Thursday, October 28, 2010

International Capital Mobility: the United States Dilemma

In this globalized world, international capital mobility must be taken as a given.

According to modern international economic theory, if international capital mobility is a given, then there are only two other policy choices left a nation, but that nation can only choose one of the two. The first is a fixed exchange rate and the second is the ability to run an independent government economic policy. By independent is meant that a nation’s economic policy can be run according to the internal goals and objectives of that nation without regard to the economic policy of any other nation in the world.

The assumption has been that a nation can follow an independent path internally so as to achieve high levels of employment as well as other social goals like attempting to put every family in the country in its own home.

The United States began following a fully independent economic path in the 1960s and with the growing mobility of capital globally following World War II, the Nixon administration found it could not continue keeping the value of the dollar tied to a gold standard. In August 1971, President Nixon released the dollar and allowed its value to float.

The basic assumption of this move was that the value of the dollar would adjust in international markets so that the United States government could inflate the economy so as to achieve full employment of its labor force. As credit inflation took place within the country, the value of the dollar would decline causing exports to increase which would keep the labor market fully engaged.

One problem: this assumed that the United States economy would stay competitive with other nations. Unfortunately, this assumption did not hold as the credit inflation within the United States resulted in a deterioration of the competitive base of American industry.

A consequence of this deterioration is that American exports could not keep up with the competition in world markets. As the value of the dollar declined, exports did not expand as the economic model predicted. Charles Kadlec reported in the Wall Street Journal that as the value of the dollar declined dramatically over the 42 years following 1967 “net exports have fallen from a modest surplus in 1967 to a $390 billion deficit equivalent to 2.7% of GDP today.” (


Is the market trying to tell us something?

In my post yesterday, I presented information cited by Tom Freidman in the New York Times who focused on a report from the National Academies listing how the United States has declined from being a leader in innovation and technology. The conclusion from this report is that the United States just is not as competitive in the world as it was fifty years ago.

Bloomberg adds further evidence that the world is shifting in terms of competitive action. How do you like this headline? “IPOs in Asia Grab Record Share of Funds as U. S. Offers Dry Up.” (

“‘What the market needs and wants is a lot more IPOs coming out of China,’ said Jeff Urbina, who oversees emerging-market strategy at Chicago-based William Blair, which manages more than $41 billion. ‘That’s where the growth is.’”

The article states that “Record demand for initial public offerings in Asia is reducing the share of U. S. IPOs to an all-time low as companies from China to Malaysia and India flood the market with more equity than ever.”

Who says the world is not shifting?

And, then, in another blow to American pride, we learn that the Chinese have built a supercomputer that has 1.4 times the horsepower of the fastest computer that exists in the United States. (

Maybe, just maybe, the United States needs to take a hard look at the economic philosophy it has based economic policy on over the past fifty years. Maybe an economic policy based upon credit inflation is not productive in the longer run after all.

There is substantial information being produced by the market place to indicate that maybe the predominant economic model in the United States, the “Keynesian” model, does not produce the results that we want. In fact, the information is pointing to the fact that, in the long run, the results that are produced by this model are exactly the opposite of what people were trying to achieve.

However, the real Keynes argued that when the facts seemed to point away from the models currently in use, one should change the models that are being used.

Maybe, just maybe, we should listen to this Keynes and not to the “Keynesian” true-believers that preach the fundamentalist gospel that has dominated economic policy making over the past fifty years.

Wednesday, October 27, 2010

Achieving National Economic Health: More on a United States Turnaround

Yesterday I wrote a post considering the United States as a turnaround candidate. ( My fourth point in the post was that a turnaround needed to begin with a change in culture and that the change in culture had to begin at the top and everything that the leader did or said should reflect that change in leadership.

A change in culture, however, cannot be achieved overnight. In doing turnarounds one must understand that it takes a long time to complete the effort and people can get discouraged and frustrated and anxious during this time because one can go a through long stretches without seeing much improvement.

A turnaround can be compared with a person returning to health after a serious illness, an illness that cannot just be cured over night. Just to take a simple case, let’s assume that the doctor tells the sick patient that to return to health the patient must change his or her lifestyle, lose a substantial amount of weight, and stop living on the edge.

Changing one’s lifestyle does not mean that a successful return to health is based on “short-term” efforts to correct a particular situation with respect to one’s current way of living.

Losing a substantial amount of weight under these circumstances would imply that the weight loss must be maintained and be consistent with the new lifestyle so that the weight, once lost, is not put back on.

And, if one is to “stop living on the edge,” then that person must stop pushing and pushing and pushing and jumping from one extreme situation to another.

Obviously, I would like to compare this picture with the larger problem of bringing the United States economy back to health. Furthermore, I would like to argue that the problems of the United States economy are not transitory in nature and require a substantial amount of time to heal. The problems of the United States economy require a change in lifestyle, a disciplined approach to conducting business going forward, and a need to stop living “on the edge.”

In the first place, the United States has arrived at the place it is in by concentrating on “short term” results. I heard Fareed Zakaria speaking on the Charlie Rose show the other night. Zakaria made the statement that maybe one of the deficiencies of democracy is that democracy seems to encourage behavior focused on the “short run.”

I have commented on the fact that back in the 1970s and 1980s politicians focused upon a four-year election cycle because we have a presidential election every four years. Richard Nixon froze wages and prices and took the United States off the gold standard in August 1971 so that he could begin to re-stimulate the economy so as to get re-elected in 1972.

Now, the time-horizon of the politician has been truncated to two years because the mid-term elections have become so important that economic policies must be aimed at getting people re-elected no matter how much chaos is created in the meantime.

Zakaria stated that all that is considered in these elections are current problems and that there is no constituency that represents those people that would be facing problems down the road. But, of course, this plays right into the way that the quote by John Maynard Keynes is interpreted: “In the long run we are all dead.” Focus on the current problems and let people in the future be concerned about dealing with the problems we create for these future generations.

I have written about some of these longer term problems. ( Because the leaders of the United States have been focused on the short run in order to get re-elected they have created policies and programs that have resulted in long term outcomes that we now have to deal with. In this respect, “maybe things have changed” and this requires the leadership to change their economic policies to deal with current problems, not with the problems that they addressed in the past.

By sticking with out-dated policies they continue to make the problem worse and contribute to the reality that keeping on the same track will only make it more difficult to regain full health going forward.

Other information on this situation has been attracting our attention recently. Some of this work has been summarized by Tom Friedman in the New York Times this morning. ( Friedman quotes a recently released report of the National Academies called “Rising Above the Gathering Storm Revisited: Rapidly Approaching Category 5”. The subtitle, Friedman writes comes from “The committee’s conclusion…that ‘in spite of the efforts of both those in government and the private sector, the outlook for America to compete for quality jobs has further deteriorated over the past five years.’”

By focusing on the short run goals over the past fifty years, America has fallen from “Number 1” to a less lofty position in the world. And, we are currently seeing the consequences of this decline almost daily. (See and

Then Friedman quotes some of the discouraging results of the study: The United States ranks “sixth in global innovation-based competitiveness, but 40th in rate of change over the last decade; 11th among industrialized nations in the fraction of 25- to 34-year olds who have graduated from high school; 16th in college completion rate; 22nd in broadband Internet access; 24th in life expectancy at birth; 27th among developed nations in the proportion of college students receiving degrees in science or engineering; 48th in quality of K-12 math and science education; and 29th in the number of mobile phones per 100 people.”

You can’t keep America competitive by trying to put people back to work in the jobs they were just laid off from; you can’t keep America competitive by stimulating businesses to continue to use their existing capital base; and you can’t keep America competitive by encouraging them to take advantage of inflation (as in housing and cars and other consumer-based capital goods) rather than by working to be productive and also to become more productive in the future.

Yet, these are all the things that the United States government has been trying to achieve over the past fifty years: putting people back to work in the same jobs they were laid off from; keeping businesses using their same existing capital base; and by encouraging people to leverage up their debt loads and take on more and more risk within an inflationary environment with bubbles popping up here and there.

