Wednesday, June 23, 2010

Follow the Dimon!

For months I have been arguing in my blog posts that the larger banks have already moved beyond the regulators although they have always been far in advance of the politicians. These latter two groups of people are attempting to create a regulatory system that will prevent the events of 2007 through 2009 from happening again.

Would somebody tell them that the big banks are somewhere else.

JPMorgan Chase announced some major changes in their top management structure yesterday. These changes, to me, are just the most visible sign that the banking of the future is going to be significantly different from the banking of the past. But, we’ll come back to this later on.

The management changes also confirm, to me, that Jamie Dimon is the pre-eminent banker in today’s world.


A long time ago I stopped looking at the “glow” of the person running things, the Chairman, President, or CEO, and I started concentrating on the people around the glorious leader. I found that the fact that the leader of an organization had very, very capable and experienced people around them was a better indicator of the quality of the person in charge than was his or her own sparkling image.

Top people have top people around them. In addition, winners help to make everyone around them perform better.

Jamie Dimon has these qualities.

I believe that Jack Welch also had them.

One person I had contacts with at one time who, I felt, didn’t have these qualities and was a disaster waiting to happen, was Donald Rumsfeld.

Jamie Dimon has a top notch team around him and is positioning them to take on the world. In my estimate, more than one of the individuals that are on this team will be a Chief Executive Officer of a major bank in the United States…or, the world.

Many people that Jack Welch had around him went on to lead major companies around the world.

But, back to the banking changes: JPMorgan is going off-shore!

The New York Times has it right, “JPMorgan Sets Sights Overseas,” ( Dimon has given out the mandate to his closest lieutenants “to start a global corporate banking business and scout out opportunities in Europe, Latin America and Asia.” Mr. Dimon, himself, has recently been in China, India, and Russia and wants to especially focus on these three BRIC countries as well as Brazil and also Vietnam, Indonesia, Malaysia, the Philippines and parts of Africa.

My suggestion: Watch what Mr. Dimon and JPMorgan do. My guess is that they will point the way to the future and will do a good job along the way!

But, what about American and Europe?

In terms of banking and finance, I am not sure the political and governmental leaders in these areas of the world know what they are doing. For one, as I have said over and over again, in terms of financial regulation…they are fighting the last war!

Politically, both areas are split and looking for direction. No one can tell at this time where “direction” will come from.

So, what better time than this to move to where the action is going to be!

If anything, the fiasco going on in Washington, D. C. is going to drive business and finance further off shore. The BRIC nations are becoming wealthier and more savvy in the world. They are also accumulating more power as will be in evidence in the upcoming G-20 meetings. But, as Mr. Dimon indicates, there is a lot more going on if one looks to the other countries he has highlighted in his recent statements.

Moving in this direction will involve acquisitions, something that JPMorgan has already started doing. To build itself into a larger presence in these markets in a timely fashion, the company will have to acquire significant other properties. JPMorgan Chase is going to get bigger.

And, Washington was concerned with the size of the banks in the United States that were “too big to fail” in 2008?

Furthermore, this doesn’t even get into one of my favorite subjects, the “quantification” of finance. What is going on with respect to the “quants” in JPMorgan? My guess is that there has been significant movement in this area as well over the past two years.

The future of banking?

Keep your eyes on the Dimon. I think you will find that it will be time well spent!

Tuesday, June 22, 2010

The Problem is "Out There"! It's China!

The quote of Stephen Covey that continues to resonate with me is "As long as you think the problem is out there, that very thought is the problem."

With all the fuss over the movement by the Chinese to allow the value of their currency to rise we hear, once again in the background, that the real problem is that the imbalances in the world are really a consequence of “an entrenched savings excess” in China. (See the article by George Magnus, “We Need More from China than a Flexible Renminbi,”

There we have it!

And, the support for this theory goes as far as Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, who came up with this idea to provide Alan Greenspan with an excuse to keep interest rates excessively low in the earlier years of the 2000s.

The problem is “Out There”!

Those Chinese just save too much! Let them be like the Americans who reduced their savings to close to around one percent of disposable income earlier this decade. The Chinese bought a large proportion of the bonds going to finance the huge deficits of the United States government and this kept interest rates so low that the Federal Reserve could reduce their target interest rates to levels that created a bubble in the United States housing market.

As Magnus writes, the Chinese do have an unreformed rural sector, an immature social security and financial system and a one-child policy. But, China is transforming. It is just not doing it at the pace that the Western world would like it to in order to reduce or eliminate the imbalances that exist internationally.

The Chinese, however, are not going to change their social policy overnight. This is one of their “no-no’s”! They saw what happened in Russia and Eastern Europe as the social order unraveled when the Communist governments in these areas fell. They vowed to keep a lid on things, culturally, as China modernized. They will not back off this controlled approach as they move toward a state capitalism and a society that is more open to the world.

But, this is not what created the huge government budget deficits in the United States. The total amount of United States debt outstanding rose at a compound rate of over 7% from early in the 1960s through the end of 2008. This was not the fault of the Chinese!

Nor is it the solution to the low personal savings rates in the United States and the huge government budget deficits going forward. The personal savings rate in the United States stayed above 7% for most of the period between the late 1950s into the late 1980s. It exceeded 10% at times!

What eventually got to the American saver was the steady erosion of the real value of the savings put aside during this time. And, as the American saver moved into the 1990s, the personal savings rate began to fall and continued to fall into the 2000s. Consumer prices in the United States rose at a compound rate of around 4% from January 1961 through the summer of 2008. The purchasing power of a 1961 dollar dropped during this time to about $0.15.

If anything may accelerate the decline in the personal savings rate in China it may be the rising rate of inflation that is being experienced there. If the real value of savings takes a precipitous drop, even the rural Chinese may begin to adjust their behavior.

The real problem in this picture is the massive amount of United States debt that is outstanding. And, the amount of debt that is outstanding is the fault of no one but the United States. But, this problem puts a lot of pressure on other countries, especially on China.

China holds about 70 percent of its foreign exchange reserves in dollars, mostly in United States Treasury securities. This accumulation began in the 1990s and accelerated into the 2000s. The United States dollar was the reserve currency of the world and United States Treasury securities were the most secure investment around in terms of risk.

I remember working with a group from China in the early 1990s that represented Chinese pension funds. This discussion took place at the University of Pennsylvania. I was not teaching at the time, I was the president and CEO of a bank.

Chinese pension funds had a very large amount of money, yet because they could only invest on Mainland China they had limited capabilities of earning a decent return on their monies and were very limited in terms of their ability to diversify their investment holdings. This group was investigating investing pension fund monies “off-shore” and they were interested in foreign exchange risk and how this risk could be hedged. And, these discussions were a part of the general discussion going on in China at the time about investing more and more of their monies and international reserves in the rest of the world.

The point is that the early 1990s represented a time in which China was opening up and investigating how it could participate in global financial markets. Being very cautious, the Chinese were learning about how to diversify into the world but keep its risk exposure low both in term of credit risk and foreign exchange risk. I don’t see much of a change in this attitude at the present time.

Magnus mentions, in his article, that because of China’s creditor status it must play a role in helping to fix the global financial imbalances. Specifically, he argues that China cannot “back away” from these world imbalances—as the United States did in the 1920s and the Japanese did in the 1980s—because, in the end, backing away will neither help the world, or themselves.

