Friday, February 25, 2011

Is the Future of Finance "Post-Human"?

Thursday, February 17, I put up a post titled “The Future of Finance is Getting Closer” ( In this post I discussed the changing world of finance and how it is being impacted by changes in information processing and the spread of information. I write on this subject fairly frequently because I believe that the continued improvement in information processing and the continued spread of information are going to dominate the future of finance…and everything else.

A reader of this post expressed concern over this assessment: derryl, stated that “John seems to be describing, not a post-industrial world, but a post-human world. Disembodied minds trading in information.”

I don’t believe that I am describing a “post-human world.” Information processing and the spread of information has been going on for a long, long time. Let me put this in context. Freeman Dyson, Physics Professor Emeritus at the Institute for Advanced Study in Princeton wrote in review (New York Review of Books, March 10. 2011) of the new book by James Gleick, “The Information: A History, A Theory, A Flood” that “Everywhere around us, wherever we look, we see increasing order and increasing information.” This is true both in the living world as well as the non-living world.

Dyson goes on to qualify this statement. This “unending supply of information is a glorious vision for scientists. Scientists find the vision attractive, since it gives them a purpose for their existence and an unending supply of jobs.” Scientists work with the increasing amount of information to identify and work with the increasing amount of order.

The concern by derryl only becomes real if the amount of information that exists is finite. Then the advancements of information technology can conceivably capture and model all that is and we evolve into “post-human world”.

The world being described by Dyson is a world in which the questions never end because the amount of information in this world is growing and will continue to grow. Thus, there will always need to be humans because there will always be questions to ask and inferences to be made.
This world Dyson sees is continually requires humans to be around to gather the new information being produced and incorporate into new concepts and models.

This is even more true of “human” activities like finance and investing. All the studies of complexity theory argue that the behavior of humans is much more “complex” than the behavior of non-living things. The reason for this is that modeling humans requires more information and more sophisticated models than is required to model non-living things. Thus, building models relating to investment behavior in a world where the total amount of information is increasing is something that cannot become “post-human.”

Dyson captures this reality by writing that “The vision is less attractive to artists and writers and ordinary people…Ordinary people may not welcome a future spent swimming in an unending flood of information.”

We see the problems in modeling human behavior in the book “The Quants” (See review: In this book, the author describes what has been called a quant-led collapse: specifically the August 2007 market meltdown. “This meltdown came in what is known as the “shadow banking system” and not the true banking system (for) the Federal Reserve really didn’t seem to know what was going on. The first catastrophe came when the Bear Stearns hedge funds were instructed to file for bankruptcy on July 30, 2007. The melt-down started in earnest on Monday August 6.” Quant firms suffered large losses on “toxic” assets.

But, the “Quants” are still in business. And, the “Quants” are still using sophisticated mathematical models to invest. As with all human problem solving activity, the humans have learned from the 2007 experience. They have modified or re-built their models to take into account the new information that has been gathered and processed. And, they now have more robust models than they did before the financial collapse.

This is a highly quantitative world, yet it is not post-human and in my view will never be post-human. Humans are problem solvers and in playing this role they must build models, test models, modify models and use models to make decisions or explain things. Humans are information users. And, in the world we are moving into will be even more information and information processing driven. It will be “smaller and faster.” (See

This world, however, is going to be a more volatile world, it is going to be a world that changes faster, and it is going to be a world that requires people to adapt to the changes that they see going on around them. One cannot “lock” themselves into the world of the past.

History has shown that the spread of information and information technology cannot be stopped. It’s spread may be postponed for a while, but it eventually will succeed in spreading.
Laws and regulations must take account of this. Congresses and regulators must take account of this. Dictators and autocrats must take account of this. Presidents and Prime Ministers must take account of this.

A danger is that this world bifurcates…divides into two…those that can work within the new paradigm and those that adjust, for whatever reason, to the new paradigm. We are seeing some of the consequences of such division. The income distribution is being determined more and more by the amount of education a person has. Jobs are splitting more and more between service jobs and manufacturing jobs. But, even this is not all. Even clerk-like service jobs are being replaced by new technology. Jobs are more plentiful in information technology and finance than in jobs connected with “making things.” Health care is going to be an employment magnet but even there the clerk-like jobs are going to be replaced by new technology.

As a consequence of these developments, under-employment has grown substantially and will not decline much in upcoming years. Capacity utilization in the manufacturing industries will remain at historical lows. A substantial re-structuring is going to have to occur in the economies of the developed nations.

The point I am trying to make is that the world is going through a period of major transitions…economically, politically, and culturally. This is a once-in-a-century thing. As with major transitions in the past, the human element has not been eliminated, but the structure of human involvement in the world has changed dramatically.

Such change can be disturbing. I know that I am feeling the effects of this change in my life…and it is not just because I am getting older!

Federal Reserve QE2 Watch: Part 3.3

The Federal Reserve injected $73 billion more reserve balances into the banking system in the banking week ending February 23, 2011.

The Federal Reserve has injected $272 billion into the banking system since the end of last year, since December 29, 2010.

Reserve balances at Federal Reserve Banks totaled $1.290 billion at the close of business on February 23, 2011.

Excess reserves for the banking system averaged almost $1.220 billion for the two weeks ending February 23, 2011.

QE2 rolls on!

And commercial banks still seem to prefer holding onto the cash rather than lending the money out. And, it seems as if a large percentage of the funds being pumped into the banking system are now going to foreign-related financial institutions. (

The major mover of bank reserves is still the Fed’s purchase of US Treasury securities. The Fed added $23 billion more Treasury securities to its portfolio last week. Holdings of Treasury securities are up almost $200 billion since December 29, 2010.

The Treasury still continues to move money around. In the past week it reduced balances it holds in it’s General Account at the Fed by almost $32 billion. (This action puts reserves into the banking system.)

Since December 29, 2010, the Treasury has reduced it’s balances in the General Account by about $66 billion.

Last week the Treasury also reduced the amount of funds it holds in it’s Supplementary Financing Account by another $25 billion. The Treasury reduced these balances by $75 billion since December 29. As the Treasury spends out of these accounts it puts reserves into the banking system. (For more on the Treasury’s Supplementary Financing Account see my post:

As the Treasury has moved funds around since the end of last year it has put more than $140 billion into the banking system that has ended up as reserve balances.

There are three conclusions I have drawn from the financial statistics I have seen:

First, the Fed is scared silly that the smaller banks in the United States (all banks other than the largest 25) will experience a massive series of failures before the FDIC can close a sufficient number of them in an orderly fashion;

Second, the largest 25 banks in the country are having a feast on the low borrowing costs that the Fed is maintaining (the FDIC reported that 95% of all bank profits in the fourth quarter of 2010 went to the largest banks in the United States,;

Third, given the mobility of capital in the world today, the Federal Reserve has become the central bank of the world and is supplying funds for potential bubbles in commodities and natural resources globally.

My question: Is conclusion one above sufficient justification for the resulting consequences of the Fed’s policy as observed in conclusions two and three?

Thursday, February 24, 2011

United States Loses 355 Banks in 2010

One December 31, 2010, the FDIC reported that there were 7,657 insured depository institutions in the United States. This was 355 less than the 8,012 institutions that were in existence on December 31, 2009. (157 banks were officially closed by the FDIC in calendar 2010.)

This is up from the 293 institutions that dropped out of the industry in 2009.

In the fourth quarter of 2010, the number of insured depository institutions in the United States dropped by 104 depository institutions.

The number of banks on the FDIC’s list of problem banks rose from 860 to 884 at the end of the year.

The FDIC does not list how many of these problem banks went out of business in the fourth quarter of 2010 or were acquired by or merged into other institutions during this period. But, the picture is not quite as rosy as New York Times columnist Eric Dash reports this morning: “And only 24 lenders were added to the government’s list of troubled banks, the smallest increase since the financial crisis erupted in late
2007.” (

Most of the banks leaving the banking industry were on the smaller size.

Furthermore, the list of problem banks does not include many other banks that are facing serious problems but have not yet qualified to be put on the FDICs list of problem banks. Need I mention the name of Wilmington Trust Bank, a bank that was considered by almost everyone as a bank that was doing OK. Then came the news of its sale last November. (

The problem list is a proxy for the number of institutions that are severely stressed, but does not include all that are still experiencing questionable futures. These latter banks have just not crossed the statistical threshold to be considered “problem banks.” Still 12% of the banking system is on the problem list.