My prediction is that the economic environment we would like to see is a long way off. “Quantitative Easing” on the part of the Federal Reserve System and further fiscal stimulus on the part of the federal government is just more of the same old medicine that has been tried for fifty years or so. It is an attempt to achieve a “short run” solution.

The sad thing is that more of “the same old medicine” will just exacerbate the longer run problems mentioned by Friedman, the National Academies, and myself in the above cited work. Unfortunately, we are now living in the “long run” as seen by the leaders of the American government over the last fifty years. Are we going to pass this “long run” on to others in a more devastating “long run” of the future?

Tuesday, October 26, 2010

The Basics of Turnarounds: the United States Situation

A part of my life has been connected with company turnarounds, bank turnarounds to be more precise. I would suggest that the United States is in a turnaround situation right now but its leaders claim that the economic model it is using is still relevant and that all that is needed is a little more time and a little more co-operation from others and everything will turn out alright.

My experience has led me to some conclusions about what is needed in a turnaround situation. (By-the-way, all my turnarounds were successful and I can say that now because I am not doing turnarounds any more.) We don’t have much space to discuss these things so let me just summarize what I believe to be the four most important factors in achieving a turnaround: the business model; information coming from the market place; the need for transparency and openness; and the existing business culture.

Although these factors relate to a business situation, I believe that they can be applied to any “turnaround” situation, including the “turnaround” of a government.

First, and foremost, an organization gets into trouble because its business model, or economic model, is not working. But, because a leader or a management team believes that the organization has gotten where it is because of that business model, they tend to stick with the model and apply the model even more forcefully.

In some cases, the success of the model has come because of the timing of the model’s use and not because of any inherent characteristics of the model are correct. To justify this statement I refer the reader to the book “Fooled By Randomness,” by Nassim Nicholas Taleb.

In terms of the economic model that the United States government is applying, and has been applying for a very long time, there is no real evidence that it works. I am, of course, speaking of the Keynesian macro-economic model.

Ever since the 1930s when the model was first presented, all I have ever heard in times of difficulty is that the reason the Keynesian model falls short is that not enough stimulus has been forthcoming. Keynesian economists contend that the Great Depression continued on for as long as it did because governments did not create sufficient budget deficits. Only the war effort, World War II, got the US out.

This criticism has been applied over and over again during the last fifty years. All we have been hearing from the fundamentalist preacher Paul Krugman is that the Obama stimulus package must be greater. He has been consistent in applying this remedy since early on in the Great Recession. More spending, more, more!

Maybe the economic model the government is using is wrong!
The application of this model over the past fifty years has produced falling capacity utilization, rising under-employment, and greater income inequality.

Maybe the economic model has not been applied correctly!

Defensive comments like these are heard over and over again within a company that is in decline.

Second, it seems that others recognize the decline in the company even though the leaders and management of the organization do not. That is, the market recognizes that the model of the organization is not working and that the organization is in decline.

And, what is the response of the leaders or managements of the targeted organization. The response is “The market doesn’t understand us!” I don’t know how many CEOs I have heard express this sentiment in the face of a falling stock price.

The thing is, the market does understand the company and the fact that the company is applying an inappropriate business model.

The market response to the economic policy of the United States? Well, the behavior of the United States government in the 1960s resulted in the need for the United States to go off the gold standard. Since the United States has been off the gold standard, the value of the United States dollar has declined almost constantly (with the two exceptions, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve system and during the 1990s when Robert Rubin was the Secretary of the Treasury).

Obviously, for the value of the United States dollar to substantially fall, almost continuously, over a fifty year period, indicates that something must be wrong with the economic model the government is using. During the past fifty years, the government has relied on a credit inflation whose foundation is a federal deficit that has resulted in the federal debt increasing at an annual compound rate of growth of more than 9% over this time period. The government has created other avenues of credit inflation through programs like those built for housing and home ownership. The whole economic model was based upon inflating the economy causing people to constantly “leverage up” and take on more and more risk.

Third, transparency and openness goes by the wayside as organizations experience decline. Cover ups abound! President Obama came into office declaring that he was going to change the way things are done in Washington. Yet, his administration is now charged with opaqueness and obfuscation like every other presidential administration. Even little bits of information, like the recent report by the special inspector of the TARP program, only adds to the accusation that this administration is hiding things. This was in all the papers this morning. (See “Treasury Hid A. I. G. Loss, Report Says,” This does not help!

Fourth, the culture of an organization begins at the top. In a turnaround situation, a new culture
must be implemented and that culture must begin with Number One. The new leader that takes on a turnaround situation must change the way things are done and introduce a new business or economic model into the organization.

However, this new business model cannot be introduced or implemented if the (new) leader assumes that little or nothing needs to be changed. And, this implementation cannot be carried off unless the members of his or her team are all on board.

In my view, things need to be changed in Washington, D. C. The evidence in the market place is hard to ignore, although Washington has done its best to shift attention to others. But, the weakness of the United States position has been observed and others (China, Brazil, and India, and others) have moved into the void to take advantage of it. (See my post

Even if the philosophy of economic policy used by the United States government was appropriate forty or fifty years ago, things have changed since then. (See my post The United States needs to be “turned around”. But, to do a turnaround, those that are in leadership positions must accept the fact that a turnaround is necessary. I don’t see this happening any time soon.

Monday, October 25, 2010

The "Do-Nothing" G-20

The finance ministers of the G-20 just finished meeting. Result: the Yankees and the Phillies are not going to be in the World Series this year. The leaders of the G-20 are going to meet in Seoul, South Korea in November. I think that we can expect little or nothing to come out of this get-together.

The whole cloud, I believe, hanging over international finance at the current moment is the economic policy stance of the United States government.

Oh, we can point our fingers at the Chinese, but it is the Americans that have set the tone for the world. And their current pronouncements about future fiscal and economic policy promise nothing more than a continuation of the past.

Martin Wolf, in the Financial Times stated it very clearly: the United States is trying to inflate China and in so doing inflate the rest of the world. (See

Joseph Stiglitz, the Nobel Prize winning economist, argues (in “Why Easier Money Won’t Work”, that “Such policies (Quantitative Easing on the part of the Federal Reserve) may come with a price…That money is supposed to reignite the American economy but instead goes around the world looking for economies that actually seem to be functioning well and wreaking havoc there.”

Mohamed El-Erian, CEO of PIMCO, stated just last week that when the Federal Reserve creates liquidity it just spreads throughout the world going where ever it wants to. Worldwide capital mobility is a feature of the 21st century international financial system.

Stiglitz continues: “The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U. S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.”

But, the United States has been conducting an economic policy for the past fifty years that has relied upon credit inflation to keep unemployment low, to provide individuals and families with homes, and to keep American manufacturers operating at high levels of output. (See my post “Maybe Things Have Changed” for October 22, 2010 at

Things began to get out-of-hand in the 1990s during the stock market boom connected with the tech bubble. Stiglitz again, “In 2001, (then) record-low interest rates didn’t reignite investment in plant and equipment. They did, however, replace the tech bubble with an even more dangerous housing bubble. We are now dealing with the legacy of that bubble, with excess capacity in real estate and excess leverage in households.”

And, these bubbles became world wide as the debt of the United States and the liquidity provided by the Federal Reserve System spread almost everywhere. The conditions we are living through at the present time were a long time in coming and have damaged other countries as well as the United States.

The world seems to be dividing into three (I previously thought it was just two) parties. The first is the emerging countries who seem to be doing OK and seem to be in the strongest position right now. These nations are the BRIC countries and others (like Canada) who have weathered the recent economic and financial meltdown in relatively good shape. The second group consists of the more developed countries, primarily in the West, that have followed economic policies not too different from the United States, like Great Britain, France, Spain, Italy, Greece, Portugal, and Ireland, who have experienced a sovereign debt crisis over the past year or so and are re-grouping by getting their financial affairs in order and adopting a different economic strategy for the future.

The third party contains just one nation, the United States. The United States is not showing any signs that it is getting its financial affairs in order. Furthermore, the economic policy philosophy prevalent in the United States government differs from what existed over the past fifty years only in terms of magnitude. The economic policy philosophy of the American government just seems to be even more of the same.