My guess is that the Chinese will not “back away” and “dump” United States Treasury securities. This is one of the reasons why the Chinese do not want to see the value of the Yuan rise too rapidly. A “quicker revaluation would act as a stealth monetary tightening not only in China but also the US.” This is because it would have a negative effect on US equity prices and also result in higher US interest rates. (See the Lex column in the Financial Times:

However, President Obama’s administration and the United States Congress continues to press for China to change the behavior of its government and the savings habits of its people. Yet, many of the major imbalances in the world today result from the undisciplined behavior of the United States over the past fifty years or so. The huge amounts of United States government debt outstanding are not the result of the government of China or the Chinese people. Why, then, should the Chinese bear the brunt of any adjustment that is to take place?

As long as the United States government and the people of the United States think the problem is out there, the problems and imbalances will not be resolved. The only one we can control is ourselves, so if anything is going to be accomplished, we are going to have to do it…not the Chinese.

Monday, June 21, 2010

China Is In The Game

China wants to play in the game. Yes, it would like to dominate the game, but that is for another time. For the present, China wants to be a player. I have written this constantly throughout my blogging career and I see no reason to change my opinion at this point.

China wants to play in the game and to do so its leaders realize that it must be a part of the game and not absent from it. But, remember two things: first, China will not do anything that it thinks might be harmful to itself in the long run; and second, China will always move in a way that “saves face.” Given these two conditions, China will be “in the game.”

The weekend news about China’s move on its currency is a case in point. The move was taken at China’s initiative. It seemed to catch the rest of the world by surprise. The move followed weeks of discussion about the possibility that China would not change the value of its currency in the near term.

China timed its move according to its dictates and not those of other nations.

Furthermore, the move pre-empts any discussion or actions by members of the G-20 at its June 26-27 meeting to highlight China’s unwillingness to play ball with the other major nations that will be in attendance. Now, the rest of the G-20 must re-boot their strategies relative to the agenda of the upcoming meeting.

China must see this as beneficial to itself and believe that moving at this time “saves face” because the news was done on its terms and not those of other countries in the world. It is keeping itself in the game.

However, China does not want events to get ahead of its plans. Although the announcement came on Saturday, when the market opened on Monday the value of the yuan was approximately 6.83 yuan to the dollar, roughly the same as it closed on Friday. By Monday afternoon, however, the yuan was trading around 6.8015 to the dollar, the highest level it has been in the modern era.

The point here is that China wants any appreciation in the value of the yuan to be incremental and not discrete. That is, movements in the yuan will tend to be more like a slow crawl and not like a discrete jump or leap. The leaders in China do not want to encourage speculators or huge currency inflows.

The signal to investors is that the value of the yuan may change but don’t expect wide swings. This is just not the way the Chinese do business.

But, I think, there is a bigger story going on here. The bigger story includes Russia and India…so we have three of the four BRIC nations as a part of what is going on. President Obama and his administration are making a concerted effort to be a part of the trajectory taking these countries into a prominent position in the world. All three of these countries are engaging each other, and talking with each other, visiting each other, and doing things with each other.

Chinese leaders have come to America and American leaders have gone to China.

New contacts with Russia show promise. Last year, President Obama called for a reset in relations with Russia. The countries have now signed a nuclear arms reduction treaty, agreed to increase cooperation in Afghanistan, and Russia has supported United States sanctions against Iran. This week President Medvedev comes to Washington to discuss business and then will visit Silicon Valley to meet with leaders in the technology field. Medvedev would like to encourage technology areas similar to Silicon Valley in Russia.

Leaders in India also are responding to invitations from the Obama administration to engage in dialogue and improved communications between India and the United States. Of these three BRIC nations, India has the longest solid ties with the United States and the greatest personal bond to see that these ties become stronger.

Not only are these three countries becoming relatively stronger in the world pecking order, but are the important reason why discussions about world business and foreign trade need to work in the larger Group of 20 nations rather than in the smaller groups that have been so prominent in the past.

Add on top of this the economic weaknesses experienced in the United States and Europe which have allowed these three, China, Russia, and India, to gain relative to “the West” faster than they would have if the financial collapse in these former areas had not occurred. These three nations are not going to back off their ascent in the world power scramble just because the United States and Europe are facing some “uncomfortable” economic weaknesses.

Furthermore, Europe has its own internal contradictions to deal with. Leadership in Europe is close to zero and the political problems that must be resolved there are almost overwhelming. And, while Europe attempts to get its house in order…the rest of the world moves on.

Brazil, the other BRIC, seems to be laying bricks lately. The current president, Luiz Inảcio Lula da Silva seems more interested in playing around with the leaders of countries at odds with the United States rather than entering into more mature relationships with the rest of the emerging world. Enough said.

What is vitally important for world trade and finance is to have these major countries talking with one another and learning about how they can work together to create a world in which all can prosper. World trade will not exist if it just benefits one or two countries.

The emerging nations are doing just that…emerging. These countries must be an important part of the world of the future. Keeping these nations down and causing resentments in a world where there are no channels for communication is not the way to build a richer and more vibrant world to live in.

The crucial thing is learning how to deal with each other. As I mentioned above, the Chinese will not make moves that will harm themselves in the long run and when they move they will do so in a way that does not make them look bad. Can we in the United States accept these two behavioral traits that seem so important to the Chinese or will we become so impatient and try and impose our self-importance on them?

Certainly, leaders in the United States cannot become “doormats” that others can just walk over. But, the time seems right for talking, for keeping channels open, for cooperation within the competitive framework, and for learning how to work with each other, accepting the quirks and psychological needs of others.

China will not always internally do the things we in the United States think that they should do…especially in some areas like human rights. We should not be silent on these things. But, I believe the world still has more to gain by building cooperation over the longer run than it does by breaking off ties. I believe that the recent economic moves by China confirm this. I believe that the leaders of China truly want to be in the game and will act accordingly.

Thursday, June 17, 2010

No Housing Recovery In Sight

Households, as a group, are gaining ground financially, but are still far below where they were in 2007. This, along with other weaknesses in the economy, is going to continue to contribute to the weakness in the economic recovery now taking place.

One place this weakness is particularly evident is in the housing sector. The recovery of the housing market helped to lead the economy out of every previous recession in the post-World War II period. In the recent experience, this has not been the case, even with special incentive programs created by the federal government to spur along a rebound.

The figure on housing starts in May 2010, an annual rate of 593,000, confirmed this continued weakness.

The recession ended in July 2009, yet housing starts have hovered around a 600,000 unit annual rate ever since. The highest figure recorded during this time period was an annual rate of 659,000 in April of this year, but the pace dropped off once again in May.

At this time, Americans are just not in a position to acquire housing. If we look at the financial position of United States households since the year 2007, according to the Flow of Funds accounts released by the Federal Reserve, the net worth of households has decline by slightly less than $10 trillion. Year-over-year, from the first quarter of 2009 through the first quarter of 2010, household net worth has risen by a little more than $6 trillion, but almost all of this increase has been in the value of equity shares, something that is not a part of the balance sheets of Main Street America. The value of tangible assets, including the value of homes, has fallen by $5 trillion since 2007 and increased only modestly year-over-year. Again, the beneficiary of any gain here has not been Main Street America.

The plight of the American household is captured in the percentage of households owning their own home and who actually have no equity in the home they are living in. David Wessel captures this dilemma in his Wall Street Journal article this morning, “Rethinking Part of the American Dream,” He cites data from the Federal Reserve Bank of New York: for example, in San Diego, 55% of households owned their own home, but the fraction of these households that had equity in their homes was between 35% and 39%; in Las Vegas, only 15% to 19% of households had equity in their homes, even though 59% of those households owned their own home. In the cities reported, Boston, Chicago, and Atlanta scored the highest in owners having equity in their own home.

