Wednesday, September 29, 2010

Monetary Warfare: the United States versus China?

Martin Wolf, in his latest column writes (

“In the absence of currency adjustments, we are seeing a form of monetary warfare: in effect, the US is seeking to inflate China, and China to deflate the US. Both sides are convinced they are right; neither is succeeding; and the rest of the world suffers.”

“It is not hard to see China’s point of view: it is desperate to avoid what it views as the dire fate of Japan after the Plaza accord.”

The basic argument in favor of China’s efforts is the Japanese experience in the 1990s. It seems as if everything goes back to this Japanese experience these days.

Maybe there is another explanation. Maybe this is what China’s leaders would like us to think.

The figures behind this discussion are those related to the world’s official reserves. From January 1999 and July 2008, these rose “from $1,615 billion to $7,534 billion—a staggering increase of $5,918 billion.” Between July 2008 and February 2009 reserves shrank by $472 billion, but rose again by $1,324 billion between February 2009 and May 2010 to reach $8385 billion.

“China is overwhelmingly the dominant intervener, accounting for 40 per cent of the accumulation since February 2009. By June 2010, its reserves had reached $2,450 billion, 30 per cent of the world total and a staggering 50 per cent of its own GDP. This accumulation must be viewed as a huge export subsidy.”

“Never in human history can the government of one superpower have lent so much to that of another.”

And, this, to me, is the key point. The key point is not what happened to Japan.

It is like the large United States corporations who have accumulated a huge amount of cash and they are, for the time being, just keeping their cash on their balance sheets. The question analysts are asking is “when will the corporations begin to invest again and get the economy moving?”

I don’t believe this is the issue for the United States corporations with lots of cash on hand. I believe that these corporations sense that a major re-structuring is in the process of taking place in the United States economy. They want to play a role in this re-structuring. Thus, the game plan is not to expand production by investment in physical plant and capital. Their plan is to merge and acquire other organizations and help re-define the landscape of American industry. I believe that this consolidation is just beginning.

I believe that this also applies to the some of the cash buildup in the banking industry and one of the reasons for the accumulation of so much cash in many of America’s larger financial institutions. These institutions want to be players in the consolidation of the banking industry.

China is observing the changes taking place in the world. It needs commodity resources. It needs production capacity. It needs world presence. In needs to extend its power into the world.

China is buying commodities or assuring commodity channels throughout the world. China is buying companies throughout the world. China is seeking and paying off new political relationships throughout the world. China is helping the world re-structure.

It would seem to me that a lot of international reserves would help it achieve these goals.

And, what is the United States doing?

It is underwriting the Chinese “re-structure” machine. Quoting Wolf, “the US is seeking to inflate China.” But, one could argue, China is not trying “to deflate the US.” China is playing a game of chess with the rest of the world. It is trying to re-position itself to be in a relatively greater position of power. It is trying to reduce the relative strength of the United States in the world and build up its own place.

And, the United States government is providing China with the means to accomplish this goal!

As with Mr. Wolf, many advisors in the United States government have been mesmerized by the events that took place in Japan in the 1990s. They couch almost every discussion about current international economic conditions in terms of Japan in the 1990s. Again, they are fighting the last war.

Japan was not trying to take on the United States. China is. And, that is the difference.

And, the President and the United States government, in their myopia, are doing all that the can to help China achieve its goal.

I would disagree with Mr. Wolf. We are not in “monetary warfare.” We are in a situation where the United States is giving China exactly what it needs to challenge America in the world!

Tuesday, September 28, 2010

The Shadow of Lula

It is remarkable to see the accolades being heaped on retiring Brazilian President Luiz Inácio Lula da Silva. Who would have believed this would be the case eight years ago.

Even the Financial Times has as its lead editorial “Brazil Dazzles Global Finance” (See “Brazilian finance will be felt increasingly in international centers.” Brazil’s development bank, with a balance sheet larger than the World Bank, has chosen London as its main foreign office.

Brazil is a player. Statements like this cannot be put in a future tense any more like “Brazil wants to be a player in the world.”

And, the Brazilian Finance Minister Guido Mantega gained global headlines this morning with his comments about “a trade war and an exchange rate war.” Brazil has one of the stronger currencies in the world right now. The value of the dollar has fallen by about 25% relative to the
Brazilian real since the beginning of last year.

Brazil is now listened to around the world.

This is just one more indication of how the world has changed.

Every day, we, particularly in the United States, must remember that things are different now. Although the United States is still a very powerful nation, quite a few other countries have increased significantly in power so that the relative position of the United States is not the same as it once was.

And, there are other hints. JPMorgan Chase has reorganized so that it can become more of an international force. Economically, it cannot just rely on its position in the slow growing United States economy anymore.

We also see the changes in leadership in the United States. For example, the bank that formerly was the largest bank in the United States has someone born in India as its CEO, Vikram Pandit, who was brought into this position to save Citigroup and turn it around.

And what about the biggest, most aggressive investment bank (now a bank holding company) in the United States, Goldman Sachs. There are rumors that a Canadian by birth, someone who has been Goldman’s Asian chief, Michael Evans, is playing a larger part in the management of the company and might even be a successor to Lloyd Blankfein, the current chief executive. Also, Mr. Evans does not have a back ground in Goldman’s trading unit, a place many other Goldman Sachs’ leaders have come from.

The world is open. People and products and services are flowing more easily from country to country.

We still see individuals that resist this fact.

It is hard to believe that this growing global integration can be ignored by investors, governments, and financial institutions, manufacturing concerns, and others who want to perform well in these times.

Well done Mr. Lula!

Monday, September 27, 2010

Questions for a Monday Morning

Beginning in 1961 with the inauguration of President John F. Kennedy, the United States government has basically operated from a “Keynesian” economic philosophy. The economists that Kennedy brought into his administration were avowedly Keynesian and the Kennedy tax cuts that followed were developed from a Keynesian model.

This has been a bi-partisan effort and Republicans are as guilty as anyone in terms of the emphasis upon stimulative government budgets. President Richard M. Nixon confessed in the early 1970s that “we are all Keynesians, now!”

Government economic policy was written into legislation beginning with the The Employment Act, Act of Feb. 20, 1946 which was followed by the Humphrey-Hawkins Employment Act, the Full Employment and Balanced Growth Act, enacted in October 1978. Congress enacted laws that required the government to produce economic growth policies that were aimed at high levels of employment.

A growing economy and high levels of employment became a necessary goal of any presidential candidate running for election (“Get the economy growing again,” and “It’s the economy, stupid!”) or for re-election.

And, what was the result?

Since 1960 through 2009 the United States economy has grown at an average annual compound rate of growth of around 3.2%. Economists in the 1960s calculated that full-employment growth in the economy was about 3.2% and so economic policy was targeting a potential for growth in the United States economy of 3.2%.

If, after 50 years, these economists were to look back they might be astounded that the economy grew roughly at what they presumed to be the rate at which the economy could potentially grow during that time period.

Yet, not all is well with the world.

These economists could argue that fiscal policy really worked. The gross federal debt grew at an average annual rate of more than 9% during this 50 year period. Fiscal policy must have worked?

Financial innovation in the United States government was astounding during this period. As Niall Ferguson has claimed in several of his history books that governments have always been the number one innovator in finance historically. The United States government certainly proved this to be true over the last 50 years.

Certainly, credit inflation was the name of the game during this time period as the private sector came to emulate the government sector in terms of creating financial innovation and financial leverage became the necessary means of competition for firms to gain an edge in financial performance.

On the way to the bank, however, certain other things happened…and these raise some serious questions.

During all of this time period, in the United States industrial sector, capacity utilization went from over 90% of capacity to about 75% of capacity. If growth was proceeding at 3.2% a year, how come our industrial base has been used less and less over this period?
Also, the big concern in terms of unemployment was that we reach and sustain a 4% unemployment rate. Yet the unemployment rate has progressively increased and the under-employment rate, hardly different from the unemployment rate in the 1960s, is now above 20%. Why hasn’t the economic stimulus put more people to work?

Housing, which used to be the backbone of the private sector is now primarily the realm of the federal government. Who owns most of the mortgages in the country?

In the 1960s there were over 14,000 commercial banks in the United States. Now, there are less than 8,000 and, in my view, we are going to 4,000 in the next several years.

We had a vibrant sector of thrift institutions in the 1960s. By the end of the 1980s the thrift industry was almost gone. By the end of 2011, the thrift industry will be gone. This was the result of sound fiscal policies?

Income inequality has risen dramatically over the last 50 years. We have found out that the wealthy or the financially savvy can protect themselves during times of inflation and credit inflation. The blue collar worker, the less financially sophisticated, the middle class cannot protect themselves nearly as well during times when hedging or speculation becomes the way to financial wealth. Weren’t the Keynesian policies supposed to help the less well off by keeping them employed?