The leaders of the United States government have presented a common front to the world: our economic policy stance is a given. Now, let’s work out world financial reform.

I don’t see how anything new can be worked out in the G-20 or any other international body if the United States continues to take such a strong position. I believe this is the underlying message sent by the finance minister from Brazil who declined to attend the meeting that was just completed.

Nothing can be done to solve the imbalances in world finance if the United States continues to be un-moveable when it comes to its economic policy stance.

The world has changed. Things within the United States have changed. This is what my Friday post ( was all about.

But, the leaders in the United States continue to focus on their navels and claim that the problem is “out there”.

And, that is the problem.

World co-operation cannot come about when one country believes it has all the answers.

As such, I see the value of the dollar continuing to decline; the world situation will continue to remain unsettled with regard to countries co-operating with one another; and I see continued economic imbalance and dislocation, both in the United States, itself, and in the world.

Friday, October 22, 2010

Maybe Things Have Changed

During my professional career, three things have seemingly dominated the American culture. First, the labor unions; second, the manufacturing industries; and the third was home ownership.

I spent my formative years in Michigan and nothing dominated the newspapers more than the activity of labor unions and the car industry. That was just a part of the society there. Of course, there was the steel industry and in the case of unions there was the coal industry and so on. Nothing is more vivid to me than the role of manufacturing and labor unions in the culture of my youth.

If anything else came close it was the idea of home ownership and the suburban sprawl. It was especially important to put the returning soldiers into homes and to help them live the “true” American life.

These days are gone, but the role they played in this earlier existence still dominates our national life and our political philosophy. Maybe that needs to change. Maybe we need to re-direct our attention.

The manufacturing industries have become a smaller and smaller part of the United States economic machine…for better or worse. The economy has shifted toward information and “information goods”. An “information good” is broadly defined as anything that can be digitized. Besides the computer industry, three other major subcategories in this area are in financial services, higher education, and government. Finance, colleges and universities, and government deal, primarily, with information and “information goods”.

The “new” structure of commerce in the United States is tilted toward the more educated, the more mobile, and the modern urban community. The “old” structure relied more on physical effort, the stationary, and the suburban life.

That is, the driving forces in this new modern world are not cars, and steel, and manual labor.

The thrust of the labor unions has also changed and it seems as if unions have spread into the area of government as the presence of government has grown in the society over the last fifty years. Back in “the good old days”, unions were connected with industry and hard and dangerous jobs and “national” monopolies. International competition was not a threat at that time.

Today, the presence of unions has radically shifted. In the United States most union members are connected with government. This is also the case in the rest of the western, democratic nations. Labor unions are still important in the automobile industry, but the automobile industry is just not as important any more. I have seen figures that indicate that something like 60% of the membership in American labor unions these days is related to government. This move has completely changed not only the location of labor unions in the United States; it has also changed the focus.

The desire to get Americans into their own homes has been present in the country since the country was started. This was felt to be important not only for individuals themselves, but for the substantial positive externalities that were felt to accompany the growth of home ownership.

Today, we may find that renting may become more prevalent in the faster-moving, more educated, “urban” workforce of the 21st century. And, this mobility is becoming more global than just national.

The economic policies of the government have been built around the above factors which, I contend, are not as prevalent as they once were.

Monetary and fiscal stimulus were more effective in an age of “heavy manufacturing” because these industries relied upon fixed capital, huge plants and machinery, and a “local” labor force. When unemployment happened, labor stayed “at home”, both in terms of location, but also in terms of skills because the workers needed to know little else. Monetary and fiscal stimulus put these workers back to work in their old jobs as sales picked up. New investment also was created as the economy rebounded.

The same is not true in the Information Age. “Information” companies do not have huge plants and large machines to maintain. Downsizing and the shifting of the employees occurs incrementally and more rapidly than in the past. People move and re-train and change. Monetary and fiscal stimulus is not so effective because the companies and have “moved on” and do not re-hire people back into their old jobs as did the manufacturing firms. The employees have also “moved on”. Furthermore, these companies do not have large capital investments to undertake that help the economy to re-start.

The labor union issue is surfacing in another way. Labor unions connected with government workers have become very important in recent years and have been very successful in gaining large settlements related to health benefits and retirement. A recent edition of the Economist magazine has covered some of the issues here. The problem: “One California mayor estimates that the effective cost of employing each police officer and fireman is $180,000 a year. That sum is not their take-home pay. For police and firefighters, the big costs occur when they stop working—retirement at 50, combined with inflation-linking, health benefits and lump sums for unused sick leave…California is also shelling out fortunes to retired state and municipal managers; more than 9,000 have retirement incomes of over $100,000 a year.”

And, these pension promises have been subject to “Alice-in-Wonderland accounting.” The Economist presents figures that pension liabilities are estimated to be around $5.3 trillion, compared with $1.9 trillion of assets. “The total shortfall of $3.4 trillion is the equivalent of a quarter of all federal debt.”

So, when it comes to governmental employees, the fighting is not over peanuts. And, this is a worldwide issue as can be noted in the riots taking place in Greece, Italy, Portugal, Spain and France over their government’s retirement and pension payments. And, yesterday it was revealed that the new austerity budget of the British government contains a reduction of 500,000 public sector jobs. “Today, the fight begins,” states the general secretary of the largest government union in the UK.

The role of labor unions in the 21st century society seems to need to be re-addressed going

Finally, the pressure of the government to achieve high rates of home ownership must be re-visited. We, in the United States, have paid a major price for the emphasis placed on this goal and the resources that were allocated toward its achievement. Payment is still coming due in the area of foreclosures, commercial real estate bankruptcies, and the resolving of government support of Fannie Mae and Freddie Mac. It is very likely that we, the people of the United States, will be paying for this bailout for many years to come.

The whole point of this post is to argue for a change in some of the assumptions behind the economic policies of the leaders of the United States government. The world has changed. Maybe our leaders need to change their outlook as well.

Or, is that too much to ask?

Thursday, October 21, 2010

Are There Bubbles All Around?

One thing we learned in the 1990s and the 2000s is that there can be asset bubbles in the economy without growth in either money stock variables or increases in consumer (flow expenditure) price inflation. The financial system seems to be flexible enough so that it can leverage up where it wants to even though monetary policy and consumer spending seem to be “in control”. This is the lesson of modern “financial engineering.”

However, the monetary statistics are not benign for most of the time period from January 1961 up to September 2008. During this time period, the monetary base which is supposedly under the control of the Federal Reserve System rose at a compound annual rate of slightly more than 6%. Total credit during this time period rose much more rapidly. Consequently, the United States experienced a period if “credit inflation” that dominated everything going on during this 47 years or so. This secular inflation drove the financial innovation that took place as the whole financial system took on more-and-more leverage and more-and-more risk.

Since September 2008, the Federal Reserve has caused the Monetary Base to increase explosively by more than 130%. However, the banking system is not lending and much of these funds seem to have ended up on the balance sheets of the banking system. Excess reserves in the banking system went from about $2 billion in August 2008 to almost $1.2 trillion in February 2010. Excess reserves for September 2010 averaged slightly below $1 trillion.

Even with all of these excess reserves, the current concern is whether or not the economy will go into a period where prices actually decline. That is, might the United States be headed for a period of deflation?

Everything mentioned above is true. Yet, there is more going on in the economy than just what we see here. In some areas, a lot is going on and in these areas we are seeing lots of upward price movement which leads one to ask whether or not these price movements are bubbles or indications of something else taking place. Certainly, the “bubbles” are not increasing employment, or capacity utilization, or getting the economy going again.

I have written about this before: “Where the Action is: The Bond Market”, I wrote in this post:

“There is a lot of money in the financial markets…in the shadow banking system…and worldwide.
Where is the action taking place?
Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates.”

Of course we know that government bond prices are inordinately high causing yields to be excessively low. But, this is also true in the market for high-grade corporate debt and for junk bonds. One could certainly argue that there might be “asset bubble” in the bond markets.

