Friday, July 30, 2010

Monetary Targets: The Latest Take

The morning papers contain articles on the newly released paper on monetary policy by James Bullard, the President of the Federal Reserve Bank of St. Louis. The basic thrust of the paper is that the Fed’s efforts to keep interest rates so low and for “an extended period” of time may eventually backfire and result in a Japan-like dilemma of stagnation and price deflation.

The “appropriate tool” in the present situation, Bullard contends, is the use of “quantitative easing.” More specifically, he argues that the Federal Reserve needs to be willing to buy longer-term Treasury issues to expand the amount of Federal Reserve Credit outstanding in spite of the fact that there are more than $1.0 trillion in excess reserves currently in the banking system.

The problem, as Bullard sees it, is a policy dilemma that results from the fact that nominal interest rates include a factor to account for inflationary expectations and that current Federal Reserve operating procedures rely on some form of what is called “the Taylor Rule” to set target interest rates. Bullard contends in his paper (which can be accessed through this article: that using the Taylor Rule can result in one of two “steady state” outcomes, one with higher interest rates yet more inflation, and the other with low interest rates and outright deflation.

The latter “steady state” position is what the Japanese have experienced. The former is where the United States has been operating. The fear is that by continuing the Federal Reserve policy of keeping its target interest rate close to zero for “an extended period” the United States will migrate from where it is now into the situation more similar to that of the Japanese.

This is why Bullard suggests that the Fed may need to focus more on “quantitative easing” going forward.

The concept of “quantitative easing” was originated early on in the financial crisis that accompanied the Great Recession. When nominal interest rates approached zero, the Federal Reserve (and the Bank of England) argued that it needed to continue to provide more reserves for the banking system (print more money electronically) even though it could not drive nominal interest rates below zero.

Quantitative monetary policy procedures went out-of-fashion in the late 1980s. Paul Volcker had used quantitative measures in the late 1970s and early 1980s to “frame” his efforts to combat the inflation being experienced at the time. However, by the late 1980s, policy makers began to lose confidence in quantitative measures for policy purposes because the various monetary measures that were used did not provide consistent information, at least to those making policy at the time.

As a consequence, policy makers relied more and more on interest rate targets and this is when the Taylor Rule came into usage. Many claim that by adhering to this rule, even implicitly, resulted in a period of relative claim in financial markets and the economy now referred to as “the Great Moderation.”

One reason given for the disenchantment with quantitative monetary measures is that so much reliance has been placed on mathematical modeling within the Fed: monetary measures just did not lend themselves to such a formal process. Hence, quantitative targets were not easy to produce and actual results were even harder to explain because of the divergent movements of the different measures.

We can observe this kind of behavior over the past two years in many of the monetary measures.
For example, if one looks at the behavior of the narrow measure of the money stock, M1, relative to the behavior of a broader measure of the money stock, M2, from 2008 through the present, one can get different signals. In the first six months of 2008, the year-over-year growth of the M1 measure was close to zero. The year-over-year growth rate of M2 was around 6%.

As the financial crisis hit and progressed in the fall of 2008, the rate of growth of the M1 money stock increased dramatically whereas that of the M2 money stock rose only modestly. In the first quarter of 2009 the M1 money stock was growing, year-over-year, at around 17%; the M2 measure had peaked in the fourth quarter of 2008 at about 10% and was beginning to decline.

Furthermore, the behavior of other monetary aggregates seemed all out of line with these money stock measures: Total Reserves in the first quarter of 2009 were increasing, year-over-year, at about 1,850%; the Monetary Base rose by about 110%, year-over-year.

How do you explain these differences? Econometric models couldn’t do it.

Two basic things were happening. First, as the financial crisis progressed, people took more and more money out of less liquid asset holdings and began putting the funds in currency or very liquid bank deposits. Although the M2 measure rose during this time period, most of its increase was coming in the M1 component.

Second, the Federal Reserve was pumping unprecedented amounts of reserves into the financial system. These funds did not go into bank lending so as to expand the money stock: the banks just held onto the money. In August 2008, excess reserves in the banking system totaled less than $2.0 billion. In the first quarter of 2009 excess reserves averaged over $800 billion.

How can you mathematically model these kinds of behavior?

And, the problems of interpretation continue. Money stock growth has dropped off. In the second quarter of 2010 the year-over-year rate of growth of M1 was just under 6.0% while the rate of growth of M2 was less than 2.0%. The non-M1 component of M2 was growing well under 1.0%. People were still putting money into transaction balances and not in savings staying as liquid as they could. The rates of growth in both Total Reserves and the Monetary Base fell dramatically through 2010 yet excess reserves in the banking system averaged more than $1.0 trillion. Banks, too, were acting very conservatively by not lending and keeping as liquid as they could.

The point of this discussion is that the Federal Reserve needs to focus a lot more on the quantitative monetary measures than they have in recent history. But, the understanding of what is going on over shorter periods of time requires institutional understanding within a historical context and not just formal mathematical modeling. The consideration of monetary variables is important for setting and conducting monetary policy!

It is still true that over the longer run, important things like inflation/deflation are still “everywhere and in every time” a monetary phenomenon. Interest rates don’t correlate over the longer run.

Bullard is arguing for a greater focus on the monetary aggregates. By buying Treasury securities in a “quantitative easing” the Fed will be expanding the monetary base. Why would you want to expand the monetary base? Because commercial banks are not lending and if the economy is going to show more life going forward, bank lending is going to have to increase and the money stock measures are going to have to start growing faster again.

Milton Friedman argued that in the 1929-1933 period, the M2 money stock measure declined by one-third. However, the monetary base rose modestly. Freidman criticized the Fed for letting the money stock measure fall. To him, the Fed needed to provide more base money to get the banks’ lending again so that the money stock would grow. Is Bullard saying we are in the same type of situation Friedman described?

Wednesday, July 28, 2010

Looking at the Dollar Again

As European financial markets seem to be stabilizing, it is time to look again at the value of the dollar. After the heat over the sovereign debt crisis cooled somewhat the value of the dollar, once more, headed south. Over the past two years or so, global markets have seemed to be saying, if the financial world is going to fall apart today, I want to be holding some kind of dollar assets. However, if I am to bet on the value of the dollar over an extended period of time, then I want to hold assets denominated in other currencies.

As one can see from this chart showing a trade-weighted index of the United States dollar against the major currencies of the world, the general drift of the value of the dollar since the early 1970s has been downward. There are two major upswings. The first relates to the tightening of credit by the Federal Reserve under the leadership of Paul Volcker. This is the upswing that goes from about 1980 to 1986. The second upswing came during the federal budget tightening led by Treasury Secretary Robert Rubin which eventually resulted in a budget surplus and lasted from about 1995 into 2001.
During the last two years or so, there have been two minor upward movements in the value of the dollar. These minor swings came during the fall of 2008 into 2009 and in the spring of 2010 connected with the sovereign debt crisis in Europe. This last upswing seems to have peaked as the dollar, once again, heads downward.
Although the rise in the value of the dollar during the first of these movements was “across the board”, the primary reason for the rise in the value of the dollar in the latter period was the movement of money out of the euro. But, given the actions of the European Union and given the results of the “stress tests” applied to European banks, confidence seems to be returning to the Euro.
So, the long-run trend in the value of the dollar still seems to be downwards.
To me, the price of a nation’s currency is still the most important price in that nation. The fact that the long-run trend of the dollar is down highlights the fact that the international financial community continues to believe that there are still structural problems in the United States that must be dealt with. And, one can add, that these structural problems are not connected with one political party or the other. Both parties have contributed to these structural problems and, until there is a major change in the way Americans think, these structural problems will not go away. Hence, the bet is still on a falling value of the dollar.
What are the major structural problems?
Let’s start with just three. First, is the federal government deficit. Again, this is not a problem that has just occurred. The gross federal debt of the United States has increased at a compound rate of about 7% from 1961 through 2009. “Official” estimates of the deficit over the next ten years are for the deficit to increase by $8 to $10 trillion. I have been a little more pessimistic, arguing that the deficits will be more like $15 trillion. The lower estimate will still keep the growth rate of the debt above 7% a year.
Second, the commercial banking system has over $1.0 in excess reserves! The Federal Reserve is planning an “exit” strategy to remove these reserves from the banking system as the economic recovery picks up steam. However, there is little evidence provided over the past fifty years or so that the Fed can or will be able to keep these reserves from getting into the spending stream especially given the amount of the federal debt that is going to have to be financed over the next ten years.
Third, there are major dislocations in terms of the allocation of corporate assets, of corporate capital, both physical and human, in the United States. (See my post To correct these dislocations will take a lengthy period of time which indicates that the country will not recover as rapidly as it would if these dislocations did not exist. This will just exacerbate the problems caused by the two situations mentioned above. Again, this is seen as a negative in terms of pricing the dollar in foreign exchange markets.
I have been a dollar “bear” for a long time. The reason is that the general thinking about economic policy in the United States has been wrong since the early 1960s. International financial markets seem to support this assessment. And, this thinking appears in both the Republican and the Democratic leadership. I had hopes that changes were taking place when Paul Volcker was Chairman of the Board of Governors of the Federal Reserve System. I had similar hopes when Treasury Secretary Robert Rubin led the charge to reduce the federal deficits in the 1990s. In each case, “the dark side” eventually prevailed.
There is nothing I see in the future to make me think that the value of the dollar will rise except in times of global financial crisis where there is a “flight to quality”. But, these will eventually run out if nothing is done to resolve the longer-run issues. As far as I can see, there certainly is no leader on the present stage that can bring about the changes that are needed. Therefore, I remain “bearish”.