And, with one out of every four or five working age people being under-employed, it is highly unlikely that there will be a stronger recovery in the housing market in the near future.

Ethan Harris of Bank of America Merrill Lynch is quoted as saying “We’re not going to see a real recovery in the housing market until the foreclosure process gets worked out. That’s…a 2012 event.” (

Delinquencies on mortgages seem to have leveled out but they still remain at a high level. Also, foreclosures remain at a high level.

The performance of loans that have been restructured remain dismal: see my post “Eventually Debt Must Be Repaid, Sixty-five to seventy-five percent of the loans restructured in the Treasury’s loan restructuring plan “re-default.”

And, banks continue to stay on the sidelines in terms of making new loans, especially mortgage loans. With one out of every eight commercial banks on the FDIC list of problem banks and many more on the edge, housing is just not going to show much bounce in upcoming months.

Households, according to the Federal Reserve data, are reducing the amount of debt outstanding, but at a relatively slow pace. This is where, I think, it is important to think about how the country is dividing along two lines, between those that are doing quite well, thank you, and those that are really struggling.

As I mentioned, the value of the financial assets of U. S. Households rose by about $5.5 billion last year, most of the increase coming in the market value of equity shares. However, those benefitting from the rise in the value of equities are generally not the ones that own a home with no equity in it. They are generally the people that are still employed and have a sufficient income. Also, they are not the ones that are in debt in a major way.

In my post on debt repayment, I quoted a report by Fitch Ratings Ltd. indicating that the individuals that were in the mortgage re-structuring program were also heavily in debt on credit cards, car loans, and other obligations. People in this second group are the ones that are excessively in debt and have neither the accumulated wealth nor the current income to pay down their debt.

It is this debt that still must be worked off before the recovery can have any bounce to it. Resolving this debt burden will also go a long way to helping the banking system regain its legs.

Consumer spending may increase modestly, housing starts may gain some, but the Americans that are in this second group will not be the ones contributing to these increases until they get their finances back in order and that may take a long time. To see this in another way, check out what is actually being purchased by consumers. Much of it is up-scale, not ordinary “stuff.”

Wednesday, June 16, 2010

Unfortunately, Debt Must Be Repaid

Fitch Ratings Ltd. is releasing a report today that points up the problems of having too much debt. Restructuring the debt of a person or a family (or a business), even when government programs help to formalize and regularize loan modifications, is not a “magic wand” that resolves the issue of debt overload.

Using data from the Obama administration’s Home Affordable Modification Program, Fitch reports that “the redefault rate within a year”, of the loans that are modified, “is likely to be 65% to 75%”. This information comes from the Wall Street Journal article, “High Default Rate Seen for Modified Mortgages,” “Almost all of those who got loan modifications have already defaulted once.”

The failure rate is likely to be high because “most of these borrowers were mired in credit-card debt, car loans and other obligations.” That is, when a person or family (or business) goes into debt they go into debt “across the board” and do not just limit themselves to one kind of debt or one type of lender.

And, the Treasury Department says, that those given loan modifications under this program have a “median ratio of total debt payments to pretax income” that is around 64%. “That often means little money is left over for food, clothing or such emergency expenses as medical care and car repairs.”

The good news is that the results of the program indicate that around one-third of the loan modifications make it through the first year. This is looked on as “good” by the Treasury Department and by a Fitch representative.

This is the reality of debt creation during a period that can be referred to as a period of credit inflation. At times like these, more and more people, families, businesses, and governments take on more and more debt until it gets to the point that the debt loads become unsustainable in some sectors of the economy.

Thus, to the first point, people and families take on mortgages, as well as “credit-card debt, car loans and other obligations” until, the second point, their “ratio of total debt payments to pretax income” becomes too large. Then, any increase in total debt payments, like a re-setting of the interest rate on a mortgage, or a reduction in pretax income, due to being laid off a job, puts the borrower into a situation in which debt payments cannot be made. Defaults occur, and a foreclosure…followed by a bankruptcy…may follow.

The “macro” government response is to provide fiscal and monetary stimulus to make sure people stay employed and to inflate incomes so that debt loads (debt payments relative to pretax income) decline. This is the Keynesian prescription!

The problem with this solution is that in a period of credit inflation, as incomes and prices continue to increase, debt loads continue to increase. If the government buys people out of their debt burdens by fiscal stimulus and monetary inflation, people (and families and businesses) don’t adjust their behavior to become more financially prudent. They just keep on, keeping on. This is another case of moral hazard.

Even worse, given the belief that government will continue to “bail out” those who have taken on too much debt, we find that those that have taken on too much debt generally go even further into debt. Take a look at what has happened over the last fifty years of credit inflation and this type of behavior is observed everywhere.

The Keynesian prescription of fiscal and monetary stimulus to keep unemployment low and debt burdens manageable only exacerbates the problem over time. That is, governmental efforts to sustain prosperity over time just postpone the consequences of dealing with the debt loads that are built up during these time periods.

Keynesian economic models, with the exception of the maverick Keynesians like Hy Minsky, don’t include the credit or debt aspects of economic activity. As a consequence, they ignore how people (and families and businesses) manage their balance sheets over time. In essence, these models ignore the very real fact that ultimately, debt must be repaid and cannot just increase without limit!

Over the past fifty years we have seen people and families and businesses and banks and governments take on more and more debt. Inflation has risen at an average compound rate of about 4% from 1961 through 2008 so that it has paid people to increase financial leverage, take on more risky assets, and finance long term assets with short term debt. And the federal government has underwritten this inflation by increasing its gross debt by around 7.7% per year for this period of time and the Federal Reserve has caused the base money in the economy to rise by 6.2% per year. The M2 money stock measure rose at a compound rate of 7.0% per year. All roughly in line with one another.

The Fitch report is presenting us with a picture of what happens when debt loads get “out-of-hand”…when there is just too much debt around.

The current response of the Federal government? Official federal government forecasts of the cumulative fiscal deficits for the next ten years runs around $9 to $10 trillion. Some of us believe that the deficits will run more in the neighborhood of $15 trillion. In terms of monetary policy, the Federal Reserve has placed $1.1 trillion in excess reserves in the commercial banking system. The leadership of the Federal Reserve expects us to believe that they will be able to reduce the amount of these excess reserves to more normal levels without the reserves being turned into loans that will expand the money stock measures by excessive amounts. (Just a reminder: excess reserves totaled less than $2 billion…note, billion and not trillion…in August 2008 before the big injection of reserves into the banking system took place.)

For one more time, the federal government is betting that by stimulating the economy and putting people back to work in the “legacy jobs” they were laid off from and by re-inflating prices and incomes that debt burdens will be reduced and we can get back to “spending as usual”. If the federal government is successful, the day in which debt loads are reduced will be postponed…once again!

However, the credit inflation causes other things to change. Over the last fifty years we have seen that in every employment cycle, fewer and fewer people are re-hired in the “legacy jobs” from which they were released. Under-employment, not just un-employment, rises and this puts more and more pressure on incomes. The ratio of debt payments to pretax incomes rise for these people. Right now, I estimate that roughly one out of every four or five potential works is under-employed, the highest level since the early 1950s.

Second, the steady inflation of the past fifty years has resulted in a larger proportion of the capital stock being un-productive. As a consequence, capacity utilization in industry has fallen to post-World War II lows. As we have seen in each business cycle during this last fifty years, less and less of this capacity is used in each recovery. This results in a drag on employment and income.

Eventually, debt must be repaid and debt loads must be reduced. The Fitch report highlights this problem. It is something that all of us should keep in mind in the upcoming months. If the situation with respect to under-employment and capacity utilization don’t change the debt loads will get even heavier.