I have been arguing for more than a year now that the actions of the Federal Reserve have been aimed at keeping things calm in the banking industry so that the FDIC can close or arrange acquisitions for troubled banks in an “orderly” fashion. This, I believe, has been one of the reasons that the Fed’s target interest rates have been kept near zero for such a long time. It is also part of the reason for the Fed’s second round of spaghetti tossing, or, quantitative easing (QE2).

The FDIC has needed the calmest environment possible to oversee a dramatic reduction in the number of banks in the banking system. As reported above, the banking system has almost 650 fewer banks in existence now than were in the banking system on January 1, 2009. That is a reduction of almost 8% of the banking institutions that existed at that time.

The other fact that does not bode well for the smaller banks in the country was just reported by the Associated Press: the profits of the big banks represented 95% of all bank profits in the fourth quarter of 2010. The big banks earned $20.6 billion of the $21.7 billion in profits earned by the banking industry as a whole. That is, only about 1.4% of the 7,657 banks noted above with assets of more than $10 billion saw these earnings.

And, bank lending. Bank lending continues to drag. I reported in my post of February 21, 2011:

“bank lending was abysmal over the past 6-week period and the last 14-week period.

Since the end of the year, loans and leases at the largest 25 domestically chartered banks in the United States dropped dramatically by about $50 billion, much of this coming in consumer lending although loan amounts were down across the board. Loans and leases held roughly constant in the eight weeks that preceded December 29 at these large banks.

In the rest of the banking system, the declines in the loan portfolio came primarily before the end of the year. After falling by about $60 billion in November and December, loans at these institutions rose slightly in the first six weeks of 2011. Notable decreases came in both residential lending and in commercial real estate loans, each declining by a little more than $20 billion over the last 14-week period.” (

My question still remains, “why should the commercial banks be lending?” A large number of the banks have balance sheets that are not in very good shape, interest rates are abysmally low, and there are still quite a few sectors of the economy, housing, commercial real estate, consumer loans, state and local governments, that are experiencing serve financial difficulties themselves.

Having $1.2 trillion of excess reserves in the banking system is not justification for the banks to be lending…especially the smaller banks.

If the banks don’t lend right now it avoids the possibility of putting another bad loan on their balance sheets. In that way they can focus on their existing bad loans.
Some people looking for “green shoots” in the banking industry claim that they have found them. Unfortunately, I have not yet found a lot to raise my spirits.

Wednesday, February 23, 2011

The Music Has Begun Again, Start Dancing?

John Maynard Keynes is remembered for many quotes and one of the most memorable ones is his claim that “In the long run we are all dead.” Keynes wrote this remark to criticize the belief that inflation would acceptably control itself without government intervention. That is, he argued that the theoretically determined equilibrium of an economy was not a good guide to the future in a very volatile economic situation.

The statement has been used, however, as an excuse for choosing the economic policy of a government based short run outcomes. The most prominent short run outcome sought over the past fifty years has been the maintenance of high levels of employment…or, low levels of unemployment.

The problem is that fifty years of government stimulus, basically credit inflation, aimed at achieving low levels of unemployment have created a cumulative build up in debt and a general attitude toward debt that perpetuates a desire for “more-of-the-same.”

And, over this past fifty years, the purchasing power of the dollar has declined by 85%; the under-employed in the country are in excess of 20% of the working force; and the income distribution has become dramatically skewed toward higher income recipients.

Not surprisingly, the economic and financial crisis of the past few years has been met with calls for more fiscal stimulus and wide-open monetary policy. The result: yearly federal government budget deficits of over $1.5 trillion with an estimated cumulative deficit over the next ten years in excess of $15 trillion. In terms of monetary policy, excess reserves in the banking system have reached $1.2 trillion. All this, of course, to get the economy going again.

Here, however, is where moral hazard enters the picture. The behavior patterns of finance people, developed over the last fifty years, “kicks in” once people see that the same old spending habits of the government are still in place.

I call your attention to the opinion piece by John Plender in the Financial Times this morning, “Bad Habits of Credit Bubble Make Worrying Comeback.” (

Mr. Plender begins: “Here we go again. The start of the year in debt markets has been marked by record low yields on junk bonds, declining underwriting standards and a return of the more dangerous innovations of yesteryear such as payment-in-kind toggles which allow borrowers to issue more debt to pay the interest bill. Even covenant-life loans, where normal borrowing conditions are shelved, have made a comeback in the leveraged buyout market and elsewhere, at a time when hapless small and medium sized firms are hard pressed to find credit.

A surplus of savings over investment is thus building up in the system and the US is once again accommodating the savings gluttons with an ongoing commitment to loose policy…No surprise, then, that the search for yield is back in evidence. With Federal Reserve chairman Ben Bernanke keeping policy interest rates at rock bottom, investors are being driven into riskier assets such as junk bonds and leveraged loans.”

Has the “music” started up once more so that people must start dancing again? Someone call “Chuck” Prince, former chairman of Citigroup, to get his “take” on the timing.

Fifty year policies are not just present in the economic policies of government. They exist elsewhere as well. Check out the Tom Friedman’s column “If Not Now, When?” in the New York Times this morning. (

Here Friedman discusses energy policy: “For the last 50 years, America (and Europe and Asia) have treated the Middle East as if it were just a collection of big gas stations: Saudi station, Iran station, Kuwait station, Bahrain station, Egypt station, Libya station, Iraq station, United Arab Emirates station, etc. Our message to the region has been very consistent: ‘Guys (it was only guys we spoke with), here’s the deal. Keep your pumps open, your oil prices low, don’t bother the Israelis too much and, as far as we’re concerned, you can do whatever you want out back. You can deprive your people of whatever civil rights you like. You can engage in however much corruption you like. You can preach whatever intolerance from your mosques that you like. You can print whatever conspiracy theories about us in your newspapers that you like. You can keep your women as illiterate as you like. You can create whatever vast welfare-state economies, without any innovative capacity, that you like. You can undereducate your youth as much as you like. Just keep your pumps open, your oil prices low, don’t hassle the Jews too much — and you can do whatever you want out back.’”

Fifty years is a long time. The buildup of fifty years of economic policies and energy policies can result in a lot of excess baggage hanging around that must be dealt with. A fifty-year build up not only requires a major re-structuring of nations and economies, it also requires a huge shift in the mindset of many, many people.

You want the deficit to come down in the short run and monetary policy to be reversed because it is potentially inflationary? It just ain’t going to happen in the near term.
You want an energy policy that is going to immediately get us off of oil so that we can stop subsidizing dictators and autocrats in the Middle East? It just ain’t going to happen in the near term.

And, so on and so on…

What seems to be missing is the leadership to change our mindset and develop a new paradigm that will set us on a pathway to re-structure our economy and our lives. I don’t think we want to dance the same old dance we have been doing for the past fifty years. Yet, it seems as if we have no choice but to start dancing again because the bank has begun to play the music once more.

The leadership just does not seem to be here, either in America, or in Europe, or in Asia. And, no one is strong enough to want to inflict on people the consequences of ‘getting the house in order again.’ I guess one can say, in line with the earlier comments of the mayor-elect of Chicago, Rahm Emanuel, that the leadership in the United States (and in Europe and in Asia) has “”let a crisis go to waste!”

The question that is still unanswered is “Has Keynes’ long-run arrived yet or do we still have to wait for it?” If it has not arrived yet, then it is still to come. Payment will be collected sometime. However, if this ‘long-run’ is still to come then my advice to those that work in financial institutions or in the financial markets is…start dancing again if you haven’t already started for the music has begun once again.

Tuesday, February 22, 2011

G-19 Plus One

“Another phenomenon on display (at the G-20 conference over the weekend) was China’s willingness to continue fighting on its own in the G-20 if necessary.” (See “G-20 skeptics wait for shift in behavior”:

“In the face of determined and often solo opposition from China, the finance ministers did not mention foreign exchange reserves in the list of indicators (to be used in determining economic imbalances in the global economy).”

Actually, the makeup of the G-20 seems to look more like a quadrilateral. At the corners: China; and the United States; and Germany; and the rest.

China seems to be holding its own against the others: Eswar Prasad, former head of the IMF’s China division stated that “With the rest of the G-20 arrayed against it, China still managed to hold its own.” China, more and more, is feeling its rising strength in international policy discussions.

Then there is the United States. Over the weekend we heard comments from Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, and Tim Geithner, United States Secretary of the Treasury.