Thank you shadow banking system!

And, the cash continues to build up on the balance sheets of “healthy” large corporations. It also appears as if many hedge funds and private equity funds are attracting “large bunches” of new money.

But, capital is almost perfectly mobile in the modern world: it can escape almost everywhere.

Because of this, writers like Martin Wolf have argued that one of the goals of American leadership is to “inflate the world” in order to get United States economic growth going again.

So, are we seeing the results of this?

Well, we might be seeing this flow of capital going into world commodity markets and also into emerging markets. There is the possibility that bubbles may be occurring here.
The movement in commodities seems to be worldwide but repercussions are being felt domestically in the United States. (See “Dilemma Over Pricing: From Cereal to Helicopters, Commodity Costs Exert Pressure”, This article indicates that, year-over-year, corn prices are up by 34%, wheat prices are up 34%, milk is up 32%, copper is up 30%, and oil is up 14%. It is also the case that sugar is up about 50% year-over-year.

The question many companies are facing is, “How can we raise prices to cover these costs when the economy is so weak?” A real dilemma!

Funds are also flowing into emerging markets. All one has to do is watch the stock exchanges in those countries. And, all indications are that large companies are looking to locate in many of these markets or acquire firms in these markets. We are also seeing the hedge funds and private equity funds looking in this direction. (See for example, “Buy-outs set to divide private equity”,

In a world where there is a fluid movement of capital, money is not going to stay at home if the home economy is not strong, structurally. The American economy is having major problems in its economy. Why would “big” money want to invest here? (See, for example, “Globalized Finance: Advantage China”,

The Federal Reserve, and the federal government, may need to change their economic models to include the fact that organizations other than domestically chartered commercial banks can create credit and can cause bubbles to occur anywhere in the world where an opportunity exists.

Modern finance with internationally mobile capital does not seem to exist in the models the leaders of the United States are using. This is one reason for my skepticism of all the new financial reform systems that are being constructed. (See my post “Banking at the Speed of Light”, Money is becoming more and more fluid and hence less and less controllable.

The American banking system may currently be dormant, but there seems to be plenty of money and plenty of action, elsewhere.

Yes, there are bubbles all around.

Wednesday, October 20, 2010

Ben and Tim: Part I

We have been living with the team of Ben Bernanke and Tim Geithner since 2006, Bernanke as Chairman of the Board of Governors of the Federal Reserve System and Geithner as the President of the Federal Reserve Bank of New York. The only person now missing from this team is Hank Paulson, who was Secretary of the Treasury until Geithner moved into that position.

During their partnership, there has been a failure to recognize the clouds that were forming in the 2006-2007 period. We have the flooding of the banking system which took place beginning in the fall of 2008. And, now, we have the sinking of the United States dollar.

It was very disingenuous of Treasury Secretary Geithner to claim yesterday that he…and the United States government stood for a “strong dollar” and “will not engage” in currency devaluation.

This stance has been taken by the United States government and every Treasury Secretary since the dollar was floated in August 1971.

Yet, the value of the dollar has fallen by around 30% on a trade-weighted basis against major trading countries since this index began in early 1973. The value of the dollar on the same basis has fallen by about 11% since March 2009.

And, where do we stand policy wise? The deficit of the United States government has fallen to $1.3 trillion in fiscal year 2010, down from $1.4 trillion in fiscal year 2009. My estimate of the cumulative fiscal deficit for the next ten years, assuming the current philosophy of government (which is the same philosophy of government that has been around since the early 1960s), is at least $15 trillion.

Monetary policy? Well, the Ben and Tim team gave us a Federal Reserve balance sheet that more than doubled to over $2 trillion from about $0.9 trillion in August 2008. Now, Chairman Ben is making noises that could lead to an increase in this balance sheet to over $3 trillion in the next year. And, with federal deficits over the next ten years that could total $15 trillion or more, it is hard to see how this balance sheet could decline by much.

The basic crisis philosophy of the Treasury and the Federal Reserve since the fall of 2008 has been to throw as much “spaghetti” as they can against the wall to see what sticks. That policy still seems to be alive and well within the halls of the Federal Reserve and the Treasury.

This approach to policy making is what international investors are concerned about at the present time.

A complicating fact relating to this picture is that the world is splitting into two camps. There is the dollar/Euro camp that is composed of the developed countries in the world who are still battling to get their economies moving again. (Note that the dollar/Euro camp is split as well. See “Fed’s Strategy Will Bring Euro Victory Over the Dollar,”

And, there is the camp that includes the rapidly emerging nations (including some others) that are experiencing relatively high rates of economic growth.

This bifurcation into the two camps is causing and will continue to cause world trade and finance pressures going forward. There may not be any change for some time about the place of the United States dollar as the world’s reserve currency. But, if the scenario presented above actually occurs, the pressure on the dollar will just continue to grow with time.

At this point I won’t get further into this discussion for the focus today is on Ben and Tim.

Why is it that I have so little confidence in the future of the economic policy of the United States government at the present time. Bernanke has been in a leadership role around Washington since 2002. Everything he has been connected with has not turned out particularly well with the exception of his ability to throw “spaghetti” against the wall. Geithner is the only senior economic advisor of the Obama administration that was with the administration at the beginning and still remains. What interpretation can be put on this survival?

Who knows, maybe Ben and Tim will go down in history as the team that saved the economy but sank the dollar.

I don’t know when in my professional career that I have been so nervous about the economic leadership in this country. My impression is that many others feel the same way I do and much of this feeling is getting reflected in the value of the United States dollar. Thus, although the value of the United States dollar will vary from time-to-time, I see no reason to believe that this value will not continue to trend downwards over the longer term.

Tuesday, October 19, 2010

China Plays the Game

The Chinese central bank has announced that it will raise the one year lending and deposit rates by 25 basis points. This has been a major surprise to international financial markets.

One can assume that this move was done very deliberately and very intentionally. The Chinese do not make policy decisions unless they are well thought-out.

The immediate reason for the move at this time: later this week there will be a meeting of the G-20 finance ministers. Next month in Seoul, South Korea there will be a meeting of the G-20 leaders.

The move is not an accident!

The International Monetary Fund just completed meetings earlier this month in Washington, D. C. Before that meeting, the United States took a strong stand on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States made an effort to get other nations to criticize the Chinese position.

The result of the IMF meeting? Little to no pressure was put on the Chinese giving indication that the United States was having no luck in its campaign to bring the Chinese “into line” on the value of their currency. The United States looked weak. (See my post on this:

If China’s action on interest rates is followed up by China allowing for a faster climb in its currency, the yuan, the Chinese will strengthen the position of their government within the G-20. It would also strengthen the role of other Asian nations as well as other BRIC nations in negotiations concerning the future of the dollar as a reserve currency.

Thus, the Chinese would build on the exhibited weakness of the United States at the meetings of the IMF in Washington and help to consolidate other nations around its leadership in world economic affairs.

Is the United States and China at war?

In one sense they are. Martin Wolf at the Financial Times of London has written, “In effect, the US is seeking to inflate China, and China to deflate the US. Both sides are convinced they are right…” (See

How has this situation developed? Well, in a real sense, the world has bifurcated. Part of the world, generally the developed countries, are struggling to restart their economies from the Great Recession, while many of the emerging countries are doing just fine, thank you.

The Federal Reserve System in the United States and the European Central Bank seem intent upon buying massive amounts of bonds to carry out a “Quantitative Easing” in an attempt to “jump-start” their economies. The prospect of this has resulted in a weakening of the dollar. This has not been looked on favorably by the emerging nations who are experiencing economic growth and even a potential threat of inflation.

As a consequence, several of the emerging nations have already taken actions to protect the value of their currency from the weaknesses seen in the American position. These nations have already considered control techniques to protect themselves from the fall in the dollar exchange rate. They are considering the possibility having dual exchange rates, one for trade payments and one for non-trade payments.

The threat here is that world will break into two currency areas, one that is dollar/euro dominated and one that is dominated by China and the other emerging nations. And, certainly, the possibility of some kind of financial controls on foreign exchange is not a settling thought.

