Wednesday, March 31, 2010

Mr. Volcker Speaks

Former Fed Chairman, Paul Volcker spoke yesterday at the Peterson Institute for International Economics. All week I had been hearing comments about this speech and how people seemed to be waiting for Volker’s remarks. Yet, this morning, there was only one report on the speech which appeared in the New York Times ( and then it was buried at the bottom of page B6 of the business section.

It seems as if Volcker didn’t really say very much. In fact, the discussion of his remarks was combined with a discussion of the words of Robert Gibbs, the White House Press Secretary. The bottom line: it is highly likely that the United States will get a re-regulation package for its financial system this year. Gibbs even said that “the Senate might move on the legislation by the end of May”.

Just a couple of comments on the issues that were mentioned in this article.

First, the article states that the legislation to “overhaul the nation’s financial system…is intended to prevent a recurrence of the conditions that led to the 2008 financial crisis and the government bailouts that followed.”

If this is what the legislation is intended to do, we have already lost the battle. As I have stated over and over again, the problem with regulatory legislation is that it is always fighting the last war.

Let me state this as bluntly as possible: We will never have “a recurrence of the conditions that led to the 2008 financial crisis!”

Financial crises do not repeat themselves.

I do agree with Carmen Reinhart and Ken Rogoff in their book “This Time is Different” that the buildup to a financial crisis is always accompanied by the cry of those riding the crest of the economic expansion that “This time is different!” This claim, however, refers to the belief of the perpetrators of the claim that no collapse will follow the buildup that they are going through.

When I say that financial crises do not repeat themselves I mean that the specific conditions preceding a financial collapse, the specific behavior of the financial institutions and the financial leaders, are always different from past collapses. There is new technology, new instruments, new institutional arrangements, and so forth. Things change significantly enough so that the new regulations put into effect at the end of the last financial collapse don’t quite apply to the conditions that exist before the next financial collapse.

This gets into my second point which addresses Volcker’s concern about the growth of the financial services industry relative to the growth in other sectors in the rest of the economy.

We are told that “Mr. Volcker was critical of the broad growth in the financial services industry in recent decades. Finance came to represent an ever-greater share of corporate profits, even as average earnings for most American workers did not rise.”

Volker is quoted as saying “The question that really jumps out for me is, given all that data, whether the enormous gains in the financial sector—in compensation and profits—reflect the relative contributions that sector has made to the growth of human welfare.”

The article continues, “He also asked whether the financial sector contributed to underlying imbalances in the economy, as Americans raided their savings and relied on a housing bubble to maintain excessively high consumptions levels.”

My response to this is that from 1961 through 2008, the purchasing power of the dollar declined by almost 85%. In this inflationary environment, many American families came to believe that the best way to “save” was to buy a house and watch the value of the house rise. In addition, they could further leverage the constantly rising value of their house to “maintain excessively high consumptions levels.”

Mr. Volcker, more than anyone else in the United States, recognized the problem created by the inflationary environment of the late 1970s and early 1980s and, during his tenure as the Chairman of the Board of Governors of the Federal Reserve System, fought inflation with all that the Fed could bring against this destructive dragon. He deserves major praise for what he accomplished at this time.

Still, over this 1961-2008 period, inflation was the major economic incentive in existence in the economy. By the end of the 1960s, commercial banks had innovated to the point that they became “liability managers” and created the ability to expand to any size that they wanted. This happened because the start of this inflationary period made it necessary for banks to have the flexibility to expand beyond the geographic and asset constraints that restricted their ability to compete.

In the early 1970s the mortgage-backed security was invented (by the government by-the-way) and in the middle 1980s the mortgage market became the largest component of the capital markets. As inflationary expectations rose and resulted in higher interest rates during this time, interest rate risk became more of an issue and the interest rate futures market was created.

Need I say more? Financial innovation thrived in the inflationary environment and, as a consequence, the financial industry grew! And, grew! And grew!

Did the “enormous gains in the financial sector reflect the relative contributions that sector has made to the growth in human welfare”? Did “the financial sector contribute to underlying imbalances in the economy”?

I think you know how I would answer both of these questions.

Another piece of the news this morning struck me. Citigroup is spinning off Primerica ( Primerica was one of the first companies purchased by Sandy Weill in the late 1980s that became part of the financial conglomerate Citigroup. Everything about financial innovation and the relative growth of the financial services sector of the economy during this inflationary period is captured in Weill’s wild ride to the top as he constructed Citigroup piece by piece.

And, now we have the dismantling of Citigroup. Is this picture the icon of the new age of finance?

Higher capital requirements can contribute to sounder financial behavior. More disclosure and increased audit standards can also contribute to sounder financial behavior. Still, we cannot build a regulatory structure that will prevent a recurrence of financial crises whether based on the 2008 experience or the experience of some other time period. Furthermore, we cannot prevent greedy politicians from supporting policies that create an inflationary bias to the economy in order to get re-elected.

Regulation of the “bad guys” on Wall Street is popular now. However, it won’t prevent a volatile future.

Monday, March 29, 2010

The Euro and the European Union

When have you last heard that the dollar might drop into the $1.05 to $1.15 range? This morning we are trading at about $1.34.

The lower number is projected if some country leaves the European Union or if there is a national default in the euro area.

The cost of protecting debt from default over the past six-months has risen dramatically in several of the major European countries: Greece leads the world in this category. But, Portugal is right behind as credit-default swap data, compiled by Bloomberg, indicate an increase of about 150% in the last six months. (Remember the debt rating of Portugal was just reduced by Fitch last week.)

Major increases in the cost of protecting debt from default have also been registered against the debt of Spain, Italy, Belgium, England, and France.

The bottom line: governments cannot just spend and spend and spend expecting either the bond markets or the central bank to bail them out. Social programs or not, a democracy has to balance the competing ends within a country and if the social programs cannot be financed through sound finance then they will just have to wait. The lesson is very clear.

Historically, it is government spending that drives the finances of a country and not the central bank. Remember the European Central Bank and the Bank of England have been much more conscious “inflation targeters” than was the United States. Also, governments, historically, were always the leaders in financial innovation and not the private sector. The late 20th century is no exception to this rule. (See Niall Ferguson’s “The Ascent of Money” and also

In the past, if a country over-extended its finances then they would generally have to devalue their currency and then proceed into the future. With a common currency, the euro, a country loses the choice about devaluation because that country is now one among many and so must accept its position in the community. The poor country that has over-extended itself must bring its budget back into line, a very painful process as Greece is now experiencing. This is tough medicine to take.

What about the countries that were prudent and disciplined? Their emphasis on sound finance is now being called a vice by some because they do not want to be overly generous to those countries that were not prudent and disciplined. (One prominent critic has been Martin Wolf of the Financial Times:

And, the current crisis is bringing out those that are or have been opposed to the European Union as it is now constructed. For example, an op-ed piece in the New York Times “Euro Trashed” by a German professor, captures some of the tone of this side of the argument: A suggestion is made that the “strong” governments could pull out of the current arrangement and form a bloc that would “fulfill the euro’s original purpose” and would not have to worry about “laggard” high-debt states.

The betting is against the euro right now. John Taylor, the chairman of the currency hedge fund, FX Concepts Inc., argues that “Those people who are calling for the euro to go up are thinking the stock market is going to continue higher and that the euro zone problem is not going to spin out of control. I disagree with both of these things.” So, of the three areas that have experienced, in the recent past, the most negative vibes concerning the value of their currencies, the United States, Japan, and the euro zone, the pointer has rotated to the euro zone, taking the pressure off the other currencies, at least for the short run.

This could change. The reason for the current focus is that the euro zone faces the most current difficulties that have to be dealt with. But, this focus could be altered overnight because of the things happening in United States financial markets. The first has to do with the Federal Reserve signaling that it will honor its statement that its purchases of mortgage backed securities will end as March 2010 ends. The 10-year U. S. Treasury issue has bounded up to a 3.85% yield again, a level it was at in June 2009, August 2009, and January 2010. The concern by some is that yield could accelerate through 4.00% in the near term.

Why is this of concern? Well for one reason, upon the reaction in the bond markets, mortgage rates have moved above 5.00% with the expectation that they could go higher as the liquidity in the mortgage area of the capital markets declines. Banks and mortgage banks have already put a hold on committing to mortgage rates in the near term because of the uncertainty connected with the future level of mortgage interest rates. This, of course, is problematic because of all the variable rate mortgages or teaser mortgages that must re-price over the next 12 months.

There is also the concern about how easy it will be to place the upcoming quantity of the federal debt coming to the market over the next six to nine months. How much added pressure these new amounts of debt will have on interest rates is highly uncertain at the present time.