The common thread in the remarks of Mr. Bernanke and Mr. Geithner: the problems connected with the international imbalances are the fault of China…or, everyone else. The United States is not responsible for any of the imbalances that have occurred.

But, people don’t really seem to be listening to “Ben and Tim” any more, a sign of the respect the United States now gets in the world.

Germany, well, Angela Merkel, the German leader, has problems at home. She is perceived as not tough enough and the feeling is that she has sold out to the rest of Europe. Thus, she is trying to re-establish herself and deal from the strength of the German economic position without sounding conciliatory.

And, the rest of the crop? Well, Nicholas Sarkozy has not taken the G-20 leadership anywhere and although he wanted to use it as a vehicle to regain his popularity in France…or anyplace else it seems. His agenda for the year seems to lie in tatters.

The others…there is no mention of them…well, with the exception of words from Brazil from


There is no real leadership anywhere, and, there is no real current crisis that needs attending.

So, everyone can basically stake out their own claims and gripe about the others.

However, this does not satisfy anybody.

Everyone knows that there are all kinds of financial and economic problems in the world. But, no one seems to be in a position to really drive home the point that something needs to be done about them.

China and the emerging nations in the world are on their own track, economic growth seems to be robust with the prestige of this group on the upswing. Momentum seems to be on their side.

The United States, the eurozone, the UK…the developed world…seems to be experiencing some

kind of a recovery…but…nothing seems to be easy.

And, a worldwide inflation that seems to be picking up steam.

As a result…the shadow of (financial) crisis seems to looming over everything in the western world.

The eurozone has not resolved its problems, either in terms of the sovereign debt issue or the healthiness of its banking systems. Many investors are just hanging around waiting for the next round of the crisis to rear its ugly head. There still is the feeling that some nations are still going to have to write down their debt. The questions there revolve around when this might occur and just how many nations will be involved.

And, with the menace of inflation growing in Europe and the UK, mediocre economic growth is keeping the European Central Bank and the Bank of England on the sidelines with respect to raising short term interest rates. Also, raising short term interest rates might disturb the financial markets.

The United States government has the cloud of a shutdown hanging over its head. And, even if a shutdown is avoided and some reduction in the budget deficit takes place, the country is still looking at a cumulative increase in the amount of government debt outstanding in excess of $15 trillion over the next ten years. But, the United States still has the reserve currency of the world, and, as long as the United States continues to hold onto this privilege, serious concern over the debt of the government will remain muted. All seems to be posture, there is really no sense of urgency.

Concern still exists in the rest of the world concerning all the reserves the Federal Reserve has pumped into the banking system. The total of commercial bank reserve balances with Federal Reserve banks, a proxy for the excess reserves in the banking system, exceeds $1.2 trillion, a rise of more than $200 billion over the past six weeks. And, the Fed continues to keep its target short term interest rate below 25 basis points and still is not expected to allow this rate to creep up for several months more at the least.

Interest rates in the rest of the world (like in China and Brazil) continue to rise and continue to draw liquid funds from the United States and Europe.

This scenario continues to promise volatility in financial markets. If the global problems are not resolved and the financial imbalances continue to exist, the world will remain unsettled and funds will flow here and there as dramatic movements take place…in financial markets…in commercial banks…in commodities…in whatever markets seem to be the most unstable for the moment.

Is it going to take another major crisis to get action? We had a major financial crisis just a year ago or so and the response to it was pathetic and remains so. Do we really need another one to get people to move?

Here is where China…and Brazil…and a couple of other countries are setting in the driver’s seat. And, the west doesn’t seem to see the situation as a game of chicken. China…and Brazil…and others are not going to blink as long as the United States and Europe continue to drive their midget car against the huge SUV being driven against them. Right now, China does not believe it has to budge from its position. The United States and Europe argue that China is being “unfair”. And, Chinese confidence seems to grow every day. The recent G-20 meeting just reinforces this picture.

Monday, February 21, 2011

Federal Reserve Is Providing Cash For Foreign-Related Banking Institutions

Since the end of December 2010 (the banking week ending December 29, 2010) the Federal Reserve has injected almost $200 billion in new reserve balances into the banking system. (See my post of December 18:

Since the end of December 2010 (the banking week ending December 29, 2010) cash assets at commercial banks have risen by more than $280 billion!

Since the end of December 2010 (the banking week ending December 29, 2010) cash assets at foreign-related banking institutions in the United States have risen by more than $175 billion!

In addition, trading assets at these foreign-related banking institutions have risen by $33 billion and a catch-all asset account has risen by $12 billion. (This catch-all account includes things like loans to foreign banks, loans to nonbank depository institutions and loans to nonbank financial institutions.)

All together these accounts at these foreign banking organizations have risen by about $220 billion in the last six weeks, about $30 billion more than the total assets of these foreign-related banking institutions have increased. One could argue that the foreign-related banking institutions are doing pretty well by the quantitative easing that the Federal Reserve is conducting. These foreign-related organizations seem to be doing a lot of trading!

During this same time period the total assets of large domestically chartered commercial banks in the United States have declined slightly.

The total assets of small domestically chartered commercial banks rose by about $30 billion.

Also, during this time period cash assets at the largest 25 domestically chartered banks rose by more than $72 billion and the cash assets at all other domestically chartered banks rose by $38 billion.

Thus, the Fed's QE2 is getting the cash out into the banking system. However, almost two-thirds of the cash seems to be going to foreign-related organizations and not to domestically chartered commercial banks!

Is this what was supposed to have happen?

Over the past 14-week period, cash assets in the banking system have risen by almost $300 billion. Again, over two-thirds of the increase (about $205 billion) came in the cash assets of the foreign-related banking institutions. All of the increase in cash holdings at the largest 25 banks came after December 29, 2010, while cash assets holdings in the rest of the banking system fell in the period before December 29 before rising in the last 6-week period.

One would think that this distribution of cash would not bode well for domestic lending. And, in fact, bank lending was abysmal over the past 6-week period and the last 14-week period.

Since the end of the year, loans and leases at the largest 25 domestically chartered banks in the United States dropped dramatically by about $50 billion, much of this coming in consumer lending although loan amounts were down across the board. Loans and leases held roughly constant in the eight weeks that preceded December 29 at these large banks.

In the rest of the banking system the declines in the loan portfolio came primarily before the end of the year. After falling by about $60 billion in November and December, loans at these institutions rose slightly in the first six weeks of 2011. Notable decreases came in both residential lending and in commercial real estate loans, each declining by a little more than $20 billion over the last 14-week period.

One interesting thing also appeared in the recent statistics. The securities portfolio of the banking system declined over the latest 14-week period by a little less than $40 billion.

However, there were huge differences in the behavior of the largest banks and the smaller banks.

The largest banks REDUCED their holdings of securities by about $96 billion; $67 billion of the total were in U. S. Treasury and Agency securities.

The rest of the domestically chartered commercial banks INCREASED their holdings of securities by almost $60 billion with a $63 billion increase in their holdings of U. S. Treasury securities.

The larger banks got out of securities as interest rates rose through November, December, and January. The smaller banks increased their securities. Is this bad timing on the part of the smaller banks?

So, here we are with the Federal Reserve pumping reserves into the banking system like crazy.
But, two-thirds of it is going to foreign-related banking institutions?

And, commercial bank lending continues to contract?

What is wrong with this picture?

I am feeling such a disconnect between Ben Bernanke’s view of the world and what seems to be going on in the world. When Mr. Bernanke speaks I really wonder what planet he is on…it certainly doesn’t seem to be the one that I am on.

Also, I am getting tired of Mr. Bernanke putting the blame for all his troubles on the backs of others. He began this practice in the early 2000s and it continues on today. He doesn’t accept the fact that some of the mistakes of the past are his. As Stephen Covey has said, if all the blame for the problems one faces is “out there”…that’s the problem!

Friday, February 18, 2011

Federal Reserve QE2 Watch: Part 3.2

The Federal Reserve’s liquidity machine continues “full speed ahead”!

In the banking week ending February 16, 2011, the Fed injected almost $31 billion in new reserve balances into the banking system.

Over the past two banking weeks the Fed has pushed almost $140 billion in new reserve balances into the banking system.

Since the end of 2010 (the banking week ending December 29, 2010) the Fed has increased reserve balances with Federal Reserve Banks by almost $200 billion!

Thus, reserve balances at the Fed, a proxy for excess reserves in the banking system, have increased by a whopping 20% over the past six weeks.

