remarkable that the followers of an individual that was as open to new information as Keynes was keep such a reductionist mindset. Perhaps it is because their only experience comes from reading a book.

Sunday, October 11, 2009

The Small Banks Are Not Doing Well

This is my monthly report on bank lending. Last month I reported on the continued absence of the commercial banking industry in loan markets. (See my post of September 10, 2009, “Bank Lending Stays on the Sidelines”: Bank lending was still absent during the most recent month, but there now seems to be a significant shift in the commercial banking industry: greater changes seem to be taking place in the smaller banks than we have seen during the current economic crisis.

This deterioration in the industry figures coincides with the increasing number of failures that are registering with the Federal Deposit Insurance Corp. (FDIC). This problem made the front page of the New York Times on Sunday: see “Failures of Small Banks Grow, Straining F. D. I. C.”, And, with more than 400 banks, almost all of them small ones, on the FDICs list of problem banks, we can expect the number of failures to grow and the bank lending figures to continue to shrink.

Total assets at commercial banks declined by $320 billion over the latest 13-week period according to the Federal Reserve. Of this total, the decline in assets over the last 5-week period was $250 billion indicating that the slide at commercial banks is not receding. Although the absolute decline in both periods of time was greater for the large banks, the percentage change was greater for the smaller banks.

What is most interesting is that the absolute decline in bank loans and leases in both periods was roughly the same for the large banks and the small banks. The decline in loans and leases over the 13-week period was $112 billion for large banks: $97 billion for small banks. However, for the last 5-week period the decline in this figure for small banks was $69 billion and $66 billion for large banks.

Commercial and Industrial loans, business loans, continued to drop at a rapid pace over the 13-week time span ($108 billion) as well as in the 5-week period ($50 billion). Relatively speaking the declines were equally divided between the large banks and the smaller banks.

The big difference between the different size banks comes in the area of real estate loans. Overall, real estate loans dropped by $113 billion over the last quarter, $48 billion over the last 5 weeks. But the decline in small banks was $68 billion for the last quarter and $38 billion over the last 5 weeks. The figures for large banks were $41 billion and $6.3 billion, respectively.

Here we find the startling difference: the small banks experienced most of the drop in real estate loans in commercial real estate loans. The drop in commercial real estate loans at small commercial banks was $36 billion for the full 13 weeks, but most of the decline came in the last 5-week period as these loans dropped by $24 billion during this latter time.

We have been hearing for months that there was going to be a problem in commercial real estate lending and that this problem was going to be centered in regional and local commercial banks. It looks as if this problem is finally hitting the banking system and is showing up in the numbers. This is an area that we are going to have to continue to watch for the economic difficulties in commercial real estate could continue to paralyze the smaller commercial banks for quite some time going forward. And, with the large number of problem banks identified by the FDIC being smaller institutions, we could see a rapid increase in the number of these institutions going under.

It should be noted that commercial real estate loans at large commercial banks actually increased over the past 13-week period and roughly held constant for the last five.

Another sign that these difficulties are piling up at the smaller commercial banks is the accumulation of cash assets at the smaller institutions and the timing of this build up. Cash assets at small commercial banks rose by $54 billion over the past 13 weeks. These assets increased by $48 billion over the last 5 weeks. That is, most of the increase in cash assets came at the time that time that the commercial real estate portfolio at these banks were declining the most.

The implication of this behavior is that the smaller banks are really starting to suffer and this is leading them to take a more-and-more conservative position in their balance sheets.

It should be noted that large commercial banks actually reduced their holdings of cash assets during this period. The decline over the 13-week period was about $5 billion, while over the last 5 weeks the decline was a whopping $70 billion. So, large banks build up their cash position over the first 8 weeks of the period and then reduced this position substantially over the last five.

The basic conclusion that can be drawn from this analysis is that the balance sheets of the commercial banking sector continue to shrink and with this shrinkage we see very little new borrowing taking place.

The big story this month is that the smaller banks in the country are really being hit with problems relating to bad assets. As a consequence, their balance sheets are suffering much more than their bigger counterparts and this is especially true when it comes to commercial real estate. Not only are the smaller banks reducing their exposure to commercial real estate loans, it appears as if this retraction from the lending markets is connected with an overall move by these banks to much more conservative lending practices.

Such a move would certainly not contribute to economic recovery, especially on Main Street. It is true that the larger banks are also contracting their balance sheets now, but they will tend to be the first ones to get back into lending when the time is right.