And, then what about the Fed’s exit strategy, the Great Undoing? How is the Fed going to act or react to all these market pressures? The exit strategy is planned to take place in an orderly financial market. What if the financial markets don’t cooperate and become dis-orderly over the next year due to everything else going on in the world? Just how is the Fed going to accomplish its Great Undoing in such an environment?

So, the emphasis is all on the euro right now and the political problems being dealt with by the nations of the European Union. Except for Germany’s Chancellor Merkel, the current batch of European leaders seem extremely weak at the present time. The weakness claim extends to the Prime Minister of England as well. What comes out of this mess is anybody’s guess right now, but it would seem that a country, like Germany, who is in relatively good fiscal shape and with a leader that can command some significant backing from her people, can be pretty adamant about what they want. The other countries in the EU may not like what Merkel is advocating, but they are not in the strongest position to suggest alternatives.

If this is the case, then it would seem as if the European Union will continue to battle on, but the debt-heavy countries that are now experiencing significant difficulties obtaining funding will have to get their houses in order for the Union to continue to function. Otherwise, as suggested in the New York Times this morning, we might see a move to one bloc of countries with a single currency who are relatively sound, financially, and all of the others who will re-establish their own currencies once again.

Politicians in the United States should pay attention to what is going on in Europe and take some lessons about their own fiscal responsibilities.

Friday, March 26, 2010

The Mortgage Market and More Plans to Aid Homeowners

There is still no better place to observe the consequences of the credit inflation of the last fifty years than the housing market.

Politically, this is democracy at work. Every wave of political change in the post-World War II period has focused on the housing market and putting “Americans” in their own homes in order that the new majority in Congress can get re-elected.

I was in Washington, D. C. during the time period that the mortgage-backed securities were being designed. The rationale for this innovation? Almost all mortgages were made in local depository institutions at that time. But, insurance companies and pension funds had lots of money to invest in longer term securities. If an instrument could be constructed that would allow local depository institutions to sell their mortgages to these companies that wanted long term investment vehicles then the local depository institutions would still have funds available to make more mortgages and put more “Americans” into their own home. And, the incumbent politicians could show their constituents the role they played in not only helping people acquire a home, but also how this effort helped to stimulate the local economy through additional home building. This surely would help the incumbents to get re-elected.

Economically this effort seemed to be sound because it would provide for an almost continued stimulus to the economy, spurring on economic growth and raising employment. A little “inflationary bias” along with this was not bad because almost all the economic models used at this time period showed a positive relationship between inflation and higher levels of employment. Inflation was good for the country!

And, these basic efforts were supplemented by the activities at the Department of Housing and Urban Development, the Federal National Mortgage Association (Fannie Mae) along with the creation of Freddie Mac and Ginny Mae and the work of the Federal Housing Authority, the Federal Home Loan Bank System, and other initiatives forthcoming from both presidential administrations and the Congress. Who could be opposed to such a worthwhile idea?

What we see is that maybe inflation was not all it was said to be. Maybe inflation, in the longer run, can actually be harmful to many of the people it was supposed to help. Maybe one of the “lessons learned” from application of the economic philosophy that dominated Washington in the last fifty years is that you can’t artificially “force” people into situations that are not fundamentally sound on an economic basis.

The efforts of the federal government over the last fifty years or so culminated in the Greenspan/Bernanke credit inflation of the 2000s. The United States experienced a housing bubble during this time period that really capped off the government’s effort to promote homeownership. Asset prices were artificially “forced” to rise further and further. And, as we saw, in the longer run the run-up in housing prices was unsustainable. So the bubble popped!

The consequence? The New York Times reports that “About 11 million households, or a fifth of those with mortgages” are underwater ( One in five homeowners with a mortgage faces a mortgage that is larger in value than the market price of their home! In addition, many of these homeowners have lots and lots of other debts which they assumed in the Greenspan/Bernanke period of credit inflation. Thus, the default or bankruptcy problem does not exist just in the mortgage area.

Inflation, in the longer run, does not help the lower income brackets and it does not help the middle class. Most people cannot protect themselves against inflation, as can the wealthier classes in society, and the tendency is for those that are not of the wealthy classes to “stretch” their budgets, especially during periods of inflation, to acquire more than they can comfortably carry, financially. Furthermore, as we have seen, inflation tends to increase those that are underemployed in the economy as well as those that are unemployed. When the music stops, the family budget problems extend beyond just paying a mortgage.

This is the dilemma faced by the government in attempting to create a program that will prevent or slowdown defaults and foreclosures. It is not just the fact that the homeowner is underwater. The problem is that the mortgagee is over-extended in other areas and has a real cash flow problem.

The initial effort to provide relief to these troubled borrowers was to reduce interest payments that would reduce monthly mortgage payments. Over the past 12 months over 50% of all mortgages modified in this way defaulted, according to a report just released by the Comptroller of the Currency and the Office of Thrift Supervision. Mortgages that are at least 30 days late climbed to about 58% over the last twelve months. This seems to be evidence that the problem is more than just one of meeting mortgage payments. (See

The next effort, promised to be released by the White House today, will focus more on writing down the value of mortgages. It is expected that this will prove to be more beneficial to homeowners because it will result in a greater reduction in monthly payments and will reduce the psychological effect of having to pay off something that is larger than the underlying value of the asset it is financing. Another portion of the effort will be to have the F. H. A. insure mortgages that are re-written with lower loan balances, a risky effort for a tax-payer supported institution that is already facing financial difficulties.

There are several problems associated with such a program. First, if financial institutions re-write or re-finance underwater mortgages, the issue becomes one of the solvency of the underwriter. Almost one in eight banks in the United States is either on the problem list of the FDIC or near to being on this list. Can these banks afford to be forced to write off these losses in the near term?

Analysts argue that one of the things the initial effort did (the effort to reduce interest rates) is that it just “spread out” the banks having to deal with foreclosures and capital write-downs over several years. This, at least, allowed the banks to slow down the write-off process allowing them to continue to “stay alive” while they worked out their loan problems. This new program threatens these banks: the losses on these loans would have to be written-off sooner rather than later. Could this accelerate the closing of banks?

Another issue relates to whether or not these problems of “underwater” mortgages are connected to bigger issues than just the foreclosure on houses. It is the case that many of the people that purchased these houses were “stepping up” to a higher living standard and doing so created other payment obligations connected with the higher living standards. Many of the people that are underwater now re-financed in the years before the financial “collapse” and took out a lot of the equity built up in their homes to finance other purchases, perhaps a second home or an addition on the home or some other expenditure that allowed them to “step up.” Without the credit built up through the inflation in their home price they would not have been able to afford the purchases out of their cash flow, even if they continued to remain employed. In these cases the cash flow problem is more than just the difficulty in covering the monthly mortgage payment.

The point is that when a person, a business, or a society attempts to live beyond their means, events will, sooner or later, catch up with them. Inflation incents people to live beyond their means. We are observing the consequences of such behavior in the problems being experienced in the housing market.

Thursday, March 25, 2010

Audits and Auditors

I would like to recommend to the readers of this post the column by Jennifer Hughes in the Financial Times this morning. The title of the article is “Lehman Case Revives Dark Memories of Enron”:

The issue at hand is the relationship between a firm and its external auditors. The reason for the attention given to this issue by Hughes is the examination of the collapse of Lehman Brothers by Anton Valukas. Although not a major thrust of the review, questions did arise in the study concerning the role of Lehman’s external auditor Ernst & Young in the accounting practices adopted by the firm.

Ernst & Young began auditing Lehman Brothers in 1994 and two Lehman of Chief Financial Officers came from this external auditor. One, David Goldfarb, joined Lehman in 1993 and became CFO of the firm in 2000. The other, Chris O’Meara, joined Lehman in 1994 and was the CFO from 2004 to 2007. It was under Goldfarb that the accounting policy with respect to “Repo 105” transactions was developed.

To Hughes, this brought up memories of the accounting relationship between Enron and the external auditing firm Arthur Andersen. Again, a very close relationship had been established between the two organizations and many Andersen staff worked for Enron over the years.

I am not out to just criticize the accounting profession and the good and proper working relations that exist between many companies and their external auditors. However, the relationship between companies and their auditors can become too cozy and can present the opportunity to do things with company books that are, let’s say, not quite what the owners would like them to pursue.

My interest in this relationship comes from my experience as a senior executive, including President and CEO, of several publically traded banking companies. Each case was a turnaround situation.

In such a situation it is vital to get the accounting books in order and presentable to shareholders and the investment community for their close scrutiny. Internally, it is good to have “fresh eyes” to perform such a review. In a troubled institution it is problematic to have the same people, from inside as well as from outside the organization, performing this exercise. The first reason for this, of course, is that these same people watched the organization become troubled and they have a self-interest in defending the status quo. This is neither good for the company nor the shareholders and, thus, certainly not good for the executives hoping to turn-around the firm.