The “piggy bank” that the middle class and finally the less-well-off were supposed to exploit and protect themselves against inflation and lead them into a better financial future eventually busted. Housing was the “piggy bank” that many were supposed to ride to retirement leisure. But, falling house prices and foreclosures are turning the dream of many into nightmares? Couldn’t credit inflation keep this ball in the air?

There are many other question going around right now. The concern is the validity of the economic model that has been the foundation of our economic policies over the past 50 years. It appears as if we got the economic growth. What happened to all the other benefits we were supposed to receive once we achieved this economic growth?

It's All About Leadership, Stupid!

I got on a Michael Douglas kick this weekend because his new flick “Wall Street: Money Never Sleeps” was coming out in the theaters. I, of course, took in Wall Street 1.0 again. Among the other Michael Douglas films I reprised, “The American President” caught my attention.

The particular line that got to me was one uttered by Michael J. Fox, who played a sort of George Stephanopoulos character to the President. The scene was set in the Oval Office of the President and the President and his chief advisors were discussing the direction that should be taken with respect to a crime bill. The conflict being addressed concerned whether or not the President should “play politics” and disappoint his friends, including his “girl friend” Annette Bening, or be true to his leanings and go for the environmental package.

He, at the time, chooses to “play politics”, and is taken to task for it by Michael Fox. The line that stuck with me was this:

“People want leadership and in the absence of leadership they’ll listen to anyone who comes to the microphone.”

This statement really resonated with me because I believe that is the situation we are in now in the United States. People want leadership, but they are not getting it.

Leadership starts with the CEO, the Chief Executive Officer.

There is no way others within or without the organization can exhibit leadership and set up the tone and the culture of the organization. But others try, especially opponents.

And, if the leader does not take charge, people will “listen to anyone who comes to the microphone.”

President Obama speaks. He is constantly speaking. Something small comes up and he goes out and makes a speech about it. Something large comes along and he goes out and makes a speech about it. The problem is that he is just speaking…not leading.

One of my firmest beliefs is that CEOs and their teams need to listen to the market and try and discern what the market is attempting to tell them. The “market” may be wrong, but, to me, the wisest action is to listen to the market and only claim that the market is wrong after a serious and thorough study attempting to support the fact that the market is correct.

What is the market saying right now?

Well, who is dominating the airways and printing presses these days? John Boehner. Christine O’Donnell. Stephen Colbert. Jon Stewart. Rush Limbaugh. Nancy Pelosi. Carl Rove. The Tea Party movement. The Party of “NO”. And, so on.

President Obama spoke at the United Nations this week…and it was just another of his many speeches. Who really listened to him?

President Obama is visiting homes trying to establish the “common touch.” Where is the leadership?

Obama is speaking a lot, but, people seem to be listening to other people who are grabbing the microphone. Conclusion: people do not feel that Obama is leading the nation.

A health care bill was passed on the watch of President Obama. But, the view of the voters is that Harry Reid and Nancy Pelosi and Congress did all of the work.

There is a new financial reform package the Chris Dodd and Barney Frank crafted. Where was Obama?

And, the earlier stimulus bill. The public perception was that the Obama administration turned this over to the Congress, fully supporting a bill that contained a lot of old programs that benefitted the interests of members in Congress. All Obama just praised the fact that a stimulus bill was passed.

The market perception seems to be that President Obama, himself, did not send up any bills to Congress in these areas; he turned the tasks over to Congress, urged them along, and accepted whatever Congress produced and sent to him.

The market does not see President Obama as “the” leader in any of these initiatives. His absence, then, has allowed the microphone to be dominated by others.

This lack of leadership has particularly been felt in the areas of economics and finance. No one seems to know where the administration is going or what the administration is going to do. What about another stimulus program? What about the Bush tax cuts? What about foreclosures? What about the big banks? What about the consumer protection agency? What about the insurance companies that are raising rates? What about the credit card companies that are raising fees? What about the Chinese currency? What about the government’s 61% ownership in General Motors? What about how GMAC pursued its foreclosure efforts? What about…you name it?

Talk about a free market!

If there is no leadership, then anarchy takes over.

There was the cry against big banks. But, the Obama administration (including the Fed) seems to be doing everything it can to help the big banks at the expense of the smaller ones. The administration talks about the United States being strong economically, yet its policies are just accelerating the re-positioning, economically, of China and Brazil, Russia and India, and other emerging nations. The administration talks about helping out the middle class and blue collar workers yet its policies promote the bifurcation of the work force, lessened capacity utilization in industry, and greater income inequality.

And, this is why people, other than the President, are dominating the microphone.

The Michael Douglas President finally did make a stand and began to tell the people where he really stood. The Michael Douglas President became a leader. Although this change came right at the end of the movie, it was the turning point of the movie. And, you knew what the President was going to do in the future, nothing more needed to be said in the movie. In taking this turn, the President began to dominate the discussion again.

Do you think this might happen in the real world? In the United States? Do you think it might happen in the near term?

Friday, September 24, 2010

The World Economy: A Time of Transition

It seems as if “Macro” forces are dominating movements in the financial markets these days. The latest call to attention of this fact is the article by Tom Lauricella and Gregory Zuckerman on the front page of the Wall Street Journal ( The “big” picture appears to be driving things and not the performance of individual investment opportunities.

Specific attention is given to a statistic called “correlation” which measures “the tendency of investments to move together in a consistent way.”

The article reports that in the 2000-2006 period the correlation of stocks in the Standard & Poor’s 500 Index was 27%, on average. However, during the events that led up to the Iraq war, correlations were near 60%. At the height of the financial crisis, October 2008 to February 2009, correlations were around 80%. They were around 80% during the sovereign debt dislocations in Europe earlier this year. In mid-August correlations dropped to 74% and now reside in the 65%-70% range.

When the prices of many or most stocks move together, individual stock picking is not the optimal investment strategy. This is why many investors have been moving to mutual funds that focus more on “macro” issues rather than on individual companies.

One of the most interesting statements in the article was this: “Prior to the financial crisis, such high correlation levels were seen previously only during the Great Depression, according to data compiled by market-strategy firm Empirical Research Partners.”

I pick up on this statement because of my belief that we are going through a tremendous period of transition. The world is changing. And, it is changing in ways that we don’t fully comprehend. As a consequence, individual “bets” are extremely risky, much more risky than “bets” that tend to aggregate outcomes.

The period of the Great Depression represented another period of major transition. During the Great Recession of the 2000s people were constantly referring back to the 1930s for “lessons learned” with respect to monetary and fiscal policies that could be applied to the current situation so as to avoid falling into as deep a hole as occurred at the earlier time.

However, the major lesson we may have to learn from the era of the Great Depression is that economies have to go through transition periods as they move from one kind of societal structure to another. In many ways, the American economy, and much of the rest of the developed world, still operated on an agricultural foundation in the 1920s. Yes, the industrial base was developing, labor unions were coming into existence, and cities were coming to dominate the rural areas but, in many ways, agriculture still dominated economic policy making.

The government in the United States supported and subsidized the agriculture sector in a way that was unsustainable relative to the emerging industrial cities. When this unsustainable effort collapsed, the economy fell apart and the 1930s through the 1940s saw America restructure from a rural society to one where prosperity resided in the cities and suburbs.

During this transition, it was not easy to pick out winning investments because no one really knew what the future was going to look like. Thus, the correlations of stock prices were high because success depended more upon how the whole economy re-structured and, consequently, how the whole economy recovered.

I believe that there are strong parallels in this respect between the current situation and that which existed in the 1930s.

Whereas America supported the farms and farmers in an earlier age because farming was “the American Way,” in the post-World War II period America supported owning a home in or near cities because it was believed that owning a home was, more or less, the right of all Americans.

Now, something else is happening. The industrial base in the United States is deteriorating, capacity utilization is around 75%, underemployment of individuals of working age is around 25%, and income inequality has become quite large. Labor unions are becoming like the dinosaurs, their species is dying. Center cities do not seem to be the wave of the future as they once were seen. And, home ownership for everyone may not fit into the future of society.

The United States government supported and subsidized the housing industry for fifty years, putting GIs into homes after World War II, financing the suburbs, rehabbing the cities, and so forth. Well, the bubble burst, just like it did for the agricultural sector.

What’s next?

That’s the interesting thing about transitions…you never know exactly where they are going to end up.

There are lots of changes taking place. Before the 1930s, the Industrial Age began: the late 19th century was just the spectacular beginning although agricultural still dominated the scene. The late 20th century saw the beginnings of an Information Age even as the cities and industrial concerns remained in the headlines.

What will an Information Age look like? That is still up to the science fiction writers.

What I am sure of is that information will continue to spread and cause changes worldwide that we cannot even imagine at this point in time. Information markets are going to become ubiquitous and innovation with respect to “Information Goods” is going to extend far beyond the field of finance.