Tuesday, July 27, 2010

Executive Compensation: A Study

The New York Times’ DealBook edited by Andrew Ross Sorkin recently carried an amazing headline, “Study: Boards Use Peers to Inflate Executive Pay.” (See,

And in this remarkable study we find the following:

“Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance.”

Well, duh!

This was done in the 1970s and I experienced it first hand in the 1980s and 1990s. Yet the quote above states, with astonishment, that “over the last several years” this behavior took place.

The authors of the academic study being reported on, Michael Faulkender of the University of Maryland, and Jun Yang of Indiana University, ”found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.”

That is, not only did corporation use peer data to determine executive salaries, the peers chosen were generally those that had the highest pay among the similar companies.

“The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years.”

Huge increases?

Oh, yes, “Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more,” according to the Economic Policy Institute, a nonprofit Washington D.C. think tank.

Note, we are talking about “major” American companies…the “big guys”. These are large bureaucratic organizations that have huge human resources divisions that are given responsibility for the remuneration and benefits of the employees of these companies.

Now, I am not disagreeing with results of the study and I am not disagreeing that these practices helped to contribute to the substantial relative growth in executive pay when compared to the “typical worker”, whoever that might be.

I am just astounded that the results of this study from the late 2000s seem to be such a surprise.

In the late 1960s and early 1970s, when the United States economy was growing at a relatively good pace and inflation began to become a part of the daily life of Americans, large companies had to seek a way to justify the compensation of their employees…all their employees.

Data from peer groups, companies of similar size and similar industry background, became useful in setting pay scales and in arguing with labor unions about worker compensation. Companies began collecting information from other similar companies that would share data and, as the use of peer data became more generally used, it started to be collected by consultants and agencies that could sell the information to interested organizations.

What could be a more reliable guide to executive, and worker, pay than information on what peer groups paid their executives…and workers.

To me, the use of peer data was ubiquitous in large companies by the end of the 1970s.

But, one must be careful with how incentives are administered. Executives found that pay scales based upon peer data could be very used to their advantage. As a consequence, executives became diligent students concerning the use of peer characteristics and of what items could contribute to higher and higher compensation packages.

Let’s see…of course…size, to pick one characteristic, makes a great difference in the compensation received by executives. Bigger companies paid their executives higher salaries.

So, let’s grow the company! Let’s engage in mergers and acquisitions! Let’s move horizontally as well as vertically! Anything to increase the size of the firm! Executives can almost always find reasons to grow their organizations.

Remember the companies we are referring to are the “big guys”!

What about the performance of these companies? That doesn’t seem to matter.

What about the fact that about 3 out of every 4 mergers consummated are unwound in seven years or less? We will just replace those assets with other mergers or acquisitions!

And, the argument can be extended to the “other” special characteristics that apply to the choice of “peers”.

That is, executives could design the strategic plans they used to guide their firms based upon the peer group they had chosen so as to achieve the largest compensation possible.

Could something like this happen? You may express some doubt if you have not read books like “Freakonomics” and “Super-Freakonomics.”

That is, you must be careful of the incentive scheme you choose to stimulate people because that incentive plan will help to determine the behavior of the people you are hoping to influence…and the results you get may not always be the ones you expect.

In this, top executives are no better or no worse than most of the rest of us. They too respond to the reward systems that are presented to them.

And, what about the workers?

Well, they could not choose either their peer group or the design of their company relative to the peer group they wanted to be compared with. Anyhow, ordinary workers competed in a whole different labor market, one that tended to have a lot of substitutes: all peer groups at this level were very similar. Thus, they could not expect much boost in pay from the use of this information.

Monday, July 26, 2010

Where Economic Success is Going to Come From

One piece of economic information that I have focused on over the past 18 months has been the Federal Reserve’s figures on capacity utilization of the industrial sector of the United States.

The story that can be read from this information is that capacity utilization in the United States has fallen from the middle of the 1960s to the present time. In 1967 when the data series was started, capacity utilization was about 90%. Over the past fifty years, every cyclical peak of capacity utilization has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85% while in the middle 2000s the peak dropped to 82%.

Currently, although capacity utilization has risen above its recent cyclical trough of about 68%, it is still languishing around 74%. One should note that as cyclical peaks during this period have been at lower and lower values, cyclical bottoms have also been at lower and lower values.

The conclusion one can draw from this is that United States industry does not seem to be “tooled-up” for the right output.

If the United States is going through a major secular restructuring both economically and financially, as some of us believe that it is, then United States industry will be restructured so as to shed some of this excess capacity.

There are many indications that such restructuring is taking place and will continue to take place over the next few years. This, of course, will mean that the economy will not recover real quickly which will mean that it will take just that much longer to resolve the “under-employment” problem.

The evidence of this restructuring can be observed in places like the front page article in the New York Times, “Industries Find Surging Profits in Deeper Cuts”: See The gist of the article is that companies are producing very good profits, not through revenue growth, but through the reductions in their cost structure, predominately through cuts in labor costs.

Of course, the real “economies of scale” in this effort are found in the larger companies. Smaller companies can reduce labor costs but they don’t have anywhere near the impact that large companies achieve when they go through a major restructuring.

Rod Lache, of Deutsche Bank: “These companies cracked the code of a successful turnaround. They’re shrinking the business to a size that’s defendable and growing off a lower base.”

Over the past fifty years industry did not downsize in this way because success seemed to come from “hoarding” labor and getting the company positioned for the next surge in sales revenue. This attitude was re-enforced by the federal government that underwrote the “nest surge” in consumer spending through fiscal stimulus programs created through deficit spending and the expansion of the money stock.

The “artificial” underwriting of economic growth by federal government largesse can only go so far. Throughout this period, the question that always lurked in the background concerned the burden of the debt being created, both private and public debt, and the economic mismatch that was being created between where the country should be technologically and where it was both in terms of physical and human capital. The growth in labor under-employment and the decline in capacity utilization over this time pointed to the fact that at some time an economic and financial restructuring would have to take place.

And how are these companies that are doing so well using their profits? They are building up their cash reserves. Jamie Dimon at JPMorgan Chase has indicated that it is not time to pay these profits out in dividends. There are just too many uncertainties present in today’s economy…and there are just too many other possible ways to use the funds in the future. Many other CEOs agree with this assessment.

The New York Times article contains a chart that shows the relationship between “Corporate Cash as a Share of Corporate Assets.” The most recent data show this relationship to be 6.1%. Guess what? One has to go back to the middle of the 1960s to find this figure at such a high level. Through most of the last fifty years the share of cash ran between 3% and 5%. This shift is huge and is taking place primarily in the larger, better positioned companies.

This same thing is happening in the commercial banking arena. The larger, more successful banks are piling up cash reserves. The smaller banks are not the ones with the profits or with the cash resources.

What does all this mean?

It means that the next few years will see a massive restructuring of industry, in manufacturing, financial services, and in other services. Reconsolidation will be in vogue, not expansion. The cash will be used for mergers and acquisitions, for rationalization of industry, for capacity reduction, and for control.

The one caution about this is that these companies cannot get too far ahead of the financial markets for investors will punish those that seem to be “jumping-the-gun”. In the Wall Street Journal we observe the warning, “Markets Say No to Expansionist Companies”: See The economy, in the near term, does not look strong. Profit performance is not seen as coming from increasing revenues, but from continued cost containment or cost reduction. Companies that appear to be moving too quickly in this environment are getting hurt by investors that believe cash should be conserved for use on another day at a different time.

Financial markets seem to want prudence now and not outright aggressive behavior.

Yet, people are getting prepared for the time when action is called for. But, the action will not be toward expansion, but toward containment. In the Financial Times we read of the return of “merger arbitrage funds”: See These funds attempt to profit from the spread between the price of a merger target after a deal is announced and the closing price at the completion of the deal. The funds “smell” something in the wind and they want to be ready when the time is right.

Gerard Griffin of GLG Partners’ event-driven team is quoted as saying: “Companies have built up large cash balances and the economy is not looking particularly strong, so earning growth will have to come through synergies.”