But, this pointed me to the problem that the financial controls that had existed were not sufficient for the company or for the executives in charge to prevent the firm from collapsing into a troubled institution. So, either the work was not getting done adequately or the executives that had been in charge did not want the work to get done adequately. Either way, the situation was not a good one for the institution or the shareholders.

It became my rule that any organization in which I was the CEO would put the job of external auditor out for bids in the fifth year of an engagement. I felt this was necessary for me to keep on top of what was going on in the organization and to have “fresh eyes” review the books and the accounting procedures on a regular basis. Furthermore, doing this periodically encouraged the openness and transparency on the part of the employees that I believed was necessary for the shareholders and the investment community.

This “rule” of mine may have been a little severe, but I was doing turnarounds at that time and the tighter time schedule seemed important to me then. Perhaps a seven year turnover of external accountants would be better, except in cases where the CFO of the company happens to be a former employee of the accounting firm doing the external auditing.

Hughes mentions in her article that Italy, among other countries, have limits on audit firm tenure. There the length of time allowed is nine years. Other countries require that the “lead partner” from the accounting firm be changed every five years. Also, there are rules about hiring individuals from the external auditing firm, rules that require a “cooling off” period for anyone joining an audit client.

To me, this requirement seems of particular importance to banks and other financial institutions. Yes, the banks are examined by the regulators and this should provide a check on what banks are doing. But, this is not enough in my mind.

When I was a bank President and CEO, I wanted the bank to have stricter requirements on what it did than the regulators. The reason is that I wanted the company to control the position of the bank and not the regulators. This also applied to the safety and soundness of the bank. That is why I wanted to ensure that the external auditors were truly independent of me and the staff of the bank. Having the external auditor “turnover” on a regular basis was one way to help achieve this goal. To my mind, any CEO that has the best interests of his/her shareholders in mind would want this to be the case.

I know that this is not the case of all CEOs in all industries. That is why some regulation of company/external auditor relationships is important. This is true especially for the commercial banking industry. Any regulatory reform that is passed should have some statement about the presence of an external auditor and the regular replacement of external auditors. This is a first round effort to insure the safety and soundness of the banking system and should, if it existed, ease some of the burden placed on the examination efforts of the regulatory agencies. It is a part of the openness and transparency that should be required for all companies, but especially for those related to banking.

I know that there is little academic research, as Hughes reports, connecting “audit, or auditor tenure, and the quality of the work.” I know that most situations and people work out well. I know the value that hiring someone familiar with your books is a “good thing” because of the complexity and sophistication of accounting practices today.

Still, I always wanted to be on top of things and continually have “fresh eyes” looking over the operations and the books. I always wanted to be challenged to do things in the best way possible. I always wanted people to push me to do better. Openness and transparency never bothered me. To me, performance always went back to how well you executed your game plan and not on how much trickery or deception you needed to win.

To me, it all comes back to fundamentals and ability. If you lack one or the other or both…I guess you need to rely on other means, like “cooking the books”, to come out on top.

Wednesday, March 24, 2010

The United States Dollar, Europe, and England

I have been a “Dollar Bear” for most of the 2000s. For the long run, I continue to be a “Dollar Bear”, at least with respect to many currencies in the world. Right now, against the Euro and against the British Pound, the investment community is telling me that Europe and the U. K. are in worse shape, fiscally and politically, than the United States and therefore I need to alter my stance with respect to these currencies.

The play in international currency markets is, of course, a relative one. How is XYZ nation doing relative to LMN nation? So, one country might be doing miserably, yet another country might be in even worse shape, and, hence, the price of the currency of the latter relative to the former will decline.

This relative price, to Paul Volcker, “is the single most important price in the economy.”
Consequently, “it is hard for any government to ignore large swings in its exchange rate.” Or, at least, it should be!

Right now, the price of the Euro and the price of the British Pound are saying that the governments in Europe and the government in England should be concerned. Things are not going right and it is costing them and their people.

Of course, there are many monetary and fiscal problems that exist in the United States. But, the markets seem to be saying that, currently, attention needs to be focused elsewhere. And, in Europe and England, the problems are both economic and political.

In Europe, the major focus has been on Greece and the unfolding soap opera that is taking place in the European Union over how the fiscal problems that Greece faces will be overcome. Verbal recognition has been given to the problems faced by Portugal, Italy, Ireland, and Spain, but until yesterday they were being put to the side.

Then, Fitch Ratings reduced the credit grade of Portugal’s debt. The problem, according to a spokesman from Fitch, was that Portugal would struggle to meet its debt commitments in the face of “macroeconomic and structural weaknesses.”

This downgrade, others said, just reflected the concern over “the underlying problems in the European Union. People are worried about the fiscal situation in the southern European economies and the prospects for those economies.”

The difficulties, however, go deeper than that. What has surfaced over the past few weeks is the political problems of running a single currency in a region where there is no single government. This situation could be workable if all the countries within a currency area followed the same fiscal policies.

As is now apparent within the EU, this is not an easy thing to do. Different countries have different national make-ups. They have different histories and experiences. And, they have political parties that are at different places in the political spectrum. The chance that all the countries will follow similar paths with respect to economic policy is “slim” and “none.”

Currently, Germany is getting bashed for the disciplined and prudent policies that it has followed in recent years. No one is doing a better job at bashing the Germans than is the columnist Martin Wolf. (See “Excessive virtue can be a vice for the world economy,” The logic of this is beyond me. Germany has worked hard, kept up its discipline, produces high quality goods, and has an export surplus and should now give up what it has worked so hard for because others have over-promised, over-spent, and mortgaged their future? As Wolf argues, the virtue of Germany is a vice in a world economy? Come on, Mr. Wolf!

The European Union is facing a political crisis resulting from its adoption of a single currency. To the most pessimistic, this was always in the works. Paul Donovan, the deputy head of global economics at UBS Investment Bank, stated that Greece “is going to default at some point” because of the political problems of the EU. He goes on: “If Europe can’t solve a small problem like this, how on earth is it going to solve the larger problem, which is the euro doesn’t work.”

England is also facing economic and political problems. First of all, it has a serious budget problem and very little is being done about it at the present time. This is because of the second problem which has to do with the upcoming election. The Prime Minister, Gordon Brown, doesn’t want to do anything relative to the budget that would further upset the electorate right before the election. However, the Conservative candidate seems to be so inept that he cannot seem to be able to forge some kind of sensible budgetary policy in order to overtake a very unpopular Mr. Brown. World markets seem to have very little confidence with what is going on in the United Kingdom at this time.

The consequence of all this? The Euro is trading around $1.33 per Euro this morning, down from around $1.51 toward the end of 2009, almost a 12% decline. The British Pound is trading around $1.49 per Pound this morning, down from around $1.68 in November 2009, about an 11% decline.

The odds seem to be in favor of additional declines in these currencies until some satisfactory resolution is reached on both the economic and the political fronts.

United States officials can enjoy having someone else being in the spotlight for a while. Still, nothing has really changed for the good in terms of economic policy for the United States. Fiscal deficits are large and are expected to remain so for the upcoming decade. The monetary authorizes still have to “undo” what they have “done”. The political situation does seem to be a little more stable in the United States than in either Europe or England.

The value of the United States dollar does continue to decline against the currencies of other trading partners, especially against those currencies in the “emerging nations.” Here the trend seems to be for the dollar to continue to decline. The near-term declines continue against the Brazilian Real, the Canadian dollar, the Japanese Yen, the South Korean Won, the Swiss Franc, and the Australian dollar.

The United States dollar is not “out-of-the-woods”, by any means. And, as we have seen, world investors can turn on a country very quickly. Six months ago, the Euro and the British Pound were doing quite well, thank you. Government officials need to beware that they still have a long way to go before the investment community can look on the United States dollar with real confidence.

Right now the dollar gets a respite. How long this will last is uncertain at the present time. It is still my belief that over time the United States dollar will come under selling pressure again. It would be best if the Obama administration used this time to re-establish some form of discipline in both monetary and fiscal policy. But, I am not assuming a very high probability that this will happen in the near future, especially with the direction Congress seems to be heading.

Monday, March 22, 2010

The Chances for a Double Dip

I believe that the probability that we will have a double dip in the economy, a second recession following on the Great Recession, is relatively small and growing smaller all of the time.

The reason that I would give for this is that economies only change directions when there is some kind of shock to expectations. To use the words of one famous pundit with respect to an uncertain future, we just don’t know when something will change with respect to an “unknown” unknown. Even in the cases of “known” unknowns, we know where a change might occur; we just don’t know the magnitude of the change.

A liquidity crisis occurs when something happens in a market, generally a financial market, and the buyers on the demand side of the market decide it is best if they just go out and play a round of golf until the market settles and they know where prices will stabilize. The job of the central bank is to provide liquidity to the market so as to achieve this stabilization of prices. The length of a liquidity crisis is usually no more than four weeks.

