Thursday, May 27, 2010

Banks, Disclosure, and Reform

Bankers can’t have it both ways. Either they are going to have to honestly disclose their positions or they are going to face more and more intrusion into their operations.

The honesty factor is a concern if banks continue to publically lie about their balance sheet positions. I have written about this before in my May 5 post “Can the Financial System Still be Trusted”, Others are providing clearer evidence of this behavior. See the Wall Street Journal of May 26, “Banks Trim Debt, Obscuring Risks”, The Journal followed this with another on May 27, “BofA, Citi Made ‘Repos’ Errors”

If banks want our trust, they are going to have to be honest with us.

The disclosure factor I am referring to pertains to mark-to-market accounting. The Financial Accounting Standards Board has proposed that commercial banks mark the value of their loan portfolios to “fair value” standards. Banks already use mark-to-market accounting for other assets on their balance sheets, although they basically don’t like this requirement.

The general argument provided by the bankers is that this mark-to-market requirement would require banks to take “big losses” on loans during certain periods of economic distress and this “could” be misleading because the loans “would probably still pay off over time” This analysis is from today’s New York Times:

This argument infuriates me. I have been the President and CEO of two financial institutions and the CFO of a third, all publically traded companies, and if I have heard this argument one time I have heard it a thousand times. And, in most cases, the statement has referred to loans that eventually were written down or written off.

The argument, ironically, is not applied to the loans that do perform! My experience is that the claim is a defensive statement from a loan officer or bank executive that is overly sensitive to the fact that they have not performed and don’t want this fact publically recognized.

I would add two things to this discussion. First, when loans start to go bad, a good management should want to identify the problems as soon as possible so that they can do something about them. Postponing dealing with loans that are experiencing some trouble can only lead to more trouble in the future. Well run institutions are ones that deal with their problems “up front” and do not try and hide them in the hopes that they will go away.

Second, bankers take risks: credit risk, interest rate risk, liquidity risk, leverage risk, and other forms of risk. This is their job. But, there is a cost of taking risk. As we have seen from the recent financial buildup and collapse, during periods of credit inflation, asset bubbles, and other cases of excess, bankers push the edge taking on more credit risk, more interest rate risk, more leverage risk, and so on.

In order to maintain our trust in banks and the banking system we need to know what the banks have done and how their decisions have affected the value of the assets on their balance sheets.

“Critics of applying fair value to loans have said the existing use of fair value has deepened the financial crisis by forcing financial firms to take unjustified losses on assets that shrank in value when market conditions worsened temporarily.” (See

Come on, be big boys and girls. You made the decisions! Accept the consequences of those decisions!

In terms of financial reform, I am more in favor of using “early warning” systems like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs ,, and “To Regulate Finance, Try the Market” in Foreign Policy, But, to go this route, financial institutions should be open to full disclosure and accounting transparency. I will write more on the Hart/Zingales approach in the near future.

I happen to believe that this kind of behavior, the encouragement of openness and transparency, represents good management practices. (See my post “On Audits and Auditors”, Using a sports analogy again: good teams and good players do not rely on trickery…they just outperform other teams and players that have to use deceit and deception to try and get the upper hand!

Good managers and good managements are not afraid of “the open air”!

The alternative is for there to be more explicit attempts to regulate and control the financial institutions. Going this direction ultimately fails (see my post “The ‘Sound and Fury’ of Banking Reform”, but it is time consuming, expensive and inconvenient in the process. And, choosing this path leads to ‘cat-and-mouse’ games that do not contribute to increasing the public’s faith and trust in the banking system and the regulators.

This seems to be one of the major problems of modern America. In my memory, there was a time when we could have faith and trust in our business and financial institutions and in our government and in each other. This ‘faith and trust’ is sorely missing now. It would be nice if some leaders appeared that actually tried to restore these characteristics to our national life. I just don’t see any of this kind of leadership on the horizon.

In my mind, banks need to take a leadership position on the “Disclosure” process and assume a stance that is more disciplined than would be imposed by any regulatory standard. In doing this they would take control of the issue.

Or, they must accept the lack of faith and lack of trust that follows a government-led effort to constrain and control them. They cannot fight disclosure and fight greater government oversight at the same time.

Wednesday, May 26, 2010

Let's Look at the United States rather than Europe for a change

Durable goods orders are up 2.9% in April. New home sales rose last month. More and more statistical releases point to a continuing recovery. More and more it appears as if the Great Recession did end in July 2009 and we are, consequently, in the tenth month of the economic upturn.

However, it still doesn’t quite feel like much of an upturn. But, economic pundits contend that there is very little chance for a “double-dip” recession even with the financial turmoil rocking Europe. One analyst argued that with the European disorder the probability of having a “double-dip” recession has risen, but from about 5% a month earlier to around 20% now. In other words, he believed that it is highly unlikely that we will have a “double-dipper.”

My concern is still focused upon the long-term fact that there is so much un-used capacity in the United States. The efforts to stimulate the economy, as a consequence, represent efforts to put people back into “legacy” jobs (the jobs from which they were released) that will continue to thwart the competitiveness of the United States in world markets and put back to work “out-of-date” plant, machinery, and labor.

If we look at capacity utilization in the United States, we see that we are using more capacity now than we did in July 2009. For April the figure was below 73.7%. However, we are still substantially below the previous peak in capacity utilization, which came in at about 81.5% in 2006. And, the previous peak before that was below the previous high before that, 85% in 1997, which was lower than the previous peak and so forth for the whole post-World War II period.

Furthermore, industrial production remains depressed from the level it attained in early 2008 and also in 2000. Both series are making progress, but we are still running way below levels that were previously attained and although the “catch up” seems to be robust, the question remains as to whether or not these measures will exceed earlier highs in the near future.

Adding to this concern is the fact that the labor situation remains weak. Unemployment in April stayed just under 10%, but the number I am very concerned about is the total amount of workers that are under-employed. I am concerned, not only with those that are out-of-work, but those that are not fully employed but want to be fully employed, the discouraged who have left the workforce, and the people that have taken lower positions, positions that they can fill but are fully qualified to perform in other more challenging jobs. My estimate of these under-employed persons runs around 25%, about 1 out of every four people who could be considered to be in the labor force.

The fact that these factors are running so low relative to “capacity” employment raises concerns about the United States achieving its “potential” any time soon. To examine this possibility we look at a comparison between the estimates of the Congressional Budget Office of potential real Gross Domestic Product and the level that real Gross Domestic Product was actually attained. Not only was the United States economy producing at a level of output only 94% of potential, the rates of growth of actual real GDP seem to lie below the rate at which the CBO is estimating that potential real GDP should grow.

The economy of the United States is recovering, but one can understand why many people really do not seem to be experiencing it. Nothing in the previous stimulus plan, or in the one being developed, or in the current stance of monetary policy, gets the United States back on track. Different types of policies are needed to renew the productive capacity of the United States so that the U. S. can become fully competitive again and fully use its resources…both human and physical. Unfortunately no one seems to be working on these kinds of policies because they rely so heavily on the private sector. Also, these policies take too long to achieve results; politicians have a much shorter employment cycle.