But, there are other changes taking place that are going to “rock” the world. One of these is the political makeup of the world. There is the rise of China and the other BRIC nations. Power collected in the G-7 has been transferred to the G-20. The IMF is changing and will have to change a lot more, moving from European and American dominance to include greater roles for South America and Africa. These changes are going to have massive impacts on the way things are going to get done.

Furthermore, the emerging markets seem to be the place to invest these days. The economies of the United States and western Europe are the sluggards as they go through their needed transitions. These emerging nations are now dealing with one another because the allocation of commodities in the world is crucial for the continued progress of these areas. All these movements are “macro” in nature.

As the transition takes place, the “old” is not going to work in the way it used to. Stock investing will be different, at least for a while. The “old” political philosophies are not going to be very effective as we are finding out in the United States and in western Europe. But, this is a part of the whole process. We must adjust and find out what works and what doesn’t work.

Those that try to force things back into the “old” boxes are not going to survive!

Wednesday, September 22, 2010

The Long View of China

“Spend enough time with Chinese officials and economists, and you will hear a story about the Japanese yen in the 1980s.” So writes David Leonhardt in “The Long View of China’s Currency” (

A few years ago, I heard something similar, only it went like this, “Spend enough time with Chinese officials and economists and you will hear a story about Russia opening up its economy and suffering large bouts of social chaos.” Here the fear on the part of the Chinese was that opening the economy up too quickly could bring on social unrest similar to that observed in Russia, when Russia began to open up its economy.

One of the best insights given to me has been the one a friend of mine gave about the future of China. He said, “The Chinese believes that they need to move in the direction of a more capitalistic society. They also believe that moving too quickly in this direction could result in societal disruption that could derail their efforts. Furthermore, the Chinese think in decades whereas Americans think within a two- to four-year horizon. Consequently, Americans will become very impatient with what the Chinese are doing.”

Just a side note: Martin Wolf, in explaining how China is achieving its remarkable growth, makes the statement that, China “is, in a sense, the most ‘capitalist’ economy ever.” This is because it is putting so much emphasis upon investment to achieve a 8-10 percent a year growth rate. However, this is a pretty dramatic generalization. (See Wolf’s column, “How china must change if it is to sustain its ascent,”

Leonhardt makes two important points I would like to give my on. First, he writes that China and the United States aren’t the only two countries in the world producing products. But, “The entire value of the product counts toward the trade deficit between the United States and China.”

China is making itself felt in many, many parts of the world. Again, we see the article this morning, “Chinese Business Gains Foothold in Eastern Europe,” ( And, we are constantly hearing about the initiatives of China in South America, and Africa, and the Middle East. And, this doesn’t fully capture the advances of the Chinese Sovereign Wealth Fund that is even buying physical assets in the United States.

China has a long term plan to obtain supply sources and build influence throughout the world. They are doing this quietly, peacefully, and continuously.

The United States is mired in the current value of the renminbi and the current trade deficit. In the meantime, the strength of the United States economy continues to slide. There have been numerous assessments recently about where the United States stands in the world economy and they have not been very favorable to the relative strength of America’s economic performance.

One of the standard arguments for a rise in the value of a nation’s currency, or, a decline in the value of a nation’s currency is that such movement will correct trade imbalances. This is only true if the relative quality of the goods produced by the countries remains the same.
The international investment community has been especially concerned about the performance of the United States economy and the economic philosophy of the United States government since the 1980s. This concern has been reflected in the continued secular weakness of the United States dollar (see my post “The Dollar and the Fed,”

The decline in the value of the United States dollar will not automatically correct America’s trade balance problems. The problems go much deeper.

And, this gets me to Leonhardt’s second point: we should not “view the exchange rate as a cure-all” because “economies, like battleships tend to turn slowly.”

China will continue to maintain a long-term view of where it is going. The United States will continue to focus on the short-term. As a consequence, the specifics of United States policy will vary this way and then it will vary that way, attempting to maintain high levels of economic growth and high levels of employment. The thing we have learned over the past fifty years is that such a short-run focus eventually fails to achieve either higher levels of economic growth or high levels of employment. Such policies have led to one out of every four individuals of employment age being under-employed, the capacity utilization of American industry hovering under 80%, and continued growth in income inequality.

Business is in a “funk” right now concerning the future. Uncertainty about future economic policy is high. Few people place much confidence in where the Obama administration is going policy-wise and even more people have much confidence that the Federal Reserve knows what it is doing.

The Chinese have taken the road to economic power that Germany, Japan, and the United States have taken in the past. This path relies upon becoming an exporter and reaping the advancements that come from successfully becoming an important part of world trade. Now comes the hard part, building up “a thriving domestic economy. Leonhardt argues that China is now moving slowly to achieve this.

My belief is that the Chinese will continue to travel along this path. Some of the bumps along the road, however, are going to come from sources like the United States that have created their own problems and now want others, like the Chinese, to bail them out from the weaknesses they have created for themselves. This situation will not change until the United States stops pointing fingers at others and takes a very hard look at itself.

Tuesday, September 21, 2010

The Dollar and the Fed

The foreign exchange markets seem to have some of the same concerns about United States monetary policy that I do. See my “Oh, No! The Fed Has More Ideas for the Economy”,

Yesterday the value of the United States dollar in foreign exchange markets fell. According to the Wall Street Journal, “The dollar fell against most rivals Monday as worries about a new round of economic stimulus prompted investors to adopt a defensive stance ahead of Tuesday’s meeting of the Federal Reserve.” (

The value of the dollar has been trending downward since early 2002 as the fiscal deficits in the United States piled up and the Federal Reserve kept interest rates down around one percent for an extended period of time. There was a respite from this trend as investors “flew to quality” during the financial collapse of September and October of 2008. As the environment calmed in the middle of 2009, the trend downward began again. In late 2009, investors once again came to the dollar as the situation in European bond markets deteriorated. This last “flight to quality” ended in early June 2010.

It is ironic that the basic “bet” in foreign exchange markets is against the dollar, yet in times of financial crisis investors flock to the dollar because of its “quality”.

Yet, once more we are facing a falling value of the United States dollar.

As readers of this blog know my “bet” is for the value of the dollar to continue to trend downwards. The reason for this is the fiscal and monetary disarray of the United States government. Fiscal deficits continue to rise in the United States. The last fiscal year produced a deficit of about $1.4 trillion. The latest estimates for this fiscal year is another deficit of about $1.4 trillion. My guess is that the cumulative fiscal deficits of the United States government over the next ten years or so runs around $15.0 trillion.

As for monetary policy we have a Federal Reserve that has pumped over $1.0 trillion of excess reserves into the banking system. Financial markets seem to be holding their breath waiting to see what the Fed will come up with next. Within the Fed there is concern over the strength of the recovery; there is fear of deflation; and there is an unspoken fear about the solvency of the banking system.

The consequence of all this is that market participants are concerned that the Fed might throwing “stuff” against the wall once again to see what sticks! Except for the time that Bill Miller (remember him) was the Chairman of the Board of Governors of the Federal Reserve System, I have never seen confidence in the leadership of the Fed at such a low point.

The current leader of the Fed was all in favor of the extraordinarily low interest rates in the 2002-2003 period. He totally missed the economic collapse because of his concern that inflation was the major issue in 2007 and 2008. Then once the financial collapse was upon us in the fall of 2008 he threw everything thing he had against the wall to see what would stick. He was hailed as a savior because the economy did not go into another Great Depression. Yet, now “helicopter Ben” seems to be wandering around in the dark once more.

The foreign exchange markets seem to be responding to this mis-management and uncertainty.
As mentioned, the last move into the dollar came in early June. The Wall Street Journal dollar index peaked on June 7, 2010 as did the Federal Reserve’s Trade Weighted Index of the dollar against major trading partners.

These measures dropped into early August when there was a slight rebound until…. Well, until Chairman Ben gave his talk at the Federal Reserve’s conference at Jackson Hole, Wyoming.

Guess what? Chairman Ben said that the Fed was considering how it could continue “quantitative easing” using funds running off from the Fed’s portfolio of mortgage-backed securities to buy more United States Treasury issues.

The value of the dollar reached it’s near term peak on Friday, August 24 in both the Wall Street Journal index and the Federal Reserve index. Monday, August 27, Chairman Ben spoke. The value of the dollar has declined in both of these indexes ever since.

And, foreign exchange markets are now showing concern over what might come out of the meeting of the Fed’s Open Market Committee meeting today.

The United States government doesn’t seem to get it. Although investors will flock to the dollar when there is an international financial crisis, the basic trend in the value of the dollar is downwards. This has basically been the case since the United States went off the gold standard in August 1971, with two relatively short interruptions. And, it has declined in both Republican and Democratic administrations.