A credit crisis occurs when something happens in a market, generally a financial market, and the holders of assets must significantly write down the value of their assets. Banks and other financial organizations may go out of business during the credit crisis because they don’t have sufficient capital to cover all the write downs that must take place. The job of the central bank is to provide stability to the financial markets so that the financial institutions can take their charge-offs in an orderly fashion so as not to cause multiple bank failures. The length of a credit crisis can extend for several years as the financial institutions work off their problem loans and those organizations that have to close their doors do so with the least disruption to “business-as-usual.”

In both cases, something unexpected happens and expectations about asset prices have to be adjusted. Extreme danger exists as long as bankers and investors persist is retaining the old expectations about prices and fail to make the moves necessary to adjust their thinking to a more realistic assessment of the situation. However, as these bankers and investors adjust to the “new reality”, they become more conservative and risk-averse in their decision making and work hard to get asset prices into line with the new financial and economic environment they have to deal with.

As the adjustment to the “new reality” takes place, things remain precarious, but, as long as no new surprises come along, the process of re-structuring can continue to lessen the problem and even strengthen the recovery. This is the state in which the United States is in right now.

The thing that needs to be avoided is a “new surprise”. What this can be of course is “unknown”…an “unknown” unknown.

In the 1937-1938 depression, there was an “unknown” unknown in the form of a policy change at the Federal Reserve System that is credited with “shocking” the financial and economic system into the second depression of the 1930s. The shock here was an increase in the reserves the banking system was required to hold behind deposits in banks, an increase in reserve requirements. The argument given for the increase was that there were a lot of excess reserves in the banking system and for the Federal Reserve to be effective at all during the time, the excess reserves had to be removed: hence the increase in reserve requirements.

The problem was that the banks wanted the excess reserves and with the increase in reserve requirements the banks became even more conservative causing another massive decrease in the money stock. This, of course, has been given as a reason for the “double-dip” that took place in the 1930s.

There are, as is well known, a lot of excess reserves in the banking system at the present time, almost $1.2 trillion in excess reserves. The Federal Reserve knows that they are going to have to remove these reserves from the banking system at some time. Hence, it has developed an “exit” strategy.

Banks and investors know that the Federal Reserve is going to have to remove these reserves from the banking system at some time. How the Fed is going to accomplish its “undoing” is, of course, the big unknown!

The fact that these reserves are going to be removed from the banking system is a “known” unknown!

But, how and when the reduction in reserves is going to take place, not even the Fed knows. Bernanke and the Fed have worked hard to keep the banking system and the financial markets aware of the “undoing” so that although there are still many unknowns connected with this undoing, the fact that the “undoing” is going to be done is a “known.”

The effort here is to avoid a policy “shock” coming from the central bank as in the 1937-1938 experience.

There are a lot of things going on in other sectors of the economy and the world, but these all seem to fit into the category of “known” unknowns: like the problems in Greece and the other PIIGS, Portugal, Italy, Ireland, and Spain. There are the problems of states, California, New York, New Jersey, and so on, and municipalities, like Philadelphia and others, but these are also “known”.

There are over 700 commercial banks on the problem list of the FDIC. But these are “known” and are being worked off in an orderly and professional way that seems to be the model of the world. (See the article by Gillian Tett, “Practising the last rites for dying banks,” The FDIC closed seven banks last Friday bringing the total for the year to 33. This is right on my projection of closing at least 3 banks a week for the next 12 to 18 months.

And, what about the United States deficit? Well, I would contend that this is a “known” unknown as well. The deficits over the next ten years or so are projected to be in the range of $9-$10 trillion. I believe that they will be more around $15-$18 trillion, but that is just a minor difference. But, the deficits are “on-the-table” even if the amounts are not quite certain. The deficits will be large and this will be a problem, but they are not going to be a surprise.

This is one reason, I believe, why the Obama administration made the effort they did to talk about the budget deficits publically, particularly with regards to the health care initiative. They are talking about the budget, whether one agrees with their projections or not.

And, just the passage of the health care legislation, I believe, will change the temper of things. This thing has been done and I think just this fact will change the environment…for the better.

There are always “unknown” unknowns lurking. There could be a blow up in the Middle East leading to a full-scale war…or in the east. There could be a political move to boost the price of oil. There could be a lot of things. But, as far as the economy itself and the financial markets: I believe that things are being worked out and things will continue to improve. Thus, the probability of a Double Dip has lessened.

Thursday, March 18, 2010

The "Dodd" Financial Reform Bill

Well, there finally is a financial reform bill!

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System seems to be back in the good graces of the political pros. So much for the independence of the Fed!

The only thing Bernanke seems unhappy about at the present time is that he would like to maintain more regulatory influence over banks that are less than $50 billion in asset size. Otherwise, he seems pretty satisfied.

The important thing is that the Fed and the Chairman of the Fed retain, or even increase, their power.

I have written on the future environment of bank regulation and so I don’t intend to go into that again at this time. This series began on January 25, 2010: see my “Financial Regulation in the Information Age: Part A” ( which was followed by Part B and Part C. Let me just say that I believe that the regulatory structure that Dodd and Congress is attempting to construct is aimed at “fighting the last war” and that the financial system, especially the part composed of large financial organizations, has already moved beyond what the politicians are fighting for. So, Congress is already behind the times.

Even more important, however, is the fact that the underlying cause of the growth in finance over the past fifty years or so, the financial innovation that took place, and the evolution of financial institutions into structures that are “too big to fail”, is not even being addressed. And, if this cause is not taken into account, any regulatory structure that Congress constructs will be doubly inadequate to handle the problems of the future.

Debt finance thrives in an inflationary environment! Need I mention again that what a dollar bill could purchase in January 1961 has declined to the point that a 2010 dollar could only buy less than twenty cents worth of the same goods and services today? The purchasing power of the dollar has declined by more than 80% since the early 1960s.

The inflationary environment that began in the early 1960s bore fruit by the early 1970s and only spread from there. The Gross Federal debt had increased by more than 40% during this time period, the largest peace-time increase in the government’s debt in history. Commercial banks had innovated to the extent that they could get-around any federal or state regulations that might limit their geographic or asset expansion by creating the ability to “manage liabilities” and hence grow to any size that they desired. The federal government had created a novel new financial innovation called the mortgage-backed security that would, in fifteen years or so, result in the mortgage market becoming the largest component of the capital markets in the world.

And, by August 1971, inflation became such a problem that President Nixon froze wages and prices in the United States and removed the dollar from the gold standard. In addition, Nixon appointed a Fed Chairman that underwrote his re-election and promoted the most expansive monetary growth in the post-World War II period to date. By the end of the 1970s decade, inflation was the number one problem in the United States. In 1978, Congress passed a second full employment bill that secured in law the “Keynesian” economic philosophy that the federal government had to achieve high levels of employment in the economy. And, as they say, with two short exceptions, the rest is history.

There is no better environment for debt and the creation of financial innovation than one that is grounded in inflation. With no constraint on the size of financial institutions, almost all of them became liability managers, banks and other financial organizations could grow and grow and grow. Where there were constraints, the environment was such that ways could be found around the constraints. And, since the constraints didn’t work in such an inflationary environment, the politicians and the regulators were even willing to remove or lessen the constraints that were still on the books. Good-bye Glass-Steagall.

Inflation, usually measured in terms of flow statistics like the Consumer Price Index, spilled over into the prices of assets, like common stocks, houses, and commercial real estate. The consumer inflation of the period before the 1990s became the “bubble” inflations of the 1990s and 2000s, and, the music continued to play.

My point is, of course, that no regulatory structure is going to withstand an economic environment in which the value of the currency declines by more than 80 percent over a period of fifty years. And, the last fifty years was a period in which the Information Age was just in its infancy. The major point in my series of posts on regulation that appeared in January was that the ability of financial institutions to innovate in the next fifty years is ever so much greater than it was in the past fifty years. Thus, the hope to “rein in” the financial system is like smoke that will just swiftly drift away into the atmosphere.

If Congress and the Obama administration want to keep a lid on the financial system they need to clean up their own house first. The attempts they are making to re-regulate this financial system, to me, are hopeless unless they abandon the fundamental philosophy that is the foundation for their economic policies. The “Keynesian” effort to keep employment at high levels in the short run hasn’t worked and it will not work in the future. The “Keynesian” effort to keep employment at high levels creates an inflationary bias in the economy. An inflationary bias produces an incentive to take on more and more debt and leverage oneself into the future. This bias is the engine that drives the excessive risk-taking that can come from accelerating financial innovation. This is story of what occurred over the past fifty years.

In conclusion, then, financial regulation is more than just controlling the behavior of “greedy” bankers!

