Sunday, February 28, 2010

Bernanke's Testimony: Reading Between the Lines

Chairman Ben Bernanke gave testimony this past week on the Fed’s semiannual report on monetary policy to the United States Congress. I believe that Mr. Bernanke’s report can be summarized in two sentences. First, the United States economy is recovering, but the recovery will be quite slow. Second, the Federal Reserve will continue to keep its interest rate target at current levels.

This testimony came during a time in which the Federal Reserve has been attempting to reveal and explain how it plans to exit from its current position, a position that includes a banking system with almost $1.2 trillion in excess reserves. Fundamentally, the Fed is ready to begin to “undo” what it has done over the last year and a half. (See, for example, my posts, and

The implicit contradiction in all of this is that the Fed’s “undoing” is to take place as the economy recovers, but, the Chairman in not willing give a hint as to when the economy will be strong enough to allow the Federal Reserve to start raising its current target level of the Federal Funds rate.

To me, the message that is being conveyed between the lines is that there are still some things so wrong with the economy (that the Federal Reserve is aware of) that the Fed cannot take a chance, even give a hint of a chance, that the target Fed Funds rate will be raised.

And, what is the basis of this fear?

Will, we can start with the state of the banking system. The Federal Deposit Insurance Corporation (FDIC) produced its quarterly report last week and indicated that 702 commercial banks were now on the list of problem banks at the end of 2009. This is up from a total of 552 banks that were on the problem list at the end of September 2009. And, the FDIC closed 2 to 3 banks per week during the fourth quarter of the year.

Given the current list, the expectation is that about 235 banks, one-third of the current total on the problem list, will close over the next 12 to 18 months, a rate of 3 to 4.5 banks per week for this time period.

Remember that there are about 8,000 commercial banks in the United States, with the top 25 accounting for well over one-half the assets in the banking system. Thus, the banks that are failing tend to be small and they tend to be “local” in nature and a failure can cause quite a disruption on “Main Street.”

The problems in the banking system go deep. The insured banks charged off 2.9% of outstanding loans in the fourth quarter of 2009. This is the largest charge off rate in the 75-year history of the FDIC.

At the end of the fourth quarter, 5.4% of all loans were at least 90 days past due, a near-term high. Specific areas of the loan portfolios are showing a large amount of stress. For example, data on construction loans to build single-family loans indicate that about 40% of the loans are either delinquent or have totally been written off. Mortgage loans still remain a problem where about 12.5% of the loans outstanding are past due.

Commercial real estate loans are the looming giant in terms of providing dark clouds for future bank loan performance. Elizabeth Warren, head of the Congressional team that oversees the TARP funds has stated that about 3,000 commercial banks face the possibility of a “tidal wave” of commercial real estate loan problems. At the end of the fourth quarter of 2009, over 6% of these loans were classified as a problem in some way.

Before these problem loan areas can be resolved, the economy must begin to get stronger, people must return to good paying jobs, and real estate values must cease falling. Discouraged workers must return to the workforce and manufacturing firms must increase the utilization of their resources. There is little evidence to indicate that these factors are, in fact, improving to the extent needed to strengthen the loan portfolios of commercial banks.

The Fed, obviously, has a good seat to observe all of these facts. And, I believe, they are very, very concerned. And, I also believe, that bankers are very, very concerned.


Because the bankers are sitting on their hands and holding onto any type of asset that will not deteriorate in value…cash or deposits at Federal Reserve banks and short term government securities.

Yes, we can say that businesses and homeowners with very good credit are not borrowing. And, we can say that consumers are not borrowing.

I don’t think this is the answer.

I believe that this situation is more like the one that was experienced in the period around 1937. Commercial banks were holding a lot of excess reserves at that time too. Also, there was no lending to speak of during that period. And, the Federal Reserve raised reserve requirements to “sop up” those excess reserves.

And, what did the banks do at that time? They withdrew even further. The banks wanted those excess reserves. They did not want to lend them out. They just wanted the protection and security of having those reserves in their hands. By taking the reserves away, the Fed caused the banks to restrict credit even further in order to return excess reserves to a level more consistent with the safety the banks wanted on their balance sheets.

Ben Bernanke, the student of the 1930s, knows what happened back then. He is, therefore, fighting on two fronts in the current climate. First, there are those that are afraid that the excess reserves the Fed has injected into the banking system will eventually be lent out and this will cause the money stock to expand and this, given the size of the $1.2 trillion level of excess reserves, will result in a higher than desired level of inflation in the United States economy.

Bernanke and the Fed must do enough, talking and maneuvering, to satisfy this crowd. Hence the exit strategy and the efforts to get Federal Reserve’s operations back into a more normal environment.

Second, however, is the fear that the excess reserves in the banking system are “desired” by the banking system and any effort to substantially reduce them in the near future could lead to a further contraction in the banking system that would ensure a “double-dip” Great Recession.

My guess is that Bernanke is not willing to take a risk on generating a further contraction in the banking system by removing bank reserves at this time. This, to me, is the message between the lines of the Chairman’s testimony in front of Congress this past week.

The Fed is ready for the great “undoing” of its balance sheet, but is not going to begin this “undoing” until it is sure that the commercial banks are willing to let go of the $1.2 trillion in excess reserves.

Wednesday, February 24, 2010

The Fed and the Treasury Maneuver

Yesterday, the Treasury announced that it will borrow $200 billion from the Federal Reserve and leave the cash on deposit with the Fed. As it initially goes on the Fed’s balance sheet the transaction is a wash.

The Treasury has two accounts that show up on the Federal Reserve sources and uses statement. (These data can be found on the Federal Reserve release H. 4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.) The first is called the U. S. Treasury, General Account, and this is primarily used to manage the Treasury’s cash position and flow of expenditures and tax receipts.

When taxes are collected, the funds flow into government tax and loan accounts at commercial banks. This transfer of funds from the private sector to the public sector causes no disruption to bank reserves because the funds stay in the banking system. (The data on U. S. Government deposits at commercial banks can be obtained in the Federal Reserve release H.6, Money Stock measures, Table 7.)

The Treasury does not draw funds out of its accounts in the commercial banking system until it begins to make payments out of its balance in the General Account at the Federal Reserve so as to cause as little disruption to the reserves held in the banking system. That is, government funds come out of the banking system and go into the Fed account, but the Fed account is being drawn down with payments to the private sector that will be deposited into commercial bank deposits.

For example, government demand deposits at commercial banks averaged $1.3 billion in December 2009. However, in January, as tax collections flowed into the government, these balances rose to $1.6 billion in the banking week ending January 4 and increased to $2.3 billion, $4.3 billion, and $5.1 billion, in the next three weeks, respectively. In the banking week ending February 1 the balances fell to $1.8 billion and then dropped to $1.3 billion in the following week as the Treasury paid out funds to the private sector.

These movements just represent operational procedures that have been established over the years to avoid major movements of funds into and out of governmental accounts. Hence, this is called the “General Account.”

On September 17, 2008, the Treasury Department announced something called the “Supplementary Financing Program”. Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

Thus, the Fed’s holdings of U. S. Treasury holdings would go up on the “asset” side of the balance sheet (this being a debt of the Treasury) and the U. S. Treasury Supplementary Financing Account would rise on the “liability” side of the balance sheet (this being an asset of the Treasury).

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.

On February 17, 2010, the Federal Reserve had a little less than $800 billion of U. S. Treasury securities on its balance sheet. Commercial bank reserve balances, mostly excess reserves, with Federal Reserve banks stood at slightly more than $1.2 trillion.

If the Fed is going to remove reserves from the banking system by open market sales of U. S. Treasury securities, then it needs to have a sufficient amount of them on hand to be a credible seller of these securities.

Although the Federal Reserve is expected to have $1.25 trillion of mortgage-backed securities in its portfolio in March, it is expected that the Fed will not want to sell these off in any large amounts because it does not want to destabilize the mortgage market and force mortgage rates to rise too fast.

Also, the Fed’s portfolio of Federal Agency debt securities is too small, about $165 billion, to help much in any exit strategy.