Tuesday, June 15, 2010

Bubble, Bubble...Where's the Bubble?

In Bloomberg Businessweek, Nouriel Roubini is quoted as saying “Zero interest rates are leading to an asset bubble globally…”

What is an “asset bubble” and how can one identify it?

Is an asset bubble like pornography? “I can’t define an asset bubble, but I know one when I see one!” Thank you Supreme Court Justice Potter Stewart.

Such a renowned economic prognosticator as former Fed Chairman Alan Greenspan couldn’t identify a bubble. He argued that you cannot identify an asset bubble before the fact. One has to wait until an asset bubble is over before you can identify it as an asset bubble. That sure builds confidence!

In Wikipedia, an asset bubble…or economic bubble…or whatever…is defined in the following way: An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.)

Others have spoken of a credit bubble. A credit bubble is a situation where the rate at which credit is flowing into the economy, financial markets or sub-segments of the economy or financial markets exceeds the growth rate of other parts of the financial markets or the economy causing the prices of assets in the economy, financial markets or a sub-segment of the economy or financial markets to rise much faster than elsewhere.

The example that quickly comes to mind is that of the housing markets in the 2000s where credit was flowing into this sub-segment of the economy at a much faster rate than elsewhere causing housing prices to rise much faster than prices were rising in the rest of the economy. Although, before the fact, as Alan Greenspan stated, he could not identify this as a credit bubble.

But, Roubini has stated that current Federal Reserve policy (“zero interest rates”) is “leading” to an asset bubble. The bubble is not here yet, but it is on-the-way.

What might be behind this argument?

Well, since December 16, 2008, the lower bound of the Fed’s target Federal Funds rate has been zero. Since that date the daily average of the effective Federal Funds rate has been between 8 basis points and 22 basis points: effectively zero.

Getting into this position of “zero interest rates” and “quantitative easing” the Federal Reserve, through the financial crisis in the fall of 2008, moved to increase the Reserve Bank Credit it injected into the system from $892 billion on August 27, 2008 to $2,245 billion on December 11, 2008, just before the “zero” interest rate target was approved by the Fed’s Open Market Committee.

Commercial bank held balances with Federal Reserve banks of $12 billion on August 27; on December 11 the total was $773 billion. In the month of August 2008, excess reserves held by commercial banks was less than $2 billion; in the month of December 2008 this total rose to $767 billion, an increase of more than 38,000%!

In the first six months of 2010, reserve balances with Federal Reserve banks and excess reserves in the commercial banking system both hovered around $1.1 trillion!

Federal Reserve releases have implied that the target interest rate will stay at such low levels for “an extended period” because of the weak economy. In recent weeks, analysts have argued that such low levels will be maintained into 2011. Now, a new study by Glenn Rudebusch of the Federal Reserve Bank of San Francisco (see “The Fed’s Exit Strategy for Monetary Policy”,, and as reported in the New York Times, argues that target interest rates may stay low into 2012!

“If the rate were raised too soon, it would be hard to reverse course, whereas if tightening is started too late, the Fed could catch up by raising rates at a rapid pace.”

But, interest rates are not asset prices! Asset bubbles or credit bubbles occur when credit (funds) flow into the economy or the financial markets or sub-segments of the economy or financial markets at a pace that exceeds the speed at which things are growing.

In the 2000s, we had excessively low interest rates and things were felt to be OK because the economy did not seem to be growing excessively and consumer price inflation appeared to be under control. Yet, we got the boom in housing prices…and, in stock prices. (Note, that neither of these prices is included in the Consumer Price Index. Housing costs are included through an imputed rental value which has very little to do with the price of a house itself.)

Much of the liquidity the Fed has pumped into the economy is, so far, just setting on the balance sheets of financial institutions…and, non-financial institutions. The commercial banks are not the only ones “piling up cash reserves. See “U. S. Firms Build Up Record Cash Piles,”

“The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.”

At some time, these cash balances, at financial institutions and non-financial institutions, are going to be used. The totals are so huge, I can’t imagine that “the Fed could catch up by raising rates at a rapid pace,” as Rudebusch suggests in his paper. When these cash balances are used, the impact will be on asset prices and not on consumer prices. This represents the potential for the “asset bubble” Roubini is talking about. And, remember, bubbles “break”!

Just one other point on this: I believe that what is happening in European financial markets is a part of this “bubble” activity. International investors are not acting like they are scared and strapped for funds. Their aggressiveness, to me, indicates that they are flush with money and hence have the confidence to be aggressive in attacking the financial condition of euro-zone countries on the sell-side. Investors “in dire straits” do not take on sovereign nations. This indicates, to me, that there are plenty of “well off” investors in the world that can move money around and “make things happen.” The European situation is a result of the U. S. “quantitative easing”. Further “quantitative easing” just exacerbates the problem!

Sunday, June 13, 2010

Commercial Banking: Still Hanging On

The commercial banking system continues to contract. Loan volumes keep falling.

Total assets in domestic commercial banks in the United States fell again over the past four weeks as the banking system continues to contract. From May 5 through June 2, total assets declined by about $105 billion while Loans and Leases dropped by $48 billion over the same period of time. This is from the H.8 release of the Federal Reserve.

In the past month, Securities held by domestically chartered banks declined by over $42 billion as Treasury and Agency securities at these institutions fell by almost $22 billion and other securities fell by $20 billion.

An interesting aside is that cash assets at foreign-related financial institutions fell by over $54 billion during this four-week period. Institutions took funds from the United States and parked them back in Europe where more liquidity was needed to weather the crisis taking place there.

Splitting this up we find that the total assets of large domestically chartered banks fell by about $86 billion whereas total assets fell at smaller banks by only $19 billion.

Driving this decline was a drop in purchased funds at the larger banks with a fall of $34 billion in borrowing from banks other than those in the United States and from a decline in net deposits due to related foreign bank offices. This would seem to mirror the turmoil taking place in Europe and indicates a reduction in the reliance in funds coming from elsewhere in the world.

Other deposits at these large domestically chartered banks rose by almost $21 billion to offset some of the decline in other sources of funds.

At the smaller banks, deposits continued to run off, declining by about $11 billion while borrowings from banks in the United States also fell, declining by over $5 billion.

Commercial and Industrial Loans (business loans) held roughly constant over the past month although they dropped by about $37 billion over the last 13-week period. Real estate loans continue to drop. They declined by almost $12 billion at the larger banking institutions and fell by over $10 billion at smaller banks. The drop over the past thirteen weeks was about $30 billion.

In addition, consumer loans dropped by over $11 billion at the larger banks over the last four weeks while they stayed roughly constant at the smaller banks.

Year-over-year total assets in the banking system dropped by $256 billion, year-over-year, from May 2009 to May 2010. Loans and leases fell by $222 during the same time period.

Commercial bank lending has declined for more than a year and shows no sign of stopping!

This, of course, is the type of situation that the economist Irving Fisher was worried about when he discussed a debt deflation. Loans that are being liquidated are not being replaced by new loans, hence the decline in loan balances. This is a difficult environment for a central bank. The monetary authority may be injecting funds into the banking system but since banks aren’t lending it feels like the central bank is “pushing on a string.” ( See

The concern is whether or not the “lending problem” is a demand problem or a supply problem. That is, if the problem is a demand problem, businesses are not going to their banker to borrow money. If the problem is a supply problem, commercial banks don’t want to make loans.