The basic trend in the value of the dollar is downward because the international financial community finds the fundamental economic philosophy of the United States flawed. I happen to believe that the international financial community is correct. For some of my reasoning on this, I refer again to my post from yesterday.

Monday, September 20, 2010

Oh, No, the Fed is Expected to Discuss More Ways to Revive the Economy!

The New York Times contains the headlines, “Fed is Expected to Discuss More Ways to Revive Economy.” (See The Fed is mulling over ideas about how it can provide more stimulus to the economy to get more “oomph” into the economic recovery.

Chairman Ben, at the Fed’s conference held in Jackson Hole, Wyoming in August, said that the Fed was prepared to “take additional action” to protect the economy from falling into a period of deflation.

My question is “why do we need more Fed stimulus”?

Let me talk about the long term. I know, Americans don’t like to talk about the long term. And, we have an election in six weeks and Americans are in the middle of a debate about tax cuts and spending plans and arguments about how we can get the economy going again. After all, Americans want something done within two years or less! (See my post “What Should the Fed do next,”

Let’s talk about the longer term anyway.

Since, 1960 Real Gross Domestic Product has grown in the United States at a compound rate of growth of 3.14% through 2009. (It grew at a 3.34% compound rate through 2007, the peak of the most recent cycle.)

This compound rate of growth is consistent with what economists have felt that the economy could grow at over the longer term. In the 1960s, the expected long term rate of growth of the economy was put at 3.20%.

My question is, could the economy have grown any faster over this time period? If you would have told an economist in the 1960s that the economy would grow at a compound rate of growth of about 3.2% over the next fifty years, would he or she have taken that growth rate and “put it in the bank”?

Could it be, unless a government creates hyperinflation or serious deflation, that governmental economic policies have very little effect over long term economic growth although it can have significant impacts on underemployment, the utilization of physical capital, and income distribution?

Yet during this time period the politicians (and many economists) have continually put pressure on the government to push for greater economic growth, first cyclically, but then also in a secular way. And yet, decade after decade the compound growth rate of the economy has remained, roughly, in the 3.2% range.

The continued pressure to “goose up economic growth” through fiscal stimulus has resulted in a continued rise in the gross federal debt of the government. The compound rate of growth of the federal debt is just under 8.0% for the 1960-2009 period of time.

This pressure on the economy has resulted in a secular climb in prices over this same period of time of slightly more than 4.0%. As I have argued before, this was a perfect environment for financial innovation and massive debt-leveraging, exactly what we saw.

This economic environment resulted in businesses, state and local governments, and families accumulating excessive amounts of debt.

This fiscal pressure to keep unemployment low kept many businesses in the same “legacy” physical plant and equipment being utilized so that the businesses could put workers back-to-work in their old jobs. As a consequence, the capacity utilization of industry continued to fall from peak-to-peak throughout the last fifty years. Maybe, just maybe, some of this physical capital should have been allowed to leave the scene.

And, in terms of labor, since the government tried to keep unemployment low by forcing the economy to hire people back into their old jobs, maybe, just maybe, a class of people became less employable in the general economy. Under-employment grew constantly over the past fifty years and now about one out of every four people of working age are either unemployed or underemployed.

Furthermore, recent research indicates there has been a serious skewing of the income distribution in the United States. Maybe, just maybe, continuous efforts to stimulate the economy through the government's fiscal policies to keep unemployment low among those that are less educated or are blue-collar workers and keep them in their "legacy" jobs puts these people at a significant disadvantage in the modern economy. If this happens then the income distribution in the economy can become more and more unbalances over time.

Maybe, just maybe, the American economy needs to re-adjust, to get itself up-to-speed in the modern world. It seems as if every week, someone else is measuring that the United States as less-and-less competitive relative to other up-and-coming nations. Could it be that the economic policies of the government created this environment?

Maybe, just maybe, American businesses and families and state and local governments need to
reduce their debt load.

Maybe, just maybe, American businesses need to modernize and up-grade their physical capital.

Maybe, just maybe, some in the American workforce need time to become employable again. (However, because of the above, some workers may never be employable again:

Forcing stimulus on the United States economy can stale the economy from restructuring and may keep people and businesses and governments from making the incremental changes they need to make in order to stay current. And, incremental adjustments are not so hurtful, so costly, and so time-consuming, as the discrete jumps in the economy that come about after things have been “forced” to stay as they were for such a long time.

Maybe, just maybe, the Fed needs to allow events to progress in a natural way. The Fed has provided the banking system with $1.0 trillion in excess reserves. The FDIC is working out “problem banks” in an orderly fashion. (Another six banks were closed last Friday helping to maintain an average of 3.4 bank closing per week this year.) It is expected that bank closings will continue at a very rapid pace well into 2011. Maybe, just maybe, this is all the economy needs at this time.

More action on the part of the Fed may only create even more problems in the future. Maybe, just maybe, the Fed needs to avoid any sign of panic at this time.

Friday, September 17, 2010

The New World Order: Smaller and Faster--Part II

Readers of this blog have confessed concern over my focus on computers that are faster and faster ( and the blue-sky idea of quantum computers. I stand by this interest.

I focus on these developments because finance and the future of banking are going to be significantly impacted by faster computers, their greater capacity to store data, and to the ubiquitous presence of these things in our lives.

So we read: “A new photonic chip that works on light rather than electricity has been built by an international research team, paving the way for the production of ultra-fast quantum computers with capabilities far beyond today’s devices.” (See “Computers Set for Quantum Leap” in the Financial Times: The technical results of this research are being published today in the journal Science.

Many people in the field felt that it might be 25 years before we saw a functional quantum computer.

“We can say with real confidence that using our new technique, a quantum computer could, within five years, be performing calculations that are outside the capabilities of conventional computers,” claims Jeremy O’Brien, director of the England’s Centre for Quantum Photonics, who led the project.

Quantum computers are going to happen. Governments cannot afford to miss out being a part of the quantum revolution in computers. Governments must have quantum computers to keep secrets. Governments must also have quantum computers for defense purposes…a country like the United States cannot afford to be second in this field.

Therefore, “Hundreds of millions of dollars” are being spent “in the field.”

Why is this so important in finance?

Finance is information!

To see that this is so take a look at the book “The Quants” (I reviewed this earlier for Seeking Alpha: In this book we see how closely the fields of quantitative finance and financial engineering have always been to information science and information theory. For example (I quote from my book review):

“It is interesting to me that the beginning of the story Patterson (the author of ‘The Quants’) tells is how math/physics whiz Ed Thorp, the Godfather of the Quants, started out on the path to ‘Quant-dom.’ Thorp, as a new member of the MIT staff, took some of his early work on how to predict outcomes of roulette wheels to a well-known member of the MIT faculty named Claude Shannon.

Shannon is known as one of the founding fathers of Information Theory, a theory that has to do with the transmittal of information and the ability to receive and discern the message conveyed in the information transmitted.”

Furthermore, “Now let me fast forward to the quant fund group known as Renaissance Technologies and its star fund Medallion. This whole group was created by Jim Simons and it is ‘the most successful hedge fund in history.’

What kind of team did Simons pull together to staff his funds? Cryptographers and people trained in speech recognition; in essence, people trained in Information Theory. They were trained to detect hidden messages in seemingly random strings of code.”

The development of computer technology and data storage in the 1950s resulted in the massive change that took place in the field of finance in the 1960s. Given the availability and greater accessibility of data related to the stock market, researchers on university campuses produced dissertation after dissertation on performance in the stock market.,

The field of finance has never been the same.

The power of quantum computers is hard to imagine. These computers will be able to make calculations that are only dreamed about in “far out” science fiction novels. These computers will be able to access data bases containing information from almost unlimited sources. The possibilities are mind-boggling.

Will these computers be used in finance?

If there is a chance to “make-a-buck” or several billion bucks, they will be used. Finance is always looking for an edge. Faster and more powerful computers are always a potential source for finding an edge.

But, back to one of my fundamental predictions: finance and financial institutions over the next five to ten years will be something substantially different from what we know now. What happened to finance and financial institutions over the past fifty years is only a prelude to what is going to take place.

Regulation on the Move: the Swaps Market

Glimpses of the regulatory process are starting to hit the news. Gary Gensler, Chairman of the Commodity Futures Trading Commission offered some insight into the process as he spoke of the evolving discussions surrounding the swaps market.

It is estimated that the swap market has over $600 trillion in contracts outstanding. (The Gross Domestic Product of the United States, in current dollars, is a little less than $15 trillion.) There are now 16 regulated futures exchanges that could handle swap transactions. Gensler expects that there may be 20 to 30 more organizations that will register as Swap-execution facilities (SEFs), organizations that would match buyers and sellers and provide more transparent pricing and information to the world.

One of the known unknowns about the swaps market is the volume of trades that will take place. Currently, swaps are created privately and are traded privately. The trading volume is not very substantial given the dollar-volume of the swaps market.