Thus, adding $200 billion to the Fed’s portfolio of U. S. Treasury securities will bring the total Treasury securities on hand to approximately $1.0 trillion and this may be sufficient to allow the Fed to “undo” its portfolio and reduce the amount of excess reserves in the banking system without having to sell mortgage-backed securities. That is, if the Treasury does not write any checks against its Supplementary Financing Account.

The Fed is attempting to get as much ammunition in place before the “battle to exit” begins. Over the past several months and weeks, the Federal Reserve has moved to position itself to “undo” its massive injection of reserves into the banking system. Last week it announced that it was returning the “primary loan” function to its pre-crisis operating procedures. (See my “Back to Business at the Fed”: This week, the Treasury is pumping up its Supplemental Financing Account. Next week, well who knows.

This process will continue over the following weeks as the Fed does all it can to prepare for its “undoing.”

Tuesday, February 23, 2010

Commercial Banks Continue to Struggle

The Federal Deposit Insurance Corp. presented us with the new list of problem banks. As of December 31, 2009, there were 702 commercial banks on the problem list of the FDIC. At the end of the third quarter of last year, the total stood at 552. If 3 to 4 banks failed every week, then roughly 39 to 52 banks failed last quarter. Thus, at least 200 new names were added to the list in the fourth quarter about 36% of the number on the list at the end of the third quarter.
The rule of thumb that I have heard used on bank failures is that approximately one-third of the banks on the problem list will fail over the next 12 to 18 months. If this holds true then about 234 banks will fail during this time period, roughly an average of 3 to 4.5 banks per week!

Right now the quarterly net loan charge-off rate and the number of loans at least 3 months past due were at the highest levels ever recorded during the 26 years that these data have been collected. As I have said many times, the important thing is that these charge offs are occurring in on orderly manner. The banks seem to be able to absorb these loses without substantial disruption to their operations. Also, the closing of so many banks by the FDIC seems to be taking place in an orderly manner without substantial disruption to the banking business.

The banking system, as a whole, continues to be risk-averse at this time as banks continue to reduce the amount of loans of their books. In this the FDIC data are consistent with the call report data released by the Federal Reserve in that the total loan balances on the books of the banking system continue to decline.

The economy may be recovering but the outlook for the banking industry remains dark. Other news released this morning point to a continued dismal future. The Gallup organization released information that suggested that 20% of all workers in the United States are underemployed.
This is a larger number than put out by the labor department and is attributed to the fact that the Gallup data are not seasonally adjusted.

However, this does not seem inconsistent to me with the information, also released this morning, that consumer confidence dropped precipitously in February from a revised 56.5 to 46.0. Furthermore, consumer expectations for economic activity over the next six months fell from a revised 77.3 to 63.8. In addition, the people that are expecting more jobs in the near future fell while the proportion of those expecting fewer jobs rose. More than 17% of the respondents expected their incomes to fall over the next six months, while 9.5% expected their incomes to increase.

This is not good information to the banks as foreclosures and bankruptcies continue to increase. Furthermore, there is more and more information about people walking away from properties after allowing their loans to go delinquent, even though they might be able to pay the loans. It seems as if more people are arguing that the decision to abandon a house is a “business decision” and not a decision about whether or not to leave a “home.” If the price of the “home” is less than the mortgage, then the “home” becomes a “house” and is abandonable.

But, banks, and others, still face several other serious shortfalls in the future. The commercial real estate situation is well known and Elizabeth Warren, head of Congressional oversight on the TARP funds has claimed that 3,000 commercial banks face a potential torrent of defaults on commercial properties.

State governments continue to teeter on the fiscal edge as state tax collections declined in the fourth quarter of 2009 for the fifth quarter in a row. State governors, meeting in Washington, D. C. this last weekend, warned Washington, as well as the nation, that the fiscal year beginning in July 2010 will be the most difficult of any met so far during this financial and economic crisis.

City and municipal governments also have their backs against the wall with many of them now considering the pursuit of Chapter 9 bankruptcy. This, too, is not a good sign for the banking community.

Both the cities and the states are soliciting Washington, D. C. for more and more stimulus money cover their needs. They obviously do not see their salvation coming from the private sector. But, what about the federal government? Is there any hope here?

One answer comes from the likes of Joe Stiglitz, Paul Krugman, and others with a similar leaning: the federal government has erred on the side of not spending enough. Washington just has to spend more and more and more until jobs stabilize, incomes begin to rise, and confidence turns upward once again.

The other side? The other side is represented by Bob Barro who has another op-ed piece in the Wall Street Journal this morning. (See Barro has contended all alone that the spending and taxing multipliers used by the Obama economics team far overstates the real effect that the government fiscal stimulus program has on the economy. To quote his results: “Viewed over five years, the fiscal stimulus package is a way to get an extra $600 billion in public spending at the cost of $900 billion in private expenditures. This is a bad deal.”

Add to this the fact that the deposit insurance fund fell by $12.6 billion in the fourth quarter of 2009 to $20.9 billion; and the only proposal on the table being to assess the banking system to replenish the fund. It looks inevitable that the federal government will have to provide some sort of assistance to help keep the fund solvent. Oh, and then there is the upcoming costs related to Fannie Mae and Freddie Mac ( But, the addition to the deficit from these outflows relates to things that have happened in the past, there is no stimulus or job creation here but some fairly sizable price tags.

None of this is good news for the banking system. Is it possible for the list of problem banks to reach 1,000? Probably not at the end of the first quarter of 2010, but maybe in the second quarter. Remember that there are only slightly more than 8,000 commercial banks in this country. Can you imagine if one out of every eight banks were on the problem list?

Monday, February 22, 2010

Inflation is in the News

There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.

This morning we see an opinion piece by Wolfgang Münchau in the Financial Times,; an article by Sewell Chan in The New York Times,; and another article by Jon Hilsenrath in the Wall Street Journal, All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.

The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”

In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.

The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!

It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.

The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.

Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.

The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”

The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.

The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.

Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.

Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.

The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.

I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.

The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.

This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.

Friday, February 19, 2010

Getting Back to Business at the Fed

The Federal Reserve, of course, garnered a lot of press headlines today because of the announcement made yesterday that it is raising the discount rate on primary credit from 50 basis points to 75 basis points. This action will become effective today.

Note that this change came at the request of the boards of directors of the 12 Federal Reserve Banks who petition the Board of Governors for a change in this discount rate. Technically, at least, the borrowers of primary credit from the Federal Reserve System still borrow from each district bank which has its own discount rate. Thus, for a district bank to change the rate it charges on loans at its discount window, it must petition the Board of Governors. This is the archaic structure still present in the rules of the Federal Reserve for the conduct of business at the discount window in each district bank.

In addition, the Fed reduced the “typical maximum maturity f,or primary credit loans” to overnight. Earlier, as announced on November 17, 2009 and implemented on January 14, 2010, the Fed had moved to “normalize” the terms on primary credit by reducing the typical maximum maturity to 28 days.

The Fed in trying to get back to business as it was before the financial crisis. This is a part of the Fed’s “undoing.” See my Federal Reserve Exit Watch,, and my Fed “undoing” post,

The basic function of the discount window in normal times is to serve as an “escape valve” for commercial banks that need “temporary” funds to cover an unexpected need. The discount rate usually costs more than other sources of funds and borrowing is discouraged by the amount of time a bank can borrow from the Fed. But, that is the whole purpose of the “window”: it is a “last resort” for banks to relieve short run pressures on their balance sheets.

In times of crisis, the discount window is, in a sense, “thrown open” to provide liquidity to the market and overcome short term liquidity crises. A classic example of such a situation was the August 1987 liquidity crisis faced by a newly appointed Fed Chairman Alan Greenspan.

Of course, the 2007-2009 financial crises required something more and the opening of the discount window was on much more liberal terms in order to prevent the crisis from worsening.

Now, “The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds.”

The Fed is trying to get back to “business as usual”. As described in the two posts mentioned above, the Fed seems to be separating its balance sheet into two parts: a balance sheet of a “traditional” central bank and a balance sheet composed of the short-term tools that were used to meet the special needs of commercial banks and the financial markets during the time of crisis.

So, these changes “are intended as a further normalization of the Federal Reserve’s lending facilities.” They are just an integral part of the Fed’s “undoing.”