My belief is that the current dilemma has been created by both sides and this is consistent with Fisher’s concern about debt deflation. In the credit inflation, everyone, banks and non-banks alike, increase their use of leverage. In Fisher’s terms, the granting of new loans exceeds the liquidation of loans so that loan balances increase. In the debt deflation period, loans are being paid down.

And, how is this showing up?

Commercial banks are holding roughly $1.2 trillion in cash assets. Non-bank companies are holding about $1.8 trillion in cash and other liquid assets. This latter number comes from the Wall Street Journal article by Justin Lahart, “U. S. Firms Build Up Record Cash Piles,”

From the article, “U. S. companies are holding more cash in the bank than at any point on record…” The total of $1.8 trillion is up 26% from a year earlier and is “the largest-ever increase in records going back to 1952.”

The reluctance to borrow/lend is coming from both sides of the market as both banks and non-banks attempt to re-position their balance sheets to protect against further bad times and to be prepared for when the economy really begins to pick up speed once again.

In addition, there is still the concern over the health of the smaller banks in the banking system. The largest 25 banks in the banking system make up about two-thirds of the assets of the banking system. The other 8,000 banks still seem to have plenty of problems. About one in eight of these “smaller” banks are on the problem bank list of the FDIC and between 3.5 and 4 banks have been closed every week this year. This number will probably grow over the next 12 months.

Furthermore, the Federal Reserve continues to keep its target interest rate close to zero. This has been a boon to the larger banks, but is seemingly in place to keep the situation with respect to smaller banks from deteriorating even further. Many analysts believe that the Fed will keep its target interest rate low into 2011. This reinforces my belief that the “smaller” banks in the United States are still in serious trouble. Federal Reserve officials will not confess that the low target rate of interest is to keep as many “small” banks open as possible. To do so would be disturbing to depositors and other customers of these banks.

The question is, are we really in a period of debt deflation? Certainly the loan figures discussed above could be interpreted that way. But, is this all that is going on.

The interesting thing to me is that the economy seems to be bi-furcating in several ways. For one, there are a large number of people that are under-employed and seem to be facing an extended period in which they will be living off of their accumulated wealth, if they have any, or on government welfare. Yet, there are a lot of people that are doing very, very well.

The “big” banks are doing very, very well while the “smaller” banks are scraping by, at best.

The Wall Street Journal article referred to above indicates that businesses, especially larger companies, have a lot of cash on hand and are doing better than OK. We know, however, that there are a lot of other businesses that are not doing so well and still face bankruptcy or restructuring.

One could seriously argue that when the economy really does begin to pick up there will be a tremendous shift in the structure of United States banking and industry. And, if I were to choose, I would bet on the “big” guys! Sorry, little guys!

Thursday, June 10, 2010

The Fed is "Pushing on a String"?

During economic times like these, economists say that the Federal Reserve is “pushing on a string”. That is, the central bank has pumped a large amount of reserves into the banking system, yet banks are not lending, and the money stock is not growing.

Excess reserves in the banking system total more than $1.0 billion. Bank loans on a year-over-year basis show a negative growth rate. And, the M2 measure of the money stock, year-over-year, is growing at a 1.6% annual rate.

The Fed’s actions are not getting transferred through the banking system to the real economy!

As a consequence, economic growth does not seem to be accelerating at the speed economists and governmental policy makers would like.

Yet, if one compares the Great Recession which we have just passed through with the second worst recession in the post-World War II period the recovery does not really look that bad.

What seems to be different is the rate of growth at which the economy was growing in 1978, between 5% and 7%, and the speed it was growing before 2008, around 3%. In addition, the economy rose out of the 1981-1982 recession accelerating into the 8% range. No one seems to be predicting that the United States economy will move into this latter range in the near future. Recovery is occurring, it is just not very robust.

Fed Chairman, Ben Bernanke, testifying before the House Budget Committee yesterday spoke of the economy growing at a 3.5% rate “in the months ahead.” Economists surveyed by the Wall Street Journal expect the economy to grow about 3% in the second half of 2010 and continue that pace into 2011. (See
No one seems to believe that economic growth in 2010-2011 will match the recovery achieved in 1983-1984. The difference? Banks aren’t lending. Underemployment seems to be hanging at post-World War II highs, near 20%, and industry is operating at a capacity near post-World War II lows. On this see my post, The economy was expanding before the Great Recession, but substantially below the post-World War II average of about 3.4%, year-over-year.
Real growth in the period 2005 to 2010.
The American economy has been showing some substantial dislocations and these are expected to persist as the recovery continues! These dislocations are not going to be corrected with short-term fiscal stimulus packages. And, so the economy will just scrape along.

Along with the factors already mentioned as reasons for why the economy has grown so slowly in the 2000s and why it might be expected to continue to grow slowly is the perception that the economy is bifurcating. That is, one side of America seems to be doing very well and another side is not doing so well at all. This may be due to the restructuring of the United States economy and the slow transition that is occurring getting us there.

For example, big banks seem to be doing very well, thank you, while banks smaller than the 25 largest banks seem to be struggling. (See Foreclosures remain high and are expected to remain high as unemployment (and underemployment) remains high. Personal and small business bankruptcies have not dropped off. Legacy industries are still in the process of restructuring and are only modestly turning around while younger industries are growing very nicely. The economy of the early 2000s is different from that of the 1990s and before and we cannot go back. And, government shouldn’t force us to go back.

This restructuring is taking place in balance sheets as well as in the structure of the economy. People and businesses that have built up relatively large debt-burdens are restructuring their balance sheets. Consequently, debt liquidation is exceeding debt creation within the financial system and this is resulting in a contraction of bank loans. This is also contributing to the slow growth in money stock measures. This is why it seems as if the Federal Reserve is pushing on a string in terms of stimulating credit expansion.

Economic recovery is occurring, but it seems as if it will be modest and uneven throughout the economy. It also appears as if the economy is transitioning into something else, the Information Economy and not the Industrial Economy, and this will take time and patience. And, maybe we don’t want the banks to expand their lending too rapidly…given the $1.0 trillion in excess reserves in the banking system. Maybe.

Wednesday, June 9, 2010

Federal Reserve Exit Watch: Part 11

The basic monetary facts are these: commercial banks aren’t lending and the money stock measures are not really growing. On the surface, it looks as if we have what Irving Fisher called, in the 1930s, the makings of a debt deflation. This is how we can interpret the statistics from the banking sector.

Contrary evidence comes from the performance of the “big banks”, the largest 25 domestically chartered commercial banks in the United States banking system. They are raking in profits right and left and are “making a killing” from the arbitrage and trading opportunities being subsidized for them by the Federal Reserve System.

The other 8,000 domestically chartered commercial banks in the United States are not doing so well. Roughly one out of every eight of these banks is on or very near the list of problem banks of the Federal Deposit Insurance Corporation. These are the banks that the Federal Reserve is trying to preserve through the low target interest rate policy it is following that is the ‘cash cow’ for the largest banks.

The Federal Reserve got us into this position by following a very destructive monetary policy in the early part of this decade. Then, once the financial system began to collapse, Chairman Ben Bernanke and the Federal Reserve threw everything it had against the wall to see what would stick.

We talk about financial innovation in the private sector! No group, organization, or institution initiated more financial innovation over the past fifty years than did the United States government and the Federal Reserve takes the individual prize for financial innovation during this period for what it did over the last three years or so. But, there was no real sophistication to the Fed’s financial innovation: the task of the Federal Reserve was to throw as much money as it could into the financial markets to protect the ‘liquidity’ of the market and its instruments.