That is, consolidation will have to take place within industries reducing industry capacity and thereby increasing capacity utilization. For the time being, however, this rationalization of industry will reduce the number of jobs that are available and will also result in changing the nature of who is employed in these more technologically advanced and productive firms.

The evidence is growing that a massive restructuring of industry is taking place. This restructuring will not speed up either economic growth or the reduction of unemployment or under-employment in the near term, only over the longer term. But, the types of things managements and companies are doing are similar to what has happened at other times. However, these restructuring events are captured in the economic writings of Joseph Schumpeter, and not in the economic writings of John Maynard Keynes.

Thursday, July 22, 2010

The Troubled Smaller Banks and Elizabeth Warren

For over nine months I have been expressing my view about the problems being faced by many of the small domestically chartered banks in the United States. Very little has been forthcoming from public officials about the problems of these smaller financial institutions. Well, yesterday, Elizabeth Warren, the Chair of the Congressional Oversight Panel, in testimony given to the U. S. Senate Committee on Finance, provided us with a little insight into what government officials are working with.

Here are some of her written comments: “The Panel’s most recent report analyzed the participation of small banks in the CPP (the Capital Purchase Program of the Troubles Asset Relief Program--TARP). Under the program, Treasury put money into 707 banks. The Panel found the experience of small banks differed substantially from that of the nation’s largest financial institutions. Seventeen of the 19 U.S. banks and bank holding companies, with assets totaling more than $100 billion, received the majority of funds (81 percent), most getting their money within weeks of the announcement of the program. Now 76 percent have repaid their TARP funds and returned to profitability. On the other hand, small banks entered the program more slowly, and ultimately most—about 90 percent—stayed out of TARP altogether. Notwithstanding the fact that those small banks that received TARP funds were required to prove their financial health, fewer than 10 percent have managed to repay their TARP obligations, and 15 percent have failed to pay at least one of their outstanding dividends. Their problems are substantial. Small banks face serious difficulties with the coming wave of commercial real estate loans resets. Moreover, small banks do not have the same access to the capital that larger banks have, and investors know that these regional and local banks are not too big to fail. Worse yet, if they cannot exit from TARP in the next few years, they face a TARP dividend that will increase sharply from 5 to 9 percent.

TARP gets its name from the so-called “troubled assets” that were weighing down the balance sheets of the nation’s financial institutions. The meltdown in the subprime mortgage market—and the eventual spillover effects into the prime and alt-A mortgage markets—saddled banks with assets composed of or derived from residential mortgages. These securities became difficult to price and hard to sell. Nearly one year after the passage of TARP, the Panel reported that these same assets continued to impair bank balance sheets. Today, some of these same assets continue to encumber the balance sheets of many banks—especially smaller banks that are also heavily exposed to commercial real estate assets, as the Panel identified in our most recent report. So long as the residential housing market remains weak and homeowners continue to default on their mortgages and fall into foreclosure, these troubled assets will continue to pose challenges for financial institutions.”

In verbal testimony, Ms. Warren provided a number: the number was 3000. She stated that 3,000 small banks faced serious problems in the future related to the residential housing market and the “wave of commercial real estate loan resets” forthcoming in the future.

I presume that this does not include the almost 800 commercial banks that were on the FDIC’s list of problem banks as of March 31, 2010 since these banks are already “problems”.

If her number is added to the number of banks on the FDIC’s list then we have close to one-half of the domestically chartered banks in the United States facing the substantial “challenges for financial institutions.”

One-half of the banks in the United States are facing “serious difficulties” and that ”investors know that these regional and local banks are not too big to fail.”

No wonder that the Federal Reserve is keeping its target interest rate close to zero and expects to keep the rate at this level for an “extended time.” Again, expectations are for this target rate to stay near zero into the third quarter of 2010, a period that goes beyond when most of these large commercial loans are supposed to reset.

The real estate bubble of the 2000s will not go away. It is the gift that just keeps on giving!

The Current Performance of Commercial Banks

Commercial bank profits are OK. Commercial bank lending is practically nil.

The prognosis for the future?

If commercial bank lending does not pick up, commercial bank profits will fall.

When will commercial bank lending pick up?

Good question, but the answer is not an easy one. Also, to get an answer, it seems as if we need to go to both sides of the desk: to those that are demanding loans and to those that are supplying loans.

There seems to be four factors that are keeping loan demand from growing. First, of course, is that a lot of people and companies are still trying to climb out of the economic hole in which they have found themselves over the past three years. We still have foreclosures and bankruptcies continuing at a very rapid pace even though below record levels. We still have massive amounts of unemployment as well as underemployment. And, we still have large numbers of the American families and businesses with extremely poor credit records.

Second, there is a great amount of uncertainty about the future of business. And, confidence is not built when the Chairman of the Board of Governors of the Federal Reserve System announces before Congress…and the whole world… that the business outlook is “unusually uncertain.” If Mr. Bernanke believes this to be true, what are the people “in the trenches” expected to believe?

Third, there are a large number of companies, mostly big companies, that are sitting on a large amount of cash. These companies are not ready to commit at the present time, but they are poised to put these funds into play, either in an expansion off-shore, or in purchasing other companies. These big companies have been profitable, much like the big banks, but they are not yet ready to put these funds to a business use. As far as wanting bank loans, that will depend upon the strategies these companies want to pursue and the cheapest way to finance them.

Fourth, consumers that have the income flow or wealth continue to pay down their debt in an effort to re-balance their balance sheets. At a time like this with all the evidence around that too much financial leverage is not “the place to be”, individuals and families are not seeking credit and are even reducing the amount of credit that they do have outstanding.

From the demand side we see the reality that the people that have the income and the cash assets are not real anxious to borrow and the only ones that really want to borrow have neither the cash flow nor the cash assets to get a loan.

This gets us to the supply side. Commercial banks, in recent months, across the board, say that they have not changed their credit standards. I take them at their word. Yet, if one compares current bank lending standards with those that were in place one, two, or three years ago, the bar is set much higher than it was. This tightening of standards was to be expected as credit standards are always raised during an economic down turn. They were raised to current levels due to the severity of the 2008-2009 financial crises and to the pressures that were brought on the banks by the regulatory agencies. Although these standards will not get tougher, they will not be eased appreciably any time soon.

The commercial banks are also hit by the uncertainty of the current economic situation and by the coming imposition of new financial reform legislation. In terms of the economic situation, loan officers have to be skeptical of business projections of future cash flows. Since the economic outlook is “unusually uncertain” banks have to be extremely careful about basing the extension of money to a borrower upon “optimistic” forecasts. Even “prudent” forecasts are suspicious because of the uncertain nature of the business environment right now.

Plus, bankers, in general, and lending officers, in particular, are “debt guys”. (Please excuse the gender specificity here, “guys” refers to all bankers and lending personnel.) “Debt guys” are taught that forecasting just on cash flows is a tricky business and so it is wise, extremely wise, to require a borrower to put up collateral behind the loan. And, if cash flows projections become even more uncertain than in the past, more collateral should be required.

But, in a very uncertain economic environment, another problem rises to the surface. This problem has to do with the “value” of the collateral. In a very uncertain economic climate and uncertain secondary markets, how can you get a good estimate of what the value of “physical” capital might be? Hence, commercial banks extend their requirements for the collateral backing of loans, now requiring financial instruments, bank deposits like CDs, compensating balances, or other cash demands. Banks are getting back to the “good old days” when to qualify for a loan, a potential borrower had to prove to the bank that they did not need the loan in order for the bank to extend the money to them.

There is another uncertainty now in play. The passage of the financial regulation reform bill introduces more unknowns into the banks’ decision making. Just the concern over higher capital requirements causes the commercial banks to become more conservative in their lending practices. Furthermore, it is unclear how other rules and regulations, some of them not even written yet (the regulators have several months to write up some of the new provisions), will affect bank policies and procedures. How can commercial banks be aggressive in their lending practices it they don’t know what the “playing field” is going to look like in the future?

Finally, there are still many commercial banks that have solvency problems. As I continually quote, about one in eight commercial banks is on the list of problem banks put out by the FDIC. This list was as of March 31, 2010. Soon there will be a new list out relating to June 30, 2010. It is anticipated that the number of commercial banks on this new problem list will be greater than was the case at the earlier date.

My estimate that another two or three commercial banks out of eight still have problems pertaining to capital requirements, or, pertaining to major credit problems in the areas of consumer or commercial real estate loans. To me, this latter problem is one of the major reasons why the Federal Reserve is keeping short-term interest rates so low and will continue to do so, as Bernanke reiterated in his testimony yesterday, for “an extended period”. Market estimates for when the Federal Reserve might increase its target rate of interest now go until at least the third quarter of 2011. This says to me that there are still many, many problems in the commercial banking industry and these problems are not going to be resolved for “an extended period.”