Tuesday, May 25, 2010

China is Changing the World

Earlier, on March 25, I raised the question “Why Should China Change?” in my post, “Why Should China Change?” (
The thrust of the post was captured in the following:

“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 is still the number one power in the world, both economically and politically, but its relative position has changed. And we continue to see that in our relationship with China (and India and Brazil and Russia).

The current ‘high-level’ meeting in Beijing of representatives from China and the United States highlights the changing relations between the governments of China and the United States. As reported in the New York Times, “the opening session laid bare a recurring theme…the United States came with a long wish list for China…while China mostly wants to be left along…” (

China is “turning into an economic superpower” according to the Times article and wants to continue along on its merry way. The United States, other than initiating an all out trade war, seems incapable of slowing down the Chinese economic machine or even getting the attention of the Chinese leaders.

Chinese President Hu Jintao did pledge to continue reform of China’s currency, but then repeated the standard operating response: “China will continue to steadily push forward reform of the renminbi exchange-rate formation mechanism in a self-initiated, controllable and gradual manner.” That is, we will change things when we want to change things and no sooner.

Secretary of the Treasury Geithner graciously replied: “We welcome the fact that China’s leaders have recognized that reform of the exchange rate is an important part of their broader reform agenda.” What else could he say?

The United States, and most of the rest of the west, is in a weakened state. But, this weakened state goes beyond the short-run. The United States is facing longer run, structural problems it must deal with. Economic growth and financial strength are important factors in world economic power. However, when a nation extends itself and stretches itself too far due to over-commitment and over-leverage, thinking it can do too much, it exposes itself to other nations that are not in a similar position.

It is the United States, the number one world power that is asking China to change. China is in a position where it does not feel the need to cave into the American requests. China is strong and disciplined. The United States is strong, but undisciplined. Therein lies the difference.

And, the (supposed) allies of the United States are little or no help. Europe is attempting to resolve the problems it created for itself. As a consequence it is slowly fading into the background. The G-7 group of nations, the United States, Canada, France, Germany, Italy, Japan, and England, is losing relevance in the world. The G-20 includes the seven, but more importantly includes several emerging nations that are more strategic to the future than is the “old boyz club” from Europe.

De-emphasize the G-7 and raise up the G-20!

The ultimate problem of the United States is its lack of discipline. For the past fifty years or so, the United States has lived for “the short-run” because, we have been told, that “in the long-run we are all dead.” The economic policy of the United States has been designed to combat short-run increases in unemployment with a constant pressure to achieve high rates of economic growth. But, this creates an inflationary bias in economic policy. Because of this the United States has seen the purchasing power of its dollar drop 85% from January 1961 until the present time, underemployment has grown to about 20% of the working age population and the capacity utilization of its industrial base has declined to less than 75% at present (but rose to only slightly more than 80% in its most recent cyclical peak).

These are not signs of economic strength. Furthermore, the value of the dollar over the past forty years has dropped by approximately 35%. Huge amounts of United States debt, both public and private, have been financed “off shore”. These developments do not put America in a very strong bargaining position.

China thinks in decades. The United States thinks in terms of the next election. Discipline does matter.

There are still many economists in the United States who argue that the government must spend more and create more debt to get the country going once again. Their fundamentalist view of how the world works blinds them to the fact that it was the loss of fiscal discipline, the exorbitant creation of huge amounts of government debt and the subsequent credit inflation that this encouraged, that put the United States into the position it now finds itself.

More spending and more debt are not going to make the situation any better. I examined this issue in my May 13 post “Government Deficits and Economic Activity”: My basic conclusion was that in the present situation where the Federal Reserve has pumped so much liquidity into the banks that big banks and big companies can play games in world financial markets and cause major problems for areas like the euro-zone. The continued creation of deficits and more government debt is not going to solve this problem for Europe…or the United States.

Until it gets it act under control and in order, the United States will be the one asking China to change the way it does things. China, given the present circumstances, will continue to do things in their own interest and at their own speed. In addition, it is my guess that other, emerging nations will begin to exert themselves in similar ways. And, the United States will not be in a position to resist their efforts.

As I said earlier, “The world has changed and we in the United States have not accepted that fact.”

All we can really control is ourselves and if we fail to do that we give up the chance to influence others.

Monday, May 24, 2010

The Focus is on Europe

The recent events in Europe have captured the attention of the world and taken the heat off of China and the value of its currency, the United States and the value of its currency, and financial reform in its various forms.

The focus, in my mind, is going to stay on Europe for a while because that is where the greatest amount of disruption to world financial markets and damage to world economic recovery can take place.

How long will this disruption and damage last?

I continue to recall a piece of advice given several years ago that has never let me down. The advice is this: If you say the problem is ‘out there’, that is the problem! That is, if you blame your problems on everyone else or everything else, your outward facing focus is the problem. Maybe you had better look at what you are doing before you start blaming someone else.

I have found this true in individuals, families, organizations, communities, businesses, and governments.

Right now, Europe is over-run with self-pity blaming speculators and the ‘irrationality’ of markets.

As a consequence, Europe has responded to the difficulties it faces with a grudging move to maintain the liquidity of its financial markets while preserving as much as it can the ‘integrity’ of its economic model. Its leaders are still trying to hold onto their model of the world.

Hence, the blame must be aimed at someone else!

And, that is precisely the problem.

The fundamental problem is that the economic model used by most of Europe is faulty and the current financial problem is one of solvency and not liquidity.

The three primary perpetrators of these fallacies are President Nicolas Sarkozy of France, Jean-Claude Trichet the head of the European Central Bank (French), and Dominique Strauss-Kahn the Managing Director of the International Monetary Fund (also French).

So far, these French leaders have been the winners of the political battles for the heart of the
European Union. So far, international financial markets have given these leaders at least a D- in terms of the plan they have devised to save union.

Where can we find this grade?

The value of the Euro has declined 18% from the middle of December 2009 to this morning.

The German Parliament has voted to support the current ‘bailout’ but throughout Germany discontent is rising concerning the leadership shown by the German Chancellor Angela Merkel. She, more than any other leader within the European Union, seems to be losing her clout.

Chancellor Merkel cannot afford to follow the French leadership.

Germany has established its position within the European Union through its strong economic growth fueled by a very robust export sector. It has also been fiscally prudent and plans to reduce its budget deficit to zero by 2016. The yield on German bonds attests to the belief the international investment community has in the intent and discipline inherent in Germany to sustain these outcomes.

It is these factors, carried over to the whole EU, that have benefitted other nations within the community to the extent that they could live beyond their means and feast off of their association with the Germans.

This, as we have seen, is an unsustainable relationship. Either Germany has to give in and accept fundamental reforms to the European Union that would seriously damage German competitiveness. Or, it has to maintain its discipline and continue to adhere to its fundamental world view.

There is no question as to what I think Germany should do!

Yet, if Germany continues to encourage its competitiveness in European and world markets and maintains its fiscal discipline, others within the European community will either have to emulate them or will have to remove themselves from this union. It seems as if we are at the juncture where there are no other choices. A wishy-washy response at this time will just postpone the outcome.