Now the banking system (excuse me, the 8,000 ‘other’ domestically chartered commercial banks) is teetering on the brink of a ‘debt deflation’ (while the 25 large domestically chartered commercial banks are cleaning up) and the Federal Reserve cannot remove whatever ‘stuck’ to the wall from the banking system for fear that the rate of failure of the ‘smaller’ banks will accelerate.

The FDIC is overseeing the closure of approximately four commercial banks a week this year and the feeling is that this rate of failure could rise to five banks a week this summer or next fall. Analysts now expect the Fed will continue its “low interest rate target” into 2011.

Wow! The big banks are going to love this!!!

The ‘other side’ question is how is the Fed going to “get the stuff” that stuck on the wall, off the wall? That is, how is the Fed going to ‘exit’ its stance of excessive ease?

We are still waiting. The only ‘trick’ it has applied so far is to get the United States Treasury to
park funds in something called the “United States Treasury, supplementary financing account.” This account has risen by roughly $200 billion since the first of the year, $175 billion over the past 13 weeks, and this has drained some of the excess reserves from the banking system.

Again, no straight, classical monetary policy: the Fed used gimmicks…whoops, financial innovations…to get us to this point. Looks like we are going to use various gimmicks…whoops, financial innovations…to help get “the stuff” off the wall.

Excess reserves have declined about $80 billion from January, a little over $70 billion in the last 13 weeks, primarily due to the buildup in the Treasury’s supplementary financing account. Excess reserves, however, still are in excess of $1.0 trillion, averaging $1.048 trillion in the banking week ending June 2.

The only thing that the Federal Reserve has continued to do over the past quarter is to continue to increase its holdings of Mortgage-Backed securities. Over the last 13 weeks, the portfolio of Mortgage-Backed securities rose by $87 billion, $16 billion of the increase came over the past 4 weeks.

And, what impact does this seem to be having on the monetary aggregates. Well, the M2 money stock measure is hovering around a 1.6% year-over-year rate of growth. If the expected real rate of growth of the economy is around 3.0% then this monetary growth is certainly deflationary.

But, note this. The rate of growth of the non-M1 part of the M2 money stock measure was only 0.3% in May, on a year-over-year basis. The M1 year-over-year growth rate is 6.8% which shows that people are still transferring their wealth into transactions balances in order to have cash to pay for their daily needs. Given all the unemployment, foreclosures, and bankruptcies, the concern is that this movement will continue putting additional pressure on the 8,000 other domestically chartered commercial banks in the country.

The United States banking system does not seem to be healthy (except for the biggest banks). The monetary system is stalled. Ben Bernanke has traveled to Detroit, Michigan to hold a discussion about getting loans out to small businesses: see his “Brief Remarks at the Meeting on Addressing the Financing Needs of Michigan's Small Businesses, Detroit, Michigan” ( The Fed doesn’t seem to understand what is going on.

This is my eleventh post relating to the Federal Reserve’s Exit Strategy. I started these posts 10 months ago because of the concern expressed over how the Fed was going to “get the stuff” off the wall. The Fed wanted to be totally transparent about how it was going to “exit” its position of extreme ease and so it started talking about what it was going to do.

The concern is still there. As far as I can see, there is little confidence that the Fed can safely lead us to the “promised land”, the land of low unemployment, strong economic growth, and little or no inflation.

The Fed has acted with very little subtlety and sophistication over the past decade. Why should we expect it to act any differently over the next ten years, let alone over the next year?

Friday, June 4, 2010

I Beat You By 200 Milliseconds, So Sue Me!

The future of finance is wrapped up in information technology. First because the technology deals with information and secondly because the technology is rapidly improving, even as I write this sentence.

In lectures I have given around the country on how information technology is going to impact the future I tell my audiences to keep their eyes on two groups of people and what they are doing with computers. First, check out what large governments, like the United States are doing about computers, because in order to keep their position in the world they must continue to be better than anyone else at killing people.

The first modern computer, the Eniac, was funded by the government in order to be able to better track the flight of artillery shells so that the army could be more accurate in hitting their targets. The Quantum Computer is going to be built because the government must be able to keep secrets and Quantum Computers are so fast that current coding systems are inadequate relative to the speed at which these new computers will be able to calculate. Also, these computers will be so fast that the ability to attack targets far away and the ability to simulate battles before they happen will be an overwhelming tool for the military. Obviously, America cannot afford to be second in the race to build the Quantum Computer.

Second, I suggested, watch what the kids are doing. If you want to know what is going to be “ubiquitous” in a few years, check out what that eight year old in your family is doing with electronic gadgets. And, by-the-way, in terms of stimulating battles and what kids are doing, read “Ender’s Game” by Orson Scott Card. In this book, a set of children are being trained to repeal an invasion of earth. The invasion is simulated by computer games with “faster than light” communications. After much practice, another game takes place. However, as we learn, it is an actual invasion and the only thing protecting the earth is these kids!

Great book…you should read it if you haven’t already read it. Actually, put “Ender’s Game” on your bookshelf right there along with “The Quants”! (See my review: The important thing, however, is that this book is hugely popular, it is what young people are familiar with, and it presents a picture of what they believe the technology of the future will be like. And, the book was written in 1985!

What does this have to do with finance?

The Wall Street Journal this morning contains the article “Fast Traders’ New Edge.” (See “Some fast-moving computer driven investment firms are getting an edge by trading on market data before it gets to other investors…The firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers.” Although these moves may only produce pennies, if one multiplies the pennies by thousands of trades, “big profits” can be made.

“The ability to estimate price moves ahead of the national best bid and offer price can give traders an advantage of about 100 to 200 milliseconds over investors who use standard market tools.”

This practice is called “latency arbitrage” and, of course, those investors that are not into it at the present time are searching for ways to protect themselves. Of course, the first thing you do is see whether or not you can compete electronically. Obviously, if you can’t compete electronically then you ask for regulation.

But, this is the world of the future. This is “Ender’s Game” only it is beyond the simulation exercises, it is the real thing. It is also a part of that netherworld that includes high frequency trading and dark pools.

My point is that advancements in computer technology are not going to slow down. If anything, these advancements will speed up. And, with the possibility that Quantum Computers will become a reality within the next decade or so the ‘speed up’ will tend to be exponential and not linear. Furthermore, the generations that will follow us expect this ‘speed up’ to happen and will look on these capabilities as just another part of their ‘normal’ lives.

If we do not comprehend this future, if our elected officials and regulators do not comprehend this future, then we will not be prepared for the economic and financial systems that are on the horizon. Hence, we will all make mistakes.

The “Quants” made mistakes this last time around. But, they are alive and well, and, I believe that it is a very safe bet to say that they have learned from their mistakes and have already modified their systems to take advantage of the most recent information available to them. Many “Quants” are trained in Information Theory, the study of the messages that are contained in strings of data, even though these strings may seem to be random in nature. Their systems are now more robust than they ever were in the past.

This is how humans become better decision makers. They adapt their models and systems so that they can make better predictions of the future in order to make better decisions or solve more difficult problems. This process is part of being a human and humans will not cease to put it into practice.

The discussion so far has been at the “top of the pyramid,” so to speak. But what about the “bottom of the pyramid”? How is technology playing out there?

This morning there appeared in the Financial Times a description of how banks in the South African Township of Tembisa are using mobile phones to develop their customer base. (See “Banks find potential in mobile phone growth,” Banks have changed over the past decade because “as the spending power of low-income groups increases, more and more banks are competing for the business of the 15m adult South Africans who had previously been excluded from the financial system.” And they are using information technology to do it!