This situation can only result in a large consolidation in the commercial banking industry in this country. Right now there are about 8,000 domestically chartered commercial banks in the United States. I remember when this number was 14,000 and this did not include an extensive Savings and Loan industry. One could see a drop by one-half or more in the number of banks in the country. And, this doesn’t even take into account the effects information technology is going to have on the banking industry in the next five to ten years.

This does not bode well for the supply of bank loans. With the changing financial regulations, the uncertain economic environment, and the changing structure of the banking industry itself, commercial banks are going to concentrate on “high quality” loans. And, if the big banks cannot find them in existing markets they will invade the local or regional markets of other banks. In fact, many banks are now talking about how the big banks are becoming more aggressive in their markets. This will not result in an increase in loan supply, but it will contribute to the consolidation in the commercial banking industry.

In short, there doesn’t seem to be much reason to expect a pickup in bank loan volume in the near future.

Wednesday, July 21, 2010

Stocks Fall After Bernanke Testimony

“Bernanke calls the outlook 'unusually uncertain" and notes the central bank is prepared to take additional action if needed. His economic outlook sees lower than expected inflation and at best a slow pace of falling unemployment levels. He notes financial conditions are hindering growth and expects interest rates to stay low for ‘extended period.’ At the same time, he says the Fed is continuing to think of ways to shrink its portfolio, and any asset sales will come gradually. Bernanke's comments to Congress are largely as expected, but some may be a bit taken aback by his comments on shrinking the balance sheet, which doesn't suggest much central bank appetite to provide additional stimulus to a troubled economy. Stocks are taking it on the chin while the two-year Treasury yield is hitting yet another record low. The dollar is holding pretty steady.” As reported by the on-line Wall Street Journal.

The markets are looking for someone to pull off some magic. Maybe we can get Nicholas Cage from “The Sorcerer’s Apprentice” to come do something special. Or, maybe the cry is for an alchemist, someone who can change the real world into something it isn’t.

One of the fundamental principles of economics, a principle of the real world, is that economic variables that are nominal in value cannot change economic variables that are real in value. Throwing more money (a nominal variable) into the economy will not reduce unemployment (a real variable). But, maybe an alchemist could do this.

Furthermore, there are some real structural problems that exist in the economy, the result of the past fifty years of inflationary monetary and fiscal policies. These problems are not going to be chased away by “Helicopter” Ben.

The first of these problems has to do with the labor markets and the current structural dislocations that labor is now facing. I wrote about this yesterday. See

The second has to do with the banking industry and the credit problems that still exist for many, many commercial banks. See

Third, the private sector of the economy is still heavily in debt. Credit card debt remains excessively high and the housing market continues to drag along the bottom. Foreclosures for the year are expected to reach 1.0 million and personal bankruptcies are still at near-term highs. Small- and medium-sized businesses continue to face financial difficulties due to having too much leverage on their balance sheet and commercial real estate is expected to remain a problem well into next year.

Commercial banks have over $1.0 trillion in excess reserves. Is their behavior going to change if excess reserves in the banking system rose to $2.0 billion?

One criticism that has been leveled at economists is that they have built their “science” to resemble classical physics with too much emphasis upon concepts like “equilibrium”. Over the past fifty years or so, one could argue that economists believed that they could use the models they developed to change the world from what it is to what they would like it to be. They assumed that they were alchemists.

In some situations there is only so much humans can do. They cannot “wave their wands” and create something that isn’t there. Reinhold Niebuhr is quoted as saying: “God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference. “

I am not, by nature a pessimist, nor am I a defeatist. There are things we can do. However, continued aggressive monetary and fiscal policies may not be appropriate at this time. In fact, I have argued that the continued use of aggressive monetary and fiscal policies over the past fifty years has actually created the problems we are now facing. (See Maybe the government needs to try other means of relieving pain and helping people to transition to a new world.

The advancement of human knowledge requires us to learn what we can change and what we cannot change. It was an advancement in human knowledge when people learned that you cannot change a common substance into gold. Then people began to find out what they could really do within the real world when they worked with nature and didn’t work against the way things are.

Maybe Bernanke and the central banks realize that there is only so far they can go. The financial crisis of 2008-2009 was minimized by the Fed’s “throw everything you can against the wall and sees what sticks” policy. Here the Fed was doing something it could do.

Now there is some form of “liquidity trap” that prevents the actions of the Fed from working through the banking system. We are in a “pushing on a string” environment. Maybe the Fed realizes that additional efforts at this time would just be trying to make gold out of a common substance.

Maybe the financial markets should realize that the Fed is not going to come up with some magic wand that will sweep away the current economic and financial problems.

Tuesday, July 20, 2010

The Long-Term Jobless in the Current Economic Malaise

I have been concerned for some time about the changing nature of the United States economy and the structure of the United States labor market. There seems to be a tremendous mis-match between the two and this portends an unhappy near term for economic growth and employment.

An article in the Monday New York Times by Peter Goodman, “After Job Training, Still Scrambling for a Job” captures the whole dilemma ( In this article, Mr. Goodman presents a well-developed argument that even after job training, many people in today’s economy cannot find jobs. One of the individuals Mr. Goodman interviewed stated in extreme frustration, “Training was fruitless. I’m not seeing the benefits. Training for what? No one’s hiring.”

Yet, Mr. Goodman argues that some industries are hiring. Some experts point out that “even with near double-digit unemployment, some jobs lie vacant, awaiting workers with adequate skills.”

“’There’s plenty of jobs in health care, in technology,’ said Fred Dedrick, executive director of the National Fund for Workforce Solutions.

Some of the aggregate figures point up this mis-match between labor and industry. First, the capacity utilization figures tell a dismal tale. Since the 1960s, capacity utilization in the United States has fallen. Every cyclical peak of capacity utilization over the past fifty years has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85%; in the middle 2000s, the peak was around 82%; and currently it is languishing around 74%. United States industry does not seem to be “tooled-up” for the right output.

Second, the under-employment of the working-age labor force has grown constantly over the past thirty years or so. The “measured” rate of unemployment indicates that about one out of every ten workers is currently unemployed. My estimate for the under-employed is that about one out of every four workers is under-employed in today’s economy.

How did we get this way?

I believe that the economic policies of the United States government helped to create this employment situation!

The reason I give for this conclusion is that every time economic growth started to slow over the past fifty years, the federal government stepped in to stimulate the economy and put people back into the jobs they had just lost. This was the Keynesian approach to the problem of unemployment.

This approach to stimulating the economy worked well in the short-run but in the longer-run failed to take account of shifting technologies and the job skills of the work force. This mis-match did not show up so much in the short-run because, especially in the earlier years, technology was not changing rapidly. However, as the last fifty years moved along changes in technology occurred at a faster and faster pace. The dislocation between the new technology and the “legacy” industrial capacity in place grew, as did the chasm between many in the labor force and the skills needed to handle the new technology in the new industries being created.

This is an unusual happening for it is nothing more than the working out of Joseph Schumpeter’s concept of “Creative Destruction”.

Applying Keynesian fiscal stimulus to this problem over and over again just exacerbated the situation. Why? Because people were either put back into “legacy” jobs or were given minor training and shoved back into the job market. Goodman writes, “Most job training is financed through the federal Workforce Investment Act, which was written in 1998—a time when hiring was extraordinarily robust. Then simply teaching jobless people how to use computers and write résumés put them on a path to paychecks.”

Goodman quotes Labor economist Carl E. Van Horn: “A lot of the training programs that we have in this country were designed for a kind of quick turnaround economy, as opposed to the entrenched structural challenges of today.”

The conclusion to this story is that over time the continued application of these Keynesian stimulus efforts causes a loss in impact. Each cycle this policy prescription seems to be less and less effective as the cumulative effect on industrial capacity and human capital grows. Capacity utilization declines and more and more workers become under-employed.

Given this conclusion, one can ask whether or not there comes a time when the fiscal stimulus program becomes almost totally ineffective? Have we reached a point where the cost/benefit tradeoff of more fiscal stimulus becomes almost all cost and very little benefit?

This, however, is not the only point that needs to be mentioned at this time. Most of the advocates of Keynesian fiscal stimulus policies are very concerned about the growth in income and wealth inequality over the past thirty years or so. The continued application of Keynesian-type fiscal stimulus packages during the past fifty years, I believe, has contributed substantially to the greater inequality in income and wealth that has occurred in the United States.

There are three primary reasons for this growth in inequality. First, the fiscal stimulus programs put people back to work in the jobs that they formerly held. The largest number of the short-term unemployed came from large firms so that the stimulus had to encourage the growth of these companies so that the workers that were laid off could be re-hired. The fiscal stimulus packages “subsidized” the growth and wealth of the big, already implanted companies. Thus, the salaries and employment packages in these areas could continue to grow over time even as the capacity utilization in these industries continued to fall.