In terms of the special tools, one part of the Fed’s crisis response was the implementation of the Term Auction Facility (TAF) on December 12, 2007. The Fed announced yesterday that the final TAF auction will be on March 8, 2010. This facility played an especially important role in providing liquidity to commercial banks during the financial crisis. It was seen as getting reserves to the banks that needed them more quickly than “normal” open market operations could. Furthermore, the funds were provided on a “term” basis. The Fed began to reduce the size of the auctions on June 25, 2009 and has continued to allow this line item to phase out as the year progressed. This “phasing out” is occurring with respect to other “special tools” as well.

We will continue to see more of these adjustments as the spring and summer of 2010 pass by. Market participants should not be “shocked” by these changes. They are a part of the attempt to return to a “more normal” basis for operations.

In my mind, eyes need to be focused more on what the Federal Reserve does with its securities portfolio, whether or not it is engaging in reverse repurchase agreements, and what it does to the pricing of the excess reserves the banks have on deposit at the Federal Reserve banks.

My guess is that movements will be made in these items before we see changes taking place in target interest rates. Acting in this way is more consistent with the past operations where the Fed has encouraged market conditions to change and then moved rates in line with the changes that already exist within the market. Historically, the Fed has preferred incremental moves to “market shocks”.

With market sensitivities being so “on edge” and so potentially volatile and with the “undoing” being such a massive job, the Fed cannot afford to have market emotions swing to extremes all the time. This would only make the Fed’s job that much harder.

Expect the Federal Reserve to be more subtle than that. The leaders at the Fed have a monumental task in front of them. I am sure that they hope that their “undoing” will not prove to be the undoing of all that has been accomplished up to this point in time.

Thursday, February 18, 2010

The Two-Sided Recovery

The stories continue to come in that the recovery is proceeding. Just looking at the morning papers gives one a feeling that things are on the mend. Note these three stories that appeared in the Wall Street Journal today.

One can even look at the charts of financial data from the Federal Reserve Bank of St. Louis and observe that the Great Recession ended in July 2009!

Yet, there is another side to the recovery that keeps us uncomfortable about where we are going. And, it is this other side to the story that creates the uncertainties of what will ultimately take place over the next five to ten years. It is this uncertainty that, I believe, is currently preventing many to commit more aggressively to the future.

This other side, the dark side, is perplexing government policy makers and sending off mixed signals to the private sector. The economy is recovering, but we need more fiscal stimulus, maybe another $100 billion package, to speed things along the way. The Federal Reserve needs to begin selling securities into the open market and just get back to a portfolio of US Treasury securities, but the banking system…well at least the small- and medium-sized banks…still has major difficulties to overcome, and, the economy is still proving extremely fragile. Starting to tighten up on monetary policy could produce major problems for the banks and for the economy recovery: when should the Fed begin removing excess reserves from the banking system.

Giving into the dark side, however, presents other problems. The federal deficit is projected to be more than $1.0 trillion per year for quite a few years, but this does not include any additional stimulus that might be approved and it assumes that a health care program will not add “one dime” to the deficit. Furthermore, it does not include major environmental programs, energy programs, and other initiatives that the Obama administration wants to “stay the course” on.

Also, questions remain about the Federal Reserve’s “undoing”. With more than $1.1 trillion in excess reserves in the banking system, concern still remains that these excess reserves can be removed before the banking system generates a lending bubble and excessive growth in money and credit. And, this “undoing” is to take place during a decade in which the federal debt may grow by $15 trillion! There is no historical precedent available to give us comfort that the Federal Reserve can “undo” what has been done and what apparently will be done without inflation raising its ugly head.

Yet, inflation is the prescription for the easing of debt burdens, and there certainly are enough debt burdens around. Greece, Spain, Italy, Portugal, and other sovereign nations have garnered a lot of press in recent weeks about their debt burdens.

But, we don’t stop there. Closer to home, news about debt problems continue to surface. Over the past month, more and more stories have hit the newspapers about the fiscal problems that states are having meeting their debt obligations. More and more information is coming out about the difficulties that municipalities are having. Note in the Wall Street Journal this morning, “Muni Threat: Cities Weigh Chapter 9”: Bankruptcy is certainly a way to deleverage!

Deleveraging continues in the private sector. Businesses and households continue to reduce debt loads, willingly or unwillingly, through foreclosure or bankruptcy or by paying down debt as cash flows allow. The bad news is that this deleveraging still seems to have quite a ways to go before it comes to an end. The good news is that this deleveraging is working itself out without major disruptions to the financial system. Most institutions recognize that a major debt problem still exists and that means, hopefully, that there will not be any surprise shocks in the future.

This brings us back to the problem of sovereign debt. The bind here is that nations do not believe that they can begin a process of slowing down debt growth let alone deleverage when their economies are still fragile and in need of fiscal stimulus.

It is here that we get into the conflicting “views of the world” that are clouding the decision making at the present time. The reigning philosophy in governmental circles, as well as in the academic and intellectual world, is that government spending and debt creation is needed to sustain the economic recovery and regain more robust growth in the future. Others are not convinced that this is the case. In this latter view, arguments are made that the current path being followed by many governments, ala’ Greece, are not sustainable and are, ultimately, self-destructive.

For now, for the United States, the betting is on continued fiscal stimulus, substantial deficits, and a Federal Reserve that is unable to “undo” what it has already done. This will be the foundation of a credit inflation that will be consistent with the economic policies of the federal government for most of the past fifty years or so. These policies are the ones that brought about an 83% decline in the purchasing power of the dollar over this time period.

But, as I continue to argue, following this kind of policy has created other problems for the United States (and other Western countries). It has resulted in the growth of under-employment and unused industrial capacity. And, it has resulted in a growing bifurcation of the society.

On this point, the latest edition of The Economist magazine contains the review of an interesting book: “The Pinch: How the Baby Boomers Took their Children’s Future—and Why They Should Give it Back” by David Willetts.” The book focuses on the chasm that has been developing in society over the past 50 years or so, a chasm between the older part of society and the younger part, between the more educated and the less educated, between those that have accumulated assets, primarily housing, and those that have not. .

Willetts argues that the “Baby Boomers” had a “piggy bank”, their own home. Though government help or subsidy or inflation, the “Boomers” were able to own a home (and possibly a second home), build up wealth by means of rising housing prices, and then even borrow against their homes to finance a comfortable old age. The “Non-Boomers” and the younger generation have not been able to access this “wealth machine”, have been unable to finance many of the things the older generation were able to finance, including more education, and face the fact that they may have to work later into life. These individuals, especially the less educated, have had to remain in “legacy” jobs and industries. The bottom line is that these structural problems will have to be addressed, sooner or later.

My concern is that although the economic recovery seems to be proceeding. The forces driving the recovery are not going toward reducing or eliminating the imbalances that have been built up in the economy over the past 50 years. Furthermore, the policymakers seem to be putting themselves into boxes that have very negative implications for the future. As a consequence, we are, at best, heading into an economic and financial future that is not different from the past: credit inflation, and further underemployment, unused economic resources and societal divisions.

Monday, February 15, 2010

Economy Still Seeks Liquidity, but Move Slows Down

Over the past sixteen months or so, since September 2008, people and businesses have moved a great deal of their wealth into very short-term assets. This continued into January 2010, but the pace has tapered off.

In September 2009, currency in the hands of the public was more than 10% higher than it was one year earlier. Demand deposits at domestically chartered commercial banks were almost 20% larger than in the same month in 2008, and other checkable deposits at commercial banks and thrift institutions were about 16% higher. Movements into these accounts represented the flight to liquidity in the United States economy that accompanied the financial crisis.

Funds also flowed into savings accounts as well: these accounts rose by 14.5%. However, small-denomination time deposits dropped by about 5% during this time and retail money funds fell by almost 16%.

There was also a shift in funds from all thrift institutions except credit unions into commercial banks over this time period.

The move into more liquid accounts continued into January 2010, but at a slower pace than was seen early last fall. For example, NOW accounts and ATS balances at both commercial banks and thrift institutions rose by 20% in the year ending this January.

Also, savings deposits at commercial banks and thrift institutions continued to rise: they rose by more than 15% from January 2009 to January 2010. (Note that currency in circulation increased over this time period at a more normal 4% annual rate and demand deposits at commercial banks rose only by 1.6%.)