And, the players are not small. “In South Africa, Capitec and African Bank pioneered the drive…” and Vodafone, the British telecoms company, “launched one of the most celebrated mobile banking initiatives.” “Instead of opening an expensive branch network, many of these new operations work with agents such as shops or bars.” Mainstream banks are following suit.

This is not the only technological initiative taking place at the “local level” in the world. Electronic finance is here to stay and it is spreading further and further into previously under-served communities every day. Remember, finance is really nothing more than information and the exchange of information.

So the Obama administration, Congress, and the regulators in Washington (and politicians and regulators in the rest of the world) are attempting to prevent the last financial collapse from happening again.

Should I smile…or giggle…or break out in laughter?

Thursday, June 3, 2010

Hotshot Traders Leave Street

Jenny Strasburg captures the mood on Wall Street in her article in the Wall Street Journal this morning:
“The competition is on to scoop up Wall Street traders and portfolio managers increasingly unnerved by the likelihood of sweeping new financial regulation.

Since political momentum began building earlier this year to limit trading for profit at Wall Street firms, traders have been exploring their options, and some have already left. Outside the banks, private investment funds looking for traders have been gearing up for a hot talent market.”

Economics works!

You change the incentives and people change…people move.

With the situation being more mobile than ever, with the technology more available and adaptable than ever, with the future more uncertain than ever…people…and the system…can change more rapidly and in more different directions than ever before.

And, that is what is happening!

This is one thing that Congress (and others) can’t seem to understand. Even after observing fifty years of the most dramatic financial innovation that has ever taken place in the world, the members of Congress seem to believe that they can “freeze” things, return to the past, and prevent the recent financial crisis from ever occurring again.

They also seem to think that the government is blameless from creating any incentives that might have a derogatory impact on the future that they want to create.

People in the Obama administration, as well as members of Congress, seem oblivious to the fact that over the last fifty years the United States government, Republicans and Democrats alike, produced a fiscal environment that created the incentives that led to a burst of innovative activity in the financial sector that produced massive changes in the way people did business and in the composition of the American economy. A brief picture of the environment.

From January 1961 through January 2009, the Gross Federal Debt of the United States rose at a compound annual rate of 7.7%. The monetized portion of the federal debt, the monetary base, rose at a compound rate of about 6.5% from January 1961 through August 2008, just before the Federal Reserve’s balance sheet exploded in response to the financial crisis that took place in the fall of 2008. The M2 money stock grew by more than a compound rate of 7.0% during the time period under review.

Thus, money and credit variables grew relatively in line with one another. Real GDP growth during this time was about a 3.4% compound rate of increase every year.

Prices, as measured by the Consumer Price Index and the GDP implicit price deflator, increased at a compound rate of about 4% during this time period resulting in a decline in the purchasing power of the dollar by around 85%. A 1961 dollar bill could only buy 15 cents worth of goods in 2008!

Inflation breeds financial innovation and the late 20th century with its relatively moderate, yet steady increase in prices, was a perfect environment for financial innovation!

The leader in financial innovation was the federal government itself, confirming what Niall Ferguson argues in his wonderful book, “The Ascent of Money: A Financial History of the World.” Ferguson claims that governments, historically, have been the primary financial innovator because of the need to fight wars. This, he continues, spilled over into the 20th century as governments needed to expand deficit financing to incorporate spending on social programs.

My guess is that in the next five to ten years we will see the biggest change in finance that we have ever seen and this change will be worldwide. I have written a little on this in a recent blog: “Changes Continue to Shakeup the Banking System”. See

The largest twenty-five banks in the United States, who control about two-thirds of U. S. banking assets in the country, are already changing their business. Again, they have already moved beyond what Congress and the administration are doing to regulate the banking system.

More important, foreign banks are changing the banking picture in the United States. Currently, foreign branches control about 11% of the total banking assets in the country. I have already stated that this will increase to 15% to 20% over the next five years or so. We see this expansion taking place before our eyes. Yesterday “China Finds a New Market for Loans: U. S.” (See Today, “China Bank IPO, Possibly Biggest Ever, Set for July.” (See And, don’t forget the sovereign wealth funds, huge accumulators of money.

The world of finance is changing because the incentives affecting finance are changing all over the world. I can’t even imagine what this world will look like with instantaneous trading, further ‘slicing and dicing’ of cash flows and other financial information, greater use of information theory to detect trading patterns (see my book review of “The Quants”,, and more and more information markets popping up around the world (see Robert Shiller’s book “The New Financial Order: Risk in the 21st Century”)!

In the field of Complexity Theory, researchers speak of times like this when systems go through the process they call “Emergence” and “Self-Organization.” It is during times like these that one structural system is transitioning into another structural system. The problem is that no one, before-the-fact, can predict how existing information systems combine with other information to produce the resulting system. Systems just “self-organize” and a new system “emerges” from what was formerly un-organized.

This appears to be what is happening now. The movement of “hotshot” traders is one piece of evidence of this. The restructuring of the big banks is another piece of evidence. The response of hedge funds to the Congressional threat to change how partners are paid is evidence of this. The changes in financial regulations around the world is evidence of this. The growth and increased aggressiveness of Chinese banks is evidence of this. And, so on and so forth.

Congress is just speeding this change along. However, they better be careful about what they wish for because my best guess is that what they get will be nothing like what they are planning for.

Wednesday, June 2, 2010

Why Krugman Is Wrong!

Talk about a fundamentalist preacher! Paul Krugman continues to rely upon his inerrant interpretation of the dogmatic Keynesian worldview as he condemns those “sinners” that have followed another path from the one he draws strength from.

Krugman’s New York Times column on Monday chastises those that take an alternative view: “More and more, conventional wisdom says that the responsible thing is to make the unemployed suffer.” (See “The Pain Caucus”,

He goes on: “What’s the greatest threat to our still-fragile economic recovery? Dangers abound, of course. But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.”

Amen, brother! Alleluia!

Right out of the creed! When you need to protect your economic doctrine, bring out unemployment and the unemployed. This goes back in history at least to Keynes and the Paris Peace Conference in 1919 when there was a fear about the spread of the Bolshevik revolution throughout Western Europe. (See my book review from October 25, 2009 of “John Maynard Keynes and International Relations”,

To support his argument, Krugman claims that America would be creating a situation not unlike that of Japan in the 1990s if the United States followed the “conventional wisdom” he disdains. “We are, however, looking more and more like Japan….[Recent data] suggests that we may be heading for a Japan-style lost decade, trapped in a prolonged period of high unemployment and slow growth.” (See the article by William Galston, “the Case Against Keynes (With Some Questions for Krugman, Too)” at

The problem is that Krugman (and other fundamentalist Keynesians) interprets the Japanese situation—and the current situation in the United States—and the current situation in Europe) as “a rare real-world example of Keynes’s famous ‘liquidity trap’ in which monetary policy loses its effectiveness.” (See the Galston article.) The Keynesian solution to such a dilemma is to engage in “pump-priming” government expenditures that, through a cumulative multiplier effect that substantially increasing private demand, initiates a self-sustaining process of economic recovery.

The difficulty with this is that it does not take into account the huge amounts of debt that may have been accumulated through the earlier credit inflation that caused people and businesses to increase their financial leverage and risk taking. It was this credit inflation that ultimately led to the financial collapse that put the economy into the current situation. The other side of a credit inflation is a debt deflation.

The problem? People and businesses (including commercial banks) may find themselves so in debt with loan and interest payments far in excess of their own cash flows that they stop spending because they must repay or write-off large chunks of debt. They choose to become as liquid as possible because they must continue to live and finance their daily needs as much as they can through any wealth they may have accumulated. They do not become liquid because of they are afraid or unwilling to commit to the purchase of investment goods. They become liquid to survive.