Second, as more and more people in these industries became under-employed, their incomes dropped relative to other sectors of the economy and their future prospects also fell. This, however, did not keep these people from piling up debts to buy cars and houses and other consumer items. These people felt confident that over time, they would continue to generate income, even if it might be somewhat sporadic. Furthermore, the inflationary environment of the past fifty years made it sensible for these people to go into debt for the inflation depreciated the value of their debt over time.

Third, the wealthier segment of the economy took advantage of the continued fiscal stimulus of the past fifty years (gross federal debt rose at a compound rate of seven percent every year) and the fact that, on average, inflation rose at a compound rate of more than four percent per year over this time period. Wealthier people have always been able to position themselves better than the less-wealthy, especially when macro-trends become as predictable as the economic policy proscriptions of the United States government, whether Republican or Democrat.

Furthermore, wealthier people have always been able to find their way into the professions that provide, over time, the greatest opportunities to earn income and create wealth. Certainly these professions would include medicine and health, legal, finance, and management some of the biggest gainers over the past fifty years.

Given these factors, how long will it take for the United States economy to re-structure itself? In the 1930s it took a long time. Will it take that long this time around?

Sunday, July 18, 2010

"Grasping At Straws" in the Banking Data

The commercial banking industry was still contracting through June. Year-over-year, that is from June 2009 to June 2010, total assets in the United States banking sector dropped by a little more than 1.5%, with the assets of large, domestically chartered banks dropping by 3.0% during this time period. The total assets at small, domestically chartered banks rose by slightly more than 1.0%.

Year-over-year, the loans and leases at commercial banks within the United States dropped by 2.5%. The drop at large, domestically chartered banks was 0.2%, at small, domestically chartered banks was about 3.0%, and at foreign-related institutions the drop was 16.0%.

An interesting pattern is showing up in the data, however, and gives us something to look for going forward. The smaller, domestically chartered banks in the United States increased their loan balances a little bit over the four-week period ending in the week of July 7, 2010.

The Federal Reserve System has defined large commercial banks as the largest twenty-five domestically chartered banks in the United States. These banks control about one-third of the banking assets in America, a total of about $6.9 trillion. Small banks are all of the rest of the domestically charted banks in the country and they number slightly more than 8,000 banks.

Over the past four weeks, all loans and leases at the smaller banks rose by almost $3.0 billion. This is the first time in the past 18 months or so that the small banks have posted an increase in total loans and leases. The increase was not large…but, we are looking for any “green shoots” that we can find.

The increase was not “across the board” but Commercial and Industrial (C&I) loans, business loans, rose by slightly more than $2.0 billion and Consumer loans rose by a little more than $6.5 billion. Real Estate loans dropped by $5.5 billion, mostly in the commercial real estate area. It should be noted that both C&I loans and Consumer loans rose for the last 13-week period, although most of the increase came in the last four weeks. For this latter period, Real Estate loans dropped by more than $21.0 billion, again in the commercial area.

We continue to hear that these smaller banks still have lots of problem commercial real estate loans to deal with and may remain reluctant to lend in this area for an extended period of time.

Remember, it is in the smaller banks that most of the problems still exist relating to bank solvency. At the end of March, there were 775 banks on the problem bank list of the FDIC, implying that roughly one out of every eight of these smaller banks were “problems.” Through July 16, the FDIC had closed 91 banks this year, roughly 3.4 banks each and every week. This pace is expected to continue for at least the next 12 months. Later this month the FDIC will release the list of problem banks it has identified as of June 30, 2010. The expectation is that the number of banks on the list will increase above 775!

At the larger commercial, the largest 25 in the country, Loans and Leases continued to decline. In the last 4-week period these large banks experienced a drop of over $16.0 billion in that line item. For the last 13-week period the drop was in excess of $81.0 billion. Declines in the last 13-week period came in all lending areas as C&I loans fell by about $22.0 billion, Real Estate Loans declined by more than $26.0 billion and Consumer Loans dropped by approximately $31.0 billion.

Declines took place in all loan categories at the large commercial banks over the past four weeks, but the drops were not anywhere near as deep as in the previous two months.

Cash assets at the domestically chartered banks finally seem to be falling. Over the past four weeks, cash at large banks dropped by $35.0 billion while the smaller banks saw cash balances decline by a little more than $11.0 billion. Over the past thirteen weeks, cash assets at the larger banks fell by $61.0 billion while they only fell by $6.0 billion at the smaller banks.

This decline in cash assets is consistent with the drop in excess reserves in the banking system over the past several months. (See

There was an interesting bump in cash assets at foreign-related institutions during this time period. In the past 4-week period, cash asset at foreign-related institutions rose by $16.0 billion; and they rose by $25.0 in the last 13-week period.

Could this jump have anything to do with the “stress tests” being administered to major European commercial banks?

I don’t remember ever having seen an increase like this in foreign-related banks in such a narrow time span.

Business loans at these foreign-related institutions dropped over the past 4-week and 13-week periods while “other” very short-term lending, which could include loans to banking offices not in the United States, experienced a substantial rise.

Could these movements have anything to do with “window-dressing” for the European “stress tests”?

The summary for this month’s review of the state of the banking industry is much the same as in previous months. The two things to keep a watch on are, first, the small increases in business and consumer lending at the small, domestically chartered banks; and second, the drop in cash assets being held in aggregate by all domestically chartered banks in the United States.

The first piece of information raises hopes that the smaller banks are beginning to lend again to businesses, although not on commercial real estate deals, and consumers, again not on real estate. In terms of the latter, the hopes for a recovery in mortgage lending do not seem very promising as some analysts in the real estate industry predict that foreclosures for the year could approach 1.0 million homes. Some analysts are even saying that banks are not foreclosing as rapidly as they could so as to avoid the housing market being too jammed up with foreclosed houses. That is, the banks are “pacing the foreclosures” so that homes can be sold faster. This does not bode well for the future.

The second piece of information raises hopes that commercial banks are feeling more confident about the future and are, therefore, reducing the amount of cash (excess reserves) they hold on their balance sheets. Not only did lending at the smaller banks increase their lending over the last four weeks, the larger banks only experienced modest declines in their loans outstanding.

Many economists have declared that the recession ended in July 2009. So, the economic recovery has been going on for almost twelve months. The major problem with this claim is that the commercial banking system has not been acting like the recession is over. This has also been reflected in the balance sheet of the Federal Reserve System and in the performance of the monetary aggregates. (See my post referenced above for a discussion on these points.)
Thus, we are scratching around trying to find positive signs in the banking statistics. With this report we are grasping at straws. But, we have not even had tiny straws

Friday, July 16, 2010

Real World Lessons of the Obama Administration

There are two things that some of President Obama’s base is finding out. First, you just cannot walk away from war. Before you are “in the office” you can say all you want about ending wars or not getting into wars, but once “you get the seat” just being against war is not a sufficient policy. There are dumb wars and there are smart wars; there are well run wars and there are stupidly run wars; but wars are always present in one way or another. To many of President Obama’s supporters, President Obama is not walking away from war, and they don’t like it!

The second thing is that powerful nations need a healthy business sector. Regardless of how important you feel the role of government is in a society, without a strong economic system that is performing well your government will always be weak relative to other countries that have strong economic systems that are performing well.

I addressed this point from a different perspective in a recent post: see “Emerging Markets and the Future”, One can deduce a similar point from Floyd Norris in today’s New York Times, “How to Tell A Nation Is at Risk,”

Norris writes: “Which governments will not be able to pay their bills?

The ones with private sectors that are not doing well enough to bail out the government.

That should be one lesson of the near default this year of the Greek government. Government finances are important, but in the end it is the private sector that matters most.

If so, those who focus on fiscal policy may be missing important things. Spain appeared to be in fine shape, with government surpluses, before the recession hit. Now Spain is being downgraded and has soaring deficits.”

The take away from these two pieces: You need to have a strong, vibrant capitalistic system in place, even if it is a state driven capitalism like that of China. The exception is those despotic nations that have a monopoly on a natural resource like Venezuela or many of the middle eastern fiefdoms, but these situations have their own problems. Economic weakness and slow growth lead to waning economic power. Check out much of Europe.

Today’s New York Times was filled with signs that the Obama administration was cognizant of the role the business sector must play in the economy in order to ensure its success and continuation. On the front page of the Times we read of the “Obama Victory” with respect to the financial reform package. This is the coin thrown to some of his supporters.

The real news, to me, is on the front page of the business sector in bold headlines: “Cut Back, Banks See a Chance to Grow: Its fight ended, Wall St. Is Already Working Around New Regulations.” (See

Funny, but some of this article seems especially like my recent post “Financial Reform: Ho, Hum”, The authors of the Times article write:

“The ink is not even dry on the new rules for Wall Street, and already, the bankers are a step ahead of everyone else…

So after spending many millions of dollars to lobby against the legislation, bankers are now turning to Plan B: Adapting to the rules and turning them to their advantage."