The chief executive of the International Swaps and Derivatives Association (ISDA) states that fewer than 2,000 standardized swaps, on average, are traded daily. The most active, the 10-year dollar swaps, only trade about 200 times a day.

One might expect that as this market develops and more transparency and openness come to the market that volumes will increase. This is the experience of other derivative markets as they have moved to more formal and standardized formats.

Gensler guesses that maybe up to 200 organizations may want to become “swap dealers.” These organizations would have to “register” under the new setup and meet regulatory qualifications for being classified as such.

Of interest is the fact that of these 200 or so organizations that might move in this direction about 75 banks could be considered to be swap dealers. This total, Gensler stated, consists of 25 global banks, 25 non-US banks that do some trading in the United States, and a further 25 US banks that are not global in scope.

“The rules could require these 75 banks to set up separate entities, with their own capital, that would be registered to trade derivatives including commodity, equity, and some credit default swaps.” (See

The new rules and regulations are supposed to be in place by July 2011. Gensler told CNBC that he has enough staff to develop the rules. The problem is that he will need at least 400 more employees to enforce them. (See

It is very, very difficult to write new rules and regulations for financial markets that were previously just “over-the-counter” markets. Even going back historically to the “standardization” of relatively simple instruments, like interest rate futures and so forth, shows how difficult it is to capture all the nuances and quirks that relate to a specific type.

The new standardized, formal markets will be forthcoming. They will be heavily used and trading volume will increase substantially as information becomes more public.

Perhaps the ultimate, bottom line conclusion to the developments described above is that the swap market will grow and prosper, including the sector relating to credit default swaps. The hysteria connected with the financial crisis has subsided and financial innovation continues on. The populist outcry against the greedy bastards that developed the derivatives industry is fading into the shadows.

So, financial innovation is alive and well. It is impossible to know what form it will take next.

Thursday, September 16, 2010

"Astonishing" Pricing Anomalies

I believe the article “Hedge Funds Reap Rewards from Treasuries” in the Financial Times is a good read for people interested in the financial markets. (See

The authors, Sam Jones and Izabella Kaminska, start right out talking about “Classic relative value arbitrage” the investment strategy which “involves betting that price discrepancies between securities that normally trade at similar values should correct over time.” The implosion of Long-Term Capital Management brought this strategy to public notice.

Hedge funds have been making a “pretty penny” recently by taking positions based upon this strategy. The reason why a strategy like this has been working is that there are “astonishing” pricing anomalies being observed in the financial markets ever since the collapse of Lehman Brothers in September 2008.

Why have these anomalies occurred?

Thank you Mr. Bernanke and the Federal Reserve System!

“Instruments that should normally track each other almost perfectly saw their prices diverge sharply as investors panicked and central banks, including the US Federal Reserve distorted bond demand by buying up huge amounts of debt as part of the emergency efforts to pump more money into the economy.”

“Thanks to continued distortions in bond supply and demand, as well as jittery investors and political intervention, funds…have been able to exploit a rich seam of arbitrage opportunities.”

These opportunities have been “less risky” than might have been expected because the promise Mr. Bernanke and the Federal Reserve have made that their interest rate policy will continue for “an extended period.” So far, that period has lasted for twenty-one months and most expect it to remain in place into next spring…at least.

I have been arguing for months now that the interest rate policy of the Federal Reserve has been accounting for the profit recovery of the biggest banks in the United States. This interest rate policy has been subsidizing the big banks and has been producing a counterpoint within the government to the attack on those banks that are considered “too big to fail.” The Fed’s policy has been underwriting the process in which the big banks will get bigger and control more and more of the assets in the banking system as a whole.

The material being reported by Jones and Kaminska is the first piece of information outside of the commercial banking industry of how the Federal Reserve (and other central banks) have been underwriting the success of participants in other areas of the capital market.

“If 2009 was an excellent year, then 2010 is still a very good year. The opportunities are huge in some cases,” says Bob Treue, founder of the hedge fund Barnegat.

My best guess is that we will be seeing more evidence pointing to exceptional returns being made on the financial market distortions created by the Federal Reserve. One can also surmise that many, many other representatives of the wealthy are making huge gains on these market situations and we will never know about them because they will not have to be reported.

I am not against people making money. Actually, I am very much in favor of this result.

What I am concerned about is that the money that is being made on these arbitrage transactions is a part of explicit government policy and that the consequences of this explicit government policy contradicts almost all of what the Obama administration is saying it is trying to achieve!

The only justification that I can give for why the government is engaged in this contradictory behavior is that it knows something we don’t and that something it knows would be tremendously scary to us if we knew it.

Tuesday, September 14, 2010

Basel III (Chuckle)

I guess I should say something about the new Basel III regulations.

I will present three “facts” that, I believe, says it all.

These three facts are as follows: 2019; financial markets rose when the news of the agreement was announced; and the agreement was more liberal than feared because a more restrictive agreement was opposed by the German government and the German banks.

First, the new capital requirements do not have to be fully met until 2019. There are some liquidity requirements that must be met by 2015, but this is still five years out.

By 2019, let alone 2015, the world banking structure will be entirely different than it is currently. The world of financial institutions is changing so rapidly due to the advancement of technology and the globalization of finance that over the next five years or so the way finance is conducted will be hardly knowable in today’s terms. I have written many times in the past year about how the United States banks have “gone beyond” the thinking of government legislators and regulators in terms of the creation of the Dodd-Frank financial reform act.

There is no way you can write successful banking regulations that attempt to prevent the recurrence of a past financial crisis. To require something to be done but then give these institutions nine years to conform…is a joke.

Second, financial markets responded positively to the news of the Basel agreements. To me, investors are saying, “Whew! The people writing the Basel rules didn’t do anything really stupid!”

Third, Germany rules the roost. How important is it for a nation to have a strong economy and its finances more under control than the other countries it is dealing with?

Very important! (Are you listening America?)

Especially in a time of economic and financial uncertainty, the player with the strong economy and the stronger financial position holds most of the cards. In order for a community to reach an agreement and have any hopes that the agreement will be implemented, the stronger nation must continue to participate in the community. Thus, concessions must be made.

One can interpret the announcement of the Basel III agreement in this way: the European community is still together but in reaching agreement it is apparent that Germany has the veto power. Germany will continue to have this power going forward until other nations get their economies and their finances in order.

Banks in Europe and in the United States were concerned about what would come out of the recent regulation writing sessions. They, of course, lobbied for less restriction and greater flexibility. The banks did want to have some influence on the outcome. The rules and regulations coming out of the negotiations could have been a lot more inconvenient for the banks.
Still, the large banks will continue on their way. Rules and regulations will always lag behind what the modern commercial bank and commercial banking industry can do, and does. I believe, that banking and finance will change more in the next five years or so than it has in the last thirty. Try and regulate that!

Monday, September 13, 2010

Still No Life in Banking

Over the last two months I have been hoping that the smaller banks in the United States were starting to lend a little bit again. I was even looking for “Green Shoots”. (See

My latest review of the commercial banking data released by the Federal Reserve gives little indication that things are picking up through August. Total assets at the smaller domestically chartered banks in the United States (defined as all domestically chartered commercial banks except the largest 25) grew by a little over $11 billion in the last five weeks. However, the cash assets of these banks rose by slightly more than $8 billion of this total. Only about $1 billion went into bank loans.

The total assets at the 25 largest domestically chartered commercial banks fell by about $26 billion during this time period, but the cash assets held by these banks dropped by even more. Cash assets fell by about $41 billion. What asset class rose? The securities held by these banks rose by almost $23 billion.

At these large banks, Treasury and Agency securities increased by about $210 billion over the last year. These banks can acquire funds at interest rates approaching zero percent and purchase securities with no credit risk and earn several hundred basis points spread on the transaction. And, there is little or no interest rate risk because the Federal Reserve has stated that it will keep short term interest rates extremely low for “an extended time.”

One can see this arbitrage situation setting up over the last year as these large commercial banks have changed the way they have financed their assets relying on less expensive sources of funds and substituting cheaper and cheaper liabilities.

No wonder the large commercial banks have been producing a lot of profits while at the same time building up their loan loss reserves!

Why should commercial banks lend when they have a riskless way to make money?

Business loans? Commercial and Industrial loans are down by more than 12% at all banks, from August 2009 through August 2010. At large commercial banks, however, C&I loans are down by even more, dropping at a 14%, year-over-year rate. In just the last 13 weeks, these loans are down by almost $12 billion which is about one-tenth of all the business loan portfolio in the banking system.

Commercial real estate loans are down by more than $140 billion. Of this drop more than half of the decline was registered at the smaller commercial banks. Of course, this is where people are expecting a lot more trouble over the next twelve months or so.