The Federal Reserve is doing to the banking system what it said it was going to do.

In the fall of 2008 and winter of 2009, Chairman Ben Bernanke tossed as much Spaghetti against the wall as he could toss to see what would stick.

It appears that we are not necessarily in the middle of Quantitative Easing 2 (QE2), but are instead in the middle of Spaghetti Toss 2 (ST2)!

The Fed continued to buy more government securities last week, increasing its portfolio by about $23 billion. This supplied reserve funds to the banking system.

The big increase in bank reserves came, once again, in the U. S. Treasury Supplementary Financing Account. (For more on this account and its use see my post This account declined by $25 billion for the second week in a row. When this account increases it “absorbs” funds from the banking system. Therefore, when it declines it releases funds into the banking system.

Thus, over the past two weeks when reserve balances rose by almost $140 billion, $50 billion of the increase came from the Fed adding more Government securities to its portfolio and $50 billion came from the Treasury releasing funds to the banking system from its supplementary financing account.

Since December 29 when reserve balances rose by almost $200 billion the Fed bought almost $140 billion in government securities (about $34 billion going to offset maturing mortgage-backed securities), the Treasury reduced its Supplementary Financing Account by $50 billion AND reduced its General Account by almost $35 billion.

This last movement was the usual seasonal swing from the build up in tax revenues toward the end of a calendar year. It still puts reserves into the banking system.

To put things into perspective: Remember back in August 2008, the total reserves in the banking system were $46 billion and excess reserves were less than $2 billion.

Now, within the span of six weeks the Federal Reserve injected into the banking system four times the amount of total reserves that was held by the whole banking system at that time. The wave that is coming looks like it is a part of a Tsunami!

Thursday, February 17, 2011

The Future of Finance is Getting Closer

I know that not all of these facts that I present below are new, but reading about the following five in the morning papers just reconfirmed my position on the future of the financial markets.

First and second, stock exchanges have become dominated by high-frequency trading and index funds.

Third, the combination of the Deutsche Bȍrse and the NYSE Euronext will continue the trend for exchanges to turn to derivatives and technology business. The model here seems to be the CME Group, “the world's leading and most diverse derivatives marketplace” which has a market capitalization that is larger than either of the two combining institutions.

Fourth, the Shanghai Stock Exchange and the BM&F Bovespa, Latin Americas largest exchange is going to announce an agreement which will include the fact that stocks will be cross-listed on both exchanges. This will put Brazilian and Chinese interests together, world-wide.

Fifth, the IBM computer named Watson beat the two “greatest” players on the TV program “Jeopardy!” This, of course, comes only a few years after an IBM computer beat the world champion of chess at his own game. And, this most recent battle of “wits” has set off a plethora of articles on the state of artificial intelligence. The advances are mind-boggling!

A sixth fact could be the unrest in the Middle East where a very serious challenge in being raised against local autocratic leaders. Part of the cause, information technology.

Why are these “facts” important to me?

They are all just another indication the spread of information and information technology continues and cannot be stopped. Not only are things happening faster, they are becoming more ubiquitous.

Once again, for those that have not yet read the book titled “The Quants”, you should because it gives us a glimpse of what the future is going to be like. (See my review:

And, this is the world that Congress (and other bodies around the world) is trying to regulate?

But, regulating to prevent 2007 and beyond from happening again is not going to protect usin the future.

It is the world that Mr. Gary Gensler, the chairman of the CFTC is trying to get his arms around and control.

But, how do you grab hold of a “whiff of smoke”?

The above facts are dramatically showing that finance is information and that the storing, processing, analysis, use and dissemination of information is going to become more and more technologically advanced as time passes. In fact, it is going to happen faster and faster.

In the future, more and more finance is going to be “quantified”; trades are going to occur at even greater speeds; and information is going to be stored…somewhere…and transactions are going to happen…well, someplace.

Regulation cannot just focus on “outcomes”. Regulation cannot eliminate “systematic” risk.
Furthermore, regulation of the kind we are used to in the United States only takes place “after-the-fact.”

The only way to really gain some insight into what is going on in financial markets is to observe what the market is saying. That is, the only way to get some kind of “advance warning” about market trouble is to watch market information.

Such systems have been suggested. One such suggestion has been given for an “early warning” methodology for the banking system. I have discussed this methodology in several posts over the past year. I will refer to just one of these posts ( that references the work of Oliver Hart and Luigi Zingales. The system proposed by Hart and Zingales is a market-based system that can raise “red flags” that regulators can respond to. In this way their system is “anticipatory” and not “reactive.”

Still, this world of the future must avoid some of the problems of the past. No regulatory system is going to be able to survive a regime of undisciplined governmental policy like we have seen in the United States over the past fifty years. Credit inflation undermines an economy and destroys discipline. (See my post

This must be considered within a world that is going through a period of transition that is monumental. Major shifts are taking place everywhere and we really don’t know what the ultimate result is going to be. However, we are moving away from a “labor”-based, manufacturing system to a “knowledge”-based society embedded within whatever the current information technology allows. The government cannot continue to base macro-economic policy on the assumption that the structure of the world still rests on the old, labor-based manufacturing system. It will just perpetuate the errors of the past.

As advancing technology allows us to do “finance” faster and in more ubiquitous ways, the techniques and tools of finance will just be used to take advantage of the credit inflation created by governments. Remember it is the wealthiest, the most trained, and the best positioned that will be able to take full advantage of the incentives created by further credit inflation.

What proof do I have for this?

Take a look at the last fifty years of credit inflation. What have been two of the fastest growing sectors in the economy?

The answer is: information technology and finance. And, these two sectors have complemented each other very well. Computer-based financial innovation has thrived in this environment of credit inflation. In fact, no other environment is so conducive to financial innovation than is an environment based on credit inflation.

And, the results of the past fifty years?

The purchasing power of the dollar has declined by about 85%. Under-employment of the working force is somewhere in excess twenty percent. And, the income distribution has become radically skewed toward the wealthier end of the scale. Need I say more?

Wednesday, February 16, 2011

Deficits, Credit Inflation, and the Dollar

Over the past decade, but especially over the last year or so, there has been a concern over when the “deficit sharks” are going to turn against the United States bonds and the United States dollar. This question has certainly arisen in the minds of many as the Eurozone has been attacked and the Chinese make moves to make their currency “more international.”

My answer to this is that the debt of the United States will not really come under attack until the United States dollar ceases to be the one reserve currency in the world. And, the United States dollar will continue to be the one reserve currency in the world for a relatively long time.

It has been the status of the United States dollar that has allowed the United States government to “get away” with its fiscal irresponsibility for the past fifty years and it is this status that will allow the United States government to “get away” with its fiscal irresponsibility for a while longer.

Since the United States debt can always be paid off with United States dollars people and nations will hold the American debt and will rush to it when there is a “flight–to-quality.” This is just what we have seen over the past fifty years, especially during the worldwide financial crisis 0f 2008 and 2009.

The United States government took on a new philosophy in the 1960s, a philosophy that allowed that it was alright to run fiscal deficits, not only in periods of recession but also in “good times” so as to achieve higher rates of economic growth and keep people employed. This philosophy was inaugurated by the Kennedy administration and was absorbed by the Nixon administration and became the backbone of the economic policies for both Republicans and Democrats continuing into the present.

This “philosophy” achieved the following results: a decline of 85% in the purchasing power of its currency; under-employment in the economy reaching at least twenty percent of the workforce; and an income distribution that is highly skewed to the wealthy.

The philosophy called for a “credit inflation” in the United States economy that would result in prices rising on a regular basis which would put people to work and with a special emphasis on home ownership for almost all Americans which provided these citizens with an asset that constantly rose in price and which became the “piggy bank” of middle classes.

The debt of the United States government has increased at a compound rate of about 7% since 1960 up through the beginning of the Great Recession.

Prices rose at rate just below 4%, as measured by the implicit price deflator of Gross Domestic Product, during the same time period.

The rate of growth of real Gross Domestic Product rose by slightly more than 3%.

During this time period the value of the United States dollar declined.

The period started off with the price of the United States dollar fixed according to the Bretton Woods rules for international finance. By the end of the 1960s, sufficient inflation had been created along with rapidly increasing capital flows throughout much of the world so that the fixed exchange rates could no longer hold. As a consequence, the United States dollar was floated on August 15, 1971 by Richard Nixon and the race was on.