The reigning problem to me is the failure of leaders, especially leaders in the United States and in other developed countries, to appreciate the changes that have taken place in the world. The continued focus of the leadership in the United States on stimulating internal demand so as to achieve something, full employment of resources, that they really can’t achieve, is leading them down the path of isolation. By continuing to follow an economic philosophy that has proven itself to be ineffective (if it ever was effective) is only creating a fissure within the world.

In effect, the United States, by pursuing the same type of policy it has followed for the last 50 years, is not only weakening itself but is providing the stage for the Chinese to exert its own leadership to those the United States policy is hurting.

The Chinese are moving to achieve a position of prominence in the world of the 21st century. What they are doing is very intentional and when they do things, they do them in their own time and for their own reasons. They are not always right, but that is not the point.

The point is that the Chinese are very deliberate in promoting themselves and their country. The United States, however, seems to be helping them achieve what they want to achieve. This cannot continue.

Monday, October 18, 2010

"Currency Chaos: Where Do We Go From Here?"

I would strongly recommend you read the “Weekend Interview” published in the Wall Street Journal on Saturday. The interview is with Robert Mundell, 1999 Nobel prize-winning economist who teaches at Columbia University. Mundell has been referred to as the “father of the euro.” (

Let me just summarize some of the points Mundell makes in the interview because, I believe, that more people should be aware of them.

First, Mundell reflects a bit on history and states that the major event of the post-World War II period was the United States going off the gold standard in 1971 and letting the value of the dollar float. “The price of gold was fixed at $35 an ounce in 1934, but by the time the U. S. got through the Korean War, the Vietnam war, with all the associated secular inflation, the price level had gone up nearly three times.” The U. S. lost more than half its gold stock and had to get off the gold standard.

No one has suggested any system, gold or whatever, to stabilize prices since. And, the “secular inflation” has continued into the 21st century.

Second, the dominance of the United States and the dollar in the world economy, which began in the 1930s, has declined. “”To be fair, America’s position (in the international community) is not nearly as strong now.” But, Mundell doesn’t “think the U. S. has any ideas, they don’t have strong leadership on the international side. There hasn’t been anyone in the administration for a long time who really knows much about the international monetary system.”

Third, it is wrong to think that the world situation revolves around the United States versus China faceoff. “It’s a multilateral issue because the U. S. deficit is a multilateral issue that is connected with the international role of the dollar.” Mundell supports the suggestion of French President Nicolas Sarkozy that discussions should begin on reforming the world monetary system. But, he argues that the Europeans must play a very important part in any discussions because the dollar-euro relationship is so important in world financial markets. “The dollar and the euro together represent about 40% of the world economy.”

Fourth, the world currency system needs to be based on fixed exchange rates and not flexible ones. Mundell believes that almost all of the volatility in foreign exchange markets is “noise, unnecessary uncertainty.” World trade will be better off without having to deal with this “noise” because “it just confuses the ability to evaluate market prices.”

The argument against fixed exchange rates is that, in a world where capital flows freely between nations, a country cannot run an independent economic policy aimed at achieving things like full employment and price stability and still maintain a stable exchange rate. This argument is called “the Trilemma problem” of international economics: you can only achieve two of these goals; capital mobility; fixed exchange rates; and an independent governmental economic policy. (For more on this see my post,

What about a country losing the ability to run an independent economic policy?

Mundell is asked the following question: “I suppose the Fed officials would argue that their mandate is to try to achieve stable prices and maximum levels of employments.”

The answer: “Well, it’s stupid. It’s just stupid.”

“The Fed is making a big mistake by ignoring movements in the price of the dollar, movements in the price of gold, in favor of inflation-targeting, which is a bad idea. The Fed has always had the wrong view about the dollar exchange rate; they think the exchange rate doesn’t matter. They don’t say that publically, but that is their view.”

Hence, the fifth point is that monetary and fiscal policy should not be conducted independently of what is going on in the rest of the world. A country, even the United States, cannot continue to inflate its currency without repercussions. The government cannot continuously ignore what is happening to the value of its currency. If a country does ignore what is happening to its exchange rate there will be consequences to pay down the road.

Sixth, “the price of gold is an index of inflationary expectations.” What is it reflecting? Mundell argues that a rise in the price of gold might indicate “that people see huge amounts of debt being accumulated and they expect more money to be pumped out.”

“Look what happened a couple weeks ago: The Fed started to say, we’ve got to print more money, inflate the economy a little bit. The dollar plummeted! (The price of gold rose!) You won’t get a change in the inflation index for months.” But, the decline in the exchange rate and the rise in the price of gold is a “first signal.”

Read the article.

Friday, October 15, 2010

The "New" Economic World Order

Experts tell us that one way to solve trade problems is to let the value of your currency fall. When the value of your currency declines relative to other currencies, your exports will rise and your imports will fall. This seems to be the accepted theory.

This seems to be what the Federal Reserve is trying to do. “U. S. officials are determined to push the dollar lower” we read in the Wall Street Journal Wednesday commenting on the minutes from the September meeting of the Fed’s Open Market Committee. (See “Fed Viewed as Trying to Devalue Dollar”:

Maybe, however, there is another part of this theory that is not being considered. Remember, in economic theory there is a “ceteris paribus” assumption attached to all models: thus we assume “all other things the same.”

One of the other assumptions made when discussing the value of a country’s currency is that the relative productive power of all the countries considered remains the same.

My question is, can we assume that the United States, over the past fifty years, has maintained its relative position in the world with respect to its productive power?

I ask this question because it appears as if the continued decline in the value of the dollar has not improved the trade balance of the United States, especially against many of the emerging nations.

The value of the dollar goes down…the trade balance…if anything…worsens.

This is not the way it is supposed to be. Thus, something else must be at work.

The United States has been on the top of the world since the late 1940s. It continues to act as if nothing has changed.

I will respond with just two broad comments on this situation.

First, the economies of the emerging nations are developing: they are developing rapidly; and they are developing in a very competitive way.

Second, the United States has followed an economic philosophy in terms of policy over the past fifty years that has weakened it in many ways. I have presented this case on many occasions in recent weeks.

“Other things” have not remained the same, yet leadership in the United States continues to assume that they have.

As a consequence, to the leaders of the United States, the problem is “out there.” The problem is China!

One of my favorite Stephen Covey quotes is this: “If you believe the problem is ‘out there’; that’s the problem.”

My belief is that as long as the leadership of the United States believes that the problem is ‘out there’, that will be the problem.

Thursday, October 14, 2010

Where the Action Is

Commercial banks aren’t lending. That we know.

But, there is action elsewhere and, I believe, that this behavior tells us a lot about how the recovery is working itself out…although it is not a recovery like the ones of the recent past.

There is a lot of money in the financial markets…in the shadow banking system…and worldwide.

Where is the action taking place?

Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates. For example, Microsoft just completed a new bond deal. On September 23, 2010, Microsoft Corp., the world’s biggest software maker, sold $4.75 billion of bonds, “at some of the lowest rates in history for corporate debt.” The offering information stated that “Proceeds may be used to fund working capital, capital expenditures, stock buybacks and acquisitions.”

This follows Microsoft’s “first ever” debt issue which came in May 2009. An analyst noted at the time, “Redmond, Wash.-based Microsoft is sitting on $25 billion in cash, so the company doesn’t need the bond proceeds ‘unless they have something big in mind.’”

And, Microsoft is not the only major company taking advantage of the AAA bond market.

Then there is the “Junk Bond” market. The New York Times trumpets “Junk Bonds Are Back on Top.” (

Jim Casey, “one of today’s junk-bond kings” and who runs the junk-bond business at JPMorgan Chase claims that “even those heady days of the 1980s” when Michael Milken ruled Wall Street and who Mr. Casey worked for at Drexel Burnham Lambert, “seem a little tame.”

So far this year, it is reported, that in the first nine months of this year corporations have raised $275 billion in this market worldwide, up from $163 billion in 2009.

“In high-yield, it’s undeniable that these are the best years that anyone has seen in their career.”