However, if the smaller banks change their “risk preferences” and become more “risk averse” during this period of restructuring it is highly unlikely that we will see them return anytime soon to contribute to an economic recovery in their geographic area. Since these organizations do not have the same access to resources as their larger counterparts, they will probably stay very conservative for an extended period of time.

Just one thing more. Last week Excess Reserves in the banking system reached an all-time high. For the two week period ending October 10, Excess Reserves averaged $918 billion! This, of course, is being allowed to happen by the Federal Reserve System as reserve balances at the Federal Reserve got close to the astronomical figure of $1.0 trillion! This figure only averaged $960 billion in the banking week ending October 7, but daily figures over the past two weeks did reach levels substantially higher.

The banking system is weak. It remains weak. Maybe some of the larger banks, the ones that got bailed out, are doing OK. This does not seem to be the case for the smaller banks. The FDIC knows this. The Federal Reserve knows this. It is not a comfortable situation!

Friday, October 9, 2009

The Beat Goes On Concerning the Dollar

More headlines this morning on the dollar strategy of the Obama administration. First, the main headline in the Wall Street Journal contains the blast: “U. S. Stands By as Dollar Falls.” (See Then the lead editorial follows up with “The Dollar Adrift.” (See

We also learn that the administration was worried enough about this type of thinking to send out Chairman Bernanke and presidential advisor Larry Summers to indicate how serious the Obama Administration is in maintaining a strong dollar.

Again the phrase “Watch the hips and not the lips” comes to mind. There is very little the administration can do right now to introduce fiscal responsibility into what they are proposing. The die has already been cast and no one sees a quick reversal of the administration’s mindset.

And, this is the problem. Time-after-time in the last half of the 20th century countries got themselves into predicaments like the one being faced by the United States. Uncontrolled government budgets with the promise of growing amounts of debt outstanding. Connected with this fiscal irresponsibility was the concern that central banks were really not independent of the national government. This is a situation not unlike that currently in place in the United States.

There were a number of books that came out in the late 1980s and early 1990s that basically asked the question: “Is national economic policy in the hands of unknown bankers and financial interests around the world?” The general scenario depicted was that of a national government that proposed large and growing budget deficits that seemed unsustainable without the support of a captive central bank that would monetize the debt as pressure on local interest rates grew. The reaction of these “unknown bankers and financial interests” was to sell the currency of that nation and force the national government to reverse direction and introduce fiscally responsible budgets.

The primary example of such a historical event was that which occurred during the presidency of François Mitterrand in France. The French Franc came under such pressure that Mitterrand backed off his budget proposals and became fiscally quite conservative and supported the independence of the French central bank.

The issue here is not so much the size of the deficits, although that can be important, or the ratio of the deficits to GDP, or the ratio of government debt to GDP. The question relates to whether or not the government is acting in a fiscally responsible way and will it continue to do so in the future. The side question to this is the independence of the central bank.

Absolute numbers are fine, but it is the direction those numbers are going that are the crucial concern.

The facts to me are as follows: since the 1960s, the United States government has erred on the side of fiscal ease in terms of the budgeting process. This has not been a Republican or a Democratic fault. The leadership in both parties has contributed to the stance of fiscal leniency that has existed within the federal government over this time period.

During this time the value of the dollar has trended downward, with one or two side-trips.

During the Bush (43) administration fiscal irresponsibility got way out-of-hand. The fiscal irresponsibility was supported by monetary irresponsibility. Thus, we get to the current situation.

Nothing has changed!

Financial markets are seeing the same behavior in the current administration that they observed in the previous administration. O’Neill, Snow, Paulson, and Geithner are all of one package. Greenspan and Bernanke are linked at the hip. And, the words coming out of the mouths of our leaders seem to be “pre-recorded.”

I have been trying to call attention to this issue for four or five years now. Very little attention has been paid to the issue even though at one time in the Bush (43) administration the value of the dollar had declined by about 40%.

The problem is that there are no good solutions to the situation when you let it go for that long. The obvious picture is that of a binge drinker that has been an alcoholic for a lengthy period of time. More and more people are going to get hurt and this will just add to the many that are feeling pain at the present time. But, that is what happens when people lose their discipline and become addicted.

The event we see over and over again in economics is that ultimately the system has to correct, either on its own or with the help of those that are a part of the system. And, the correction takes place sooner, or, later, but it eventually takes place. Unfortunately along the way, as with alcoholics, some of the best attempts of “friends” to cure the patient only end up exacerbating the situation.