Dollar indices have only been in place since about 1973 because the dollar only began floating in late 1971. But, since then the value of the United States dollar measured against major currencies has declined by about 25%. (Remember the other major countries inflated their economies as well. And, many had currency crisis as well during this time period.) Against a broader range of currencies the dollar has declined by closer to 70% over the same time period.

There is no question that the “rest of the world” believes that the economic policies of the United States government are flawed. Just look at what the market is telling us!

However, the United States dollar is the one reserve currency of the world. Thus, the United States can get away with a lot of “stuff” that other governments cannot get away with.

And, the United States government has constantly argued that it is for a “strong dollar.” And, by the United States government I mean both Republicans and Democrats.

The United States government has lived off of its privileged position of having the one reserve currency in the world. It continues to live off of this privilege because it is still going to be a while before the United States dollar loses its position as the one reserve currency in the world.

This privilege has meant that the United States government does not have to conduct a “disciplined” fiscal policy because any consequence of its lack of discipline is sufficiently far off in the future to not really matter.

I presented my response to the current budget proposal of the Obama administration and the Republican posturing in my blog post of February 15. See “The Obama Debt Machine,” ( My conclusion is that we will have more of the same…more credit inflation.

So, that is my forecast for the “alpha” investor: the economic philosophy of the United States government has not changed.

Oh, there will be interludes in which “prudence” is popular. These will be like the “Volcker interlude” in the late 1970s and early 1980s when monetary policy was used to try and stop inflation, and the “Clinton interlude” in the 1990s when the federal budget was brought into balance. But these were just temporary diversions from the trend.

Maybe Charles “Chuck” Prince, the former chairman and chief executive officer of Citigroup, will have the last laugh. Prince, who made the remark that captured the attitude of the early 2000s, stated that “as long as the music keeps playing, you’ve got to get up and dance.”

In periods of credit inflation, taking on more debt, taking on more risk, mismatching maturities, and aggressive financial innovation pays. As Prince admitted, Citigroup got up and danced.

Dancing pays during a credit inflation. However, you need to be agile enough to sit out the intermissions when the musicians take a break as they did during the Great Recession.

All indications point to the fact that the “music” will continue on. The name of the dance is “credit inflation” and this dance will continue, with some periods of intermission, until the United States dollar ceases to be the one reserve currency of the world. Until then there seems to be little or no way to discipline the United States government for its profligate budgetary ways.

Tuesday, February 15, 2011

The Obama Debt Machine

My estimate for the cumulative deficit over the next 10 years before the Obama budget was announced this week: in excess of $15 trillion.

My estimate for the cumulative deficit over the next 10 years after the Obama budget was announced this week: in excess of $15 trillion.

I see no leadership coming from this administration (or the Congress) to achieve anything different in the future. There is no evidence of the will to take leadership on the United States economic ship.

We have arrived at this position through the actions of both Republicans and Democrats. There is no evidence that this condition will change in the near future.

Everything is the same, with one exception: we are heading full steam into the 2012 presidential election.

Our history: We have had 50 years of credit inflation that has brought us to this position.

Forecast: credit inflation will continue for the foreseeable future.

Monday, February 14, 2011

Federal Reserve QE2 Watch: Part 3.1

I usually don’t write up Fed actions within the month unless something seems to be going on. Last week, bank reserve balances at the Federal Reserve went up by $108 billion. I thought that this increase was significant enough to warrant some notice.

There was really only one “factor” supplying reserve funds this past week. This was a net increase in U. S. Treasury Securities held outright by the Fed of almost $30 billion, which brought the Fed’s holdings of Treasury securities up to $1.167 trillion. The portfolios of Federal Agency securities and Mortgage-backed securities did not change a bit.

Furthermore, Thursday afternoon, February 10, the Federal Reserve announced that it would purchase about $97 billion in U. S. Treasury securities in the upcoming week. This total would include about $17 billion to replace the runoff in the Fed’s holdings of mortgage-backed securities, implying that there would be a “net” increase in securities holdings that would be a part of QE2.

The question we can’t answer is whether or not there will be other operating factors on the Fed’s balance sheet that the Fed needs to deal with.

This past week, the banking week ending February 9, 2011, there were substantial movements in two of the Federal Reserve accounts of the United States Treasury. The first movement was in the Treasury’s General Account and this amounted to a little more than a $55 billion reduction in the account.

This movement seems to be seasonal in nature, but was not offset this year, as it often has been in the past, by offsetting sales of government securities. That is why the decline contributed $55 billion more to bank reserves.

In 2009 there was a seasonal year-end buildup in the Treasury’s General Account which peaked in January 2010 and then dropped off to its spring low in April. This year the General Account built up to a peak again in early January before beginning to drop off.

Year-end tax receipts build up at the Fed which causes the peak to occur in early January. From these accounts the Treasury pays out more than it receives thereby causing bank reserves to increase. The difference is that this year the Fed did not sell Treasury securities to withdraw the reserves from the banking system. That would be counter to QE2 if they did..

The other actor in this play is the Treasury’s Supplemental Financing Account. (For a discussion of this see my post of April 19, 2010 ( The Treasury’s Supplemental Financing Account reached a total of $200 billion in May 2010 and remained at this level until the banking week ending February 9, 2001. The account dropped by $25 billion which reduced the balance in the account to $175 billion. Reducing this account, like reducing the General Account, puts reserves into the banking system.

The Fed allowed an amount of $80 billion to flow into the banking system in the banking week ending February 9, 2011, all from government checks from the Treasury’s deposit balances at the Federal Reserve. There were roughly $3 billion offsets to this on the balance sheet so that only a net of $77 billion actually ended up in the banking system through this activity.

So, the actions were relatively “clean” this week and they resulted in $108 billion going into bank reserves at the Federal Reserve, roughly $30 from the Fed’s purchase of securities and $77 billion coming from government checks from the Treasury’s deposit balances at the Fed going into the private sector.

To my knowledge the $1,187 billion of reserve balances at the Federal Reserve at the end of business on February 9, 2011 is that largest total this account has ever reached!

The question this raises is this…are the reserves being pumped into the banking system getting into the private sector? Is all this Federal Reserve activity having any impact on the money stock numbers?

I am afraid I cannot give any different answer to this question than I have over the past year. The money stock measures are increasing but the reason for these increases still seems to be that people continue to move balances from other earning assets into assets that they can use to transact with. That is, people, in general, are reducing asset balances that were held for a rainy day or were part of their savings and have moved them into assets that they can use for daily purchases of goods and services.

I continue to think this is not a good sign. It is a sign that people are drawing down savings to have cash on hand to pay for daily needs. It is a sign that many people and businesses do not have sufficient income or cash flow to maintain their transaction balances and so have to bring money in from their savings in order to buy food, housing and so forth.

The good new is that bankruptcies and foreclosures are not increasing as fast as they once were.

The bad news is that they are still increasing at close to record rates.

How does this show up in the monetary statistics. Well, currency holdings by the public were increasing in January at a rate, almost 7%, that was roughly twice the rate of a year ago. These year-over-year increases are not near the heights that were reached in the darkest period of the Great Recession, over 11%, but they are high historically.

Demand deposits are also increasing at a fairly rapid pace. The year-over-year rate of growth of demand deposits was about 14% in the fourth quarter of 2010. In January, this figure reached 20%. The highest it reached during the Great Depression was something over 18%.

Note that the growth of the non-M1 part of the M2 measure of the money stock has increased over the past year, but at a very tepid rate. In the fourth quarter of 2010, the year-over-year rate of growth of this component of the M2 money stock measure was slightly over 2%. In January 2011, the year-over-year rate of increase rose to almost 3%, the highest level it had been in several years.

The reason is that the rate of decline in small time accounts and retail money funds slowed dramatically. In the first quarter of 2009, each of these accounts were falling at a 25% rate. In January 2011, the rate of decline in small time accounts was 21% and the rate of decline in retail money funds was around 13%. So, the non-transactions account part of the money stock measures have not declined…have even picked up…but the accounts associated with savings have experience a decline in their rate of decline.

So where are we? About where we have been for two years or so. The Fed keeps trying to push on the accelerator…and the private sector continues to scramble for survival.

What is amazing is that consumer spending and consumer sentiment seem to be picking up. Again, I can only argue that the American society has split. The wealthier, those that are still employed, still live in their own homes, and still have sufficient cash flows are spending. Those that are not fully employed, that have lost their homes or businesses, and those that must rely on their past accumulations of savings are in pretty poor shape. This is the only way I can explain the statistics I see on a daily basis.

