Thursday, May 13, 2010

Government Deficits and Economic Activity

Something is different this time. There is high unemployment, about 10% in the United States, and the politicians are crying that the political issue is jobs, jobs, jobs.

The resultant policy should be to increase government spending and increase fiscal deficits. Right?

Doesn’t seem to be.

What’s going on?

The international financial community is in charge this time and they are exerting their will.

The international financial community is doing very well, thank you! Central banks have subsidized the big financial institutions and big financial players with their “Quantitative Easing.” These large institutions have plenty of money and so they are not running scared. And, this money can appear and disappear all over the world without being controlled. And, they are using the money. See “The Banks’ Perfect Quarter” at

In the past, the big institutions like JPMorgan, Goldman Sachs, and Bank of America and so on would have to wait until the Federal Reserve eased monetary policy by providing the financial markets with sufficient liquidity. Then their performance would begin to increase as the economic recovery progressed. But, even then, they never reached the heights that they are attaining now.

In addition, as the Federal Reserve began to stimulate the economy, it kept interest rates in line. That is, the Fed kept interest rates low, but did not let interest rate spreads get excessively “out-of-line” because that might cause the Fed to lose the sense of the financial markets they were operating within. The idea was to loosen but keep the market “taut” so that it could continue to monitor where market pressures were coming from.

The concept of “taut” came from sailing: if I am sailing a boat and I have a small craft attached to the boat with a rope, the idea is to keep the rope “taut” but not too “tight” or not too “loose.” The reason being is that if the rope is “taut” you know where the small craft is. If the rope is too “loose” you do not know where the small craft is; if the rope is too “tight” the rope can snap if the small craft is subject to another force. You want the rope attachment to maintain just the right amount of pressure, so that you know where the small boat is but not too tight so that the small boat breaks away from your ship and you lose it.

But, keeping money markets taut did not provide many trading opportunities, at least, not trading opportunities like the ones that exist today.

Today large financial institutions, internationally, are facing a bonanza market for raking in huge profits. The central banks have provided them with this opportunity to trade and it is almost risk free. And, the central banks have let the markets know that this situation will exist for an extended period of time! Wow!

Putting this in prospective, however, we see that the European Union and the governments of the U. K. and the U. S. have, over the past 50 years, created an inflationary environment that has created massive financial institutions that thrive on trading, not on what was formerly known as banking. These governmental institutions have, themselves, led the move toward financial innovation through the creations of Fannie Mae, Freddie Mac, Ginnie Mae, and the Mortgage-backed securities. These were not private sector initiatives.

The incentives that existed in this world of credit inflation promoted trading and arbitrage and further innovation. Forget the fact that the profits that come from trading activities is a “zero-sum” game in which there is someone that loses exactly what someone else wins.

Trading worked for the “big guys” and they learned how to do it very well.

That is exactly what is going on right now. The large, international financial interests are scouring the world in search of “targets”. And, no one is a better target than a government that has lived way beyond its means for many years. But, governments like these are crying “foul” because they feel they are being taken advantage of even though they were the ones that got their country in the position it is in through long periods of undisciplined, profligate behavior.

What is different this time is that these huge, financial giants are being subsidized by the central banks and they are traveling the world to use what has been given them.

I believe that we will look back on this time and say that the Obama Administration was perhaps the largest contributor to an unequal distribution of income the world has seen.

How can I say this? Well, we are seeing a major bifurcation of the world today, more so than the one that existed relative to the Bush 43 tax cuts. Major amounts of wealth are being created in most major financial markets. And, the traders love volatility. These people are getting everything they want and need. So are other many firms in other areas or sectors of the market.

But, those unemployed are not building up their wealth, and those people who are underemployed are not building up their wealth, and those individuals that are foreclosed on are not building up their wealth, and the small businesses that are going into bankruptcy or cannot get a loan from their local bank are not building up their wealth.

Seems a little unfair, doesn’t it?

The Federal Reserve states that it is keeping interest rates low, waiting for the economic pickup to spread into the distressed sectors of the economy. The longer the Fed holds to this stance and explains it’s reasoning in terms recovering economic growth, the longer I look for other reasons for such a policy.

My conclusion: there are many banks that are smaller than the biggest 25 that are in deep trouble. In addition, there are many businesses that are in deep trouble that might even put these “less than giant” banks in more trouble. Also, the Fed quickly encouraged the European Central Bank to move to “Quantitative Easing” and then supported this move by re-opening the swap arrangements the Fed had with other central banks. The rumor is that this re-opening of the swap window will postpone even further the “extended period” of time that the Fed will keep its target for the Federal Funds rate at its current level. Seems like we have a massive “solvency problem” in the world and not just in the United States.

What is different now? Large financial institutions around the world have enormous amounts of funds they can deal in and excessively large interest rates spreads to work with and large amounts of market volatility to trade off of and a promise by the central banks that interest rate risk will not be a problem. Given this ammunition, governments that are or have been undisciplined in running their fiscal affairs, are “sitting ducks” for these traders.

So governments are being forced to reduce spending and not increase it, to reduce deficits and not increase them. To get re-elected politicians may want to focus on jobs, jobs, jobs and health care programs and other social welfare initiatives. However, they may not be able to do that this time!

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