Surveys have indicated that banks are easing up on lending terms. Well, that may be true, but this is still not resulting in any jump in commercial bank lending.

We are told that businesses and consumers are reluctant to borrow. I believe that this is true. There are two reasons for this. First, many businesses, families, and individuals are still reducing the debt load they had built up over the last decade or more. With the economy so weak, it still represents a substantial risk to go further in debt given the uncertainty about future prospects.

In addition, many of the companies that are better off are accumulating large amounts of cash balances. The play here, I feel, is that mergers and acquisitions will pick up over the next year or so. Analysts are still shaking their heads about all the activity that took place on this front in August. My guess is that companies believe that they can achieve better market share and even have a chance to gain sustainable competitive advantages in their markets by building scale through acquisition of financially “weak” companies as opposed to attempting to expand on their own at this time. Keep the cash so that you can move as quickly as possible when the time is right.

Bottom line: it seems as if very few banks want to extend money to businesses at this time; and very few institutions (except for the federal government) want to put on a lot more debt at this time.

There will be no recovery of any strength without a pickup in commercial bank lending. I have written about this earlier: This is one reason why I am skeptical of the spending and tax-cutting proposals presented by President Obama last week. The economy is in a position where debt positions, both in the financial and non-financial industries have to be worked out and this will take time.

I continue to believe that the Federal Reserve will continue to keep short term interest rates at or near their very low current levels until the commercial banking industry stabilizes. The Fed and the FDIC are doing a good job in helping the smaller banks work through their problems. Still, there are a sizeable number of the smaller banks that are still in serious trouble and asset values are still the problem. As mentioned above, there are anticipated difficulties ahead in the commercial real estate area and some investment portfolios are still substantially under-water.

With all these difficulties, why should these smaller banks, in aggregate be expanding their loan portfolios? The main thrust in the commercial banking sector over the next twelve to eighteen months is still survival and consolidation.

My prediction still remains: over the next five years or so the largest 25 domestically chartered banks in the United States will come to control about 75% of banking assets in America, up from about 67% at the present time.

Friday, September 10, 2010

It's a High Frequency World

Gillian Tett raises some interesting questions in her Financial Times article today: “What can be done to slow high-frequency trading?” (

She closes her piece with the most important economic question that can be asked: “To my mind, the real question which needs to be discussed—but which regulators are still ducking—is why ultra-fast trading is needed at all?”

The answer: people believe that they can make money if they have a slight edge in the speed at which they can make trades.

I don’t think that this answer is changed by going into the debate relating to the neurological research which argues that “the brain has two contradictory instincts: part of it is hard-wired to chase instant gratification; however, another part of our brain also has the ability to be ‘patient’, and delay immediate gratification for future gains.”

This is just the argument raised by the behavioral finance and economics researchers. (See my review of the book “Snap Judgment” for a discussion of this issue: The general assumption that accompanies this train of thought is that “instinctional” behavior is irrational and therefore not productive.

To quote from Tett’s article, “in practice innovation…has a darker, impatient side too: as markets have become deeper, and more liquid, that has enabled trading to become more frenetic; similarly, as information has become more frequently available this has encouraged skittish, herd behavior.”

But, life is full of situations in which “instinct” or the ability to make quick decisions is of crucial importance. For example, we need military leaders that can make decisions “on-the-spot” as well as those that can plan out strategies for long, drawn-out battles. The military trains people over-and-over again to develop the perception and experience to make decisions in the “real time” that is necessary for winning battles and winning wars.

We can find examples in many fields where “immediate” action is needed. The education and training in these areas is intense and efforts are made to find the people that are the very best in their ability to diagnose a situation and come up with the “right decision” as often as possible.

The real difference is the capability of the person or persons making the decisions. In the military, in medicine, and in many other professions, there is a hierarchy in terms of who makes the decision. Hopefully, the people that rise to the top are those individuals that can perform well and are able to make good “snap” decisions if they are needed.

Sometimes there is licensing or other forms of identification that require test taking and hurdles to overcome in order to get the certification or advancement that will put the “right people” in the “right spot” for a specific type of “real time” decision.

In economics, these tests or hurdles are called “barriers to entry”.

In the trading of stocks and other investment vehicles, there are low barriers to entry into the industry and this includes the costs one must pay to enter an industry. As a consequence, there are many traders and not all of these have the “jet pilot” capabilities to execute trades at the speeds that are now available.

The crucial thing is that in areas where quick decisions need to be made, a premium is paid to those with the education and training, the experience, and the mental capacity to make such decisions. As I stated in the post cited above, successful decision making, over any time period, depends upon “cold analytical methodology and steely discipline, characteristics that most people, who rely too much on their instincts, don’t possess.” That is, some people are better decision makers than others, even in the very short run.

People are going to engage in an activity where they believe that they can make money. So high-frequency trading is going to take place. Individuals that cannot perform within such an environment are going to lose, and could lose a lot.

The concern of the other market participants is “what damage can these not-so-good traders do to the overall market?” As Ms. Tett states, one result of the move to high-frequency trading seems to be “more market volatility.”

The fear in this: “rising levels of speed, impatience—and short-terminism—might have actually made the (financial) system less efficient, and rational, than before” this increase in speed.

My feeling with this is that speed is something we are going to have to live with. I have argued this point before in my post “Banking at the Speed of Light”. ( The point is that this “speed up” is happening all over the world in different kinds of decision making. It is just that high-frequency trading is getting a lot of publicity now and thus attracting a lot of debate.

In the post just mentioned, I cite the example of events happening in South Africa relating to the use of mobile phones by commercial banks to develop their customer base. In this example the discussion was around the 15 million adult South Africans that had previously been excluded from the financial system. And, the players in this effort are not small.

But, this points to another issue, the growing strength of the “new rising powers” in the world as discussed in an opinion piece in the Financial Times titled “The new disintegration of finance.” (See The authors, Stéphane Rottier and Nicolas Véron, are concerned about how the effort to organize and co-ordinate global financial regulation and supervision is facing issues that might reverse the trend to great co-operation. One of their concerns is that “Financial institutions from emerging countries are beginning to overtake their western peers. New financial centers are gaining market share, while emerging countries are asserting themselves in global financial rulemaking, and increasingly resist standards proposed by the member of the old north Atlantic consensus.”

This is the world of the future. This is how competition is going to progress. See “The New World Order: Smaller and Faster”, my post of August 31, 2010 ( I think most of you know how I feel about the ability of regulations to control this world. I think most of you know that I believe that many, if not most, of the big players have already moved beyond what American…and world…regulators are trying to do with respect to financial institutions and markets. Laws, regulations, and regulators must deal with processes and not “outcomes.” I have written about this many times in my posts.

Hold on, it is going to be an interesting and exciting ride!

Thursday, September 9, 2010

What Should the Fed (and the Federal Government) Do Next?

This morning there is a series of articles in the opinion section of the Wall Street Journal titled “What Should the Federal Reserve Do Next?”. It consists of several short pieces written by well known economists. I recommend that you read them.

I would especially recommend the opinion piece written by Allan Meltzer, a professor of economics at Carnegie Mellon University and the author of “A History of the Federal Reserve”. The following quote is, I believe, especially important for the monetary policy of the Federal Reserve…and for the fiscal policy of the federal government.

“In ‘A History of the Federal Reserve,’ I concluded that the principal mistakes the Fed has made have resulted from giving excessive attention to current events and forecasts of highly uncertain near-term developments. By focusing on the short-term, the Fed neglects the longer-term consequences of its actions. The transcripts of FOMC show that the members are paying little attention to medium- and longer-term consequences.” (

Unfortunately, we are in a short-term world. Everyone focuses on “current events and forecasts of highly uncertain near-term developments.” As a consequence, there is a tendency to over-react to situations and, in doing so, set the stage for further difficulties down-the-road.

The policy-cycle has gotten shorter and shorter. Richard Nixon believed that he lost the 1960 election to John Kennedy because the economy was not performing well. Thus, when Nixon became president he focused on making sure the economy would be expanding during the 1972 election. He froze wages and prices and took the United States off of gold in August 1971 because he believed it was necessary to contain the inflation begun in the Kennedy-Johnson years so that he, Nixon, could re-stimulate the economy so that he would be re-elected.

This four year cycle became the “thing” for Presidents. Slow down the economy immediately after getting elected so that the economy could be re-started in time to get re-elected.

In the 1992 election, “It’s the economy, stupid!” became the mantra of the Clinton campaign. And this approach appeared to be was in Clinton’s election.

But, then a funny thing happened: the cycle shortened. The mid-term elections became the thing. Whereas the Democrats controlled both houses of Congress when Clinton took office, the 1994 congressional elections turned the tide and resulted in the President facing a hostile legislature for the rest of his tenure. Focus was placed on mid-term elections as well as presidential elections.