Thursday, February 10, 2011

The Worldwide Cash Buildup In Corporations

One of the most wildly optimistic articles I have seen on the economic recovery recently appeared yesterday in the Wall Street Journal: its title, “Corporate Cash Hoards Offer Hope.” ( This article begins

“Time to splash the cash? The corporate dash for liquidity that started in 2008 and accelerated in 2009 is starting to reverse. Spending on capital goods, advertising and software is rising. With consumers deleveraging and governments feeling the pinch, corporate spending is key to the recovery. And the conditions may favor acceleration.

There are certainly no capacity constraints on spending. Nonfinancial corporates globally have $4 trillion of cash, up 38% from 2007, according to Citigroup's corporate-finance advisory group. Even allowing for higher liquidity buffers in an uncertain world, some $2.4 trillion could theoretically be surplus to requirements. The profit recovery and rising revenues mean companies are throwing off free cash. Borrowing conditions look good, too: The bond markets are wide open, and banks are lending more freely.”

By-the-way, did you see that Microsoft, a company that has tons and tons of cash, issued more bonds on February 4, 2011. It raised another $2.25 billion (over $6.0 billion offered) which goes along with the $3.75 billion raised in May 2009 and the $4.75 billion was raised last fall. That is almost $11.0 billion!

Our author states that corporate spending is now going for “capital goods, advertising, and software.”


Microsoft has continually stated that the funds it raised could be used for “stock buybacks, building up working capital, or corporate acquisitions.”

People who have read my posts before know where I stand.

I believe that a large portion of this cash buildup is going to be spent on...”corporate acquisitions.”

And, the phenomenon is worldwide. The following chart accompanied the Wall Street Journal article. As we can see, the buildup in cash is not just a United States thing. And, the acquisition binge we have started on is global, not regional or national. A lot of acquisition have already taken place or are in the works. Many more are on the way. Acquisitions to take advantage of the rise in commodity prices. Acquisitions to get into new markets. Acquisitions to get into major nations. Acquisitions to build scale. And, so on.

This is a time of transition...worldwide. The emerging nations are becoming stronger relative to the developed nations. The middle east is facing major upheaval. We are transitioning from a manufacturing world based on the worker to an information world based on knowledge. Old thought patterns are changing. The way to run governments is changing. Literature is changing. Political commentary is changing. Religions are in turmoil. We communicate by twitter, chat, and text. Nothing is settled.

Information is spreading, as it always has, only the speed is accelerating and this is causing major adjustments in the way people live and do business and govern. And, it is changing the way businesses are structured and organized.

Can you imagine a non-American organization owning the New York Stock Exchange! Can you imagine a Chinese bank owning an American bank! Part of the re-structuring of the world is that the barriers are really breaking down and in a way that has never happened before. And, so on and so on.

When I discuss the subject of corporate cash I always get comments regarding the amount of corporate debt that is still outstanding with the argument that the corporate debt is just the other side of the balance sheet from the cash that is being accumulated. Therefore, the buildup is just a lot of noise.

I would argue that non-financial businesses, as well as financial businesses, are divided into those that are still overly leveraged and are not doing so well and those that are doing very well, thank you, yet are issuing debt that costs them very little, so as to build up cash treasure chests.

The question I ask those that are doing very well is, “why are you issuing debt if you are just going to buy back your stock or build up your working capital.” These companies are profitable and are generating sufficient cash to buy back their stock or build up their working capital. They don’t need to issue debt to do these things.

The companies that are not doing very well and are highly leveraged are another story. They are not generating sufficient cash flow to de-leverage or they cannot raise any cash to reduce their leverage.

The picture is simple. There are a large number of the latter firms that are not going to be able to re-structure their balance sheets in such a tepid economic recovery. These firms will eventually succumb to the need to seek buyers in order for the existing organization to have any chance in the future, even as a part of another company.

And, a lot of the cash rich companies or organizations are “off shore”…that is, these potential acquirers are not American companies; yet they are seeking to purchase American enterprises.

And, whether or not you like it, a lot of organizations are going to get a lot bigger and everything is going to become more global. The most direct way this is going to happen is through mergers and acquisitions. But, M&A will not add jobs nor will it result in faster economic growth immediately. In fact, they will do just the opposite.

Housing and the Economic Expansion

The Great Recession is over. Remember, the recession ended in June 2009 getting close to two years ago.

To many, it sure doesn’t feel like it. Since the second quarter of 2009, over the last six quarters, real GDP has grown by 4.5%. The average year-over-year growth rate for the five quarters since the recession ended is 2.3%. This is way below historical experience.

The reason: housing usually leads the economy into a recession, and, housing usually leads the economy out of the recession.

Not so this time.

And, this is why we are in the mess we are in. Housing is not going to rebound any time soon.

For one thing, banks and thrift institutions (what are they?) really don’t want to provide financing for mortgages. They really don’t want to hold mortgages. For another, the mess with Fannie Mae and Freddie Mac is so uncertain and confused and uncomfortable that they want to have as little to do with mortgages as possible.

In order to understand this I had to go through the mortgage process myself last year. I have no problem getting a loan. I went to the bank where I do most of my business and asked about getting a loan. Sure, they said, and arranged a meeting with the mortgage banker they do business with who approved my loan and all of a sudden my mortgage is with Fannie Mae and I am making payments to the mortgage servicing subsidiary of a major bank somewhere far to the west of Philadelphia. Never in my life have I had a mortgage in the hands of Fannie Mae. Oh, well…

This is, to me, the paradigm of the banking industry. Banks, especially smaller banks, don’t want to hold mortgages on their balance sheets. And, this is just what we wanted it. In the late 1960s and early 1970s when I was in Washington, D. C. and we were creating the mortgage-backed security the idea was to get mortgages out of the commercial banks and thrift institutions and into the hands pension funds and insurance companies who needed long-term assets. Then the depository institutions could lend more.

Why did we create the mortgage-backed security? So, politicians could get re-elected. If more families in America could own their own home through things the government did, then they would be more likely to vote back into office the people that were responsible for their owning their own home.

Likewise with lower income housing, after all, the number one job of politicians is to get re-elected.

So, the United States government got into the business of inflating the housing sector so that
more-and-more American families could own their own home.

How successful was this? Well, in the early 1970s, no mortgages were traded on any capital market in the world. Michael Lewis’ incredible book, “Liar’s Poker”, related to the middle- to late-1980s, and was a large part about the market for mortgage-backed securities which had become the largest component of the capital markets. And, as they say, the rest is history.

But, housing was always the fulcrum on which economic cycles turned. The basic reason was that housing construction could easily be started up and stopped and started up again. The longest post-World War II recessions (before the Great Recession) were one year and 4 months in length and there were only two of them. In order to slow down economic growth and fight inflation, the Federal Reserve would raise interest rates and this would cause mortgage lending to slow down or stop for a time. After sufficient time the Federal Reserve would lower rates once again, mortgage lending would pick up and economic growth would expand once more.

Business lending always lagged the movements in mortgage lending.

It seems as if mortgage lending and housing construction has tapped out. The credit inflation of the housing industry of the last sixty years cause sufficient dislocations that it is going to take a while for the United States economy to re-structure so that the housing industry can pick up once again.

Financial institutions are still facing major, major problems related to the housing industry, not counting the major problems relating to commercial real estate. Commercial banks are slowly accepting the fact that they are going to have to buy back many troubled mortgages, especially mortgages that were sold to Fannie Mae and Freddie Mac. Bank of America has paid back a little, but more is expected. JPMorgan Chase also has a large exposure. What is the hole? Standard & Poor’s has estimated that banks will have to buy back around $60 billion in bad mortgage loans which they sold to others. Some estimates place this total as high as $150 billion. (

In addition to this, the latest statistics indicate that more than one in four mortgages outstanding are underwater, that is, these mortgages are on homes that have a market value less than the amount owed on the mortgage. Homeowners facing this situation are still walking away from their obligations. Who picks up the difference? And, housing prices still remain weak in many markets within the nation.

About one in four individuals in America are either unemployed or under-employed. Savings can only go so far in keeping up payments on the home mortgage. And, 30 states have run out of money in their unemployment trust funds and are borrowing from the United State government to cover the shortfall. How long is this going to continue to be covered?