Of course, the critics of Germany see such a German policy as disastrous. Following the German model of reigning in wages and social benefits and achieving real control over fiscal budgets would result in further dislocation of economic resources in Europe accompanied by social and political upheaval.

The problem is that these other European nations have put themselves into a position where there are no ‘good’ solutions! Years-and-years of profligate living eventually lead to a situation where nothing they can do provides happy answers.

The only thing these loose-living nations can hope for is for time, cause “things will get better in the future!” Yeh, sure!

I don’t know how many times I have heard this response in business and elsewhere. “The market doesn’t understand us!” “All we need is some time and things will work themselves out!” “It’s just that there are some ‘greedy bastards’ out there that want to make money off of our misfortune!”

Europe, your economic model of the world doesn’t work! The only way you are going to really get out of this mess is to change your economic model. Deficits and a lack of social discipline don’t contribute to economic health. But, it is so much easier to blame someone else and following Germany would be a disaster.

There remains a lot to work out in Europe. These issues are not going to go away overnight. How long things remain unsettled there depends upon how quickly people realize that the problems are internal and not a result of “irrational markets” and the greed of speculators. It is very difficult, however, to realize that your model of the world requires modification. Perhaps such change is generational…but, can we wait that long?

Friday, May 21, 2010

The "Sound and Fury" of Banking Reform

Well, the Senate finally passed a banking reform bill. It is said that President Obama wants to sign the final bill around July 4.

All I can really say about the bill is that it represents a lot of “sound and fury signifying nothing.”

The bill will be costly. The bill will result in a lot of inconvenience.

But, banking and finance will recover and will continue on their merry old way!

The reason that I say this is that finance is just information and with the accelerating pace of information technology in the United States and the world, finance will continue to expand and prosper. The regulators cannot control how information is used or transformed!

History has shown that information spreads and although the pace of its spread can be slowed down, it has never been stopped. Just ask all the religious medievalists in our world today that are fighting a losing battle and are defensively striking out at everyone else.

I have stated some of the reasons for my position in a series of posts beginning January 25, 2010: see “Financial Regulation in the Information Age”;

I have also highlighted the place of information in the practice of modern finance in my review of the book “The Quants”: see

Furthermore, attempts to reform and re-regulate the banking system will ultimately do more damage to banks that are not among the 25 largest banks in the country than it will do to those banks that the administration and Congress are really after. And remember, the largest 25 domestically chartered commercial banks in the United States control about two-thirds of the banking assets in the country.

Another factor that I have tried to stress over the past year is that the largest banks have already moved on. The legislation in front of the Congress is aimed at preventing the last financial crisis from occurring again. In my estimation, the largest banks are beyond this feeble effort and are moving into areas we will learn about in the next round of “popular” books explaining what has happened to our financial system.

An example of this was a recent report in the press about how Congress is trying to alter the status of how hedge funds reward their managements so that more of this income is taxable. The response of the industry was to have already hired scores of lawyers to “get around” any legislation about hedge fund fees.

Can you imagine any other kind of response from the financial industry…or, for that matter, any industry?

Reform and re-regulation face a moving target and, consequently, they are aiming their efforts at the past, not the future.

The financial reform package will change the playing field for a limited amount of time. However, in this age of information you can bet that the lag between what “the Feds” do now and how the financial system reacts to these actions will be shorter than ever before.

NOTE: we now have 775 commercial banks on the list of “problem banks” put out by the FDIC, up from 702 banks at the end of 2009. When this latter list was presented, I argued that the FDIC would close between three and four banks a week for the next 12 to 18 months. We have been averaging 3.8 banks closed every week this year through May 14. Using a rough “rule of thumb” my estimate now is that at least four banks will be closed every week through the end of 2011.

I still have grave concerns about the solvency of the 8,000 “smaller banks” in the United States. I define the “smaller banks” as any bank below the top 25 largest banks in the country. These 8,000 “smaller banks” control only one-third of bank assets in the United States. I derive this concern from the actions of the Federal Reserve who continues to subsidize the banking system with extremely low interest rates, and the FDIC. Although the Fed and the FDIC are not “owning up” to this problem, everything they are doing raises questions about how solvent these smaller 8,000 banks really are. I guess the big issue concerns what would happen to the value of bank assets IF interest rates were to rise. Would this result in a “cascade” of “small” bank failures?

Thursday, May 20, 2010

Is Germany resisting the "Race to the Bottom" in Europe?

Germany, and Angela Merkel the German Chancellor, clearly lost the battle over the bailout package and the European Central Bank’s move to buy bonds. (See “Where’s the Leadership in Europe,

Is Germany and Merkel now trying to stage a “comeback”?

There are certainly signs that Berlin is attempting to re-asset itself in the moves it made on short selling and other complex bond transactions. Furthermore, Merkel is asserting herself into the financial reform debate. At a meeting of the G-20 Thursday: “German Chancellor Angela Merkel said Thursday she will push her Group of 20 counterparts to accelerate steps to tighten political control over financial markets and add new taxes on banks. Ms. Merkel also said she will push G20 leaders to coordinate their strategies as they look to withdraw stimulus measures enacted during the financial crisis.“ (

Politically, in the German state itself, Merkel needs to exert herself to defend Germany and Germany’s support of a sound fiscal and monetary stance within the European Union. The political feedback to the Chancellor’s position on the bailout was immediate and dramatic. She and her party lost seats. To maintain her coalition, it seems as if she must place herself in a stronger position.

Within the broader picture, however, someone needs to step up in Europe and show some real courage, something that will not be easy. That leadership has been sorely missing and the decline in the Euro to a four-year low just underscores how the market is ‘grading’ the response of the European Union to their current financial crisis. The immediate reaction to the German actions was disappointment in the response of the rest of the Union. There obviously is no unity within the European community.

Yet, the German movement is not without reason.

Someone has to step up to the plate.

Unfortunately, the European Union has tolerated the lack of discipline and incompetence in its member nations for years. As a consequence, there has been a “race to the bottom”; a movement to the lowest common denominator and the recent financial crisis is the result. And, now all members of the European Union are suffering.

Nature does not allow a vacuum to exist for very long in any human association. If the association allows the undisciplined or incapable to dominate, then the performance of the association comes to reflect this bias. Need I present a sports analogy?

The other alternative is for the members of the association to have standards set by the disciplined and capable where a situation can be achieved in which the rising performance of the community is shared by all.

A successful union has enough benefits for all to share. In an unsuccessful union no one is really happy!

In the European Union it seems as if there is no one else to turn to but the Germans for this leadership. It is certainly not going to come from France. France is the epitome of the acceptance of the mediocre. France’s leadership has guided the European Union into the state it is now in. It is not the future.

Will other nations listen to Germany? Will new leadership be established in the European Union?

I’m not sure that the rest of Europe is ready to get ‘disciplined’. There is a lot of ‘mouthing’ of the need for discipline, but are the nations doing this talking ready to change things for the longer term or will they revert to old habits once the immediate crisis is over? Can governments that really ‘tighten up’ be able to be re-elected in Greece, and Spain, and Portugal, and other places? Will other nations in the European Union really stand for German discipline and leadership?