It is estimated that “about 75 percent of the deals are aimed at refinancing, rather than taking on additional debt.” The risk profile of the companies has gone up!

And, who are big players helping to underwrite these deals? Let’s see, JPMorgan, Bank of American and Merrill Lynch and Citigroup…the top four!

Further action?

Well check out the private equity interests. They are raising capital in the billions. To do what? “Many banks are looking to sell large portfolios of commitments to private equity funds that they made during the credit bubble.” Banks are doing this because these “assets” are underwater and also because new higher capital requirements will make their “ownership” very expensive.

This just points to a whole host of private equity interests moving into the area of distressed assets. And, they are moving in aggressively. We read the article in the New York Times this morning about short-seller David Einhorn, the founder of Greenlight Capital. (See “A Bear Roars”, One of the interesting insights relating to the work of Mr. Einhorn is the detail that Greenlight Capital put into its “due diligence” of the target.

The attention being focused on “distressed assets” today is not just a casual thing. Fund managers are aware of the risks they are under taking, just as they are aware of the potential returns that are available. As some have said, they are “taking care.”

One analyst remarked on the condition of the market: “We are seeing a steady river of deals” and “we expect this stream to carry on for some time.”

This is all part of the movement I reported on in “Corporations are Hoarding Cash and Keeping Their Powder Dry,” (

There seems to be a tremendous re-structuring of the economy taking place. I now believe that the re-structuring that is going on is beyond the power of the government to reverse. I believe that a similar re-structuring took place in the 1930s and 1940s, a re-structuring that the government, at that time, could not reverse. The 1950s represented the start of a “new era”.

The structure of the industrial base of the United States is dis-located with American industry using only 20% to 25% of its capacity. The structure of the work force is dis-located as 20% to 25% of the age-eligible workers in the United States are under-employed. And, the income/wealth distribution in the United States has become more and more skewed over the past fifty years.

These “dis-locations” will not be resolved by what corporate America seems to be doing now. Large companies, large banks, private equity funds, hedge funds, and other money sources are building up their cash reserves. They are looking, I believe, to buy assets, to buy “distressed companies” and so forth.

Imagine that Microsoft, a company that had never issued any debt in its history, has raised over $8.5 billion in new cash over the past 18 months or so while it is sitting on $25 billion in cash. Can you picture this money going to fund working capital and capital expenditures? I can’t but I can certainly see it going to fund stock “buybacks” (which raises its ability to purchase other companies) and to fund acquisitions.

Actions like this, however, will not result in higher levels of employment or greater investment in capital that would spur the economy along. If anything, a re-structuring, like the one I am writing about will have exactly the opposite effect.

Yet, this may be how the economy goes about recovering!

As I said above, I now believe that the re-structuring that is going on is beyond the power of the government to reverse. If this is true, neither a further quantitative easing on the part of the Federal Reserve System nor additional fiscal stimulus on the part of the federal government will do much in the way of achieving a more rapid economic recovery. If I am correct, the economic re-structuring will take place at its own speed. But, this will require a different response on the part of the government.

Wednesday, October 13, 2010

"There is no limit to the dollars the Fed can create"

I read Martin Wolf’s column in the Financial Times this morning and was taken aback by what I read there. (See “Why America is going to win the global currency battle”:

Here are two quotes:

“There is no limit to the dollars the Federal Reserve can create”;


“In short, US policymakers will do whatever is required to avoid deflation. Indeed, the Fed will keep going until the US is satisfactorily reflated. What that effort does to the rest of the world is not its concern.”

In other words, “the US must win” the currency wars!

This sounds something like the fundamentalist preacher Paul Krugman who, seemingly, will never see a federal government deficit that is big enough to satisfy his tastes.

This argument is countered by Allan Meltzer, a historian of the Federal Reserve System.

“The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes.” (See “The Fed Compounds Its Mistakes,”

“We don’t have a monetary problem, we have 1 trillion or more in excess reserves so it’s literally stupid to say we’re going to add another trillion to that.” (This can be found at

Meltzer argues that the end to this will come through the marketplace. He states in the Wall Street Journal article:

“The market’s response to the talk about renewed bond purchases includes a 12% or 13% decline in the value of the dollar against the euro. This depreciation occurred despite a weak euro, beset by potential crises in Ireland, Greece and Spain. The dollar’s decline is a strong market vote of no confidence in the proposed policy.”

And in the Bloomberg article

“Sooner or later the bond market hawks are going to say, ‘How are they going to get rid of that $2 trillion of excess reserves?’ and the answer is they don’t know.”

The question is, in my mind, how long can the Washington policymakers hold out against the pressure of the international investment community?

In my professional experience…the international investment community always wins…it is just a matter of time!

I know that Robert Rubin is not much in favor these days, but I still believe that he was absolutely correct as the Secretary of the Treasury in the Clinton administration when he argued that the United States could not continue to create large fiscal deficits because the bond markets would not continue to support government debt issues if the deficits were continued.

President Clinton accepted Rubin’s arguments and moved to reduce the budget deficits. The result was a decline in United States interest rates and a huge run-up in the value of the United States dollar.

Rubin sensed the threat the bond market and the foreign exchange market represented to the ability of the United States government to continue along in an un-disciplined fashion.

I see no one in the United States government now that accepts the conclusion of the foreign exchange market.

My experience in business, both in running financial as well as non-financial companies, is that one ignores what the market is trying to tell you at enormous expense. I don’t know how many chairmen, presidents, and CEOs I have heard that claim that “the market just doesn’t understand what we are doing.”

Guess what?

The market does understand what you are doing and that is why it is moving against you.

I find it scary for someone to say,

“There is no limit to the dollars the Federal Reserve can create”;


“What that effort does to the rest of the world is not its concern.”

The voices of the dogmatists are getting “shrill” now. The world is not behaving according to their model. Let’s just hope that a government that does not see things going its way does not do anything rash out of desperation.

The recovery is taking place. However, it is taking place at a much slower pace than anyone wants. Maybe, just maybe, the healing needs to take its time so that a solid recovery can be attained. Quick fixes may do more damage to the patient over time than making sure that the recovery really heals the illness.

Tuesday, October 12, 2010

Globalized Finance: Advantage China

In recent posts I have written about how international capital mobility has expanded since the 1960s to the point where one cannot imagine the world without freely flowing capital. Sebastian Mallaby has presented a confirming essay on this in the Financial Times, “The Genie of Global Finance is Out of the Bottle,” (

“The truth is that, however cogent the case for reining in financial globalization, sheer momentum will carry it forward…the bottom line is that, once a country has a sophisticated capital market, it is tough to keep foreigners out.

It is even tougher to exclude a particular class of foreigner, which is why the understandable urge to impose portfolio sanctions on China will prove impractical. The US has sold around $3,000 billion worth of Treasury bonds to foreigners, and perhaps only a third of those are held by China—if Beijing wants to bulk up its holdings tomorrow, it can buy plenty from Middle Eastern sovereign funds. Once finance is globalized, it just is not possible to deglobalize it cleanly. The genie is out of the bottle. We must find ways to live with it safely.”

Take de-globalization off the table.

What is one way to live with this freely flowing capital mobility? Certainly not inflation.

Yet the United States government has acted over the past 50 years on an economic philosophy that has created an almost constant credit inflation. This has left the United States is a weakened bargaining position relative to other nations in the world. (See one of several posts I have recently written on this subject:

The United States has justified the need for this “independent” economic policy to ensure high levels of employment within the country. However, international financial markets have not given the United States high marks for such a policy as the value of the United States dollar has declined by about 40% throughout the period this policy has been in effect.

The justification for allowing the dollar to decline in value has been that this will help to stimulate American exports and help correct the American balance of payments.

Well, the Chinese (and other emerging countries) are buying goods from the rest of the world. However, they are not consumer goods…they are capital goods.

A headline opinion piece in the New York Times by Andrew Ross Sorkin trumpets “Worrying over China and Food” ( The concern is over the fact that a “consortium of state-backed Chinese companies and financiers may make a takeover offer for Potash that rivals a $38.6 billion hostile bid from BHP Billiton.”