Within such an environment, the Keynesian solution of pump-priming which leads to credit inflation becomes the only real response because it leads to inflation. To Krugman, Galston argues, “The root of the Japanese crisis is deflation, and the only remedy is a credible shift to a long-term inflationary policy.”

Although not stated in the “liquidity preference” arguments for such a policy, inflation reduces the debt burden because it reduces the real value of the debt. Inflation is always a way to get out-of-debt. The problem is, inflation encourages more financial leverage and more financial risk taking. This is what we in the United States have been doing for the last fifty years. And, ultimately it does not prevent the problem of a financial correction, it just postpones it.

Getting ones financial books in order is not necessarily a bad thing. It appears that Ireland is pulling out of its crisis situation after enduring “one of the worst recessions of any developed economy since the Great Depression.” (See the Bloomberg article:

Also, the United States in the 1990s presents an example fiscal prudence which contributed to a period of sustained economic growth. The Clinton administration pulled off a very successful policy of deficit reduction which was accompanied by the longest post-World War II period of economic expansion on record. So it can be done.

Other countries around the world are showing the fruits of fiscal discipline in the face of the economic slowdown of the past three years. Even with the turmoil in Europe, manufacturing seems to be recovering around the world, in the U. S., in the U. K., in Canada (where the Bank of Canada just raised interest rates yesterday over concerns about its robust economy), and in Australia, Brazil, China, India, and Japan.

The lingering problem connected with the buildup of debt is the “debt overhang” that remains once the peak of the credit cycle has passed. Yes, there may be liquidity problems connected with reversing out of the expanding economy into an economy that is contracting. Any reversal of direction will experience a dislocation of markets. But, the liquidity problem is a short-run phenomenon. Once the short-term problem is eradicated, the issue becomes one of getting the balance sheets of individuals, businesses (including commercial banks) back into a more conservative structure. And this can take time and can hinder the strength of the recovery.

But, unless one is inflating the country out of its debt load, this re-structuring of the balance sheets must take place for the recovery to become a healthy recovery. There will be pain during this time. But, living beyond ones means for fifty years creates a situation that is uncomfortable for some. Unfortunately, the people that are hurt are not generally the people that really profited from the credit inflation that caused the excesses.

Perhaps focusing on longer term financial discipline might be better for workers over time rather than concentrating on every little short-term wiggle in unemployment. Certainly, the countries that are paying more attention to longer-run issues (like China) are going to put a lot more economic pressure on those countries that only focus on the short run (like the United States and Europe). For more on this see “How China is Changing the World”

Tuesday, June 1, 2010

Europe and the Solvency Issue

More and more people are becoming aware of the fact that the problem in Europe is one of solvency and not liquidity! Yesterday, the European Central Bank warned “that euro-zone banks face a €195 billion in write-downs this year and next due to an economic outlook that remained ’clouded by uncertainty.’” (See This is equivalent to slightly more than $239 billion.

Not only that but it is estimated that these banks will need to refinance roughly €800 by the end of 2010. (See This is equivalent to about $984 billion or roughly $1.0 trillion.

More and more people are beginning to realize that countries within the European Union are going to have to restructure loans and this will mean that many euro-zone banks are going to have to write down many of the assets they have on their balance sheets. Hence, we face the problem of the solvency of the banking system.

Why has it taken so long for these people to realize that the problem is a solvency problem?

The reason, I believe, is that the mainstream economic models we have been working with over the past 50 years have focused upon “liquidity” issues. Debt has played very little role in these models.

Yes, I know that some ‘fringe’ economists like Hyman Minsky wrote about these issues, but try and find any kind of a discussion of debt and solvency in major macroeconomic textbooks.

Many post-World War II discussions of money and the demand for money are “framed” within the terminology developed by John Maynard Keynes in the 1930s, around the term liquidity preference, “The term introduced by Keynes to denote the demand for money.” (This is from the Glossary of the macroeconomic textbook by the Keynesian economist Olivier Blanchard.)

Moving from liquidity preference we get the concept of “liquidity trap” from the Keynesian dogma: “The case where nominal interest rates are equal to zero and monetary policy cannot, therefore, decrease them further.” (This, too, comes from Blanchard.) That is, people want to hold money and don’t want to loan money to invest in plant or equipment or inventories and so forth.

Obviously, this latter possibility resonates with Keynesian fundamentalists in terms of the situation that has existed over the past year or so.

The problem with this is that the idea of liquidity preference and the liquidity trap apply to the future. People don’t want to invest privately and just want to hold money because the expectations of future investment performance are so low and so risky that money is the safer way to hold their wealth. This is why, in the Keynesian paradigm, government deficit spending works because people will buy the government debt and the government can then “invest” and put people back to work whereas the private sector cannot.

But, what if the problem is that people and businesses (including banks) are so in debt that they cannot spend and that the cash they are holding is to provide them with funds to exist on in the future? That is, what if people and businesses are bankrupt or are facing bankruptcy because of the debt they have accumulated and are hoarding their wealth in very liquid assets so that they can buy what they need out of what remains of their wealth?

Maybe economic cycles are connected with credit inflations or debt deflations, cumulative buildups of debt followed by the need to unwind the excessive use of leverage built up in the earlier period. This cyclical behavior contains the problem of solvency, not liquidity. (Keynes, interested in the short run, focused on liquidity. Irving Fisher, the prominent American economist from the 1920s, focused on the longer run and wrote about debt deflations.)

It seems that economic policymakers in Europe (and in the United States) have been interpreting the problems of the last two years or so as a liquidity problem. Hence the responses of the leaders of the European Union have been couched in terms of solving their economic and fiscal issues by making sure that there is sufficient liquidity in financial markets for them to continue to function. Yet, the problems have not gone away because the issues of restructuring the debt and asset write-downs have either been ignored or pushed under the covers so that they don’t have to be discussed.

This has been true in the United States as well. The United States Treasury Department responded with the TARP program that was, at least initially, aimed at providing liquidity for ill-liquid assets on the books of banks and other institutions. (See my post of November 16, 2008,”The Bailout Plan: Did Bernanke Panic?” Furthermore, much of the effort of the Federal Reserve in 2008 and 2009 was aimed at providing liquidity to the banking system and the financial markets and not to problems of solvency.

In fact, I have been arguing over the last six months or so that the real reason why the Federal Reserve is keeping its target Federal Funds rate so low is that there are real asset problems in many of the small- to medium sized commercial banks. The Fed is keeping the rates low so as to help the banking system escape the “solvency” problem of the smaller banks from getting worse while the FDIC works through the liquidation process. Note, again, that the FDIC is closing more than 3.5 banks per week through May 28, 2010 and has 775 banks (There are about one out of every eight commercial banks on the problem list!) on its watch list, a number that is still increasing every quarter.

“The challenges for banks in the 16-nation euro-zone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries, and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans.” This quote is taken from the New York Times article referenced above.

The source of this concern? The European Central Bank!

The problem with a solvency crisis is that ultimately assets must be written down to more realistic values. In the cumulative process that occurs in the euphoric credit inflation that precedes a debt problem, asset values attain unrealistic levels. That is why people and businesses (including banks) continue to leverage up their balance sheets.

Valuations eventually must be put on a more realistic basis. This is where the European Union is at the present time. The unanswered question is, how far must valuations be reduced to achieve this realistic basis. And, of course, the bigger concern is whether or not these reductions can be achieved without inducing a cumulative debt deflation. No one really has the answer to either of these questions before the fact.

However, the excesses of the past must be paid for!