Wednesday, March 17, 2010


Martin Wolf introduces this name, a combination of China and Germany (as opposed to “Chimerica”, a name invented by Niall Ferguson and Moritz Schularick), to discuss the economic policies of the two countries in his opinion piece, “China and Germany unite to impose global deflation.” (See
Wolf’s approach is not inconsistent with that of Paul Krugman, whose recent work was discussed in my Monday post “Why Should China Change?” (See The only difference is that Wolf includes Germany in the discussion.

The basic premise is that China and Germany, “although very different from each other,” are pursuing economic policies that are very similar. Both have huge trade surpluses and massive surpluses of saving over investment. “Both believe that their customers should keep buying, but stop irresponsible borrowing.”

The Germans have “picked” on the European Union; the Chinese have “picked” on the United States.

In Wolf’s assessment, “the surplus countries are most unlikely to win.” The real loser, however, will be the world.

The problem with this analysis seems to be that all of the writers engaged in this discussion accept “the war” as only an economic war. A more correct assessment of the situation might lead one to conclude that what is going on is more political than just economic. What is going on is the shifting battle for relative national position in the world pecking order. The time is especially propitious for changing the political landscape as some countries are experiencing massive shifts in their economic strengths. And, the list is not just limited to China and Germany.

In the European frame of reference, the initial focus was on Greece, but economic problems abound for Spain, Portugal, Italy, and France. And, don’t forget the difficulties being faced by Ireland and England.

Economically, Germany is substantially better off than these countries and does not want to be made weak by giving these other countries a “free ride” to recovery. Why should Germany have to suffer economically because of the undisciplined budget policies of these other nations?

China, on the other hand, is smelling weakness, and, as a consequence, is seeing this as a way to improve its relative position of influence in the world. But, it is also pursuing this path in many different ways, establishing diplomatic relations with nations around the world, especially those that are wealthy in natural resources, buying companies all over the world, and gaining influence in the scientific and technological community. China’s influence is growing everywhere.

Others are on the move as well recognizing that the time is right for them to exert themselves in the world.

The argument that is being raised by Wolf and Krugman is that the behavior of the Chinese and the Germans is detrimental to the economic recovery of the other western nations. Continuing along the path they are now following will prevent the United States and France and Spain and the UK and others from getting back on their feet and this will result in a collapse of world trade and, hence, the economic well-being of everyone.

But, that is solely the economic analysis. It does not include the political aspects of the situation.

There are very few times in world history when the position of the nations of the world can be substantially altered. The period from the 1910s through the 1940s was such a period. As we know, the United States moved into a position of dominance during that time, both economically and militarily.

At the present time, some countries are sensing another massive shift in world power. And the potential big players are China, India, Brazil, and Russia. Germany and Japan would like to be there. And, there are others: Canada, Iran, and Argentina.

Nations who have a longer-term time horizon and see the world in decades, like China and India, are not going to let this opportunity pass. They also do not see that the issue of change will be resolved in the next ten to twenty years. In the short run we, individuals, may all be dead, but the nations will live on.

And, this is precisely the problem. Over the past fifty to sixty years, the countries that are now experiencing the most problems focused on the short run and, as a consequence, created an economic environment built upon a lack of saving, debt creation and inflation.

It says a lot when some of the leading intellectuals of this philosophy, “Keynesians” like Oliver Blanchard, propose that the solution to the current difficulties is to create higher targets for inflation. (See “The Lure of Inflation’s Siren Song” by David Reilly: Included in this piece is the quote, “Inflation can achieve what no congress can, fast reductions in fiscal deficits," Christian Broda, head of international research at Barclays Capital.) My response to this is “Doesn’t Anyone Understand Inflation?” (which can be found at

Now, we have Wolf and Krugman arguing that those that are in the stronger position economically should “bail out” those that acted imprudently in the past. And, here is where the concept of moral hazard comes into play. If the countries having problems right now do get “bailed out” by those that are economically stronger, why should they, once they have recovered from their economic difficulties, act in a disciplined manner in the future? As with other institutions that have been “bailed out”, there is little incentive to for them to act prudently going forward.

The “Keynesians” have had their day. We are living with their legacy. We cannot expect the Chinese or the Germans to give them another chance. We cannot expect the Chinese or the Germans to place the future that they see within their grasp in jeopardy in order to rescue those that have willingly become addicted to more and more debt in their lives.

The ethos of the 1950s and the 1960s may have dominated the last fifty years, but it is my guess that the 21st century will be determined by what takes place in the 2010s and 2020s. The complete lack of fiscal discipline in the United States over the last eight years or so may have accelerated this transition in ways that we do not yet understand. One of the problems in dealing with such changes going forward, however, will be a failure to recognize that certain changes have already occurred.

Tuesday, March 16, 2010

The Federal Reserve and the Smaller Banks

The Open Market Committee of the Federal Reserve System meets today. No one is expecting that there will be any change to the Fed’s target Federal Funds rate. The reason given is that the economy still remains exceedingly weak with the unemployment rate remaining just below 10 percent and the inflation rate as measured by the consumer price index less food and energy, the Fed’s preferred price measure, hovering between a one percent and a 1 ½ percent, year-over-year rate of increase. This latter fact combined with the information that there is a lot of unused capacity in United States manufacturing is believed to be the primary argument for keeping the target interest rate at such a low level.

I, too, believe that the Open Market Committee will not change the target rate of interest at this time, but I still believe that the Federal Reserve is still very troubled about the condition of small- and medium-sized banks. To repeat the statistics again, the FDIC has more than 700 banks on its problem list with the expectation that over the next 12 to 18 months there will be three to four banks closed, on average, every week. The small- to medium-sized banks in this country do not appear to be in very good shape.

To raise rates at this time and remove reserves from the banking system could make the situation amongst the small- to medium-sized banks much more difficult. Yes, according to Federal Reserve statistics, small domestically chartered commercial banks in the United States make up only about 34% of the banking assets of domestically chartered banks in the United States as of the first week of March 2010. (The largest 25 domestically chartered banks therefore makeup about two-thirds of the assets of domestically chartered banks in the country.) Therefore, about 8,000 banks in the United States hold only one-third of the bank assets in the country. Perhaps this is not sufficient to worry too much about.

However, one could argue that another reason, perhaps the main reason, that the Fed does not want to raise its interest target is the shaky shape of this portion of the banking system.

The smaller banks in the country hold about $320 billion or about 9% of their assets in cash assets in the first week of March. This is up from 6% one year ago!

Furthermore, these banks hold about 12% of their assets in Treasury and Agency securities with another 7% of assets held in other securities. (This total of 19% is up from around 17% one year ago.)

Thus, these banks hold almost 28% of their assets in cash or marketable securities. This is up from about 23% at the same time in 2009.

One keeps looking for “green shoots” amongst these smaller banks. The bigger banks are going to make it now and do not present much of a worry to the Feds. In fact, the bigger banks are raking in the profits, one way or another.

The problem is, that I don’t see much happening in the smaller banks. The total assets of the bank are about the same as one year ago, but as the above figures show these banks have gone 100% risk-averse. It seems as if they are just holding on, hoping to survive the worst.

Total loans and leases at these banks are down a little more than 6% year-over-year. However, these totals are down almost $88 billion over the past 13 weeks, a drop of almost 4% in about three months.

Commercial and Industrial loans are down around 9%, year-over-year, although they have only dropped about $6 in the 13-week period ending March 3. Business loans are down severely and show no sign of picking up. This has got to have an impact on Main Street because the businesses that deal with these banks have few alternative sources of funds.

Another major area of concern to the small- to medium-sized banks is their portfolio of commercial real estate loans. These loans are down by more than 5% year-over-year and down almost $40 billion over the last 13-week period.

This is an area of major concern to these smaller banks and are expected to be the source of extended troubles to the banks over the next 18- to 24-months. This is the area over which Elizabeth Warren, the head of oversight for Congress of the TARP funds, has expressed extreme anxiety.

The fear that one has in this area is that the loan problems of these small- and medium-sized banks have not really been fully worked out. As such, these banks are behaving in a very conservative fashion for a reason. They are building up cash assets and liquid assets in order to provide protection for themselves to weather potential loan charge offs over the next year or so. If interest rates begin to rise and the Fed begins to withdraw reserves from the banking system, these banking organizations could be forced to charge off many of these loans and this could cause severe damage to their capital positions. It is my belief that the Federal Reserve is cognizant of this situation.

Overall, the Federal Reserve is keeping excess reserves in the banking system at record levels. In the two weeks ending March 10, 2010, excess reserves in the banking system average roughly $1.2 trillion.

The banking system as a whole is recording about $1.3 trillion in cash assets in the banking week ending March 3. This is divided up between Large Domestically Chartered banks about $570 billion, Small Domestically Chartered banks about $320 billion, and Foreign-Related institutions about $460 billion. (What is perhaps interesting is this latter figure which was about $230 billion one year ago. Just what is going on with these foreign-related institutions?)