The Obama administration and those in Congress that wrote the bill had to have enough in the bill to “declare a win” but many are looking at the legislation as just a cost and an inconvenience. Main street must be given something to justify the possibility of re-electing those currently in office. But, Wall Street must be healthy so that the Administration can stand up to China!

Financial institutions spent a lot to keep a lid on Congress and its “spewing into the gulp” and in this respect have been more successful than BP with its oil spill. But, now that the cap is on in terms of the financial reform bill going to the President, it is time to get back to business. And, really, that is what the administration wants as well.

The third important headline on the front page of the business section (the other two articles were there too) is “With Token Settlement, Blankfein Unscathed”, The New York Times claims that the deal Goldman Sachs reached with the Securities and Exchange Commission was a “Token”…mere pocket change. The people from the S. E. C. declared this to be a victory. What a joke! Well, now we can get back to business!

Just one more piece of information being shared this morning: Treasury Secretary Tim Geithner seems to be very opposed to Elizabeth Warren becoming the head of the new consumer protection agency created by the financial reform package. She is apparently too strong, too emotional of an advocate for the consumer. It seems as if such a person would rock the boat.

The reality of the situation seems to be that the Obama administration needs a strong, rebounding economy. It needs a strong, rebounding economy to not lose much ground in the elections this November. And, it needs a strong, rebounding economy to give the United States more bargaining power in the world.

The United States is still the number one economic and military power in the world. It is just that at this time, with a somewhat weakened economy, room is given to those large emerging nations to be more assertive in world affairs and to gain confidence in their ability to present their positions in world forums. Again, see my post on “Emerging Markets and the Future.”

The Obama administration is walking a narrow line. It cannot afford to lose the support it has been given in the past by the Independent voter and the middle of the political spectrum. And, it cannot afford to be captive of the sovereign wealth funds of the world that control large amounts of financial capital.

In order to achieve these goals, the Obama administration cannot stifle the United States business engine. The issue it now faces is how to support Wall Street and business without appearing to be abandoning Main Street. The danger the administration runs is that in attempting to walk this narrow line, it might not please anybody.

Thursday, July 15, 2010

A Picture of China and the Future

One should read the article by Gillian Tett in the Financial Times this morning. The title in the print copy is “Asia Pulls Strings Behind Scenes as Eurozone does Bank Test U-turn,” ( The article presents a vivid picture of the world of the future, something people are going to have to get used to.

The scene: the meeting of the G-20 in Busan, South Korea, June 4-5, 2010.

The subject matter: whether or not the eurozone governments should publish the results of the stress tests being performed on the largest banks within the region.

The result: the “eurozone governments performed a U-turn, by finally agreeing to publish the results of such tests.”

The reasons given: one argument was that lobbying had taken place inside the European Central Bank and this caused the change; another argument was that United States Treasury Secretary Tim Geithner persuaded his eurozone counterparts to alter their position.

Tett reports, however, that it was the “powerful Asian investment groups and government officials” that won the day. These officials “expressed alarm about Europe’s financial woes” and indicated that future purchases of eurozone bonds might be substantially reduced until more information was available to them on the health of Europe’s banks.

“That, in turn, sparked a sudden change of heart among officials in places such as Germany and Spain.”

This is important!

It is important because this is, more and more, the way that the world is moving.

Note, this encounter took place at the G-20, not the G-8. The smaller group is fading into the shadows because it does not include the emerging nations that are becoming relatively more important in the economic and financial affairs of the world. It is less easy for the United States to dominate the larger group and there is no history of total United States dominance in this group as there is in the smaller group.

Second, the emerging nations included in the G-20 have substantial amounts of wealth and their economies are in better condition than are those of their western counterparts. These nations are becoming more comfortable with the power they possess.

In one sense, events could not have broken more favorably for these emerging nations than they did. Before 2008 the question always seemed to be “When would China and the other emerging nations catch up with the United States and Europe in terms of economic power? These nations were coming along, but a productive and growing United States would be hard to catch. People thought that it would be the 2020s or the 2030s before the relative gaps would close significantly enough to alter political relationships.

The Great Recession changed all that! The United States and Europe have had lots of problems to deal with. And, not only was their economic strength tested, but their focus was diverted away from the improving performance of the emerging nations. And, these economies apparently will remain weak for an extended period of time. China, and the other BRIC nations…and a few more…have been testing the waters, standing up to the “big guy” or “big guys” and testing just how far they can push the envelope.

The result is that the leaders of these emerging nations, political and business, are taking a more aggressive stance in almost every area of concern. And, by-and-large, the United States and Europe and the UK are having to take it. They are just not in a position to put up much of a fight.

Third, the competition taking place in the world is not just between the United States (and Europe) and each BRIC country. Competition is also becoming quite fierce between these countries. (Note another article in today’s Financial Times about South Asia. The subheading states that “India’s failure to match its economic clout with local influence has heightened Delhi’s concern over losing out to China in what is set to be a long-running battle for ascendancy.” (

But don’t leave out Russia and Brazil. Each of these countries, in its own way, is gaining relative to the United States, but also is engaged in competition with China…and India.

And what about Japan? And, Canada? Then there are several other players in the world.

What did we just see in the newspapers? Pictures of BP president Tony Hayward meeting with the president of Azerbaijani. BP has turned to the middle east to either raise additional capital or sell assets. But, Citigroup did that along with a dozen or more other major corporations from the west.

Countries not only have to be concerned about their position relative to the United States (and Europe) they have to consider how they stand relative to a dozen or more other nations in the world. This is not an environment in which these nations can “stand down.” They must be strong and competitive against all comers.

So, things are changing. Ms. Tett’s article just points to the fact that the influence of China is growing along with their confidence. This is also being seen in the behavior of the leaders of other nations, like the connections Brazilian President Lula da Silva is making with the leaders of countries that are not necessarily friends of the United States, like Venezuela and Iran.

This situation is not likely to change unless these emerging nations plunge into a Great Recession and have to re-focus their efforts on re-building their economies and restoring their financial wealth.

Also, as Ms. Tett implies, China and the other emerging nations are still testing the waters. “There is little sign those investors are being ‘intimidating’.” Yet, they are in the process of finding out how far they can go. But, this process will continue and that is why examples like the one presented in her article are a harbinger of the future. Tomorrow, these investors might by “intimidating”!

Economic and financial wealth is spreading throughout the world. Influence and power follows economic and financial wealth. In the emerging competition taking place in the world between the United States and other countries and within the other countries themselves, it is hoped that the competition does not boil over into wars, either trade wars or fighting wars.

Unfortunately, these wars have not been avoided in the past. The question is, what kind of world can the United States and the other emerging nations create that will allow economic and financial competition to take place within and between nations without the competition deteriorating into trade wars or fighting wars?

The signs of the future competitive world are there. How the world works out this future is the big issue.

Wednesday, July 14, 2010

Liqudity Traps are For Real

When I was studying economics, the idea that an economy might face a “liquidity trap” seemed absurd. Basically, the concept of the liquidity trap was that the monetary authorities could not “push on a string”. In other words, the liquidity trap represented a time when the central bank could inject a large amount of reserves into the banking system and people (and businesses) would prefer to hold more money than to hold debt. Thus, funds could not get into the bond market which would mean that businesses would not invest in inventories, plant, or, equipment, and the economy would stay mired at a low rate of activity.

This was why deficit spending on the part of the government was necessary, at least for those following the Keynesian dogma, because it was the only way to increase aggregate demand and re-charge economic activity.

Well, we are in a liquidity trap. The Federal Reserve has injected more than $1.0 trillion of excess reserves into the banking system and has kept short-term interest rates close to zero. And, commercial banks have not lent these excess reserves so they continue to rest on the balance sheets of the banking system. The question is, what needs to be done next?

Furthermore, the government has tried deficit spending to spur on the economy, but this effort seems to have had a less-than-dramatic impact on the economic recovery now seemingly underway. Keynesian dogmatists argue vociferously that the problem is that the government has not spent enough…that the Obama administration has been too timid.

But, this approach to the concept of liquidity traps hinges upon the assumption that the crucial economic relationship is found on the asset side of the balance sheet, on the division of assets between holding money or holding bonds. The analysis completely ignores the liability side of the balance sheet. Nothing is said about the amount of leverage the economic unit has built into its balance sheet. Hence, the issue of whether or not an economic unit has “too much” debt doesn’t even enter the picture. And, this is the problem.

There is an article in the Financial Times this morning that I believe does a good job in addressing this issue. The article is “Leverage Crises are Nature’s Way of Telling Us to Slow Down” by Jamil Baz, Chief Investment Strategist for GLG Partners (

Baz argues that the near-collapse of the world financial system followed by a deep recession was “a crisis of leverage.” The ratio of total debt to gross domestic product in the United States reached 350 percent in 2007. Whereas nations could perhaps maintain a level of 200 percent and still achieve healthy economic growth, the 350 percent figure that remains in the United States (and that also exists at higher levels in many of the leading developed countries) cannot be sustained.