Thursday, October 8, 2009

The Falling Dollar is Front Page News!

The front page of the Financial Times captures the concern that has been expressed by this writer for at least the last four years. Today we see “Obama’s critics pounce on falling dollar as fears grow over currency:” (

I don’t believe the focus is precisely spot on for the cause of the problem is not just Obama and the Obama administration. The Republicans are just as responsible for this crisis as is the current administration. And, the issue, to me, is not “whether or not” the dollar will remain a reserve currency. But, we will get to that.

The underlying problem is the fiscal irresponsibility of the United States government, with the exception of one administration, beginning in the 1960s. In the 1960-1968 period, the Gross Federal Debt increased at an annual rate of 2.8%. This was not bad but the die was cast. President Nixon (“We are all Keynesians now”) oversaw the beginning of excessively rapid growth rates for federal debt. The president that followed him continued these excesses. Between 1968 and 1978, the debt rose by 8.5% a year and between 1978 and 1992 the federal debt rose annually at a rate of 12.6%. During the 1992 to 2000 period the Gross Federal Debt rose by just 3.6% per year, but the budget was in a surplus by the end of the Clinton administration.

From March, 1973, right after the dollar was taken off the gold standard (again by John Maynard Keynes Nixon), until January 1992, the value of the dollar dropped by 14.5% against a basket of trade-weighted major currencies. This decline includes the period of time that Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System, a time of monetary tightening that actually brought the value of the dollar substantially above its March 1973 level. The drop in the value of the dollar from 1985 through 1992 was precipitous.

After rising by 16% over the 1992 to 2000 period, the value of the dollar plummeted during the fiscal slackness of the Bush (43) administration. By the end of this term in office the dollar was down 23%, but at one time the dollar had declined by about 40%. As the economic and financial crisis beginning in 2007 worsened there was a “flight to the dollar” for safety reasons and that is why the dollar was down only 23% at the end of the Bush (43) administration.

However, the decline has resumed. As the Financial Times points out, the value of the dollar against major currencies has fallen by 11.5% since the Obama administration has taken office.

Why? Because the Obama administration has created the expectation that the Gross Federal Debt will increase by at least the amount it increased annually in the 1968 to 1978 period!

And, although administration officials have said that they support a strong dollar (see my post of October 5: the current leadership in Washington, D. C. seems to have about the same credibility in the market place as did the leadership in the Bush (43) administration. “Watch the hips and not the lips!”

Furthermore, yesterday the Congressional Budget Office released figures on the deficit for the fiscal year ended September 2009. It was an all-time record of $1.4 trillion! And, the estimates for the upcoming years threaten this record.

As I said earlier, I am not that concerned about the United States dollar and its reserve status. That will be a lingering concern and will take care of itself. However, there are three things that I am worried about.

First, right now, there is no end in sight of large fiscal deficits. The concern of the marketplace is that deficits at this level are unsustainable. Furthermore, with all the reserves the Federal Reserve has put into the banking system, market participants are rightfully concerned that a large portion of these deficits will have to be monetized in order for the future deficits to be funded.

The last half of the 20th century was a period that international financial markets penalized national governments that created large deficits which where seemingly going to be monetized. The most notable example of this was the time when François Mitterrand was the leader of France and had to back off from excessive budget deficits and a government controlled central bank. But, there are many other examples.

The United States escaped this punishment, although the value of the dollar did decline substantially in the 1973-2008 period, because of its position in the world and the fact that the dollar was the only reserve currency in the world. The Volcker episode and the Clinton surplus postponed the day of reckoning, but the excessive budget deficits resumed with Bush (43). This time period may be at an end!

So, my first concern is that, in the face of continued excessive budget deficits, the value of the dollar will continue to decline. This is my fundamental scenario for the next five years or so.

Second, because of this, the bargaining power of the United States in the world will be weakened more than necessary. With the rise of the BRIC countries and the Euro-zone the relative position of the United States in the world is shrinking. (See my post of October 6: If the value of the dollar continues to decline, the bargaining power of the United States will be just that much less. This is not the way to world leadership.

Third, as the value of the dollar declines, American assets, physical assets like companies and resources, become cheaper. The “Buy America” plan can then accelerate from the pace that it has been on over the past eight years. A weaker dollar is nothing more than an invitation for foreign interests to purchase more and more of America.

The problem of the declining value of the dollar is real. Maybe we are at the stage where the political implications of the falling dollar will gather more attention. I can only hope so.