Manufacturing businesses are only running at three-fourths of capacity, up slightly from historical lows. With so much idle capacity, businesses are not interested in purchasing more capital and hiring more workers to create jobs and incomes. Purchasing seems to be very skewed…basics and luxuries…and computers. This is not very encouraging for a near term pickup.

With little or no housing pickup, expectations for a strong business pickup are pretty low. And, the Fed’s QE2 is not going to have a major impact on the reduction in unemployment or under-employment!

People have one way out of this dilemma in the short run. Inflation!

Inflation may not put the people back into a job, but it can cause housing prices to rise and this can buy them out of the underwater situation. Still, commercial banks, I believe, want to have as little to do with holding mortgages as possible. And, if they originate, or get their mortgage banking friends to originate mortgages, who are they going to sell them to?

Even so, all this will just postpone the housing problem until another time, just like we have done for the last sixty years. We just see high levels of under-employment, low levels of capacity utilization, high amounts of inflation, more debt and more debt, and where does this end?

The Great Recession is over. However, the Great Recovery is nowhere in sight.

Wednesday, February 9, 2011

Inflationary Expectations, the Dollar, and the 10-year Government Bond Yield

On Saturday, Allan Meltzer made the statement that “Inflation is coming.” Like the 1970s, we are in for another bout of high unemployment and inflation, which “flummoxed” the Federal Reserve’s policy committee and created a situation in which ”inflation and unemployment rose together throughout the decade.” (

The market evidence for this?

“Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness.”
The above chart shows that value of the United States dollar relative to the Euro. As the line rises the dollar weakens. In the early part of 2010, the Eurozone seemed to fall apart as the fiscal problems faced by sovereign governments created a financial collapse. The Euro declined against other currencies in the world.

By the summer of 2010, some quiet had returned to Europe and the Euro began to strengthen again against the dollar moderating late in the season around$1.27. However in late August 2010, Fed Chairman Ben Bernanke announced that QE2 was on the horizon and, as can be seen, the value of the dollar fell dramatically reaching the $1.40 neighborhood in November.

Although the value of the dollar rose again toward the end of the year, it again appears to be under siege as the dollar has fallen back into the $1.36-$1.37 range. So, in spite of its weakness, the value of the United States dollar seems to be losing ground relative to the Euro.

The key to this behavior Meltzer believes is the expectation of inflation. It is assumed by many that inflationary expectations get built into interest rates. I have just written on the current situation, the recent changes in inflationary expectations and the possible future movement in interest rates. See my post, “Long-Term Treasury Yields and Inflationary Expectations.” (

Here we have a chart the yield on 10-year Treasury securities. Note the decline in the yield that took place in the early part of 2010 to the fall. Many argue that this decline was due to a flight-to-quality as the investors left the sovereign debt of Eurozone countries and brought their money to invest in US Treasury securities.

Whereas the announcement of the coming of QE2 came in late August (and rates bounced up on the very next trading day after the Bernanke speech), the actual plan of action for QE2 was released in October and the Fed began conducting the QE2 in November. As can be seen in the above chart, the yield on 10-year treasuries has risen ever since. The last day in this chart is February 4. On February 8, the yield on the 10-year treasury security closed over 3.70 percent, a rise of 150 basis points since the late August date of Bernanke’s speech.

The argument can be made that participants in the financial markets are so sensitive to the possibility for future inflation that on the very next market trading day following the Bernanke statement, inflationary expectations began to build in the bond markets. And, the buildup of these inflationary expectations was also experienced in the market for the United States dollar and the dollar traded weaker even to the Euro even though the Eurozone was experiencing many fiscal and financial problems.
One can see this more clearly in tracing the value of the dollar indexed against major currencies. Here it is obvious that the dollar is trading at the lows reached over the past year and is even threatening the post- World War II lows reached in the summer of 2008.
It appears as if many investors in world financial markets agree with Allan Meltzer that, in fact, “Inflation is coming.” It is just the United States government that doesn’t see this.

Tuesday, February 8, 2011

The Games Banks Play

I would like to recommend another article on bank accounting practices. This is the article by Michael Rapoport in the Monday’s Wall Street Journal titled “’Toxic’ Assets Still Lurking At Banks.” ( I don’t want to repeat all that is in the article because I would just copy the article. So, I highly suggest you read the whole thing. But, the issue has to do with when and how do you recognize the value of loans and securities on the balance sheet of a bank.

How does one know what value should be placed on a commercial bank franchise?

The answer: in the current environment, one doesn’t.

I have had my say (once again) on the “mark-to-market” controversy: see “Risk Management: Key in Future Economic Performance for Banks. (

In my mind, not only are bankers attempting to fool the regulators and the investment community…they are trying as hard as they can to fool themselves.

Rapoport quotes the banking expert Bert Ely: "In a lot of cases banks are probably deluding themselves" about the future value of those securities, and whether they will ultimately recover as much from those securities as they contend they will”

Bankers are notorious for “deluding “ themselves.

“The sun will come out…tomorrow…bet your bottom dollar…that tomorrow…”

But, Rapoport just discusses information from the top 10 banks in asset size and the data come from the September 30 financial reports.

As readers of this blog know, much of my concern has been with the banks that are smaller than the biggest 10 banks…or the biggest 25 banks.

We just don’t have any idea how deep the pool of trouble is for most of the banking system.

We get some encouragement from a recent Congressional study. Quoting from another Wall Street Journal article: “ A year ago, Elizabeth Warren, who headed the congressional panel overseeing the Troubled Asset Relief Program, predicted a "tidal wave of commercial-loan failures." On Friday, at a follow-up hearing on commercial real estate held by the same oversight panel, Patrick Parkinson, a Federal Reserve official, said that "worst-case scenarios are becoming increasingly unlikely." (

One year ago, Elizabeth Warren stated at a Congressional hearing that 3,000 commercial banks were going to experience serious problems in their portfolio of commercial real estate. I am glad to hear that “worst-case scenarios are becoming increasingly unlikely.”

So, how many commercial banks are going to experience serious problems in their commercial loan portfolios? How many more are going to experience more problems in their securities portfolios? How many more have not recognized on their balance sheets assets that are still “toxic” or “troubled”?

In order to obtain some idea of how bad the condition is of the “smaller” banks, I look at the behavior of the bank regulators that should know.

First, the Federal Reserve System: the Federal Reserve System has put over $1.1 trillion in excess reserve into the commercial banking system and is still engaging in “quantitative easing” to “get banks to start lending again.” However, the “smaller” banks are still not lending.

Second, the behavior of the Federal Deposit Insurance Corporation: the FDIC continues to close 3 banks per week and it looks as if it will continue to close 3 banks a week for the indefinite future. And, this does not include the banks that disappear from the system because they have been acquired.

These are the two government agencies that really should know how bad off the banking system is...and they are acting in this way?

The Fed is providing funds to keep a lot of commercial banks open so that they can either be closed in an orderly fashion by the FDIC or be acquired outright by another bank, domestically or by a foreign source.

The problem is that because of the accounting rules, investors, regulators, and even bankers don’t know what shape the banking system is in. But, every quarter we seem to get several “surprises”, banks being taken over or acquired because of their financial condition. And, no one seems to have seen these “surprises” coming. How many more Wilmington Trust’s are there out there?

Monday, February 7, 2011

Federal Reserve QE2 Watch: Part 3

At the close of business on February 2, 2011, the Federal Reserve System recorded a total of $1.1 trillion of U. S, Treasury securities on its balance sheet. To be more exact, the number was $1,138,166 million.

Thirteen weeks ago, the Fed held just $842,008 million in Treasury securities. Thus, the Fed’s holdings of these securities have gone up by almost $300,000 million or $300 billion or $0.3 trillion over this time. QE2 seems to be in full swing?

Thus, in the last three months, the Federal Reserve has surpassed the holdings of U. S. Treasury securities of China, a little less than $900 billion, and of Japan, a little less than the China.
At January 31, 2011, the Total Public Debt of the United States Government was $14.13 trillion.

Thus, the Federal Reserve System currently holds a little over 8 percent of its government’s debt!

The QE2 program of the Fed stated that the Federal Reserve would buy $600 billion of United States Treasury securities over a six month period and would buy an additional $300 billion in these securities to offset the amount of Federal Agency securities and Mortgage-backed securities that resided on the Fed’s balance sheet and were maturing during this time period.