However, the withdrawal of funds from small-denomination time deposits and from retail money funds accelerated. The former deposits dropped at a 21% rate over the twelve months ending in January while the latter fell by almost 27%.

Again, the evidence pointed to a shift in deposits from thrift institutions to commercial banks. Overall, at thrift institutions all checkable deposits and time and savings accounts rose by only 1.7% in the year ending January 2010. Taking credit unions out of this total and you get an actual decline at all other thrift institutions. At commercial banks, the total of these accounts rose in excess of 9%.

This shift in funds has had a very dramatic impact on the two narrow measures of the money stock. In January 2010, the year-over-year rate of growth of the narrow, M1, measure of the money stock rose by 6.5%: the year-over-year rate of growth of the broader, M2, measure of the money stock increased by just 1.9%.

These rates of growth are substantially less than they were in the middle of 2009, when the growth rate of the M1 measure was in excess of 17% and in the M2 measure was around 9%. These numbers were, of course, not generated by the actions of the Federal Reserve but by the movement of assets in the economy as the economy de-leveraged and moved into more liquid assets.

The fact that these rates of increase were not driven by the Federal Reserve can be shown in the January figures. The rates of increase in the M1 money stock (6.5%) and in the M2 money stock (1.9%), bear no relation to the injection of reserves into the banking system that has taken place since September 2008.

If we look at the year-over-year rates of growth for January 2010, we observe that total reserves in the banking system rose by over 29% and that the monetary base increased by almost 17%. Obviously, the reserves that have been forced into the banking system have not found their way into loans and thereby into deposits. This, of course, is why the excess reserves of the banking system remain so high, reaching a new average high of $1.119 trillion in the two banking weeks ending February 10, 2010.

The behavior of the banks is confirmed in the numbers produced by the Federal Reserve on the commercial banks. The banking industry continues to shrink in terms of asset size and the amount of bank loans, every kind of bank loan, is dropping. The commercial banking industry, on net, is just not lending. See and

Historically, a 2% growth rate for the M2 measure of the money stock is incapable of producing economic growth. In fact, to sustain this number would imply a deflationary economy.

However, there are two contradictory things going on here. First, as mentioned above, the growth rate in BOTH measures of the money stock over the past year or so has been generated by people and businesses de-leveraging, becoming more liquid, and moving existing assets around. This is the deflationary scenario.

The growth rates in BOTH measures of the money stock have not been achieved through Federal Reserve actions. The reason is, of course, that the banks aren’t lending! If the banks continue to stay on the sidelines, money stock growth will continue to be anemic…at best!

Second, the inflationary scenario, the Fed has injected over $1.1 trillion of excess reserves into the banking system. A major concern is whether or not the Fed can unwind this injection without having repercussions on bank lending, money stock growth, and inflation. We can only hope that the Fed is successful in its “undoing.” See

We need to keep an eye on these figures because it is going to be important to observe how people are allocating their assets and how they are spending their money. Couple this with information on lending in the banking system and we should get some idea of the health of small- and medium-sized business, the hoped-for foundation of an economic recovery.

Sunday, February 14, 2010

The Banking System Continues to Shrink

According to the latest statistics of the Federal Reserve on the banking system, the banking system, as a whole, continues to shrink. Over the last 12 months, the total assets of all commercial banks in the United States banking system shrank by $560 billion or by about 5%. In the three months ending in January 2010, total bank assets dropped about $170 billion, with about $40 billion of the drop coming in January, itself.

Concern is still focused on the small- to medium-sized banks. Last week additional attention was focused specifically on 3,000 of these banks in terms of the problem loans they have on their books. (

Elizabeth Warren, who heads the TARP oversight panel, is quoted as saying: “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

There are a little more than 8,000 banks in the United States banking system and they had about $11.7 trillion in assets in January 2010. The largest 25 banks in terms of asset size held about $6.7 trillion in assets or about 57% of the assets in the banking system. “Small” domestically chartered banks held about $3.6 trillion in assets or around 31% of the assets in the United States banking system while the assets of foreign-related institutions amount to $1.4 trillion or 12% of the assets of the banking system.

So, there are a very large number of very small banking institutions that make up only about one-third of the bank assets in the country.

The total assets at these “small” banks dropped by $42 billion in January 2010, although by only about $14 billion in the last three months. The more interesting thing, however, is in the composition of this decline.

During this time period the loans and leases at these “small” banks fell by $20 billion in January and by $36 billion over the past three months. These banks are just not lending!

The primary decline came in real estate loans: they dropped $12 billion in January and $22 billion over the last quarter. We have, of course, heard of the problems these banks are facing with respect to commercial real estate loans and the numbers support this concern. At the “small” banks, commercial real estate loans fell by $10 billion in January and by $21 billion since October 2009.

Things were not very robust in other lending areas, but the declines reported in these other loans were not nearly so dramatic. I will call attention to the fact that consumer loans dropped by about $5 billion at these small institutions in January, a rather substantial decline.

Another indication of the difficulties “small” banks were facing is the decline in the securities portfolios at these institutions. Securities dropped by $31 billion in January, a time in which the “large” banks and the “foreign-related” banks both added securities to their asset portfolios.

And, where were the “small” banks building up their assets? In Cash Assets! Cash assets at “small” banks rose by $8 billion in January, and the increase totaled $21 billion over the last three months.

The smaller banks in the United States are putting more and more assets into cash as their balance sheets and loan balances shrink. This certainty supports the idea that many of these banks are in severe straits.

Large banks, on the other hand, actually reduced their holdings of cash assets in January by a whopping $71 billion. Over the past three months they reduced they cash assets by $118 billion.

These banks were not putting funds into loans, however. They were putting funds into their securities portfolio, adding $17 billion in January and increasing the portfolio by $60 billion over the last three months. The vast majority of these funds went into United States Treasury securities or federal agency securities. One can certainly sense a riskless arbitrage-type of strategy going on here.

Loans and leases at these large banks actually dropped in January by $46 billion, being spread fairly broadly over Commercial and Industrial loans (dropping $11 billion), Real Estate loans (dropping $18 billion) and Consumer loans (dropping $11 billion). It should be noted that in the consumer loan area there have been massive declines in credit card and revolving credit, $14 billion in January alone, but $27 billion over the last three months.

American commercial banks are not lending…period!

The largest banks seem to be living off of the riskless arbitrage situations that are available. They are doing little to nothing to help stimulate the economy along. But, why should they get into risky business and real estate loans when they can earn a pretty handy return without risking anything? Thank you, Mr. Bernanke!

The smaller banks seem to be drawing up the ramparts, becoming more and more conservative. This is where the loan problems are and the behavior of these organizations certainly lend credence to that belief. The fact that these banks are even getting out of their securities raises additional concern about the seriousness of their situation.

Note: The behavior of foreign-related institutions during this time period is also of concern. In the last three months, foreign-related institutions reduced their securities portfolio by $19 billion, their trading assets by $26 billion and their loans and leases by $33 billion, a total of $78 billion.

And where did they put the proceeds of this reduction in assets? They increased cash assets by $73 billion!

Foreign-related institutions in the banking week ending February 3, 2010, held $473 billion in cash assets, 38% of all the cash assets held by the banking system in the United States.

I don’t know right now, whether or not this fact should be a concern, but I would like to understand a little bit more about the situation of these banks. The “small” banks in the United States are moving in this direction because of the “poor” state of their loan portfolios. Is this move on the part of the foreign-related institutions of a similar nature? Or, are they going to move assets out of the United States?

Friday, February 12, 2010

Inflation is Just Not Understood!

Funny time to be talking about inflation, but the top economist at the International Monetary Fund brought it up.

Oliver Blanchard, now serving at the IMF while on leave from MIT, has co-authored a new paper and has publically presented the results which have been reported in the Wall Street Journal: Mr. Blanchard is now saying that central banks that were shooting for a 2% rate of inflation in their deliberations concerning monetary policy should shoot for something more in the neighborhood of 4% “in normal times.”

Economists of Mr. Blanchard’s philosophical bent just don’t seem to understand!

Inflation IS NOT the solution!!!

But, Inflation could very well be the problem!!!