The consequence is that at some time in the future the United States and other developed countries are going to have to deleverage. But, deleveraging is going to be costly in terms of future economic growth. We, in essence, have to pay for the past sins we have committed in building up such an enormous debt structure.

Baz presents “three hard realities we need to bear in mind” that result from having too much leverage. These hard realities are:
  • When you are bankrupt, you either have to default on your debts or you save so you can repay your debts;
  • Policy choices under such circumstances are not appetizing with one school of thought advising taking morphine now followed by cold turkey later and the other school proposing cold turkey now;
  • If you are a politician, you may be under the illusion that you are in charge whereas the real decision-maker is the bond market.

He concludes: “maybe leverage crises are nature’s way of telling us to slow down. Policymakers can ignore this message at their own peril. In their anxiousness to avoid past mistakes, they run the risk of an even bigger mistake: fighting leverage with still more leverage, a strategy that might suitably be dubbed “gambling for resurrection”.

The liquidity trap now being faced by policy makers comes from the liability side of the balance sheet. People and businesses are faced with the choice of either going bankrupt or increasing their savings so as to repay their debts. As Baz says, “This is neither ideology nor economics, simply arithmetics.”

But, it does mean that commercial banks may not want to lend and people and businesses, in aggregate, may not want to borrow. Pushing on a string in this case has little or nothing to do with the asset side of balance sheets and everything to do with the liability side of balance sheets. The Federal Reserve cannot force the commercial banks to lend or people to borrow.

The liquidity trap looked at in this way is real and has been operating for more than a year.

The problem is that if you consider the liquidity trap in this way you can clearly see the dilemma presented by Baz in terms of the policy choices that are currently available. This is why one could argue that it took so long for the Great Depression to end. People and businesses had to work off their debts…they had to go “cold turkey” for a while. In this sense, the economists Irving Fisher and Joseph Schumpeter were closer to understanding the economic situation that existed in the 1930s than was Keynes!

If Baz is correct then the choices are pain now versus more pain in the future. The problems associated with the increased leveraging of the economy cannot be put off forever. Debt must eventually be paid down!

Tuesday, July 13, 2010

So Long to the Savings and Loan Association

Well, the final nail is being hammered into the coffin. The Savings and Loan industry is going to be “legacy”…and, rightfully so.

The New York Times writes the obituary: “Financial Bill to Close Regulator of Fading Industry,” “The most remarkable piece of the financial regulation bill that Democrats hope to send the president this week is the directive to dismember and close the Office of Thrift Supervision. The decision is all the more remarkable because it cuts against the grain of a bill devoted to expanding federal regulation, and because it has had virtually no opposition, save for the obligatory protests of the agency’s senior management.”

The original Savings and Loan Association was created to help Americans own their own homes. The S&Ls deposits were time and savings accounts, no transaction accounts, and the assets of an association were mortgages. An S&L could hold 80% of its assets of more in mortgages…not mortgage-backed securities or any other type of synthetic concoction of mortgage instruments or derivatives. These were the single family mortgages of individual families, most of them known personally by the people who ran the association.

Furthermore, these financial organizations were mutual institutions. That is, they were owned by their depositors. No stock holders, no maximizing shareholder value, no gimmicks, no nothing. By law they took time and savings deposits and, by law, they originated mortgages to hold on their balance sheets.

How did they make money? Well, for much of their history they paid 1 ½% to 2% interest on their deposits and collected 4% or so on their mortgages. Their expenses were extremely low. In a typical institution there were only one or possibly two managers (men) and a clerk and maybe two or three tellers or a receptionist (all women). They were mutual institutions so that they did not have to earn anything like 15% on paid-in equity. A 1% return on assets was really good and it just went into the surplus account anyway. Remember George Bailey (Jimmy Stewart), the Bailey Building and Loan Association and the movie “It’s A Wonderful Life.”

The demise of the industry is just another example of how much inflation can be the “stealth” destroyer of stability. The health of the industry was dependent upon the interest rate spread presented above. And, in non-inflationary times when interest rates remained relatively stable, the S&Ls could prosper because the interest rate spread they earned paid for expenses and added to the association’s surplus.

There were cyclical problems, but regulators, specifically using Regulation Q (Reg Q), put a lid on the rate that these institutions could pay depositors so that a positive interest rate spread could be maintained although this “lid” caused something called “dis-intermediation”, an outflow of deposits, that put pressure on the liquidity of associations. This disintermediation was just a time period these institutions had to go through until interest rates stabilized once again.

However, this disintermediation problem points up the underlying weakness of the Savings and Loan Industry. The industry was built on the foundation of interest rate risk: the assets of the typical Savings and Loan Association had an effective average maturity of twelve or thirteen years. The deposits had a maturity of…well, they were very short term deposits.

The periodic problem of disintermediation pointed up the underlying risk that existed within the industry. However, the inflation of the 1960s basically killed the industry. As inflation rose toward the end of the decade, interest rates rose as inflationary expectations got built into the term structure. That is, interest rates, both long-term and short-term, rose.

Well, the typical S&L saw the cost of deposits rise by a substantial amount almost across the board while the return they earned on their assets rose only modestly. All of a sudden, thrift institutions were faced with negative interest rates spreads and they could not exist in such an environment.

This is when deregulation started and accelerated dramatically through the 1970s. Basically, the idea of a thrift institution was dead by then. Not only did regulators allow balance sheets to become more like commercial banks, bank executives were drawn into the industry to run the thrifts. And, of course, thrift institutions were allowed to shed their “mutual” charter and become stock institutions. I took one thrift institution public in 1985 and ran another thrift that had just gone public in 1987.

I have spent a lot of time over the past two years writing about how inflation in the United States over the past 50 years or so basically undermined the financial system as it was known, created a tremendous environment for financial innovation, and helped to change the makeup of American society, where employment in financial services reached 40% or more of the workforce when, before 1980, employment in financial services had never exceeded 15% of the workforce.

The inflation created by the federal government since January 1961 forced the collapse of the post-World War II international financial system as the United States took itself off the gold standard on August 15, 1971 and floated the United States dollar. The inflation of the 1960s resulted in the rise in interest rates that destroyed the foundation of the thrift industry in the United States and created the conditions that led to the Savings and Loan crisis of the late 1980s and early 1990s. The continued inflation of the late 20th century led to the stock market bubble in the 1990s (the boom), the demise of the Glass-Steagall Act, and the asset bubble (both in the stock market and housing) of the 2000s.

The difficulties we have been experiencing in the last few years can also be traced back to the inflation of the past fifty years. Yet, inflation is sneaky and people tend to forget it in pointing their fingers at the “bastards” that “caused” the financial collapse.

The economist Irving Fisher captured this situation in his book titled “Inflation”: “If it is inflation and the one who profits is the business man, the workman calls the profiter a ‘profiteer.’ The underdog reasons as follows: ‘How did I get poor while you got rich? You did it, you dirty thief. I don’t know just how you did it; your ways are too subtle, sinister, dark and underground for simple me; but you did it all the same’

But, none of us—neither the farmer, nor the workman, nor the bondholder, nor the stockholder—thinks of blaming the dollar. So the real culprit stands on the curbstone watching us poor mortals as we beat out each other’s brains, and has the last laugh.” (This was written in 1933.)

So, good-bye to the Savings and Loan Industry. You did America well. But, your time is past. Rest In Peace (RIP).

Mr. Bernanke and the Fed Don't Know What is Going On!

Recently, the Federal Reserve has held 43 meetings around the country on the financing needs of small business. These meetings began February 3, 2010. Yesterday, Mr. Bernanke hosted a forum on small business lending at the offices of the Board of Governors of the Federal Reserve System in Washington, D. C.

The conclusion of all these meetings about the financing needs of small business?

“Mr. Bernanke’s remarks,” on Monday, “suggested that the Fed was not sure why lending had contracted.” (See “Small-Business Lending is Down, but Reasons Still Elude the Experts,”

Now there’s a confidence builder.

The Federal Reserve and its Chairman don’t know!

And, they held 43 meetings around the country plus the one on Monday and they haven’t a clue?

I have been writing about the decline in business lending at small banks (in fact at all banks) for 18 months now. Did the Fed just become aware of this fact early this year and are now just trying to understand what is going on?

Go back to your equations, Mr. Bernanke!

The Federal Reserve, the federal government, most economists like Mr. Bernanke, and politicians don’t understand debt. Their models don’t include debt and their thinking doesn’t include debt. They seem to believe that debt is something that can be issued without fear of having to pay it back and if one does get into trouble because of the debt that was issued in the past then they can just issue more debt and that will get them out of their problem.