Bush (43) experienced a similar turn-around in the 2006 election where the Democrats once-again established their control in Congress.

Now presidents must get re-elected, but also get “their” Congress re-elected.

Current economic policy making in the United States is on a very short string…not that it hasn’t been for a long time.

The problem this creates is that the economy is never allowed to fully adjust to the economic dislocations that appear over time. The efforts to re-stimulate the economy are over-whelmingly aimed at putting people back to work in the jobs and industries that existed before the previous recession. As a consequence, the economy never fully adjusts as it needs to.

Several things can happen. Human capital does not evolve as it should to meet the changes in technology taking place. The result is that unemployment rises, but even more important under employment rises. America now faces the problem that about one out of every four individuals of working age is either unemployed or underemployed. Income inequality is highest in sixty years.

The capacity utilization in the United States has dropped continuously since the 1960s and still rests substantially below the previous levels attained. It is expected that the near-term peak in this measure will be well below the previous peak. This, I contend, is a result of the government’s efforts to force resources back into “legacy” physical capital. (See my post

Another area of major concern is the debt burden taken on by individuals, businesses, and governments. In the past fifty years, the federal government has created deficits and excessive monetary growth to combat unemployment and income inequality and sustain as much economic growth as it could. This has been the perfect environment for people to take on more and more debt…and that is exactly what they have done.

However, history shows over and over again that debt levels can eventually reach heights that are unsustainable. And, when this happens, the debt loads have to be worked off. The relevant question is, have we reached that stage where people must de-leverage and work with lower debt levels? If this is the case, working off current debt loads will not be easy.

It takes time for economies to re-adjust and re-structure. Debt loads have to be worked down. Labor must be re-trained. Legacy capital must be replaced with physical capital more attuned to the age. And, continued monetary and fiscal pressure only delays such adjustment and makes American commerce less competitive. (See “U. S. Falls in Ranks of World Economy,”

Furthermore, the existing panic in United States policy making, both monetary and fiscal, is creating a world exactly the opposite of what policy makers seem to be attempting to achieve. For example, the Fed’s low interest rate policy is subsidizing the largest financial institutions and creating a world where more and more of the banking assets in America will be controlled by the largest banks. Currently, the largest 25 domestic commercial banks control 67% of the assets of the banking system. Analysts believe that this will go to 75% or 80% in the next five years.

In addition, the ranks of the middle class are dwindling. The low interest rate policy of the Fed has encouraged big companies, big banks, and the wealthy to borrow but these borrowers are just sitting on the cash waiting to engage in an acquisition binge once the economy starts to pick up steam. The middle class? Well, the middle class, those that have paid their bills, who have stay married and worked hard throughout their lives and have saved: this middle class is facing the fact that they will earn next to nothing on their savings. (See “Falling Rates Aid Debtors, but Hurt Savers,”

United States policy makers, in an attempt to stay in office, have advocated monetary and fiscal policies aimed at putting people back to work and making it easy for these people to buy “things”, especially houses. They continue to follow such “populist” policies in order to get re-elected and maintain their power. Both parties are guilty. (See my “Wall Street Greed vs. Washington Greed,”
The speech given recently by President Obama offering $350 billion in new economic stimulus, even though some of this is aimed at “longer term” projects, appears to be an example of just another politician experiencing the panic that comes with an upcoming election.

Wednesday, September 8, 2010

Watch the Currency, Stupid!

The value of a currency is “the single most important price in a nation’s economy.” So claims Paul Volcker.

If this is the case then the eurozone continues to have problems.

As information has filtered out that European banks may have more problems than originally thought given recent “stress tests”, the Euro has shown continued weakness, almost across the board.

“The euro suffered and haven demand sent the yen and the Swiss franc to record highs amid renewed concerns over the health of the eurozone financial system.

Analysts said nervousness was heightened by news from the German Banking Association, which said the country’s 10 biggest lenders might need another €105bn of additional capital. Hans Redeker, of BNP Paribas, said the outcome of the European bank stress tests were being put in doubt.

He added that there were increasing signs that countries on the periphery of the eurozone, such as Greece and Portugal, were showing a frightening decline of growth momentum with the risk that these economies were moving into a debt spiral.” (See

This news seemingly resulted in declines in the euro against the dollar (down 1.4%); against the pound (down 1.2%); against the yen (down 1.8%) and to a record low against the Swiss franc (down 1.6%).

With all the weakness the United States dollar has experienced in recent months against other major currencies, the value of the dollar has shown substantial strength against the euro since the problems in the eurozone were exposed earlier this year. The euro reached a near-term high against the dollar in early December 2009, but then fell about 21percent against the dollar into early June 2010 as European nations rallied to stem their joint fiscal crisis. The euro recovered some after a “combined solution” was reached, but its value has declined once again and still rests around 16 percent below the December high.

Furthermore, there still seem to be unknown unknowns surrounding some of the nations in the eurozone (see “EU Probes Hidden Greek Deals as 400% Yield Gap Shows Doubt”; and some of the banks (see “German banking weaknesses come to light”;

Financial markets don’t like surprises.

It appears as if there are still some surprises to surface within the eurozone.

These revelations will continue to apply pressure to the leaders in Europe. It is so hard to form a common union where people want to maintain all the privileges of independence (fiscal and otherwise) yet hope to produce a common good (greater economic strength and unity).

Like any marriage, the partners have to give up some of the things that they cherished as individuals. Furthermore, openness and transparency is a “must” for any such relationship. The road to “unity” may be quite bumpy at times, but the partners must work through these periods and establish common understandings and good habits.

In the case of nations, there is an information market in which people can “bet” on whether or not the marriage will succeed. This market is the foreign exchange market. Right now, the market value of the euro is declining, indicating that the investors are concerned about how the eurozone marriage is working out. This weakness in the euro will continue until the fear of surprises disappears.

Tuesday, September 7, 2010

Bank Honesty is the Best Policy: the European Case

If the history of banking tells me anything, it tells me that banks are only fooling themselves if they think that they can hide bad assets and then outlast the drag these bad assets put on their performance.

Headlines read,” Europe's Banks Stressed By Sovereign Debts Regulators Ducked” ( and “Europe’s Bank Stress Tests Minimized Debt Risk” (

What do these people think they are doing? Who do these people think they are fooling?

Covering up a bank’s position always comes back to haunt the bank.

Now, we hear that not only have the bank’s covered up their positions, but regulators and government officials have covered up the real position of the European banks.

“Europe’s governments can’t afford to question the quality of bonds they’ve sold to banks, says Chris Skinner, chief executive officer of Balatro Ltd., a financial industry advisory firm in London. “Bankers have got Europe’s governments in their pockets, primarily because politicians cannot change the way lenders do business without undermining confidence in sovereign debt,” he says.

The secret of getting out of a financial quagmire is to identify everything, recognize and accept your problems, and then do something about them.

To me, this is one of the reasons why the restructuring of the American banking system is proceeding as well as it is. I believe that the FDIC (and others) has identified most of the problems in the commercial banking industry, and they are substantial. But, they are generally known. The FDIC, along with the Federal Reserve, is working to resolve these banking problems in an orderly fashion. The FDIC is arranging mergers and is closing banks on a regular basis and the Federal Reserve is subsidizing the banking industry by keeping its target interest rate close to zero and by maintaining massive amounts of excess reserves in the banking system.

One does not see this happening in Europe. As a consequence, clouds still hang over the financial markets as, for example, yields on 10-year Greek bonds are around 11.25 percent relative to yield of about 2.25 percent on similar German bonds. This is true on other debt issued by Eurozone countries and this risk issue also shows up in the spreads on bank bonds.

There are more questions about “when” Greece is going to default on its bonds rather than “whether” it will default on its bonds.

Economic recoveries cannot really take place until the banking system of a country is sufficiently healthy. (See my post, “No Banking, No Recovery” on the situation in the United States:

But this problem seems to go deeper. This is from the Bloomberg article.

“While they’re stuck with their government bond holdings, Europe’s banks are also still carrying much of the troubled assets they had during the 2008 meltdown. Euro-zone lenders will have written down about 3 percent of their assets from the peak of the credit crisis by the end of 2010, compared with 7 percent for U.S. banks, the IMF estimated in April. The steeper writedowns by U.S. banks are partly because they held a higher proportion of securities, the IMF said.

That doesn’t excuse the lack of candor shown by many European lenders about the unsellable assets on their books, says Raghuram Rajan, a finance professor at the University of Chicago. “European banks haven’t owned up to the large amounts of toxic debt that they hold,” says Rajan, who was chief economist at the IMF from 2003 to 2007.

“The stress tests weren’t severe enough,” says Julian Chillingworth, who helps manage $21 billion at Rathbone Brothers Plc, an investment firm in London. “Many bond investors aren’t convinced the Greeks are out of the woods.” And if the Greeks haven’t emerged from their crisis yet, then neither have the European banks that hold their debt”.