As I keep saying, the post-World War II policy favoring an inflationary economic policy gained power on January 20, 1961. The basic format for such a program was followed, almost religiously, by Republicans as well as Democrats, into the 2000s. As a consequence, a United States dollar that could purchase one dollar worth of goods on January 20, 1961 could only purchase about seventeen cents world of goods in the summer of 2008.

Furthermore, inflation could not keep unemployment, or even more important, underemployment, down, as was originally believed and it could not keep industry working near capacity throughout the last 47 years or so. In fact, if anything, inflation forced manufacturing to focus on rising prices rather than productivity and this contributed to rising underemployment and declining capacity utilization. For more on this see my post, “The US Economy: Not Back to Business as Usual,” of January 8, 2010:

Inflation did create a “boom-time” for finance. Finance loves inflation because inflation that runs ahead of inflationary expectations reduces the burden of any debt outstanding. And what did we see between 1961 and 2008? We saw the greatest blooming of financial innovation in the history of the world and a rapid expansion of the finance industry relative to the rest of the economy that was even condemned by the people most responsible for the creation of the inflationary environment.

I have labeled this type of environment one of credit inflation (as opposed to debt deflation). It is referred to as credit inflation because it can incorporate price inflation, as in the case of the consumer price index) and asset inflation, as in the case of housing prices, boom, stock market boom, and so forth. Credit inflation relates to any time credit in the economy or in subsectors of the economy increases at a faster rate than the normal growth rate of that particular economy or that part of the economy.

And, this was a perfect time for financial innovation. I have just reviewed the new book titled “The Quants” by Scott Patterson, and he mentions many times in the book that the period from the 1960s into the 2000s, the period of the Quant-boom, as a period of “money ease”. In essence, monetary ease “lubricated” the Quant revolution helping to underwrite the massive growth in the financial industry and the development of the “shadow banking system.”

Of course, as Patterson describes, there were some consequences to pay for this expansion. But, I will let you read his book, or, at least, my review of his book, to gather his “take” on the subsequent financial collapse.

This gets me to the main point of this post. Blanchard, and other economists who think along similar lines, work with macroeconomic models that do not really include debt or the changing burden of debt in their models. Thus, the inflation in their models cannot provide an incentive for economic units to increase their use of debt and the subsequent buildup of debt can have no negative implications for the future performance of the economy. Inflation that causes an increased use of leverage and additional risk-taking cannot be explained in their models.

Thus, inflation remains the best solution to this brand of economist for the achievement of economic growth and lower rates of employment. The earlier debates about the Phillips curve seem to be irrelevant to them, let alone earlier discussions about debt deflation.

We are currently in a very precarious situation. Even with unemployment remaining so high and the economy staying so sluggish, more and more people are expressing concern about credit bubbles in the economy. China, who has recovered from the world economic collapse as fast as anyone, is showing tremendous concern about the possibility that bubbles may be forming in its economy and has taken measures with respect to its banking system to prevent such bubbles from occurring.

Still, our banking system contains $1.1 trillion in excess reserves and the Federal Reserve is faced with the problem of “undoing” this injection of reserves into the financial system. See my “Tightening at the Fed”:

Some economists still believe that re-flation is the only real solution to the current situation of a stagnant economy and massive federal deficits.

To me, Oliver Blanchard and these other economists that think like him just don’t get it! Yet they stick with the models that they have used over and over again and claim, if anything, that the reason why their solutions to the problem have not worked is because they either have not been tried or that they have not been implemented in a large enough size.

To my mind, their models and the solutions they have presented, have been tried and they have been found wanting. To me, to come up with a call for accepting higher rates of inflation in the future is, at a minimum, absurd. In fact, it scares me!

Thursday, February 11, 2010

Small Bank Loan Problems

A set of findings that will be released today by the Congressional Oversight Panel which oversees the TARP effort highlights exactly the problem I have been focusing on for the past year. The problem is the health of small- and medium-sized banks.

“Nearly 3,000 small U. S. banks could be forced to dramatically curtail their lending because of losses on commercial real-estate loans.” This from the article by Carrick Mollenkamp and Maurice Tamman in the Wall Street Journal, “TARP Panel: Small Banks are Facing Loan Woes.” (

Elizabeth Warren, who heads the TARP oversight panel is quoted as saying, “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

My question is, why has it taken so long for this concern to surface at this level? This is vital information!

There are just over 8,000 in the United States. This means that from one-third to two-fifths of our banks face serious troubles with regards to their commercial loan portfolio, let alone any other problems they might face in their loan portfolios.

At the end of the third quarter, the FDIC had 552 banks on their list of problem banks. We will not get the report on the number of banks on the problem list for the end of the fourth quarter until later this month. The number of problem banks was expected to rise this year anyway before this information came out, but this is certainly not good news.

The rough rule of thumb is that one-third of the banks on the problem list can be expected to fail, and, using the third quarter figures, this means that two to three banks will fail each week for the next twelve to eighteen months. So far this year, we are roughly on track with this pace.

There are two problems here. First, the number of failing banks. The deposits and loans of these banks have to be absorbed into the banking system and this represents a de-leveraging of banks and the banking system that is consistent with the de-leveraging that is going on in the rest of the economic system.

Secondly, and this is what the Wall Street Journal focuses on, is that this atmosphere is not conducive to an expansion of loans. Whereas most of the big banks, (remember that the top 25 banks in the country have over 50% of the bank assets in this country) have become very active again, the small- to medium-sized banks do not have neither the resources nor the markets to pick up their lending or deal-making activity.

Unless you have worked in a smaller bank, you don’t realize the effort and the commitment of resources that is needed to work with troubled-lenders, especially if a substantial part of your portfolio is in loans that are having problems. You have neither the will nor the means to give much of your attention to making new loans.

Furthermore, even if you are not a part of the 3,000 banks facing a large amount of loan problems, why should you be lending much now? First of all, if you seem to be surviving, you are probably very, very thankful that you are not in the same position of these other banks and are feeling a great deal of relief. Yes, relief, but you are still wary, because the whole thing is not over yet.

Second, and I know this from my experience in turning around banks, if you don’t make a loan, that loan cannot go bad on you. The probability of this is 100%. That’s about as close to certainty that you can get in these very uncertain times.

The other side of this is something that I have said this many times before in these posts. The good news is that things seem to be pretty quiet on the banking front. Let’s hope that this quiet continues. Quiet is good, because it can mean that the bad and the not-so-bad situations are being worked out. And, if the economy continues to improve, some of the bad situations will become not-so-bad situations and some of the not-so-bad situations will actually become acceptable situations.

So, keep your fingers crossed.

This whole situation is further evidence of the extent that credit inflation enveloped the United States (as well as the world). In a credit inflation, it pays to go further and further into debt and to make more and more loans. At least, as long as the credit inflation can continue.

The leveraging and the moves to riskier assets usually begins with the larger institutions and then works its way through the economy. In most situations, the smaller institutions are the last ones to really follow the increased exposure that has been taken on by larger banks. However, more and more people and institutions succumb to the environment the longer the credit inflation continues. But, the increased risk taking does spread throughout the economy.

When the credit inflation stops, then de-leveraging must take place and this can be a long, slow process. And, again, the smaller institutions tend to trail the larger institutions. Thus, it is not surprising that the small- and medium-sized banks are still dealing with these problems even though the larger institutions have moved on.

Unless, of course, the government is able to “goose up” credit inflation again and eliminate the need to de-leverage.

The extent of the problem relating to “loan woes” is still substantial. The existence of this problem will weigh on the officials in the Federal Reserve System because a tightening of credit will just exacerbate the existing fragility of the banking system. The Fed does not want its “undoing” of the excessive amount of excess reserves in the banking system to be the “undoing” of the commercial banking system, itself.

The commercial banking system has always been a part of any economic recovery in United States history. It is hard to see how much of a recovery is possible if the commercial banking system, this time around, is “frozen”. At least for the small- and medium-sized banks.

Guess the loans to small- and medium-sized businesses will just have to come from the government!

(Please accept this last statement as being ironic!)

Tuesday, February 9, 2010

Two Ponts about Debt and the Economic Recovery

The Internet, print journalism, and the broadcast media contain story after story about the debt problems in the world. A wider audience just learned this week a new acronym: PIGS, or PIIGS if you will. This, we all know now, stands for Portugal, Ireland, Greece, and Spain, or, some include Italy.