The banks, particularly the 8,000 banks that are smaller in size than the largest 25 domestically chartered banks in the country, face three factors that are particularly troublesome. First, many of these banks have troubled assets on their balance sheets, especially commercial real estate loans that must be re-financed over the next 18 months or so. Debt can go bad and those that hold the debt must reduce their net worth, their capital, when they write the debt off.

Second, the business environment, both in the United States and in the rest of the world, is very uncertain. The future is very unpredictable and this makes balance sheets extremely fragile. This situation makes banks very unwilling to commit to create more debt on their balance sheets and it also makes businesses, very reluctant to add more debt to their balance sheets. In fact, there are plenty of incentives for these organizations to actually reduce the amount of debt on their balance sheets.

Third, banks need capital, not more debt. About one out of every eight banks in the United States is on the list of financial institutions that are facing severe problems as determined by the Federal Deposit Insurance Corporation. My guess is that maybe three other banks in eight in the United States need a capital infusion. And, with new financial reform legislation about to be enacted, commercial banks will be facing higher capital ratios and a more diligent examination of bank capital positions. Banks are going to be very careful about creating more additional debt that place them in a precarious position relative to the new capital requirements.

What is there not to understand?

And, the headlines read, “Bernanke in call for banks to lend more,” (See

The Federal Reserve is keeping its target rate of interest between zero and 25 basis points and has injected $1.0 trillion of excess reserves into the banking system! This is to provide incentives to banks to lend.

And, the fundamentalist preacher Paul Krugman shouts at the top of his lungs about “The Feckless Fed” who is “dithering on the road to deflation.” (

Krugman and his whole fundamentalist crowd not only believe that additional spending and more debt on the part of the government is needed at this time but that we need the forgiveness of consumer debt so that consumers can start borrowing and spending again, and we need the Fed to force commercial banks to support more borrowing on the part of businesses so that they can invest in inventories and plant and equipment. Then we inflate the real value of the debt away so that issuing debt is not so painful.

Isn’t this just the attitude that got us into the situation we are now in?

Unfortunately, this attitude seems to have prevailed in history as arrogant governments over time have lived off of issuing more and more debt and then inflating their way out of their responsibility to pay it off. On this issue see the books by Rogoff and Reinhart, “This Time is Different,” ( and Niall Ferguson, “The Ascent of Money,” (

There was another time, in the spring and summer of 2008, when Mr. Bernanke and the Federal Reserve didn’t seem to know what was going on. The consequence of this ignorance has been pretty severe.

To think that people can say that Mr. Bernanke and the Federal Reserve don’t know what is currently going on in the banking system they oversee and regulate is downright scary. The American people deserve better!

Sunday, July 11, 2010

Federal Reserve Exit Watch: Part 12

This is the twelfth edition of the Federal Reserve Exit Watch. The first edition was posted in August 2009. The Great Recession, many contend, ended in July 2009 and, at that time, the major task of the Federal Reserve System appeared to be the task of reducing, as judiciously as possible, the massive amount of reserves that the central bank had put into the banking system to combat the threat that the Great Recession might turn into a second Great Depression.

On July 8, 2009 on the Fed’s balance sheet, total factors supplying reserve funds to the banking system totaled over $2.0 trillion, up from around $0.9 trillion one year earlier. It was September of 2008 when the liquidity crisis hit the financial system in the United States which resulted in the rapid injection of funds into the banking system to protect the system from a series of systemic failures. In July 2009, excess reserves in the banking system average around $750 billion.

The concern at that time was that all of these excess reserves in the banking system would eventually end up in the money stock and this would result in inflationary pressures threatening significant increases in consumer and asset prices.

One year later on July 7, 2010, total factors supplying funds to the banking system amounted to about $2.4 trillion. Excess reserves in the banking system totaled more the $1.0 trillion. Obviously, the Federal Reserve System did not remove reserves from the banking system during the past twelve months.

The reason given for not removing reserves from the banking system is that the economy has remained excessively weak: and the Federal Reserve will not start removing reserves from the banking system until the economy seems to be picking up momentum.

My belief has been that the health of the smaller banks in the banking system, those 8,000 or so banks that are smaller than the 25 largest banks, is still not good and the Fed will not begin to remove reserves from the banking system until these non-big banks get in much better shape. With about one in eight banks in the United States on the problem bank list of the FDIC, the banking system is a long ways from being healthy.

And, the Fed has promised that it will continue to keep its target interest rate close to zero “for an extended period” of time. That is, banks should not be afraid of rising short term interest rates any time soon. Many market analysts don’t expect short term interest rates to begin rising until after the start of 2011.

One crucial thing to understand about the operations of the Federal Reserve over the past 12 months is that the injection of funds into the banking system through the fall of 2008 and into the summer of 2009 consisted primarily of “innovative” efforts by the central bank to provide liquidity to specific parts of the money and capital markets. The reserves injected into the financial system were not anything like the classical operations of a central bank which mainly came from the sale or purchase of U. S. Treasury securities in the open market and discount window borrowings from the district Federal Reserve banks.

A major part of the exit strategy of the Fed related to the reduction in these “special” sources of funds and moving back into more traditional forms of central bank operations. Therefore, in the initial stages of the Fed’s exit strategy, efforts were directed at seeing the “special” sources of reserves decline as their needs receded and replacing the reduction in reserves with the purchase of securities from the open market.

The twist in this effort was that the Fed focused, not on the purchase of traditional source of open market securities, U. S. Treasury issues, but on acquiring a lot of mortgage-backed securities, up to $1.250 trillion worth, in order to provide support for the mortgage and housing markets, and on acquiring Federal Agency issues. On July 8, 2009, mortgage-backed securities on the books of the Federal Reserve System totaled about $462 billion. On July 9, 2010, this total reached $1.1 trillion. Federal Agency issues rose from around $98 billion on the earlier date to $165 billion on the latter date. U. S. Treasury securities rose as well, but only by about $104 billion.

Thus, in this 12-month period, total factors supplying reserve balances rose by $341 billion, and the amount of securities the Federal Reserve bought outright rose by $826 billion. The portfolio purchases replaced a lot of the “special” sources of funds supplied to the banking system by the Fed over the past ten months. This was an important part of the Fed’s exit strategy.

So, in the past 12-month period, the Fed actually increased the amount of excess reserves in the banking system. However, in the last 13-week period, excess reserves have actually fallen slightly. One could strongly argue that the decline in excess reserves has come more from operating factors rather than from any overt efforts to reduce bank reserves.

One cause for the reduction in excess reserves was the increase in U. S. Treasury deposits at the Federal Reserve in the Supplementary Financing Account. This is an account set up by the Treasury Department to specifically help the Fed drain reserves from the banking system. (See my post of April 19, 2010, “The Fed’s New Exit Strategy”, During the past 13-week period this account rose by $50 billion, helping to bring down bank reserves. Other operating factors that drained reserves from the banking system was a $12 billion increase in currency in circulation. Also, reducing reserves was a decline in central bank liquidity swaps that fell by about $8 billion during this time period.

Over the past thirteen weeks, these factors draining reserves from the banking system was offset by about $50 billion in Fed acquisitions of mortgage-backed securities.

The net effect of all factors affecting reserve balances: a $50 billion decline in excess reserves.

Over the past four weeks Federal Reserve actions have remained relatively minor. Excess reserves in the banking system fell by about $19 billion, but this primarily resulted from operating transactions like the increase in currency in circulation and a rise in U. S. Treasury balances in the Treasury’s general account which is usually connected with tax receipts. So the last 4-week period can be considered to be uneventful.

One other thing we need to check in this analysis is the behavior of the M1 and M2 measures of the money stock. All that can be said here is that the growth rate of these two measures continues to be modest and actual growth rates have been achieved by people and businesses re-arranging assets rather than from commercial banks making loans. The year-over-year rate of growth of the M1 measure in June was about 6% while the M2 measure rose by only 1.6%.

Note that the non-M1 component of M2 grew by only 0.6% during this time period. This was because, small denomination time deposits at financial institutions have fallen by more than 22% over this time period and Retail Money Funds have dropped by more than 25%. All of these funds seem to have gone into demand deposits, other checkable deposits, and money market deposits, part of M1. This, as I have written before, is not a sign of health in the economy because people continue to transfer funds out of interest-bearing accounts and into forms of money that can be used for spending. This is a sign of desperation not of an improving economy.

A consequence of this has been that the required reserves at commercial banks have continued to rise so that the Federal Reserve must increase the total reserves in the banking system so as to keep excess reserves constant.

One other measure reflecting this shift in assets: monies in Institutional Money Funds have also fallen by 25% year-over-year.

The conclusion to this Exit Watch report is that the Federal Reserve HAS NOT YET started taking reserves from the banking system. That is, over the past year the Fed has not, if fact, exited. And, people and businesses in the aggregate still need to reduce their portfolios of invested funds in order to have money available for spending on their daily needs.