Watch the hips, not the lips!!!

If the nations in the European Union other than Germany fail to get their acts together, will Germany and the German people be able to drop their standards of performance to the level of the ‘bottom’?

My guess is that the Germans do not want to be mediocre.

Therefore, disunity and disgruntlement will continue to rule in Europe. And, this will not be good for the Euro.

What might change attitudes in Europe?

The answer might be years of falling further behind the United States, China, India, Brazil, Russia, and other emerging nations. The European model, as it now stands, cannot compete in this world of the future. Competition is going to be fierce and nations that thrive on low performance and undisciplined behavior will fall further and further behind. But, this is a message to all nations, including some that are in the list just presented.

Unfortunately, Europe stands in a position to cause a lot of disruption to others. It is still important enough to let its failures cause dislocations in the world economy.

The United States should applaud the behavior of the Europeans. The behavior of the Europeans and the decline in the value of the Euro takes a lot of attention off of the value of the United States dollar and the weakness it has experienced due to the undisciplined behavior of the United States government with respect to its fiscal and monetary policies.

Still, I would like to see Germany and Angela Merkel succeed. I would like to see a strong Europe and a strong Euro. But, maybe I am just being sentimental.

Sunday, May 16, 2010

How Can The Economy Grow Without Bank Loans?

The economy seems to be picking up steam, yet bank lending does not seem to be keeping pace. Also, money stock growth does not give off positive signals in terms of how people are allocating their short-term assets in the banking system.

The question is: can the economy continue to pick up if people are staying very conservative in terms of their asset allocation in the banking system and the banks, themselves, continue to stay out of the lending market?

Overall, the total assets in the banking system (according to the H.8 release from the Federal Reserve System) have only grown modestly in recent months, up 1.3% from March to April at all commercial banks in the United States, with large banks (the twenty-five largest banks in the United States) showing a 2.1% rise and all other banks increasing at a 1.0% rate.

Over the past year Total Assets at all commercial banks are down by -1.5%, decreasing by 0.8% in the largest banks and rising 1.0% in the larger banks.

The problem with this is that the rise in the last month is due to a reporting change in the banking system and is not the result of real growth. On March 31, banks were required to bring a substantial amount of securitized loans onto their balance sheets from being accounted for as memoranda items.

The vast majority of this movement was connected with consumer loans. Thus we see that from March to April consumer loans at all banks rose by slightly more than 31%. The largest banks saw the greatest change, rising over 35%, while the smaller banks consumer loan accounts rose by slightly more than 17%.

The thing is, consumer loans are not increasing. The increase is coming solely fromt the change in the accounting for these securitized consumer loans.

All other loan classifications rose by much smaller amounts over the past month but actually declined over longer periods of time.

For example Commercial and Industrial loans, business loans, at all commercial banks rose by only 0.6% from March to April. They are actually lower over the past three months, down 4.0% and down 18.0% year-over-year.

Commercial banks are just not lending to businesses! And, this is across the board, in both the biggest 25 banks in the country and all the rest. Over the past year Commercial and Industrial Loans at large commercial banks dropped by over 19% while this same category of loans at small banks dropped by almost 9.0%

Real Estate loans have not fared any better. Up only modestly in the past month, these loans have declined for the past three months, the past six months and the last 12 month. Again, Real Estate loans at the biggest 25 banks have declined by slightly more than 2.0%, year-over-year, and they have declined by a little more than 4.0% at the smaller banks.

Shall we take these modest increases as a positive start to the increase in bank loans? Well, one month does not make a trend. We need to keep watching the banks to see if loan volume is increasing giving us some feel that not only loan demand is rising, but that the banks are actually lending again.

Cash assets at all banks declined over the past month. Whether this was a response to the Treasury’s use of their Supplemental Financing Account at the Federal Reserve (See my posts: “Federal Reserve Exit Watch Part 10”,; and “The Fed’s New Exit Strategy?”, or the portfolio behavior of the banks themselves, there was a fairly sizeable drop in cash asset at all commercial banks.

Still over the past three months cash asset rose at both the biggest banks and the smaller ones. Again, the direction the banking system is taking with respect to excess reserves is still unclear. All one can say is that they have declined recently.

The banking system is still facing the fact that people are continuing to move their assets into the banking system and primarily into transactions accounts. This is seen by the fact that the M1 measure of the money stock has risen by almost 7.0%, year-over-year in April while the M2 money stock measure has risen by only about 2.0%. Thus, since there is almost no growth in the M2 measure of the money stock, there must be a substantial amount of shift between the non-M1 portion of M2 to the M1 measure.

In fact the total non-M1 M2 has risen by only 0.4% from April 2009 to April 2010.

As I have argued many times before, this is very conservative money management on the part of asset holders. People are putting their funds into transactions accounts so that they have them for spending. They are removing funds from non-transaction accounts which are less liquid and, with interest rates so low, not worth the effort of keeping their funds in these accounts.

This movement is also picked up in the decline in Retail Money Funds which have dropped almost 28%, year-over-year, and Institutional Money Funds which have dropped about 23%, year-over-year. These declines have continued at rapid paces for the last three months and the last month as well!

The efforts of the Federal Reserve are not being translated into bank loans or money stock growth. Monetary policy is not being translated into assets that support economic growth!

People and businesses are still in a defensive mode with respect to their asset management!

The Great Recession is over and the recovery has begun. Yet, the statistics coming from the banking system do not promote a lot of optimism. This is consistent, I believe, with consumers that are still reeling from being unemployed and losing their homes and with a banking system that is not out-of-the woods in terms of solvency issues (except for the largest 25 banks, of course.)

Strong recoveries are usually connected with strong growth in bank loans and the various measures of the money stock. Especially important is an increase in commercial and industrial loans…business loans. This is not happening.

From all we see the large banks are making a “killing” being subsidized with extraordinarily low interest costs. We learned last week that many large manufacturing and industrial business firms are sitting on huge amounts cash and other assets ready to “make a killing” when things do start to pick up. The big guys are in great shape!

If anything the financial collapse, the Great Recession, and government policy have done for big business what they could not have done for themselves. The transfer of wealth in America is going to be huge in the next five years or so thanks to Bush 43 and Obama 1. Greater wealth inequality…here we come!

Thursday, May 13, 2010

Government Deficits and Economic Activity

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

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

Doesn’t seem to be.

What’s going on?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Seems a little unfair, doesn’t it?

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

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

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

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

Wednesday, May 12, 2010

The European Union: It's a Question of Leadership

The dust is clearing around the recent negotiations in Europe concerning the “bailout” bill and what we are seeing, at least to me, is unnerving.

“France has won!” (“Paris seen as trumping Berlin at EU table” at

“The French government yesterday vowed to ‘reinvent the European model.” (“Sarkozy triumphs in his bid to rewrite the rules” at

The press has predominantly been following German Chancellor Angela Merkel over the past month or so as she struggled to achieve a “German” twist to the negotiations concerning the fate of Greece and the bailout package that was needed to keep the EU together.