Sorkin states that “The politically charged subtext is this: Do we really want the Chinese to control the company that has the largest capacity (in the world) to produce fertilizer?”
But this is not all from the morning papers as other headlines read “China Takes New Bite at U. S. Energy” ( and “China Turns to Texas for Drilling Know-How” ( It seems as if the China National Offshore Oil Company (Cnooc) is investing money in Chesapeake Energy, an investment “in onshore U. S. energy assets.”

Contrary to an earlier effort by Cnooc to acquire Unocal, a bid that caused grave concern in the United States Congress, this bid seems to be gaining favor because the Chinese will only have a minority ownership (one-third of the company) which means that this position will not be a “credible threat to national security.” The reason for this is that “Chesapeake will retain operational control of its…shale assets.”

What is the old saying about someone who gets their foot in the door?

But, this pattern is occurring all over the world as China intentionally expands its global reach in owning or influencing physical capital…owning all or part of companies.

And, who is underwriting this expansion? The United States government!

The United States government has outsourced to China and others the savings it needs to finance its massive deficits. The Federal Reserve System continues to keep interest rates excessively low exacerbating the credit inflation that that was begun at an earlier time.

And the response of the United States government? It is China’s fault that they are taking advantage of the excessive amounts of credit that have been created in the United States. And China will not change its behavior even as the United States government signals it will continue to follow the same policy it has followed for most of the last fifty years. No matter that this economic policy has brought the United States to the position it now finds itself in.

Bottom line: as Mallaby has argued, finance has been globalized and this trend cannot be cleanly reversed. Given that this is the case, continued efforts to inflate credit in the United States will only worsen the trade position of the United States and make the value of its currency sink even further. In such a situation, who cares about US firms outsourcing jobs to other countries. Instead, let’s just sell US companies to foreign interests and keep those jobs right here in the United States. That is, the jobs will not have to be outsourced to another country…they will just be outsourced to foreign-owned American firms located here in the United States.

Monday, October 11, 2010

Coming Crunch for Smaller Banks?

Two months ago I was hoping I was seeing some “Green Shoots in Smaller Bank Lending,” ( Last month I found very little encouragement in the banking data released by the Federal Reserve: “Still No Life in Banking,” (

The most recent data seem to indicate that things may be getting worse.

Remember, as of June 30, 2010, the FDIC listed 829 banks on its list of problem banks, and these banks are the smaller ones. Note that this is more than ten percent of the commercial banks in the banking system. Elizabeth Warren, in congressional testimony, has stated that there are at least 3,000 commercial banks facing major problems in the future, primarily in the area of commercial loans, ( I have made my own forecast that the number of domestically chartered banks in the United State will drop from around 8,000 to less than 4,000 in the next five years or so (

Total assets in the smaller banks in the United States (the smaller domestically chartered commercial banks consists of all banks below the top 25 in asset size and make up about one-third of the banking assets in the United States) are about the same this year as they were last year. Yet, cash assets in these banks increased by almost 38% from August 2009 to August 2010 and by more than 2% in the four week period ending September 29, 2010.

The concern, of course, is that the smaller banks are preparing for more trouble in the future. The larger banks are now in the process of reducing their cash assets: the cash asset at large, domestically chartered banks are down about 4% over the last four weeks; down about 5% over the past thirteen weeks; and down about 6% over the past year.

Thus, the decline in excess reserves that has occurred in the banking system over the last six- to eight-week period, has come in the big banks indicating that they are prepared to adjust to a new lower level of liquidity in the banking system.

However, the smaller banks are not ready to become less liquid, just the opposite. This, to me, indicates that the Federal Reserve is staying “extremely loose” not so much because the economy is weak, but because the solvency of the smaller banks in the banking system is in question.

There is no doubt that the smaller commercial banks in the United States are getting more conservative. Loans and leases at these smaller institutions continue to decline; they have dropped about one percent in the last four weeks.

The thing to keep an eye on, however, is the commercial real estate portfolio. In the smaller domestically chartered banks, the decline in these loans on the bank balance sheets seem to have accelerated in the past four weeks and in the past thirteen weeks from earlier time periods.

Commercial real estate loans have declined across the board, but the concern is that commercial real estate loans make up about 26% of the assets of the smaller domestically chartered banks and only are about 8% of the assets of the large banks. The declines in the smaller banks have a proportionately larger impact than does a similar decline in the big banks. Furthermore, this is where Elizabeth Warren pointed us to in her congressional testimony.

The two categories of loans that have recently increased at the smaller banks are “Revolving home equity loans” and “Credit card and other revolving plans.” The home equity loans at these smaller banks have risen by about 2% over the past 13-week period and are up slightly over the past 4-week period. At the big banks these loans are down by over one percent for the longer period and down slightly less than one percent for the shorter period.

Credit card and other revolving debt at the smaller institutions is up by over 4% in the past 13-week period and up by about 3% in the past 4-week period. At the larger banks, these numbers are down 3.5% for the longer period and down one percent for the shorter period.

Recent analysis of credit card debt indicates that, for the larger issuers, much of the decline in credit card debt has come because of these organizations charging off bad debt.

Could it be that the smaller banks are not charging off their delinquent home equity loans and credit card or revolving consumer debt because they don’t have the capital to absorb the losses? Could this be the reason that these loans are increasing at the smaller banks and not at the larger banks?

If one accepts this analysis, then the smaller banks have a lot to do on their balance sheets in the future to handle not only troubled commercial real estate loans but to handle revolving credit debt. Do the smaller commercial banks have the capital to go through this process?

There remain many concerns about the commercial banking system. Now that people expect that we will go through a period in which the profit performance of the larger banks is to be relatively flat, might this put even more pressure on the overall United States financial system?

My guess is that the big banks will do just fine. The problem is with the smaller banks, and the situation does not look encouraging for them. I still believe that this is the main reason why the Federal Reserve is keeping excess reserves in the banking system at such a high level. The Federal Reserve, in my mind, is scarred silly that there still may be massive bank failures in the future. The FDIC has been smoothly working through bank closures and helping many distressed institutions to find partners to absorb them. The question remains as to whether the massive amounts of liquidity in the banking system will allow this “work out” to continue its smooth and quiet pace in the face of growing problems with commercial real estate debt and consumer revolving debt?

Sunday, October 10, 2010

You Can't Lead Out Of Weakness: The IMF Meetings

With each international meeting it is becoming more and more obvious, the United States is dealing from a weakened hand.

The New York Times makes it very clear: “Despite loud calls from the United States; and more muted appeals by Europe, Japan and other countries, the annual meeting of the International Monetary Fund did not succeed in placing significant pressure on China to allow a prompt and meaningful rise in the value of its currency.” (See “Financial Leaders Decline to Press China on Currency,”

The language in the concluding statement of the policy-setting committee of the IMF “was benign.” Everything was postponed to the G-20 meeting in Seoul, South Korea in November.

The United States took a strong position on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States Congress made its will known in late September. Treasury Secretary Geithner also spoke out about the need for action on the part of the Chinese. President Obama has even made mention of the issue.

But, policy-makers are “wary about pressuring China too severely.”

Right now, China seems to hold the cards and no one is willing to move strongly against their position.

Most revealing is the fact that the United States seems to be in no position to press its points with its own actions and does not seem to be strong enough to command support among the other nations that might side with it.

Furthermore, the central bank of the United States, the Federal Reserve System, appears to be on the verge of another round of “quantitative easing”, something that world financial markets have reacted to by selling dollars. The world investment community has not given the United States a very good grade in terms of how its government has managed the monetary and fiscal policy of the country over the past eight years or so and sees these additional efforts as just a continuation of the lack of foresight and discipline and will in its economic policymaking.

If this is the prevailing attitude in the world about the economic policy of the United States, then one can only project further declines in the position of this country in the evolving discussions about world financial arrangements.

The United States has dealt itself a weak hand in world economic affairs. Unless it steps back and re-assesses how it got here and what it needs to do to change the situation, it will just continue to further weaken its position. And, it is very hard for a nation to lead when it is continually hurting itself.