The problem is debt!

The solution? Well, we don’t quite know that yet.

How did the problem arise? In my mind, the problem has arisen because of the attitude that has prevailed in the world over the last fifty years or so relative to how governments should conduct their fiscal affairs.

Beginning in the 1960s we saw more and more governments turn to budget policies that could stimulate employment and economic activity through the creation of spending that would add to the aggregate demand in their countries. These policies began with the argument that budget deficits should be produced only when the economy was below full employment. But, governments found these policies so attractive in terms of attempting to get re-elected that budget deficits were produced whether or not the economies of their countries were running below full employment.

This attitude created an environment of credit inflation, as well as price inflation, that did three things. First, it caused economic units to focus on finance and financial engineering. Second, it resulted in structural unemployment as many, many people were hired or re-hired back into “legacy” jobs and not the jobs of the future. This hurt lower income and less educated people the most. (See Bob Herbert’s column in the New York Times: Third, it ended up transferring a lot of the wealth of the country offshore to China, the Middle East, and other places.

There are two points I would like to make about all this credit creation and the piling up of debt.
The first point is that, ultimately, those people, companies, and nations that have little or no debt WIN over those that issue lots and lots of debt.

The situation is similar to that historically called “the Phillips Curve.” The Phillips Curve captured the tradeoff between unemployment and inflation and the economists that developed this tool used it to show how, for a little bit of inflation, a government could buy a lower amount of unemployment.

Milton Friedman destroyed their case by arguing that the Phillips Curve was dependent upon a given assumption about inflationary expectations. He showed that the tradeoff between inflation and unemployment remained stable only if inflationary expectations remained the same.

However, even if people are fooled in the short run, the presence of higher inflation than they expected would eventually lead to an increase in inflationary expectations. Thus, to get the same decline in unemployment the government would have to create a higher level of inflation. The tradeoff resulting in constantly rising inflation, which is what the United States observed through the 1960s and 1970s.

The same type of situation exists for the creation of debt. A company or a nation can benefit from the creation of “more leverage” or more deficit spending. However, as more and more credit is created, people, companies, or nations must issue more and more debt to keep retain or even increase the benefits of their debt creation relative to others. Credit inflation, once started, is self-feeding!

Of course, when the credit bubble bursts, as it did for the world in 2007 and 2008, all the debt built up becomes a huge burden, especially if economies dip into a period of price deflation. The solution to a situation like this? Well, one solution is inflation: make the real value of the debt burden less and less.

Again, the problem is that each cycle of re-flation tends to be greater than those of the past. But, this is the easy way out. Re-flation was the intellectual model that came out of the 1930s and, in its various forms, was incorporated by government’s worldwide beginning in the 1960s.

The problem is that re-flations ultimately never work, because the deeper and deeper people, companies, and nations get into debt, the more and more of them attempt to deleverage. If governments’ don’t want deleveraging to happen then they continue to re-flate. The cumulative effect of this is hyperinflation, and those countries that hyper inflate don’t win. The 20th century has many examples of the consequences of hyper inflation, the German case in the 1920s being the most pronounced.

But, before fully finishing this strand of thought, let me introduce my second point and it has to do with the effects of deleveraging. If the private sector realizes that it is over extended, debt-wise, then it will attempt to pay off debt or at least reduce its debt burden sufficiently so that it can operate once again. But, if economic units in the private sector begin to save more or sell assets in order to pay off debt, aggregate spending declines and this slows down or prevents an economy recovery from taking place.

John Maynard Keynes identified this “fallacy of composition” in the 1930s and labeled it “the Paradox of Thrift.” That is, while it is all well and good for individuals to increase their savings and pay off their debts, the very act of withdrawing spending from the economy reduces aggregate demand and the output of goods and services. So, even though it is good for people to save and pay off debt, individually, it is bad for the economy and everyone becomes worse off because of this prudent behavior.

The thing is, when they get badly burned, lose their homes, lose their jobs, and lose their wealth, people and businesses do “pull back”. And, their standards change. This, to me, is one reason why the stimulus policies of the 1930s were not very effective. They could not overcome the desire of people and businesses to restructure their balance sheets. People had to re-group. One sees the consequences of this in the 1950s: people and businesses were very, very conservative then in the way that they spent and managed their money. The near-term experience that dominated their thinking was the depression years of the 1930s. And, in many ways, this continued into the 1960s for the older generations.

So who benefits during the time that follows the bursting of the credit bubble? Those without a lot of debt!

To me, the creation of debt eventually impacted the world in two ways. First, during the last 50 years or so, many resources were diverted into financial engineering. Even companies that were primarily in manufacturing gave more and more attention to financial engineering. This distracted these companies from what should have been their main focus: manufacturing goods and industrial innovation. The emphasis on financial engineering changed the whole society and many of the best and brightest young people opted out of careers in engineering and applied science and went into the finance industry. Employment in financial firms grew dramatically relative to employment in manufacturing and production.

The second way the world was impacted is through the redistribution of wealth in the world. Massive amounts of wealth have been transferred over the past 20 to 30 years out of the West and into the Far East, the Middle East and Brazil. Who did American companies turn to in the financial crisis for capital? Who is Europe and America now turning for help? Where are we learning about this transfer? See the morning papers for starters: “China Lists $9.6 Billion in Shares of U. S. Companies”:

This is not a winning strategy for those countries, businesses, and people who took on a lot of debt!

Monday, February 8, 2010

"Fed to Bare Tightening Plan"

I would recommend reading the article by Jon Hilsenrath with the title “Fed to Bare Tightening Plan” which appeared on the front page of the Wall Street Journal February 8. ( In this article Hilsenrath discusses the issues and possible actions the Fed may face in “credit tightening…once the Fed decides the economy has recovered sufficiently.” This is a good follow-up piece to my post of February 7 titled, “Everything is in Place: Federal Reserve Exit Watch Part 7.” (

The problem facing the Fed?

Hilsenrath lays it out: in the financial crisis “the Fed took extraordinary action to prevent an even deeper recession— pushing short-term interest rates to zero and printing trillions of dollars to lower long-term rates. Extricating itself from these actions will require both skill and luck: If the Fed moves too fast, it could provoke a new economic downturn; if it waits too long, it could unleash inflation, and if it moves clumsily it could unsettle markets in ways that disrupt the nascent economic recovery.”

This week in testimony before the House Financial Services Committee, Chairman Bernanke is expected to begin laying out a blueprint of how the Fed expects to undo this “extraordinary action.”

The Fed has a major new tool to use in this “undoing”. This tool is something called “interest on excess reserves” which the Congress gave the central bank in October 2008. In essence, this is interest paid for doing nothing! Right now, just for holding the $1.1 trillion in excess reserves the Federal Reserve has freely given the banking system, the banks receive the interest rate of 0.25%, which is above the effective Federal Funds rate that has been around 12 basis points for a very long time.

The Federal Reserve doesn’t want the banking system to lend out this $1.1 trillion so the idea is, when the Fed is ready to start its “undoing”, it will raise the interest rate paid on excess reserves. This would, hopefully, make it more desirable for the banks to retain the excess reserves than to lend them out to businesses or consumers, thereby inflating credit and the various measures of the money stock.

In essence, the Fed has printed $1.1 trillion in bank reserves and it will subsidize the banking system whatever it takes to keep them from becoming too aggressive in their lending.

Let’s see…the government wants the banks to begin lending again…but, the Fed doesn’t want them to be lending.

Makes a lot of sense!

As Randy Quaid stated in “National Lampoon’s Christmas Vacation,” this is “the gift that keeps on giving.” Suppose I give you $1.1 trillion dollars and then let me pay you 25 basis points, 50 basis points, or whatever it takes for you not to go out and use that $1.1 trillion in any other way. Sounds like a pretty good deal. But, as we know, the Fed has lots and lots of profits from which it can pay this interest.

What is it we are doing for Main Street amongst all the deals we are giving Wall Street?