Many in Germany did not like what her leadership has achieved as people voted against her party last Sunday making it ever so much more difficult for her to lead her nation.

Sarkozy, the president of France, kept a very low profile…for him.

And, who seems to have come out on top? France!

France’s intent? To build a new structure with greater budgetary policy co-ordination and more effective fiscal rules. In essence, to follow the French model, allowing the spenders to spend and the savers to pay for what the spenders are spending on.

The start is a vast loan facility to distribute cash quickly to “a stricken member” without prior approval from other national governments…especially Berlin! (However, the current effort is to last only three years, but once begun…)

Also, Sarkozy is said to be very happy with the decision of the European Central Bank to start buying euro-zone government debt. This is a massive step toward “Quantitative Easing” something the ECB had been constantly resisting.

The ECB has been “Bernankied”!

This shift in policy direction is seen by Sarkozy as “irreversible” and puts France in the driver’s seat.

In my mind, this “victory” just exacerbates the “race to the bottom” (See “How the euro-zone set off a race to the bottom” at

The feeling in Germany? The newspaper Bild Zeitung puts is very simply: "The 'safety parachute' for the euro is the ultimate crime for Europe. We Germans have made sacrifices for a stable euro for the last 10 years, with wage restraint and sacrificing pension rises. We have paid the price while others have been partying at our expense . . . Europe's path to a transfer union is simply a road to its ruin."

And, what direction are you betting the euro will go?

This whole muddle returns to the question of leadership and in Europe.

Unfortunately, I don’t see anyone there that I would call a real leader.

In terms of the leadership at central banks, the head of a central bank can only go so far in achieving a monetary policy independent of the party that rules a nation.

NOTE: Check out what recently happened to the head of the central bank in Argentina!

Ben Bernanke and the Federal Reserve System have never acted independently of the presidential administration in Washington, D. C. whether it was the Bush 43 administration or the Obama administration.

The only show of independence that Bernanke and the Fed has made is to keep the Congress from conducting an audit of them.

Alan Greenspan was the lackey of whoever was in the White House.

This is why the financial markets expect that sooner or later massive governmental deficits will be monetized. Central banks cannot forever “hold out” against a government that wants to continue to live way beyond its means.

And, because of this Jean-Claude Trichet should not be judged too harshly. The “profligates” are in charge and a central banker can only fight back so hard. At least if they want to keep their high profile position.

So, we go back to the victory that France has achieved. If people were uncertain over the future of the European Union and the future of the euro, in my mind a lot of that uncertainty has been removed.

The major uncertainties now relate to when the periodic financial upheavals are going to take place, how severe they will be, and how long it will take for a European leadership to arise that will have had enough of the “race to the bottom”?

Weak leadership always caves in to the popular short run viewpoint!

Tuesday, May 11, 2010

Three Perfect Quarters: Goldman, JPMorgan, and BofA

The news is out! Three perfect quarters!

JPMorgan Chase and Bank of America join Goldman Sachs in turning in a perfect quarter. See “3 Big Banks Score Perfect 61-Day Run” at

Before, we only knew that one of these three had achieved this performance. See my post “Goldman’s Perfect Quarter”:

According to the New York Times: “Despite the running unease in world markets, three giants of American finance managed to make money from trading every single day during the first three months of the year.
Their remarkable 61-day streak is one for the record books. Perfect trading quarters on Wall Street are about as rare as perfect games in Major League Baseball.”

It was something to have just one bank achieve this perfect record. But, THREE!!!

As I said in the previous post: THANK YOU MR. BERNANKE!!!

Who loves the big banks? Why the Federal Reserve does! Keep the subsidy flowing, baby!!!

And, now Congress is going to audit the Fed.

The Fed seems to be at an all-time low in the eyes of Congress and the public. The Fed, by some, is given credit for “saving the world”. Yet, they don’t appear to be getting much credit for it these days. Ah, the problems with being a savior!

Central banks used to be well-respected institutions and their heads used to be the solid leaders of finance and banking.

Not anymore.

I don’t remember a period in which the Fed has lost more prestige or more good-will than it has in the past seven or eight years. Not even Bill Miller achieved this kind of record!

Goldman Had A Perfect Quarter

This may sound like a ridiculous headline, but it appeared in the Wall Street Journal today. (See
The reason for the headline is that the Goldman Sachs traders made money every day the firm traded in the first quarter of 2010!

The article states: “Traders raked in more than $100 million daily for 35 days and made no less than $25 million daily during the rest of the three-month period, according to the regulatory filing on Monday. The streak was a first for the Wall Street firm, which typically loses funds on at least a handful of days in a given period.”

On that basis Morgan Stanley had a more typical quarter. Morgan Stanley lost as much as $30 million daily on four days during the quarter. The other days, well, they made money far in excess of the losses.

What the government takes away with one hand the government gives back with another.

While the government chastises Goldman and its management and sues it for securities-fraud, the Federal Reserve subsidizes Goldman with super-low interest rates.

During the first quarter of 2010, Goldman could borrow money for up to six months for 20 to 50 basis points. They could lend these funds out for almost 400 basis points, RISK FREE. And the Federal Reserve promised them that these spreads would continue to exist for an “extended period” of time!

Goldman Sachs should send Mr. Bernanke a big basket of fruit accompanying a big “THANK YOU, MR. BERNANKE” card.

Wish I could play this game!

And, now the European Central Bank seems to be getting wise to the game. And, our Federal Reserve system is going to support the ECB through currency swaps!

And, then the figures come in on Fannie and Freddie! And, with all the new spending programs coming from the Obama administration it is hard to take seriously the feeble coins that are tossed to the study of how to get the federal deficit under control. Official forecasts place the federal deficit under $10 trillion for the next ten years. I still believe that deficits will accumulate more toward the $15 trillion to $18trillion range.

The Fed is going to “tighten up” in the face of all this junk? Or, will they pull a “Trichet”. Or, has Jean-Claude Trichet, the Chairman of the ECB, pulled a “Bernanke”?

The problem, as I have written many times before, is that when a nation puts itself into a position like the United States (and many of the European nations and England) finds itself, there are really no good choices to left for it. However, the tendency is that once a nation finds itself in such a hole, they continue to dig deeper as the United States (and the European community) is now doing.

Peter Boone and Simon Johnson write in the Financial Times this morning about “How the euro-zone set off a race to the bottom.” (See The EU dug its own hole and now they continue to dig the hole deeper and deeper.

The Euro-zone system “encourages “a race to the bottom”—led by governments in smaller countries, which relax fiscal and credit standards to win re-election.”

I would add that this claim could be leveled against the United States and Great Britain just as well as they raced to provide more and more social services and housing to the electorate in order to get re-elected and justified borrowing massive amounts of money, both domestically and internationally, through Keynesian arguments that there was an infinite supply of funds available to governments.

The governmental emphasis on generating huge deficits, on financial innovation and creating massive incentives to inflate the amount of credit outstanding, changed the whole environment of finance. And, of course, the very people that created this environment, the various presidential administrations of the past fifty years and their co-conspirators in Congress, now condemn what they have created and sue it. Yet, they also continue to underwrite it through bailouts and subsidies like the monetary policy of the Federal Reserve called “Quantitative Easing.”