If we are going to have banking systems that are stronger and less subject to systemic risk, bankers, regulators, and public officials must realize that good risk management includes openness and transparency. Bankers, historically, have been among the leaders in securing the “cover up” of bank positions and the quality of bank assets. They do not need the help of regulators and politicians to reinforce this tendency.

Monday, September 6, 2010

Federal Reserve Non-Exit Watch: Part 1

Last month I presented Part 13 of my exit watch of the Federal Reserve. In the summer of 2009, the Fed stated that it was going to remove reserves from the banking system to reverse the massive injection of reserves that took place in late 2008 and early 2009.

The Federal Reserve really did not “exit” over this 13 month period. In fact, bank reserves and excess reserves actually increased during that time period. From my post on
August 10, 2010 (see

“Here we are 13 months into the “exit watch” and there has been ‘no exit’ of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.”

Over the past month, the Federal Reserve has backed off from this policy of removing reserves from the banking system because of the concern over the fragile condition of the smaller banks in the United States and the failure of unemployment to fall. Chairman Bernanke has spoken about the need for the Federal Reserve System to focus on the economy while “the FOMC will do all that it can to ensure continuation of the economic recovery.” This is from the speech he gave at Jackson Hole, Wyoming on August 26 (see my post

Thus, the “Federal Reserve Exit Watch” becomes the “Federal Reserve Non-Exit Watch.”

There are two areas to focus on in this “Non-Exit Watch.” The first relates to all of the “innovations” the Federal Reserve created to bailout various financial institutions (like Bear Stearns and AIG that “blew up” the Fed’s balance sheet) and to engage in “liquidity swaps” with other central banks throughout the world. The plan is for these accounts to decline incrementally as assets are worked off or that the need for central bank liquidity swaps declines.

Over the last four weeks ending September 1, 2010, these Federal Reserve accounts that were created during the financial crisis have declined by $16.4 billion. Central bank liquidity swaps have fallen to almost zero and the other “crisis” portfolios the Fed maintains continue to run off. Still the Fed’s balance sheet maintains more than $150 billion in assets that are connected with the financial upheaval.

Over the past 13-week period these accounts have dropped by a little more than $22 billion. These accounts should continue to decline in the future, but the pace of decline will not be large.

The second area relates to the securities portfolio of the Fed. As a part of its support of financial markets, especially the mortgage market, the Federal Reserve bought substantial amounts of mortgage-backed securities and federal agency securities. A part of the “exit” strategy of the Fed was to let these securities “run off” as they matured thereby helping to reduce the excess reserves held by the commercial banking system.

It appears as if the “non-exit” plan is to replace the maturing mortgage-backed securities and federal agency securities with outright purchases of United States Treasury issues. In this way the Fed will keep funds in the banking system so as to encourage bank lending and economic growth but will reduce the role that it has played in specific sub-sectors of the financial markets.

It appears as if the Fed began this program within the past four-week period. Between August 4 and September 1, the volume of mortgage-backed securities at the Fed dropped off by $14.5 billion and the amount of federal agencies on the books of the Fed fell by $2.9 billion.

United States Treasury securities “held outright” by the Federal Reserve rose by $9.3 billion so that the volume of all securities held by the Fed dropped by only $8.1 billion. Note that this action was concentrated in the last four-week period for this behavior was not observed in the nine earlier weeks of the last 13-week period.

Overall, reserve balances with Federal Reserve banks fell by $27.2 billion over the last four-week period. Part of the drain from the Fed was the seasonal rise in both currency in circulation and bank needs for additional vault cash during the summer to handle the vacation pickup in the demand for currency. These movements result in an increase in factors absorbing reserve funds which reduces reserve balances at Federal Reserve banks. As a consequence, the excess reserves in the banking system remained relatively constant. There are always these “operational” factors occurring that the Fed must take account of in order to help the banking system function as smoothly as possible.

Given what Bernanke and others at the Federal Reserve have said, we must keep our eyes on what the Fed does with its securities portfolio. The Fed does not seem to want to maintain its mortgage-backed securities portfolio or its federal agency portfolio at the levels achieved earlier this year. It appears that the Fed will allow the volume of these portfolios to decline naturally as they mature and run off. The thing to watch is whether or not the Fed replaces this run-off with the acquisition of United States Treasury issues.

The good thing I see about this is that in “normal” times the Federal Reserve has primarily conducted its monetary policy using the Treasury market, either through outright purchases or through the repurchase market. Thus, to reduce the amount of mortgage-backed securities and federal agency securities in its over-all portfolio and to increase the proportion of Treasury securities is, to me, a good thing.

However, even though the Federal Reserve, over time, is going to have to withdraw the excessive amount of reserves it has pumped into the banking system, this is not going to happen in the near term. There was a lot of “bad” economic news that came out in August. This “bad” news had a very negative impact on the polling statistics of the President and created a very dark picture for Democratic politicians looking forward to the November elections. Within such an environment, the Federal Reserve and its officials must appear to be working to accelerate the economic recovery and help put more people back to work.

Thus, the Fed is not likely to allow reserves to decline by much in the banking system, although I doubt that they really want to increase reserves much throughout the fall. For the time being, it looks as if the best bet is that the Fed will let the runoff continue in mortgage-backed and federal agency securities, replacing them with purchases of Treasury securities. This will take place while the Fed allows the “crisis” assets to continue to decline as they are resolved. The only deviation from this picture would occur if the economy or the banking system took a turn for the worse.

Friday, September 3, 2010

Mr. Bernanke's Testimony

How important was Ben Bernanke’s testimony given to the Financial Crisis Inquiry Commission?

Well, the New York Times reported it on page B3 of the Business section and the Wall Street Journal reported it on page A6 of its first section. Ho hum!

This more or less puts the testimony in the class of Alan Greenspan’s efforts to recover his reputation once he stepped down from the position Bernanke now holds.

The important thing, to me, about the testimony is what it says about one of the leaders of economic and monetary policy in Washington, D. C. these days. I have just commented on this leadership recently.

“Economic leadership of the United States currently rests in the hands of individuals that were an instrumental part in the excessive credit inflation of the 2000s. Ben Bernanke was a member of the Board of Governors of the Federal Reserve System and a vocal supporter of Alan Greenspan’s move to keep the Federal Funds target rate around one percent in 2003 and beyond, having joined the Board in 2002. Timothy Geithner became President of the Federal Reserve Bank of New York in 2003. This position has a permanent vote on the Open Market Committee, so that Geithner was in on all votes during this time as was Bernanke. After a short stint as the Chairman of the President’s Council of Economic Advisors in 2005-2006, Bernanke became Chairman of the Board of Governors of the Federal Reserve System in February 2006. Geithner moved from the New York Fed to become Treasury Secretary in January 2009.

These two leaders, arguably the most important leaders in economics and finance in the United States government, have held top positions and been voting members of policy boards during one of the most un-disciplined times in United States history. And, their lack of discipline continues, as is evident by the speech given by Bernanke last Friday at Jackson Hole, Wyoming. The only policy that these two people follow is one of throwing everything they can at a problem and seeing what works.

The problem is that their interest rate efforts in the 2003 to 2005 period led to a housing bubble and stock market bubble which resulted in the collapse of the sub-prime market in 2006 and 2007. Their response to this break-down resulted in the financial disaster of the 2008 to 2009 period when the government threw just about everything it could at the disaster in order to try and avoid worse. We are now in 2010 and the evidence of the lack of discipline is still around us. Consumers are plagued with debt fostering record numbers of foreclosures and personal bankruptcies. Businesses are overwhelmed with debt, not only with high-yield bond debt but also with commercial real estate loans and foreclosures and bankruptcies are also high in this area. State and local governments are piled high with debt and we find that states and cities are cutting back on the most basic of services including the release of fire fighters and police. And, the federal government faces budget deficits that some estimate will result in $15 trillion or more in additional debt over the next ten years.”

And, Mr. Bernanke is so disingenuous as to say about letting Lehman Brothers fail: I wasn’t “straightforward” in my statements about the condition of the company. In his view “Lehman didn’t have enough collateral to support a loan from the central bank.” That is, there were no choices!

Then Mr. Bernanke says, “This is my own fault, in a sense...”

What is this “in a sense” business! Either you did or you didn’t!

Going on, “I regret not being more straightforward there because clearly it has supported the mistaken impression that in fact we could have done something. We could not have done anything.”

Thank you Mr. Greensp…whoops…Mr. Bernanke.

I have yet to hear anything, from Mr. Bernanke, Mr. Paulson, or anybody, that has changed my mind concerning that time back in September of 2008. My post on the events of that specific period is titled “The Bailout Plan: Did Bernanke Panic?” (See”

This is the leadership we are now getting in Washington, D. C. Need I say more?