What about the Fed’s portfolio of securities purchased outright? As of Wednesday, February 3 the total portfolio amounted to $1,912 billion. Of this total, $777 billion were in U. S. Treasury securities. In the near future, this account will bear the burden of asset sales to reduce bank liquidity. Initially, the proposed methodology to achieve these sales is through “reverse repurchase agreements” or “reverse repos.” This is discussed in my post mentioned above.

But, the Fed hopes to have$1.25 trillion in mortgage-backed securities on its balance sheet by March 2010. Last Wednesday, it held $970 billion in its portfolio. It seems as if these securities are NOT going to be available for sale for a while because of the precariousness of the mortgage market and the housing market. The Fed certainly doesn’t want to do anything either in terms of dramatically higher interest rates or lack of liquidity in the mortgage market to disturb a recovery in housing. Don’t count on these securities being used to reduce the $1.1 trillion in excess reserves in the early stages of Fed tightening.

The Fed also has $165 billion in Federal Agency debt securities. Don’t expect these securities to be an active part in the Fed’s “undoing.”

Thus, it seems as if the prescription for the “undoing” is to sell U. S. Treasury securities, first through “reverse repos” and then through outright sales if the banks are congenial with a reduction in reserves and to pay interest on excess reserves to keep banks from lending out their “excess reserves” should loan demand increase or if the banks are not congenial with a reduction in reserves.

How much comfort does this “blueprint” give me?

Not a whole lot!

The Greenspan/Bernanke Fed gave us excessively low interest rates from late 2001 into 2005 (the effective Federal Funds rate was below 2.00% for all of this time period); “measured” rate increases ran into 2006 (Hilsenrath introduces one of the problems with this approach in his article. Rate increases that are “too” predictable can “fuel a borrowing boom” because of the predictability of the rises.); Bernanke publically claimed that there were no problems in the housing market and in subprime mortgage lending during this time period; the Bernanke Fed failed to foresee the economic downturn which began in 2007, but also had no clue to its potential severity; and, to combat the financial crisis, the Bernanke Fed followed one rule and that was to throw everything it could into the financial markets so as to err on the side of providing too much liquidity.

I see very little understanding of financial markets in this performance and no exhibition of “touch” in these actions. It does not leave me with a great deal of confidence that the “undoing” will proceed smoothly. My guess right now is that the Fed will wait too long to begin the “tightening” and that will put them into a world in which none of the actions that are available to them are desirable…much like the fiscal policy stance of the U. S. government right now. This is a problem, however, that one experiences because of the excesses in the past.

Sunday, February 7, 2010

Everything is in Place: Federal Reserve Exit Watch Part 7

Looking at the Federal Reserve figures for Wednesday, February 3, 2010, one could argue that just about everything seems to be in place for the Fed to execute its exit plan. The Fed will still purchase some more Mortgage-backed securities and there are some other residuals left from the world financial crisis that still remain, but these are now relatively minor parts of the picture.

On Wednesday, February 3, 2010, the Total Factors Supplying Reserves to the banking system totaled $2,231.3 billion or a little more than $2.2 trillion. The Securities held outright by the Federal Reserve amounted to $1,911.6 billion or approximately 85.7% of the total factors supplying reserves.

To put these numbers in perspective, on Wednesday, December 5, 2007, Total Factors Supplying Reserves to the banking system equaled $920.4 billion and Securities held outright amounted to $779.7 billion or 84.7%. The Fed did have outstanding $46.5 billion in repurchase agreements which, if included, made about 89.8% of their balance sheet related to securities.

On February 3, 2010,the Federal Reserve had no repurchase agreements outstanding.

I go back to December 2007 because one has to go back that far to get to a Fed balance sheet that does not include “special” line items that were constructed to combat the financial crisis. In December 2007, the Term Auction Facility (TAF) was initiated. During the time the TAF existed total funds supplied through this facility reached several hundred billion dollars. On Wednesday February 3, 2010, funds supplied to the banking industry through the TAF were only $39 billion, down $37.4 billion over the past four weeks and down by $101 billion in the last 13-week period.

In preparing to remove excessive amounts of reserves from the banking system the Federal Reserve has been allowing the “special” facilities that have supplied reserves to banks to “run off” while the Fed has replaced these funds with open market purchases.

Another area in which this has taken place has been in central bank liquidity swaps. This facility was also started in December 2007. At one time central bank liquidity swaps were in the hundreds of billions of dollars. On Wednesday, February 3, swaps totaled $100 million.

In the last four weeks and the last 13-weeks, the other items on the Federal Reserve statement did not change dramatically. To me what I have presented in the last three paragraphs pretty well sums up what the Fed has been doing to get itself ready to begin removing excess reserves from the banking system…when it decides it is time to do so.

Over the past 13-week period, reserves have been removed from the banking system by a reduction in funds available through the TAF ($101 billion) and through a decline in central bank liquidity swaps ($32 billion) or a total of $133 billion.

During this time, the Federal Reserve has purchased open-market securities of $214 billion. Thus, total factors supplying reserves during this time rose by $81 billion from these factors.

Over the past 4-week period, the TAF has been reduced by $38 billion and central bank liquidity swaps declined by $10 billion or a total of $48 billion.

Federal Reserve purchases of open market securities totaled $66 billion. Total factors supplying reserves from these factors rose by roughly $18 billion.

I have not discussed the factors that have been absorbing bank reserves over the past 4-week and 13-week periods because they have been impacted by some wide swings in the deposits of the federal government, much of which are technical in nature. And, these factors should not play any important role in how the Fed removes reserves from the banking system.

The bottom line in this discussion is that it seems to me that the Fed has basically eliminated or reduced most of the facilities that it created over the past two years that can have a major impact on the creation or destruction of bank reserves. The two major facilities are, of course, the TAF and central bank liquidity swaps.

The Federal Reserve now has one thing to work with in withdrawing reserves from the banking system: its portfolio of open-market securities. The Fed’s balance sheet is composed of roughly 85% open-market securities held outright. (A shown above, as a percentage of the balance sheet this is not too far off what the composition of the balance sheet was in early December 2007.)

The Fed has already had some recent test runs using “Reverse Repurchase Agreements” (reverse repos), or, selling securities to securities dealers under an agreement to repurchase. The idea here is to test the market’s reception to the withdrawal of funds from the banking system. Since the reverse repos are only temporary, the funds withdrawn will be put right back into the system avoiding any disruption that might be caused by the sale of the securities.

In this way, the Fed can “feel” its way toward withdrawing the excess reserves from the banking system. On one side is the question about is how the Fed will react to a pickup in bank lending and a rapid rise in the growth rates of the money stock. On the other side, the Fed wants to avoid a catastrophe like the 1937-1938 period in which reserve requirements were raised at a time when banks seemed to have had a lot of “excess reserves” on their hands, but really wanted to keep excess reserves on their balance sheets.

Bernanke, a historian of the Great Depression knows this lesson all too well. That is why a suggestion like that of Andy Kessler, a former hedge fund manager, which appeared in the Wall Street Journal last Thursday morning, “Bernanke’s Exit Strategy: Tighten Reserve Requirements” ( seems a bit absurd.

My belief is that Mr. Bernanke and the Fed are going to, at least initially, take things slow. When they begin to exit they are going to engage in some reverse repos and see how the banking system reacts. Then they will do some more…and then some more. The strategy: basically stepping out into the river to see how deep the water is. And, then stepping out a little further…and then a little further. The hope is to avoid falling in over their head, causing a further contraction in the banking system that would lead to another financial crisis.

In doing this the Fed keeps the reserves in the banking system if the economy remains slow or if the banking system wants to hold onto the funds. However, in this plan they start to remove the reserves, testing the market all along the way, so as not to pull the reserves out too quickly.

The problem is on the “up-side”. If bank lending does start to accelerate then the banks will want those “excess reserves” for loans. And, the funds are already on their balance sheets. In such a case the questions will be “How fast will the Fed sell the securities on its balance sheet?” and “How high will the Fed drive up interest rates in order to avoid a credit inflation from breaking out in the United States?”

As we have seen in other periods of time, we can simultaneously be in a period of economic stagnation and still experience a credit inflation. Bernanke has not earned his “star” yet! He still has $1.1 trillion of EXCESS RESERVES in the banking system that must be removed.