All I can say about the quantitative easing is that there must be a very large number of the remaining 8,000 “small” banks in the banking system that are in very serious financial difficulty for the Fed to continue to maintain this policy and subsidize the further growth of the “big” banks!

There are no good decisions left. And, I fear, that the ultimate resolution of this situation, as Boone and Johnson argue, is for these profligate nations to default, “either through repudiations or inflation.”

However, things don’t stop here. What this situation points to is the weakening of the influence of the Western nations, especially that of the United States. Given the current situation, why should China bow to any wishes made to it by the United States government except to those that are particularly in their interest? (See my post, “Why Should China Change?”: The same applies to India (see a very interesting article in the Financial Times this morning, “India: The Loom of Youth”: and Brazil. The United States (and Western Europe) have made these countries relatively more powerful and independent. And, given the current position of the United States (and Western Europe) why should the countries be generous to the dominant power in the world?

The world has changed over the past fifty years and the United States has contributed significantly to its own relative decline. (Watch this played out in future meetings, like that of the G-20.)

And, it has contributed to Goldman being perfect!

Monday, May 10, 2010

More on Europe's 'Trilemma'

The name of John Maynard Keynes became prominent once again with financial collapse beginning in 2008 and the “Great Recession” that followed. I would like to introduce his thinking once again to maybe put the idea of the “Trilemma” into a historical perspective.

Yesterday, I wrote of the idea of the “Trilemma” and how it applied to the current situation in Europe (see “Europe’s ‘Trilemma’, Today I would like to hold up an earlier example that I believe highlights the difficulties faced by the European Union in attempting to resolve the problems it now faces. The earlier example is that of the United States going off the gold standard in August 1971.

The basic economic framework the world worked within in the 1950s and 1960s was created at the Bretton Woods conference in July 1944. Essentially, the Bretton Woods system was a fully negotiated monetary order aimed at governing monetary relations between member nations. The conference included 730 delegates from all “allied” nations which numbered 44 at the time. Out of this conference grew the International Monetary Fund (IMF) and the body that became the World Bank. These latter organizations became operational in 1945.

Primary among the obligations flowing out of the Bretton Woods system was the obligation for each country to adopt an economic policy that would maintain a fixed exchange rate (within a range of plus or minus one percent) in terms of gold. The IMF would be used to bridge temporary imbalances in a country’s balance of payments.

Historically John Maynard Keynes came to dominate the discussions at Bretton Woods and the resulting agreement that was signed by the participants reflected many of his ideas, some of which he had been promoting for twenty years or so. For more on the role Keynes played in international financial discussions during the 1919 to 1945 period see the book by Donald Markwell titled “John Maynard Keynes and International Relations” (

Keynes was very forceful in promoting two policies he felt were crucial for the peace of the post-World War II period: the first was fixed exchange rates; and the second was independence for nations to follow their own economic policies. What he did not want was international capital mobility. That is, capital flowing freely between countries.

The driving force behind these policies was the worker unrest that dominated Western Europe in the post-World War I period which, of course, included the Great Depression. Of great concern was the possibility that Western civilization, the culture that Keynes was prominent in, was under siege. The problem was the Russian Revolution and the fear of potential Bolshevik revolution throughout Europe in the 1920s and 1930s.

It was crucial to Keynes that governments kept workers “fully employed” and not allow their (nominal) wages to decline. To do this, governments had to adopt economic policies that promoted “full employment” and that were necessarily independent of other nations so that they could respond to their internal labor markets.

The way to achieve the autonomy of the economic policy of governments was to fix the exchange rate of the currency.

But, there was a third part of the plan. The international movement of capital needed to be discouraged. Of course, at the time, gold was still an important aspect in the international movement of capital. Coming out of the experiences of the 1920s and 1930s there was grave concern that capital should remain inert, at best. A very lucid exposition of the existence of this attitude can be found in Liaquat Ahamed’s award winning book, “The Lords of Finance: The Bankers Who Broke the World” (

So, in line with the conclusions of the “Trilemma” argument, the post-World War II world implemented just two of the three policy goals. The Bretton Woods agreement created a world in which there were fixed exchange rates and autonomous national economic policies, but discouraged free international capital mobility.

The result: relative stability in the system during the 1950s when governments were generally conservative in terms of their monetary and fiscal affairs. However, in the 1960s, nations began to implement “Keynesian” type fiscal policies (note the “Keynesian” tax cut enacted by the Kennedy/Johnson administration) connected with a monetary policy stance that encouraged inflation (note the inflation/employment trade off in the popular economic model labeled the Phillips Curve). By 1968 or so, we Americans at least, were all “Keynesians” according to President Richard Nixon.

What occurred in the 1960s was the re-ignition of inflation and inflationary expectations as the Johnson administration pursued a fiscal policy that included both “guns and butter.” As inflation and inflationary expectations grew, financial innovation advanced as commercial banks became more international in scope and began raising funds throughout the world through the management of their liabilities. Note, for one, the development of the Eurodollar deposit.

International capital market mobility became a reality!

As a consequence, the Bretton Woods system could not hold. According to the “Trilemma” diagnosis, the world was trying to live with all three of the policy goals connected to the “Trilemma” and one of them had to go.

President Nixon believed that full employment was very important to him in terms of his re-election bid and so the autonomy of his administration’s economic policy could not be aborted. Furthermore, globalization was in its infancy and business and finance were pushing as hard as possible to keep international capital markets expanding. Hence, the fixed exchange rate had to go!

On August 15, 1971 President Nixon announced to the United States (and to the world) that America was going off the gold standard and the value of the dollar would be floated. The world was now different than it was before.

The basic reason I wanted to bring this episode to your attention was to provide some historical backing to the dilemma now facing the European Union. The “Trilemma” problem is relevant to what they are trying to achieve. Ignoring or assuming that Europe can overcome the conclusion reached in the “Trilemma” analysis is foolhardy. Therefore, we shall all be waiting to see how the European Union can resolve their dilemma. Enacting a bailout package is only a stopgap to dealing with the real issues the leaders of the EU face. The problem concerns the absence of real leadership in Europe!

Sunday, May 9, 2010

The Dilemma for Europe

One of the most important conclusions reached in modern open-economy macroeconomics is captured in what is called “The Trilemma.” The principle presented in this analysis is that governments cannot achieve all possible policy goals simultaneously.

More specifically, a government cannot, simultaneously achieve a fixed exchange rate, international capital mobility and economic policy autonomy. Only two can realistically be achieved at any one time.

Governments within the euro-zone have been attempting to achieve all of these goals at the same time. And, that is why they are experiencing the current difficulties. The euro represents the fixed exchange rate between euro-zone countries. Although an attempt has been made to bring economic policies within certain boundaries either through stated requirements to join the community or ongoing standards of behavior once a country joins the euro-zone, strict adherence to these rules have not really been observed. Consequently, nations within the community have been able to act with relative autonomy in regards to the economic policy they have followed.