The loan portfolios of the large banks continue to contract as well. Total loans and leases are down about 7% year-over-year, and have dropped $85 billion over the last 13-week period. The two biggest declines registered come in Commercial and Industrial Loans, $31 billion, and Residential loans, also around $31 billion. There does not seem to be much activity in the Commercial Real Estate portfolio, contrary to what seems to be happening in the small- to medium-sized banks.

The conclusion?

No “green shoots” but lots of problems remaining in the smaller banks!

Surveys coming out from the Federal Reserve indicate that fewer banks are tightening up their lending standards. This is promoted as a good sign. Other indicators in housing construction, foreclosures, and bankruptcies are seen as pointing to a turnaround in the banking system.

I don’t see it yet. And, I don’t think that the Federal Reserve really sees it yet.

The banking system must begin lending again if we are to have an economic recovery and job growth. Many companies seem to be tapping the capital markets as debt issues climb. However, these are not Main Street businesses. And, history teaches us, the banking system must be there to underwrite any expansion of business activity because for many, Main Street is the only place they can raise funds.

Monday, March 15, 2010

Why Should China Change?

Paul Krugman takes on China in his column this morning: “Taking on China”: He begins, “Tensions are rising over Chinese economic policy, and rightly so” because it “has become a significant drag on global economic recovery.”

Why should China change direction at this time?

There was a time when the United States could do just about anything it wanted to. It was, by far, the strongest economy in the world. It had, by far, the most powerful army on the planet. It provided, by far, the best education anywhere. In essence, it could get away with about anything.

In fact, there are quite a few nations now in addition to China, such as Brazil, India, Russia, Canada to name a few, that can ask the same question, “Why should we change direction at this time?”

The gap has closed. There has been more and more talk about this diminishing gap. One of the more prominent books on the subject is by Fareed Zakaria titled “The Post-American World and another is by PIMCO’s Mohamed El-Erian’s “When Markets Collide.” The problem arises, not because the United States has been replaced at the top. No, the United States will remain the world’s number one power, economically and militarily, for many more years.

The problem is that the relative gap has changed putting the nations mentioned above relatively closer to the United States and this, consequently, gives them a stronger position is how things are played out. We see this in the shift to the G-20 rather than some other G-something. We see this in discussions around the World Bank and the International Monetary Fund. We see this in the growing influence of these other countries around the world.

The world has changed and we in the United States have not accepted the fact.

Why should China change direction at this time?

China is growing stronger and stronger. The United States, and most of the rest of the west, is in a weakened state. The United States, and most of the rest of the west, has gone through a very severe financial crisis and the worst recession since the 1930s. The United States, and most of the rest of the west, is beginning to recover, although the pickup has been very weak up to the present point.

Krugman is arguing that those big bad Chinese are hurting us when we are weak, when we are least able to defend ourselves.

Well, we got ourselves into this situation. We, the United States, created an inflationary environment which resulted in the purchasing power of the dollar declining by about 85% over the past fifty years or so. We, the United States, produced an environment that fostered, even celebrated, the creation of debt. We, the United States saw the value of our currency in international markets decline steadily, with a few exceptions, over the past fifty years. The only respite experienced recently has been that the dollar and U. S. Treasury securities have become a haven for risk-averse investors throughout the world.

Now, the United States is suffering through the consequences of this lack of discipline and is pointing its finger at the big bully that is taking advantage of the situation.

But, the big bully is pointing his finger back at the United States and even accusing the United States of not playing fair itself. (See “Chinese Leader Defends Currency and Policies”, China is even playing international economics against the United States (see China Uses Rules on Global Trades to its Advantage”, and continues to acquire natural resources, companies, and trade ties throughout the world (see “CNOOC in $3bn Bridas deal”,

Imagine the nerve of these people!

In the end, the lack of fiscal discipline comes back to haunt one, whether it be a person, a family, a business, or a nation. On the upside, the ride can be great. However, once the bubble bursts, there are no good choices available to one. There is pain regardless of what one does.

Now, however, there are other players in the game and this lack of fiscal discipline can really hurt. The economy of the United States, and the rest of the west, is weak, budget deficits are projected to go on forever, and the dollar is expected to weaken again as international investors become less risk-averse. We need everyone to cooperate with us so that we can bail ourselves out of our past behavior.

Unfortunately, that is not how the world works. And, it is human nature to sense weakness in others. The United States, and the rest of the west, is in a weakened state right now. It will not always be so, but it is for the time being. Thus, others have an opportunity to increase their relative position within the world.

My guess is that China does not plan to overdo it for they have more to gain in the future if trade is more open than not. One piece of advice someone gave me several years ago about the Chinese has proven to be very perceptive. They said that whereas people in the West have very short time horizons, generally in the three to five year range or less, the Chinese have a much long perspective of history. They think in decades rather than years.

I believe that the Chinese know that they will be better off over the longer run if world trade is more open rather than more restricted. Hence, they will not go far so as to create a trade war that will be detrimental to achieving a more open world trade. China’s investments in natural resources and companies throughout the world underscore this bet.

However, the United States is in a weakened position. Thus, the Chinese can achieve more now by taking advantage of this weak position and still achieve the longer-term goal of more open trade. The United States is in no position to resist this and will not be in a position to resist this for some time. And, it would hurt us more to act aggressively at this time to introduce more trade protection than it would China. Hence, advantage China.

Quite a few other countries are also in a position of strength relative to the United States at this time. Brazil seems to be following a more and more independent line. India is acting more in tune with its own interests. Russia, except for its athletics, is also stepping out here and there. And, so on and so on.

It is interesting to see people from the school of economics that led the United States into the position it is in, like Krugman and Joe Stiglitz, begging for help from others in the world that are taking advantage of the weaknesses created by the application of the policies forthcoming from that school. The lack of discipline has consequences. Why should we expect or depend upon others to bail us out of the conditions that we ourselves have created? Why should China change

Thursday, March 11, 2010

"Sharing the Pain: Dealing with Fiscal Deficits"

Over the past week or so, I have spent a lot of time on sovereign debt and the problems being faced by various nations across this planet with respect to their budget deficits. I suggest the article “Sharing the Pain” in the March 4, 2010 edition of The Economist as a good compilation of issues relating to the situation many countries are now facing. This piece is contained in the briefing, “Dealing with Fiscal Deficits,”

We can separate the discussion into three categories: the problem, the pain, and the pragmatic response.

First, the problem. History shows us that when economies slow down, budget deficits appear or widen. Revenue growth declines as the needs to increase outlays rises. Put this general movement on top of decades of undisciplined management of government budgets and you can get “one hell of a problem”

The Economist article states that “deficits in several countries have increased so much and so fast during the economic crisis of the past 18 months or so that it is generally agreed that remedial action will be needed in the medium term. Deficits of 10% or more of GDP cannot be sustained for long, especially when nervous markets drive up the cost of servicing the growing debt.” It continues, “when markets do lose confidence in a government’s fiscal rectitude, a crisis can arise quite quickly, forcing countries into painful political decisions.”

Second, the pain. History shows, according to Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, that it is highly unlikely that the “rich countries” of the world will experience a burst of rapid and prolonged growth. “Sluggish growth is more likely” and “the evidence offers little support for the view that countries simply grow out of their debts.”

“So, short of debt default or implicit default via inflation, that leaves just two other ways of closing the deficit. Spending must be cut or taxpayers must pay more.” Hence the pain!

Here we can point to the situation in Greece where much of the effort to return some fiscal discipline to the country is falling on cuts in government wages and in social benefits. This has resulted in substantial personal retrenchment and civil unrest. Today we read of a second general strike in the nation that closed all public services. See, “New Strike Paralyzes Greece,”

The deficits are so large in most of the affected countries that minor adjustments to spending or taxes will have little or no impact. The budget adjustments that must be made are quite substantial: hence the depth and breadth of the pain.

In recessions that are relatively minor, government monetary and fiscal stimulus seems to restore economic growth, thereby rectifying the situation and minimizing the pain. But, in a recession of the magnitude of the Great Recession the government does not seem to be able to “buy” itself out of the trouble. Hence, the spread of the pain.

Furthermore, there is an added difficulty that enters the picture in the more extreme cases. Those that are more affected by the recession and by the adjustments that need to be made in government budgets may come to see the changes as a break in the “social contract” of the country. This government that saw to their welfare, put them to work, and sustained them through the minor crises of the past, now seems to be abandoning them. And, for whom? The international financial community!

Obviously, if we get into this state of affairs, the emotions can become quite high, as in Greece.

This leads us into the third category which has to do with what government can do in such situations. The problem with the situation brought on by large budget deficits and a growing national debt is that there are no good solutions. Anything the government does in an attempt to get the budget under control while encouraging the economy to recover hurts someone.