Friday, February 5, 2010

Fiscal Stimulus

In order to justify the fiscal stimulus packages of the federal government we must be able to find some relationship between the government expenditures and the performance in the economy. Currently, there seems to be very little statistical connection between the year-over-year rate of growth of the real economy and the rate of growth of government expenditures.
Here is a chart showing the relationship between the year-over-year rate of growth of the real nondefense expenditures of the federal government (the upper line) and the year-over-year rate of growth of real GDP (the lower line). The first quarter pictured in the chart is the fourth quarter of 2007, the quarter in which the Great Recession is said to have started. The pattern is not changed when total federal government expenditures are used.

The average rate of change for real nondefense government expenditures during this time period is 5.9%. As you can see from the chart, the actual figures seem to be above the average during the earlier part of the period and below the average toward the end.
Also, you can see that the year-over-year rate of growth in real GDP was at its highest level in the fourth quarter of 2007 (+2.5%) and declined progressively reaching its trough of a negative 3.8% in the second quarter of 2009. With the large jump in real GDP in the fourth quarter of 2009, the year-over-year rate of growth became positive again, showing a 0.1% gain.
Fiscal policy on the spending side did not seem to play much of a role in the trajectory of the economy during the recession up to the present time. If anything, the recovery seems to have begun without much contribution of federal spending.
The factors that contributed the most to the swing in real GDP growth are real Gross Private Domestic Investment and Real Exports.
The trough in the rate of decline of real investment expenditure occurred in the quarter that real GDP troughed and showed a remarkable improvement, especially in the fourth quarter of 2009. The particular sectors that were strongest in the third quarter and the fourth quarter were nonresidential purchases of equipment and software and residential construction. The construction of nonresidential structures continues to be in a hole.
The pickup in the purchases of equipment and software is a good indication that, at least, in some business areas, companies are acquiring products that will contribute to their more efficient performance as the economy picks up. In terms of the investment in residential construction the best explanation that can be given is that things have been down for so long that any construction seems to be an improvement.
Real exports also moved higher in the third and fourth quarters of the year and outpaced increases in real imports. This movement can be associated with the decline in the value of the United States dollar in the second half of 2009.
However, the major contributor to the increase in real GDP in the third and fourth quarters of 2009 was the rise in nonfarm private inventories. These inventories had declined constantly from the fourth quarter of 2007. There was a slight increase in nonfarm inventories in the third quarter, but the increase in the fourth quarter was substantial. Analysts are interpreting this rise in inventories as being a very positive sign for the economy because it indicates, to them, that some businesses are becoming optimistic enough about the possibility of rising future sales that they are building inventories to meet the potential increase in demand.
The good news is that there seems to be some life out there in the economy. The bad news is that the good news does not seem to result from the fiscal stimulus coming from the government even though the government is building up massive amounts of debt to support it spending programs.
Obviously, the large deficits are resulting more from a shortfall in revenues than from the increases that are taking place in spending. However, the government needs to be aware of what it can accomplish and what it is accomplishing. The perception of the people and the perception of the financial markets are crucial to the success or failure of a presidential administration. Right now, the spending programs appear to be contributing little toward improving economic activity.
Consequently, the perceptions about what the administration is achieving don’t seem to be that favorable for the Obama team. And, the new budget figures released this week didn’t seem to help that perception at all. (See Somehow, the president is going to have to turn this around or it is going to be a long three more years.

Wednesday, February 3, 2010

Households Continue to Suffer

I’m trying to make sense out of the economic recovery. According to a growing number of people the Great Recession ended in July 2009 or, at least, somewhere in the third quarter. There continue to be “green shoots” that are popping up here and there.

Still, I am uncomfortable. I’m usually a pretty optimistic guy and I don’t like being considered as a “gloomy Gus”. But, some things in the economy continue to nag at me.

Households, at least how we used to know them, are having a difficult time. The major issue remains employment…or unemployment. However, another issue that can’t be ignored and that will impact employment patterns over the next five to ten years is the restructuring of industry and commerce. Restructuring often requires changes in skill sets and changes in geographic location.

In terms of employment we have just learned that companies in the United States cut an estimated 22,000 jobs in January, according to ADP Employer Services, the smallest decline in two years, and much lower than the recorded 61,000 decrease in December. The January result showed that 60,000 jobs were lost in the goods-producing area but in service industries 38,000 jobs were added to payrolls, the second consecutive increase. This was not a bad result, but employment is still declining. (

Most estimates for the unemployment rate in January remain in the 10% range. Very little improvement is expected in this measure in the first six months of this year. Furthermore, the projections of the unemployment rate used by the Obama administration in the budget proposals released this week are anything but encouraging.

These figures do not include numbers on discouraged workers who have left the labor force or those individuals that are working part-time but would like full-time employment. The rate of underemployment in the United States is in the neighborhood of 17% and is expected to remain around this level for the foreseeable future.

One of the reasons for underemployment to remain this high is the restructuring of industry and commerce that is going on in this country. As I have reported, capacity utilization in the manufacturing industries remains quite low and has not even come close to returning to 1960s levels in the past 40 years. (

The trend in United States manufacturing has been downward for a long time as industry has shifted from the heavy sectors to areas that produce higher-tech products. Some industries, like the auto makers, have had to decline due to diminished demand in the United States. Other industries, like chemicals, are relocating labor-intensive operations to other countries.

From December 2008 to December 2009 there have been large declines in capacity in the United States in areas such as textiles, printing, furniture, and plastics and rubber products. Industries where substantial increases in capacity have taken place are the producers of semiconductors, of communication equipment, and of computers. Shifts like these have major impacts on labor skills and the location of employees. (

It is important that these shifts take place. One of the problems with job stimulus packages sponsored by the federal government is that they tend to ‘force’ people back into the jobs that these unemployed have lost. This is not good because it reduces the incentives for industries to change even though it generates revenues for producers, like car manufacturers, and income for workers, like autoworkers. However, industries that need to change must change some time and postponing the change only exacerbates the magnitude and pain of adjustment. Need I mention the United States auto industry again?

This change is being reflected elsewhere and it has an influence on how political power is distributed in a country. The number of American workers that are in labor unions has been experiencing a downward trend that mirrors the decline in United States manufacturing. What is additionally interesting is the shift that has taken place within the overall union workforce: in 2009, public employees that are members of a union rose to more than 50% of total of all union workers. The decline in union membership connected to the manufacturing sector has been hidden because of the rapid growth in those connected with government employment. This is just another indication of the restructuring of the labor force. (

Added to this is the large shift that has taken place in home ownership in the United States. Home ownership peaked in the United States in 2004 when 69% of all Americans owned their own home. This peak was reached through the emphasis placed on home ownership in the United States, government programs to get people into their own homes, and low interest rates.
However, this rate has fallen to 67% at the end of 2009 and is expected to continue to decline as people lose their homes through foreclosure or bankruptcy. The rate of home ownership could fall into a range of 62% to 64% that was the case in the early 1990s. This represents a massive shift in the asset holdings of United States households for homes are still, by far, the largest asset held by households in America. (

This continued decline does not seem unreasonable given the hard facts facing many homeowners in the United States. In the third quarter of 2009, 4.5 million homeowners had seen the value of their homes drop below 75% of their mortgage balance. This figure is projected to hit 5.1 million, or 10% of all homeowners, by June. Research has indicated that this 75% figure is the level at which people really consider walking away from their home. (

These numbers make me feel uneasy…and that is an understatement. The basic reason for feeling uneasy is that I don’t see a “normal” economic recovery reversing these trends. The United States is restructuring from the excesses of the past, of “forcing” industry to not modernize, of “forcing” people to become homeowners, and so forth and so on. It is always the case that restructuring takes place: sooner or later. Now, seems to be OUR time!

The problem is that this restructuring has ramifications for other areas of the economy. Small- and medium-sized banks have lent money to these home owners and they are the ones that these households will walk away from if they leave. Commercial real estate developers will also walk away from the banks, maybe more easily, as we have seen, than the households themselves. Many businesses that are restructuring or downsizing will not be borrowing from the banks so business loan demand will stay low. And, one can think of many other areas in which repercussions may be felt.

I like to be optimistic about things, but I can’t get these “less-than-happy” conditions out of my mind.