Tuesday, October 6, 2009

"Europe's Plot to take over the World"

There is an interesting article in this morning’s Financial Times (10/6): “Europe’s plot to take over the world” (see It was interesting to me because it has always seemed to me that the one who controls the writing of the agenda for a meeting is the one that most often ends up controlling the results that come out of the meeting.

And, according to my reading of Gideon Rachman’s comments, this is exactly what Europe is trying to do.

The thrust of Rachman’s argument ties in with my post of October 5 (see “What’s the dollar’s place in the new financial order”: where I discussed the changing nature of the world’s economic and financial relationships as observed in the changes occurring within the G-20 (and the lessening of importance of the G-7) and the jockeying of nations for position within the World Bank and the International Monetary Fund.

Whereas so much attention has been given to the rising strength of the BRIC countries of Brazil, Russia, India, and China, Rachman focuses on the bureaucratic reality of the evolving organizational structure of the G-20 itself. There are three points the author makes that I think are worthy of consideration.

First, Europe dominates the leadership of the G-20. Whereas Brazil, China, India, and the United States are represented by one leader each, the Europeans had eight positions at the conference table: Britain, France, Germany, Italy, Spain, the Netherlands, the president of the European Commission and the president of the European Council. Furthermore, the primary international civil servants at the meeting were Dominique Strass-Kahn, the head of the IMF, Pascal Lamy, the head of the World Trade Organization, and Mario Draghi, the head of the Financial Stability Board and these are all Europeans. The only other civil servant of similar weight was Robert Zoellick, the President of the World Bank, and an American.

Second, the Europeans seem to have a grasp of what is going on in the world than do the other participants at the G-20 conference. Rachman ties this back to the experience of the Europeans at European Union summits. The Europeans seem to be well advanced in the techniques of “bureaucratic paper-shuffling”, a process of introducing issues that they never let go of and which have important political implications in the upcoming years. Rachman argues that the European Union “advanced” from the very start “through small, apparently technical, steps focusing on economic issues.” The method used was to build the union through “the common management of common problems.”

Third, Rachman states that “the kernel of something new has been created. To understand its potential, it is worth going back to the Schuman Declaration of 1950, which started the process of European integration. ‘Europe,’ it said, ‘will not be made all at once, or according to a single plan. It will be built through concrete achievements, which first create a de facto solidarity.’”

The agenda is bigger than forming a G-3, a group of the United States, China and Europe. The world of the future cannot be organized by just these three territorial giants. The world of the future is either going to be integrated in a way that many might conceive of as inconceivable, or, the world is going to collapse into separate blocks with limited international trade and cooperation.

The model for this last scenario is the world at the start of the 20th century. World integration was discussed then for the world was open in the early 1900s in a way that has not been equaled since. Yet, the world conflict taking place in the 1910s split the nations apart leading up to conflicts of the 1920s and 1930s and the second world war that followed.

For the G-20 to help the evolution of the world into something approaching the first scenario the United States is going to have to adjust its attitude. Yes, the United States is still going to be the most powerful nation in the world, both economically and militarily, but it is going to have to change its belief that it can act, either economically or militarily, independently of the rest of the world.

If Rachman is even close to being correct on his view of how the G-20 might evolve, the United States is not going to be able to get away with continually allowing the value of the dollar to decline. The United States cannot have it all! Other countries must adjust their behavior as well (for example, the savings rate in China must fall), but the day is coming when the United States is going to have to accept the consequences of the irresponsible fiscal and monetary policy of the last eight years. And, the current administration cannot continue to add to these policy blunders going forward as they now seem to be doing.

Something new is happening. And, Nicolas Sarkozy and Angela Merkel, and other leaders in Europe are not going to let this opportunity pass them by. They will talk about cooperation with the United States, internationally, but they want the United States to get its shop in order. France, and Germany, and Britain, all went through the economic wringer in the last half of the 20th century as international financial markets took their governments to task for irresponsible fiscal policy and extremely loose monetary policy. They certainly are going to ask for the American government to exhibit a little more discipline going forward.

For people interested in the value of the United States dollar, my view is that the value of the dollar will continue to decline until the United States government stops talking about achieving a strong dollar while running up trillions and trillions of dollars in deficits and actually begins to act to achieve a strong dollar. How long this will take depends upon how much pressure is exerted in organizations like the G-20, the World Bank, the IMF, and elsewhere. This pressure will only continue to grow as the G-20 achieves more influence and these other international organizations are given more and more responsibility to oversee international financial markets. This is not going to happen, however, overnight.