This is why governments must be very pragmatic in what they propose. Doctrinaire approaches just do not seem to work. There are only two suggestions from the historical perspective that seem to have borne some fruit in the past. The first is that there needs to be some “social cohesion” in the country to achieve some success in the effort to get the country’s budget under control. The second is that governments “should focus on spending cuts rather than tax increases.”

The article in The Economist points to two instances where successful government tightening has taken place in recent memory: Sweden and Canada. In both cases the crisis in the country became acute enough and the ruling governments acted in a sufficiently pragmatic way so that voters finally got behind the efforts. However, this social cohesion was not always achieved on the first attempt.

Some of the social cohesion can be gained by raising some taxes, especially on the “better off”. This may be the “quid pro quo” for the less well off to accept the other things that need to be done. The downside to this is always that the “better off” have more escape hatches that will allow them to avoid any imposition of taxes they feel are excessive. And, many countries in the past twenty years or so have built up reputations as “low tax havens” to attract business. Ireland, for example, lowered its corporate tax rate to just 12.5% and is very reluctant to increase this and harm the climate they benefitted so much from. If taxes go up on these people and businesses, they can be very mobile and move to less oppression environments. Also, tax evasion can be a huge problem especially against sales or value-added taxes.

So, the burden of fiscal tightening falls on the spending side but this is not an easy road either. And, when one looks at the “big” targets for cuts, good arguments for not making cuts abound. Military spending is not a major item in many countries needing budget cuts, but it is in the United States. Here, there are two wars being fought and the need to maintain the world’s “top” military machine and keep it current through research and development makes the budget almost non-touchable.

The next major item that comes up on the list to consider is government employment. Over the last 50-60 years, governments throughout the world have exploded in terms of providing employment. Over the last several years the rate of government hiring has gone up, especially in the United States, in an effort to deal with the financial crisis and the Great Recession. Is it realistic to think that governments will shrink in size or in terms of payroll expenses? This is where Greece and Ireland and Portugal and Spain have promised to do something. And, of course, this is where much of the civil unrest has come from.

Next, social programs, a huge item in many government budgets and the primary cause of the expansion of government budgets in the post World War II period. (For more on this see Niall Ferguson’s book “The Ascent of Money: A Financial History of the World.) The Economist suggests that one area that can be rationalized here is the pension system in these countries.
And, there are other ideas available.

The thing the article (implicitly) points out is that the way out of the fiscal dilemma is not easy. But, I suggest three further things that need to be considered. First, leadership. The countries facing the problems discussed here need to have someone out in front that is understood and trusted. The only way out of this situation is pragmatic: not progressive, not conservative, not liberal, not socialist, or any other dogmatic approach. But, to achieve the “social cohesion” necessary for success, there must be leaders that draw people together.

Second, the proposed solutions cannot just force people back into the way things were. One reason for the depth and breadth of the Great Recession is the changing structure of the society and culture. (For more on this see my post, If this is true, then the leadership must be forward-looking rather than serving just entrenched interests.

Finally, this will not be easy. As The Economist article closes: “There are many battles over deficits to come. Well chosen policies that foster growth may make them less fierce. They may be bloody even so.” Amen.

Wednesday, March 10, 2010

A Time for Crybabies

The headlines of the day: “European Leaders Call for Crackdown on Derivatives” ( and “Call for Action on Speculation Rules” (

Alternative headlines to these are “Financial Markets Call for Crackdown on Undisciplined and Irresponsible Government Budget Behavior” or “Call for Action on Fiscal Policy Biases.”

This is the time for cry-babies and the leaders of many nations in the world are not letting us down.

Their basic theme is “All our problems can be laid at the feet of the financial community, its innovations, and its speculative behavior. We need better and tougher regulation and we need stricter laws and rules about what can be done. Doing this will make everything better!”

This, however, is getting “cause and effect” turned around!

My question is, “Who created the inflationary environment of the last fifty or sixty years that resulted in the financial innovation and speculation that resulted? Who promoted almost perpetual government budget deficits, in recessions as well as booms, and who underwrote this deficit spending with supportive monetary policies that encouraged the expansions but fought the contractions? Who is responsible for the 85% decline in the purchasing power of the United
States dollar since January 1961?”

The stage was set in the United States in 1946 when Congress passed the “Full Employment Act of 1946.” In 1961, an administration took over the presidency that was devoted to the Keynesian full employment policy. In 1971, President Nixon in an effort to stimulate the economy to get himself re-elected claimed that “We are all Keynesians now!” In this effort to get re-elected, Nixon appointed Arthur Burns as the Chairman of the Board of Governors of the Federal Reserve System. Monetary policy supported the effort to achieve the economic goals Nixon believed he needed to have in order to get re-elected. Then in 1978, Congress enacted the “Full Employment and Balanced Growth Act”, often referred to as the “Humphrey-Hawkins Full Employment Act.”

The true test of government monetary and fiscal policy, as written into the law of the land was full employment and high levels of economic growth. And, explicitly or implicitly, countries throughout the free world followed this pattern in the post World War II world.

And, what resulted from this policy bias?

Well, by the last half of 1968 we had high-grade corporate bond rates in the 6.5% range. These yields had not really gotten much above 4% until late 1959 into 1960, and did not cross 5% until the middle of the latter decade. It was during the late 1960s that researchers started discussing the presence of “inflationary expectations” in interest rates, a concern that vanished toward the end of the 1920s.

In the 1960s we also saw the first real post-World War II financial innovation take place. The primary source of business credit at that time was the commercial banks. As the presence of inflation spread and in order to expand their capacity to lend and to compete against banks worldwide, United States commercial banks developed the negotiable Certificate of Deposit, the Euro dollar, and the use of Commercial Paper to raise funds through bank holding companies. Large banks ceased to have funding limits on their ability to raise money to lend. This was an omen for the future.

In August 1971, President Nixon froze wages and prices and took the United States off of the gold standard. Inflation had obviously reached a point where it had become a concern of the nation.

The bid to get Nixon re-elected re-ignited inflationary pressures and his predecessor Gerald Ford attempted to Whip Inflation Now! (The WIN campaign) By the middle of 1979 inflation had become so bad in the United States that President Jimmy Carter had to appoint someone of the prestige of Paul Volcker to take over at the Fed and “get serious” about the high levels of inflation existing in the country.

In the 1980s financial innovation was rampant. One only needs to go to the Michael Lewis book, “Liar’s Poker” to get an idea of how much financial innovation had taken over Wall Street by the middle of the decade. Increasing tensions between the Reagan administration and Volcker resulted in Volcker resigning in August 1987. Someone much more conciliatory, Alan Greenspan, got appointed Fed Chairman.

All one needs to be said about Greenspan is that the term the “Greenspan put” was created during his tenure. Greenspan supported economic expansion, but protected financial markets on the downside. In the 1990s the United States experienced credit bubbles, the best known being the dot-com boom…and bust. The 2000s saw bubbles in both the housing market and the stock market. And, during the credit inflation of the 1990s and the 2000s financial innovation exploded!

And, I haven’t touched on the governmental deficits created since the 1980s that the Federal
Reserve was helping to underwrite. But, enough said about the United States.

Leaders throughout the free world behaved in this manner through much of the last fifty years. There were, of course, earlier periods in which the cry-babies came out. This occurred numerous times, but the blame then was placed on those “shadowy people” known as “the international bankers.” Government deficits and loose monetary policy resulted in a sell-off of the currency of the country. This sell-off continued until the government made some efforts to bring on fiscal discipline and give some independence to its central bank. But, again, the governments assumed little of the blame; it was always the fault of “the bankers”.

Governmental leaders just don’t get it. Inflation becomes the music that everyone has to dance to. As long as inflation continues the dance goes on. As Charles “Chuck” Prince III, the former CEO of Citigroup famously said, “As long as the music continues to play, you must keep dancing.” And people and governments kept borrowing, bankers and other financial geniuses continued to craft new financial innovations, and bonuses continued to rise. And the music went on and on…

One of the difficulties of economics is that in most situations it takes time for things to work themselves out. That is, there can sometimes be a long lapse of time between the cause of something and the effect that the action brings about.

A classic example given is the long run impact of rent controls. Rent controls are great for renters in the short run. But, if low rents result in landlords reducing the amount of maintenance applied to the rent-controlled properties, the properties deteriorate in quality. Blame is then assessed against the greedy landlords and not against the rent controls.

We see a similar situation in the case of the financial speculation the governmental leaders are crying out against. Blame is assessed against the “bankers” and not against those that created the inflationary environment that produced the financial innovation and subsequent financial transactions. Unfortunately, a lot of people, those that can’t really defend themselves, get hurt in the process.