Finally, membership in the euro-zone has provided all nations with greater access to international capital and this, as much as anything seems to have been one of the major attractions to countries on the periphery of Europe to join the body. Becoming a member of the euro-zone has allowed less credit-worthy countries to gain access to capital and at lower interest rates than would have been possible had they remained independent. In this, the creation of the euro has been a great success.

However, that very success is undermining the community. Ken Rogoff, the co-author of “This Time Is Different,” agues in the May 6 edition of the Financial Times, that “Europe Finds that the Old Rules Still Apply,” (See It seems as if people, and governments, living well beyond their means ultimately have to “pay the piper.”

Martin Wolf in his of May 4 raises the question, “Must All Capital Inflows Always End In Crisis?” ( One conclusion is that if a country has a large capital inflow and it cannot allow for a change in the value of its currency in the foreign exchange market then it must adjust its internal economic policy. If it is not willing or cannot do so in a sufficient magnitude then a financial crisis must take place.

And, this brings us right back to the Trilemma dilemma. A country cannot have a fixed exchange rate, run an autonomous economic policy, and enjoy the fruits of international capital flows. So, the question boils down to the problem of how is this going to be resolved?

The International Monetary Fund has now moved to approve a three-year, €30 loan to help the Greek government. Also, French President Nicolas Sarkozy and German Chancellor Angela Merkel Sunday said they are in complete agreement with measures to be unveiled later on Sunday by the Ecofin, the group of the European Union's 27 finance ministers.

NOTE: Exit polls predict Merkel defeat in federal state election (see making it more difficult for Ms. Merkel to effectively govern in Germany.

So, the euro-zone seems to be moving toward some combined help for Greece and possibly others within the European community. But, there seems to be an absence of real leadership. And, that is a problem, for people really don’t like a leadership void. How this void is going to work itself out is anyone’s guess right now.
The problem is, as I see it, that in situations like this one the drift goes one of two ways. Either the community moves toward the country that is most fiscally sound, in this case Germany, or the community moves toward those that are the weaker links: Greece, Portugal, Italy, and Spain.

If left alone, I would bet that the countries that are more in control of their finances would come out on top! Why? Well, because the less disciplined ultimately have to get their act together in order in order to be able to compete with those countries that are in better shape than they are.

One can easily use a sports analogy in this case and that is why sports can be so popular because it can be used to explain life. Usually, the most talented and most disciplined player or teams come out as the winner or champion. Other individuals and teams know that they must practice and train and discipline themselves if they are going to have a chance to compete. Those that don’t have the attitude to commit themselves to this regimen are not kept around.

But, we have another model to work with. In this model, those that are weakest and least disciplined draw on others so that they can keep playing the game. Here, the weakest links become a drag on the performance of others and define the nature of the relationship.

Why are Greece…and Portugal…and Spain…and Italy…having such a difficult time? Their economies are as undisciplined as are their finances. They still, according to Rogoff in the article mentioned above, are emerging nations, if not worse. Their entry into the European Union provided them with an opportunity to move beyond the “emerging” classification more rapidly than the amount of time usually needed to achieve this maturity. The problem is that these countries have “wasted” the opportunity. They have used their access to capital to “buy off” voters with social programs and benefits and have devoted very little attention toward developing a more competitive economy.

Bailing these countries out only exacerbates the situation. Can these countries really deliver the fiscal discipline needed to move into the modern world? The rioting in Greece does not give us much hope for such an outcome.

One further problem seems to be that European banks have purchased too much of the debt of these countries. And, in this respect, the difficulty is not just the Greek debt, but the debt of these other countries that people are now raising questions about. Of course, this is the problem when something turns out worse than thought. Thus, questions arise about others with similar difficulties.

Coming to the support of the Greek government may be a signal of the extreme concern that exists over the safety of the European banks.

Few officials want to talk about a debt restructuring. The problem again seems to be the feeling that if the Greek debt is restructured then this will have to be followed by a restructuring of the debt of other European nations. Then the problem just becomes that much more severe.

Yet, the economics of the situation give little hope that the Greek government, and possibly other governments, will be able to resolve their situations through massive changes in their governmental budgets. That is why many analysts are betting that, sooner or later, a write down of the debt will have to occur. The picture is something like that enacted by Argentina who wrote down their debt by 50%.

I would argue that this is the only real way to begin the move beyond the solvency crisis.

As far as the fate of the euro and the euro-zone? According to the “Trilemma” analysis, the only way the euro and the euro-zone can survive without recurring “political” difficulties is to coordinate the economic policies of the member nations. That is a lot to hope for at the present time…or, maybe at any time.

Thursday, May 6, 2010

Euro Solvency?

The financial markets hate uncertainty. It is the unknown that creates uncertainty and unexpected new information often creates uncertainty because investors must not only absorb the new information but must also translate what they have learned into action!

This is what I tried to emphasize in my post of April 28, 2010, “Greece: The ‘Surprise’ That Breaks The Camel’s Back” ( Recently we were given knowledge that the budget deficit of the Greek government was much worse than we had been told, and, as a result of this news, the rating on Greek bonds was lowered. Immediately, investors began to sell off these bonds.

The financial market unrest continued. Then the European Union and the International Monetary Fund came up with its bailout package of €110 billion “to save the euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so.” (

The problem is, as I pointed out in this last post, that the response was aimed at preventing a liquidity crisis and not a solvency crisis. These two types of financial crises are different and a failure to understand the difference and react in the appropriate way can just exacerbate a problem and not solve it.

The Federal Reserve under Ben Bernanke has been guilty of this very thing and, as a consequence, has contributed to the lingering solvency problem in the “less than mammoth” banks in the United States banking system today. (I have discussed this in many other posts.)

A liquidity crisis is a short run phenomenon related to the disclosure that the price of a certain financial asset should be different from what it had recently been trading at. The buy side of the market disappears and the price of the financial asset drops, sometimes precipitously. In the classical case, the central bank comes into the market and makes sure that there is sufficient liquidity in the market so that the price of the asset in question stabilizes and trading can resume.

The prices of other similar assets may be caught up in this uncertainty but the response of the central bank is enough to stabilize the market.

A solvency crisis is different. In a solvency crisis the value of the assets must be written down, but the concern is over the ability of the institutions that own the assets to cover the value write down with the equity capital they possess. Of course, the value of the assets may go up at some time in the future but in general these institutions must “work off” these assets over time in a way that does not exhaust their capital base.

Otherwise, if the effected institutions have to write off these “underwater” assets immediately they may have to be closed.

A solvency crisis takes a much longer time to get over than does a liquidity crisis. That is why so many small- to medium-sized banks are still having so much difficulty even with massive amounts of liquidity available in the banking system.

The problem with the current situation in the European Union is that the situation is not one of liquidity, but one of solvency. There is a very real concern in the market for sovereign debt about whether or not certain nations within the EU can maintain their solvency given the debt load their governments have assumed and given the very weak nature of their economies.

There is a question about the ability of certain governments to be able to pay-off their debts. And, if these debts cannot be re-paid, what will happen to the solvency of the banks and other institutions that now hold this sovereign debt. Special concern exists about commercial banks in Germany and France. Some think that the real reason for the Greek bailout is to keep several major banks in Germany and France from failing. (See the second post mentioned above.)