Friday, October 8, 2010

The IMF Bowl: the United States versus China

With the IMF annual meeting taking place this weekend in Washington, D. C., it is hard to pick on any other topic than what is happening in economics and finance in the world.

The underlying story: the United States has not been challenged, financially as well as economically, in many years and has grown comfortable with its position as the Number One Player (NOP) in the World.

Plot line: the United States will not fall from its position as NOP but other countries are becoming relatively stronger, especially China.

Scenario: China smells weakness in the United States position. When an “opponent” smells weakness, that “opponent” steps up its game. Most experts expected China to “step up its game” at some time in the future, but they did not expect this behavior to happen so soon.

Response: the NOP calls “foul”! The first reaction of the NOP is to claim that the “opponent” is cheating or playing dirty. The NOP tries to get those on the sideline into the game in order to overcome the pressure that the “opponent” is applying to the NOP. China bashing has become de rigueur in the United States, especially for those running for office in this fall’s elections. (“China-Bashing Gains Bipartisan Support,”

Script: the battle goes on. This conflict is not going to be resolved this weekend. Nor is the conflict going to be resolved at the G-20 meetings in November. The conflict, for the time being, is going to be played out on the playing fields. The “opponent” is going to push the NOP and is going to hit the NOP on many different fronts.

For example, another move by the “opponent’ is the effort by the Chinese to make its currency, the yuan, more global. Last week, electronic trading of the yuan began. Further efforts are underway to expand this trading to banks in the United States and in Europe. (“Yuan Goes Electronic in Global Market Bid,”

“China’s government has made a series of moves in the past year to encourage the yuan’s use outside China, an effort to become less dependent on the dollar for trade and investment. The moves are allowing pools of yuan to accumulate in bank accounts outside of China, particularly in Hong Kong.

Hong Kong banks have been trading the currency among themselves, but through over-the-counter trades where the banks contact each other directly or through brokers.”

This new move will mean that prices and trading amounts will be posted for all to see.

The effort to improve its relative position in the world is not going to stop. China is making efforts on many fronts to strengthen its position in the world. The contest is on.

Leaders in the Obama administration, from the President to the Secretary of the Treasury on down, are speaking out more forcefully against the actions of the Chinese.

World leaders are observing this conflict and are trying to keep the discussions civil and “in bounds”. This is why someone like the managing director of the IMF, Dominique Strauss-Kahn, as well as others, are attempting to temper the rhetoric and bring things into the existing organizations that deal with trade and international finance. (“IMF Chief Steps into Dispute over China’s Currency Policy,”

Players crying “foul” can only achieve so much. Sooner or later the NOP will have to modify its game plan and raise its play to another level. The “opponent” is not going to lessen its pressure as long as weakness in perceived in the NOP.

And, where does this weakness show? One very prominent place this weakness shows is in the value of the dollar. Since the early 1970s when the dollar was taken off the gold standard, the value of the dollar has declined by about 40%. Except for the “flight to quality” periods experienced during the financial unpleasantness of the 2008-2009 period, the dollar has continued to be in decline from the level it reached during the Clinton years. The international investment community is not “in love” with the fiscal and monetary policy of the United States government.

This contest between China and the United States is for real. The pressure from the Chinese is not going to abate anytime soon. The “rest-of-the-world” is not in any position to contain this conflict unless it shuts down world trade, something it will not do.

This means that the United States must get its act in order. The United States cannot compete with 20% to 25% of its industrial capacity not being used. The United States cannot compete with 20% to 25% of its labor force under-employed and not trained sufficiently to work in the modern economy. The United States cannot compete when its government creates incentives for people to protect themselves from credit inflation rather than engage in productive pursuits.
And, fiscal stimulus by the government and quantitative easing on the part of the monetary authorities will not correct these problems. They will only indicate to the Chinese how weak the United States has become.

This contest between China and the United States is for real. The only way the United States can “raise its game” is by focusing on what can make it more competitive. I don’t believe that the United States will ever again get the “free ride” it benefitted from over the past thirty years or so. So, the United States government must change the way it does business.

The Chinese are only the first in line to “take us on”. Right behind them are the Brazilians, the Indians, and, of course, the Russians, again. And, right behind them is a whole host of other nations.

Thursday, October 7, 2010

Discipline, Especially Related to Financial Discipline, is a Bad Word

What appears as the lead in the Huffington Post this morning?

“What a Waste: Companies Using Piles of Cash to Buy Back Stock, Not Generate Jobs!” This headline points to an article in the Washington Post:

It was the lack of discipline that got this country where it is now. The recipe that some people are pushing for is “more of the same!”

The United States has been a show case for the “lack of discipline” over the last fifty years. The credit inflation initiated by the federal government has grown and expanded to almost every sector of the economy. Almost everyone, public and private, has leveraged up to the hilt over this time period.

The question remains: did we reach levels of debt that were unsustainable and had to be reduced?

Other questions follow: Have we misdirected resources in ways that have left one out of every five people of employment age untrained for employment in today’s workforce? Have we, like Japan, created surplus capacity in industry through fiscal stimulus and excessively low interest rates? Have we provided incentives that the wealthy can take advantage of, which the less-well-off cannot?

And, the problems swirl around us.

Elizabeth Warren pointed to the 3,000 commercial banks in the United States that are seriously in trouble and face enormous pressures due to the commercial real estate loans that are coming due or re-pricing over the next 12 to 18 months.

There have been numerous articles over the past week or so about the fiscal woes that cities face. (See the New York Times article “Fiscal Woes Deepening for Cities, Report Says”:

“The nation’s cities are in their worst fiscal shape in at least a quarter of a century and have probably not yet hit the bottom of their slide,” states a report by the National League of Cities.

What about the financial health of the states? “Right now there isn’t really anywhere to turn” as many states are now cutting aid to cities, says Christopher Hoene, one of the authors of the report. “The state budgets are in a position where they are more likely to hurt than to help.”

And, this doesn’t get into the problems individuals are having holding onto their jobs or homes.

Who seems to be doing well and positioning themselves to move into the future? Well it seems as if large companies and large banks are doing all the positioning at the present time. (See my post Corporations buy back stock to better position themselves for future moves in the acquisition area. A higher stock price gives them more bargaining power when they are negotiating a “for-stock” transaction.

We are just seeing the tip of this iceberg. In August, acquisitions were unusually high in the manufacturing area for this time of year. We have not seen the September figures yet, but we are seeing lots of movement.

How can one doubt this movement with headlines like this one that appeared this morning in the Wall Street Journal: “GE Goes On Binge For Deals” (

In the article, John Krenicki, chief executive of GE Energy is quoted as saying, “This is another sign we’re playing offense.” There are “lots of choices organically and inorganically to grow the business.”

The article goes on: “GE Vice Chairman John Rice said last month the company has the firepower to spend about $30 billion on acquisitions over the next two to three years.” He added, however, that “we’re not going to run out and buy something just for the sake of buying it.”

But, this is not going to add jobs to the economy and it is not going to produce a lot of investment expenditures, both of which would help to spur on an economic recovery.

The United States is re-structuring. It appears as if more discipline is being exercised by those in a position to move forward. It also appears that those that are “under water” are scrambling to get their lives back under control.

The correction will not be comfortable or easy. But, calls for people and businesses to forget their efforts to bring discipline back into their lives will just postpone the fact that discipline will, at some time, have to be brought back into their lives. In fact, we may have reached the point where there is no going back…the thrust of the last 50 years may not be able to be sustained…and discipline will be re-established.

There is no question that this re-structuring is going to be very, very hard on some people. But, that is why one needs to be disciplined in what one does, even in the go-go years. Getting back the discipline is always hard. Perhaps the hardest part is to realize is that some, in the go-go years, were pushed to go beyond what they could really achieve at the time: these individuals were given incentives to put aside their discipline with the impression that their lack of discipline would not come back to haunt them.

The lesson that apparently needs to be learned over and over again is that, ultimately, a lack of discipline catches up with you. Discipline then has to be re-established. Re-establishing discipline is painful. But, there is no such thing as a free lunch.