Whereas the renters got hurt in the previous example; workers, the people that were being helped by the governmental policies, are the ones that end up suffering when the music ends and people stop dancing. See “Irish Take Bitter Medicine to Survive Age of Red Ink”:

Tuesday, March 9, 2010

The Problems of Recovery

Comparisons abound between the Great Depression of the 1930s and the Great Recession of the 2000s. So far, we seem to have avoided the depths that were reached in the earlier experience, but we still have to consider whether or not the breadth of the two might be similar. That is, almost everyone one forecasting the recovery of the United States economy in the 2010s seems to be expecting that it will be a long, slow process.

The comparison I would like to consider in this post is the possibility that both of these periods represent a time in which the United States economy was going through a substantial structural change. Many people that have studied the 1930s period argue that the economy that existed in the United States in the 1950s was substantially different from the one that existed in the 1920s. Huge shifts took place in both manufacturing and agriculture throughout the 1930s and these shifts were just accelerated in the 1940s, a period of world war. The underlying cause of this change: technology had changed and the American economy had to adjust to become a modern nation. However, the mismanagement of the financial crisis in the 1930s just exacerbated the depth of the decline.

The argument can be made that major structural changes had to take place in the United States economy as it entered the 21st century. Changes of the magnitude of the present adjustment did not take place during the shorter, less severe recessions of the post-World War II period because the buildup of technological change takes time in order to build up a sufficient backlog of the new technology to really be disruptive. By the end of the 1990s, the structural change connected with the move from a society based upon manufacturing to an information society was ready to occur.

This buildup was not really a sudden one. It has been occurring throughout the last fifty years or so. I believe that the decline in the figures on capacity utilization for the United States captures this change very well.

Note in the accompanying chart that capacity utilization continues to decline throughout the whole period since the late 1960s. Obviously, cycles in this measure took place that were related to the various recessions occurring during the time span, but each new peak in capacity utilization never exceeds the peak it had reached in the previous cycle.

This, I believe, captures the changing nature of the United States economy and the movement from the foundational base of the Manufacturing Age to the growing impact of information technology and the Information Age. The conclusion that can be drawn from this is that the United States economy is not going back to where it was. But, this will take time.

Let me just point out three important factors that are playing a huge role in this change: evolving technologies, changing structure of the labor market, and the rise of the emerging nations.

First, the core of American commerce is not going to be manufacturing as we have known it. The future belongs to information technology, biotechnology, and knowledge. For the government to attempt to “force” workers back into jobs they held in the manufacturing world is just going to postpone the changes that WILL take place and threatens the stability of the society by re-establishing the inflationary environment of the last fifty years.

Second, the age of the labor union is past: non-public sector labor unions are legacy. There was a time when labor unions were needed to temper the pressures and demands of the industrial age of the large corporation who needed large numbers of physical laborers. These unions now compose less than half the union population in America yet have an over-sized impact on the politics of the country. In the next fifty years, the importance of the labor union is going to decline, economically and politically, as the United States moves from the manufacturing base that has dominated the last fifty years into the Information Age described in the previous paragraph.

Third, the United States, although it will remain the number one economic and military power in the world, is going to see its relative position in the world decline. The reason is that major emerging nations are beginning to feel their power and exert it. The immediate group of nations that come to mind are the BRICs. But, there are others. China, as we well know, is starting to exert its influence throughout the world. We see Brazil directly challenge America in the World Trade Organization concerning tariffs and subsidies. (See “Tax Move by Brazil Risks US Trade War”: And, more of this is to come! This is going to provide its own pressure for the economic structure of the United States to change.

These adjustments are going to take time. There will be substantial pain for those of working age who are not trained or educated for the new era. I believe that even the number of underemployed, 16%-17% of the work force, under-estimates the structural problem that exists. Thus, the estimate of 11 million new jobs that are now needed in the economy to get us back to where we were before the Great Recession began also under-states the problem.

Investment-wise, just as in the 1950s, the whole structure of opportunities available is changing from the earlier age. But, one needs to consider the new format of the economy that is evolving out of the manufacturing age in developing ones portfolio strategy. Similar to the 1930s, the 2000s are producing a modernization of the United States that will alter the world as it has been known and will produce a world that we can’t even hardly imagine yet.

Monday, March 8, 2010

Federal Reserve Exit Watch: Part 8

Looking at the Federal Reserve statistics these days is rather boring. As has been reported over the past month or two, the Fed has gotten its balance sheet in position for the “great undoing.” And, now it is just waiting.

One can divide the Fed’s balance sheet into three components: the “regular” portion which is roughly equivalent to the asset side of the balance sheet of the Fed in the “good old days”; the portion of the balance sheet that consists of line items related to the “new” facilities created to combat the financial collapse; and the “liability” side of the balance sheet which includes Treasury deposits and reverse repos, the account the Fed has stated it will use in the “undoing” of the excess reserves it has injected into the banking system.

The “regular” portion of the Fed’s statement now represents over 90% of the assets of the central bank. Almost $2.0 trillion of these assets are in the form of securities that the Fed has purchased on the open market and holds outright. The only real movement here is in the Fed’s holding of mortgage-backed securities which, on March 3, 2010, amounted to slightly more than $1.0 trillion. The Fed has stated that this account will reach $1.25 trillion by the end of March.

The Federal Reserve has added, net, $175 billion of the mortgage-backed securities to its portfolio over the last 13-week period, roughly $70 billion in the last four weeks.

In terms of the “new” facilities, the Fed is letting these items run off as the assets run off, are written off, or are sold. Over the last 13 weeks, since December 2, 2009, these accounts have declined by slightly more than $100 billion. Over the past month, since February 4, 2010, they have declined by $30 billion.

Overall, therefore, the Federal Reserve has supplied roughly $76 billion to the building of reserve funds over the last 13 weeks and slightly more than $30 billion over the last 4 weeks. Rather a non-event if you ask me.

In terms of factors absorbing reserve funds, the interesting item here is the Supplementary Financing Account of the United States Treasury. I wrote about this account on February 24, 2010 for it seems to be something that the Fed/Treasury is also planning to use during the “undoing”. For more on this see my blog post:

What has happened in this account is that it has been increasing. It reached a low early this year at $5.0 billion, as the Congress had to approve an increase in the federal debt limit. Since February 4, 2010 this account has increased by $20.0 billion. The Federal Reserve announced that an agreement had been reached with the Treasury Department that the Fed will borrow $200 billion from the Treasury and leave the cash on deposit at the central bank. As explained in my post, this borrowing will be used by the Fed to help it “undo” excess reserves in the banking system. It seems as if the Fed is starting to build up this facility slowly so as not to be disruptive to the banking system.

If we combine all the factors supplying reserve funds to the banking system and factors absorbing funds from the banking system we find that commercial bank’s Reserve Balances with Federal Reserve Banks increased by roughly $70 billion in the last four weeks and over the last 13 weeks: thus, very little changed in the banking system over the last quarter of a year.

If we look at the statistics from the banking system itself, we see that excess reserves in the banking system rose by about $110 billion.

What the Fed did, as it has for an extended period of time now, went directly into the excess reserves of the banking system. Commercial banks, as a whole, are just sitting on their hands and doing nothing. This allows the Fed to do all its repositioning in order to prepare for the “great undoing” without throwing any more uncertainty into financial markets.

The Federal Reserve is still “sitting on the fence”. Its dilemma is that the banking system still remains extremely week…except, of course, for the big banks. For more on this see two of my recent posts: “The Struggles Continue for Commercial Banks”,, and, “The Banking System Continues to Shrink”, The Fed cannot move too fast to remove excess reserves from the banking system for fear that this “undoing” may result in many more bank failures among the small- to medium-sized banks.

Of course, the economy remains weak and the Fed has used this excuse for not removing reserves from the banking system and raising short-term interest rates. This may be a cover for their real concern over the systemic weakness of the small- and medium-sized banks in the United States.

On the other side there is the continuing fear over the possibility that sooner or later the excess reserves in the banking system will turn into bank loans which will result in an expansion of the money stock measures which will result in a worsening of inflation. With over $1.1 trillion in excess reserves in a banking system that used to carry less than $100 billion in excess reserves there is substantial doubt that the Fed can smoothly remove all of these reserves thereby preventing possible inflation or even hyperinflation. Nothing like this has ever been experienced in history before.

So, we sit and wait.

The good news is that things within the banking system seem quiet now. The FDIC continues to close banks without major disruptions to banking markets or local economies. The focus of financial markets seems to be on Greece, Spain, Italy, the Euro, and California, New York and other political entities. That is good for the banking system!

Some have pointed to a potential problem arising from the sale of assets recently conducted by the FDIC. The argument is that now that these assets have a price, will other banks have to “mark-to-market” similar assets that they carry on their balance sheet? And, if they have to mark these assets to market, will this speed up the number of banks actually failing or force banks that seem to be doing OK into insolvency?

In the circumstances we now find ourselves, boring is good! Let’s hope it stays boring. Or hope that the situation becomes even more boring.