Just providing Greece the ability to be able to roll over its debt in the next twelve months or so is an attempt to make Greek debt “liquid”. The hopes are that this will buy time for the Greek government to “right its ship” so that it will be able to meet its financial obligations and then go bravely forward. The financial markets have responded by saying that the Greek situation is not a problem of market liquidity but a problem of government solvency: the government, as it appears now, cannot pay its bills.

The concern over solvency has spread. If Greece lied to its debtors, maybe other countries have been doing so as well. Maybe these other countries are not as well off as was thought. Hence, a need to check other “undisciplined” countries out.

The credit ratings of Spain and Portugal were lowered (with Portugal facing additional review concerning its credit rating). Isn’t this evidence enough. But, of course, other countries are on the radar screen: countries that have been particularly profligate like Great Britain where the Labour Government outspent the rate of inflation since 1997 by 41%! But also Italy and Ireland.

What we seem to be seeing in the world is a realignment away from countries that have over-stayed their welcome in the credit markets. We see this especially in the currency markets. The value of the euro has plunged against the dollar and other major currencies. Today, May 6 it hit a 52-week low around 1.26. In other areas of the currency market the move seems to be away from the currencies of countries having “debt problems” to those that appear to be more secure.

The same thing has occurred in bond markets. The rush to United States Treasury bonds has been phenomenal over the past week. The two-year Treasury was yielding about 1.07% April 23 while the ten-year Treasury was yielding around 3.82%. These two yields have dropped to 0.79% and 3.39%, respectively, a major move!

When uncertainty increases, market volatility also increases. If we look at one index of market volatility, the CBOE’s VIX index, we see it peaking over 40 today, up from around 20 or so over the past week and in the 15-20 range before that. The market appears to be spooked and this means one might expect the volatility of the financial markets to remain high in the near future.

The major problem going forward is leadership: who can lead the eurozone and Great Britain out of this mess? The concern is captured in Landon Thomas’ article in the New York Times, “Bold Stroke May Be Beyond Europe’s Means,” ( In the case of the eurozone, there is no leader. And, this has been a problem the detractors of this union have pointed to since before the euro was put into place. There is an economic union but no political union. It is like herding cats and given the cracks that are occurring in the structure, many are wondering if this economic union can last for more than two or three years more.

In Great Britain, there is going to be a “hung” Parliament. But, who really wants to rule in jolly ole England. Some are saying that if the new government (‘hung’ or not) really does what it needs to do with respect to the fiscal condition of the nation, these politicians will not be able to be re-elected for the next ten- to fifteen years because they will be so unpopular. Shades of Greece?

The bottom line: governments have lived beyond their means. Certain ‘brands of economics’ have argued that this is possible because people don’t really take into account future tax liabilities or future inflation. They are very ‘current minded.’ It just seems possible that this philosophy has run its course!

Wednesday, May 5, 2010

Why Should We Trust the Financial System?

Every day, it seems as if people are given more reasons to distrust financial institutions and the leaders of those financial institutions.

Lloyd Blankfein has become a joke!

Banks are not to be believed!

And, governments and members of governments have even lower ratings!

Finance is supposed to operate on trust and financial markets are said to function because people have confidence in them.

Well, if this is the case anywhere at the present time it must be in a parallel universe.

And, the stories continue. “It’s an open secret on Wall Street that many big banks routinely—and legally—fudge their quarterly books.”

“Window dressing is so pervasive on Wall Street…”

“The big question is the extent to which other banks (other than Lehman Brothers and Bear Stearns) used, and still use, creative financing, and whether they, like Lehman, broke any rules.”

These quotes are from the New York Times article “Crisis Panel to Probe Window-Dressing at Banks”:

It is not just the big banks. It is on the public record that the Greek government lied to the world about its fiscal position. What other governments might be falsifying their records?

State and local governments in the United States are not forthcoming about their financial commitments and liabilities such as those connected with the funding of pensions and other contracts. And, many of these entities are facing the bankruptcy court these days.

Ponzi schemes come in many different flavors.

But, those that work in financial markets claim, at least in theory, that the markets are efficient, that the prices that exist in financial markets reflect all relevant information. They assume that participants in financial transactions are “sophisticated” meaning that the participants are canny professionals who have all the information they need.

That is why the executives at Goldman Sachs can, in good conscience, argue that their customers are “sophisticated” and are “big boys, fully capable of looking after themselves.” (See “Goldman and the ‘Sophisticated Investor” in the Wall Street Journal this morning,

What! The financial wizards claim that investors have all the information they need, yet they hide information from the public on a regular basis!

And, why does Lloyd Blankfein look silly testifying before Congress or on the Charlie Rose program?

Government officials hide information from the public on a regular basis!

And, then these same officials cry foul when financial markets sell off once the information on their lies becomes known.

Hello, Bernie Madoff…

We now know that Lehman Brothers and Bear Sterns used “shadow financial vehicles” and produced results that mislead investors and regulators. This seems to be the case most of the time in terms of companies that fail.

I know from the bank turnarounds that I was involved in, one of the first requirements of the new management was to open up the books and let the world know what actually was going on in the “troubled” institution. When this was done, the basic response I got from the investment community was one of “incredulity” and “disbelief.” The investment community could not believe that I was willing to make the books as open to them as I did. But, once they got used to this “openness” they began to trust me and what was being done at the troubled institution.

Secrecy, to me, is the worst thing the leadership of an organization can pursue. But, then, people tend to run to secrecy when things go wrong because they either were not capable of running the organization or because they made bad decisions.

As a consequence, my experience has made me a firm believer that openness and transparency, in all financial institutions…and governments…are a requirement for sound finance. Openness and transparency are a requirement for the building of trust in organizations and the system so that investors will have confidence in markets.

Openness and transparency should be one of the building blocks for any new financial reform and re-regulation that takes place.

Yet, the Obama Administration and the Congress seem to be focused on the past; they are fighting the last war. And, this means that any reform package they get will be out-of-date and irrelevant when it is passed. As the New York Times article reports “JP Morgan Chase and Goldman Sachs are examining how to use shadow vehicles to help them borrow money in the future.” The article points to such major players as BSN Capital Partners in London as one firm that has created such vehicles for banks in the past. Even the best seem to need secrecy!

International financial markets still don’t know all they need to know about the Greek situation…and the Spanish situation, and the Portuguese situation, and the Irish situation, and the Italian situation, and the English situation, and so on and so on. International financial markets still don’t know all they need to know about who holds the debt of these countries and how much of an impact would take place if the debt where to be substantially written down.

So we see that another financial crisis has taken place because the expectations of investors were surprised. (See my post Maybe we are asking the wrong question, that question being “Why have investors lost confidence in these euro-zone securities?” May the question should be “Why did investors have confidence in them in the first place?”

Tuesday, May 4, 2010

Greece and Insolvency

A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.

Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.

Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.

Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.

But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See

By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.

There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!

The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.

Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.

Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.

Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.

The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.

It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.

Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.

The Piper eventually has to be paid.

The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.

This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?