As stated above, the Federal Reserve added $296 billion of U. S. Treasury securities to its balance sheet. During this time period the Fed lost $91 billion in Federal Agency securities and Mortgage-backed securities reducing the net addition of $205 trillion to its overall portfolio of securities as a part of QE2.

Over the last four week period, the Fed acquired $107 billion in U. S. Treasury securities, but had a runoff of $30 billion in these other securities so that the “net” new purchases added up to $77 billion.

But, this was not all going on that affected the amount of reserves in the banking system. One very big “happening” was that the settlement of the AIG bailout as the Fed’s involvement in this effor. “The Board's statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," reflects the closing of the American International Group, Inc. (AIG) recapitalization plan, which occurred on January 14, 2011. The recapitalization plan was designed to restructure and facilitate repayment of the financial support provided to AIG by the U.S. Department of the Treasury (Treasury) and the Federal Reserve. Upon closing of the recapitalization plan, the cash proceeds from certain asset dispositions, specifically the initial public offering of AIA Group Limited (AIA) and the sale of American Life Insurance Company (ALICO), were used first to repay in full the credit extended to AIG by the FRBNY under the revolving credit facility (AIG loan), including accrued interest and fees, and then to redeem a portion of the FRBNY's preferred interests in ALICO Holdings LLC taken earlier by the FRBNY in satisfaction of a portion of the AIG loan. The remaining FRBNY preferred interests in ALICO Holdings LLC and AIA Aurora LLC, valued at approximately $20 billion, were purchased by AIG through a draw on the Treasury's Series F preferred stock commitment and then transferred by AIG to the Treasury as consideration for the draw on the available Series F funds.”

Basically, this adjustment, along with some other minor runoffs of other “financial emergency” management accounts, removed about $35 billion from the banking system over the past 13-week period and about $22 billion in the past 4-week period. Assuming the Fed offset this reduction in bank reserve with the open-market purchase of Treasury securities, this drops the “net” QE2 injections of reserves into the banking system to $170 billion over the last quarter and $55 billion over the last four weeks.

As always, there are the ordinary operating transactions the Federal Reserve must account for because these transactions, like movements in currency in circulation and movements of Treasury Tax and Loan monies, impact bank reserves. The Federal Reserve usually offsets these items so as to smooth bank adjustments in the regular course of business.

Over the past 13-week period, the Fed had approximately a net of $72 billion in operating transactions to offset. Over the past 4-week period, this total was approximately $7 billion.

Removing these amounts from the Fed purchases of Treasury securities, we find that the Fed bought $98 billion in securities that added to bank reserves over the past 13 weeks, and bought $48 billion over the past 4 weeks. In effect, these numbers reflect the “net” impact of securities purchased to increase bank reserves over this period of time.

Thus, one cannot say that over the last 13-week period the Fed bought almost $300 billion in U. S. Treasury securities as a part of the QE2 program because of all the other things going on during this time.

The Fed did buy over $90 billion in Treasury securities to offset the amount of securities that were running off in the rest of the portfolio, part of the $300 billion the Fed said it was going to do, but this cannot truthfully be considered a part of the $600 billion of new purchases it was supposed to undertake. And, one can make the case that the full amount of the almost $200 billion in purchases was not a part of QE2.

The real question concerns the effects this increase had on the banks and the economic system. Because of timing differences the following data don’t exactly foot. For example, reserve balances held at the Fed increased by $98 billion over this time period. The information we currently have from other sources indicate that the monetary base, which consists of bank reserves and coin and currency held outside of commercial banks, rose by almost $95 billion at the same time. So, we are roughly in the same ball park. One should also note at this time that all these data are non-seasonally adjusted!

Of the $95 billion, roughly $80 billion in the increase came in bank reserves and $15 billion came in currency held outside of banks. Of the $80 billion increase in bank reserves, about $12 billion of this was due to the increase of required reserves of commercial banks. Note that individuals and businesses are still moving their funds from money market accounts and small time and savings accounts, to demand deposits and other checkable deposits, and away from thrift institutions to commercial banks. (We will have more to say on this later this week.) The demand and checkable counts have higher reserve requirements than do the accounts that the funds have been moved from. This still remains the major reason why required reserves have increased over the past several years as well as currently.

So, $68 billion of the increase in total reserves went into excess reserves. Bank loans continued to decline in January (I will address this next Monday) so it appears as if commercial banks are still taking the excess reserves and putting them into “cash” rather than lending them. (Again there is a difference between the behavior of the big banks versus that of the smaller banks.)

The conclusion one can draw from this is that the Fed has been executing QE2, but has not been as aggressive as some people have thought when looking at just the aggregate dollar amount in the Fed’s portfolio of Treasury securities. The Fed still has other things going on that must be taken care of and this modifies any interpretation one can give to the aggregate figures. In terms of the banks: the banks still appear to be putting the “new” reserves the Fed is injecting into the banking system into excess reserves. So far, QE2 does not seem to be producing any substantial results in the banking system.

Friday, February 4, 2011

It's Your Fault, Not Mine!

The headlines this morning from London: “Fed Denies Policy is Causing Rising Food Prices.” (

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, spoke to the National Press Club yesterday and basically said:

“It’s Your Fault!”

The response: “No, it isn’t!”

Bernanke’s come back: “’Tis too!”

And, so we see the basic defense the leader of our central bank relies upon. “The problem is ‘out there’, it’s not in here!”

Bernanke: “I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U. S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries. It’s really up to emerging markets to find appropriate tools to balance their own growth.” (

Throughout his history at the Fed, Bernanke has always seen our problems as coming upon us from someone else or somewhere else in the world. Our problem in the early 2000s was the fault of the Chinese because they saved too much! Our problem in the housing bubble was that others in the rest of the world purchased the mortgage-backed securities being created to finance residential real estate! Our problem in the summer of 2007 was that inflation still had to be combated because prices were rising too fast in the rest of the world. (See chart in this article on world food prices to confirm this: And, now, other countries are not acting strongly enough to combat rising food prices in the rest of the world.

Here is the problem: Bernanke is so focused on the fact that nothing is our fault that he is constantly behind the curve. Yesterday, I wrote in my post

“But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?” (

Bernanke’s thought process might be correct in a world in which the international flow of capital was severely constrained. Bernanke is a first class world academic when it comes to studies of the Great Depression of the 1930s. That world was a world of severely restricted flows of capital between countries.

In fact, the limited international capital movements was a part of the policy prescriptions of the world at that time. John Maynard Keynes was a strong advocate for restricted capital flows in the world. (

Keynes, and other participants in the construction of the Bretton Woods international financial system, built constrained international capital flows into the very rules of the post-World War II monetary framework.

The reason for restricting international flows of capital? In such a regime, countries could conduct their economic policies independently of one another. In such an environment, a country could forget about what was happening “out there” and focus solely on what was happening “in here.”

The world didn’t cooperate with this desire to limit capital flows and as the barriers to international flows of capital broke down in the 1960s, the Bretton Woods system had to go. The final nail in the coffin was applied by President Richard Nixon on August 15, 1971 as he took the United States “off gold” and floated the value of the United States dollar.
Capital flows freely around the world and so the United States cannot just act as if it is the only player in the world. Yet, this seems to be exactly what Bernanke wants.

Answer this: what three countries or organizations in the world hold the most amount of U. S. Government debt?

In order of magnitude: the United States with $1,138,166 million as of the close of business on February 2, 2011 ($1.138 trillion); China, a little less than $0.9 trillion; and Japan, a little less than China.

What can we take-away from this?

Capital is flowing freely throughout the world!

The contribution made by the United States to these flows is enormous!

The flows of this capital must look like a huge wave coming up on their shores, like a tsunami hitting most of the countries in the world!

But, Mr. Bernanke argues that “…emerging markets have all the tools they need to address excess demand in those countries. It’s really up to emerging markets to find appropriate tools to balance their own growth.”

What he really is saying is, "I want to do my thing...and I am big enough to do what I want. You just have to live with what I do. I can have an independent economic policy because of my size. Too bad you are not big enough to be able to conduct your own independent economic policy."

Mr. Bernanke has invested too much of his intellect in the study of the 1930s. Mr. Bernanke needs to become a part of the 2010s.

Thursday, February 3, 2011

Long-Term Treasury Yields and Inflationary Expectations

The yield on the 10-year Treasury bond closed at 3.48 percent yesterday. Just a little over five months ago the yield on the 10-year Treasury bond was at 2.48 percent, a full 100 basis points lower than the current yield. What’s happening and where are we going?

Two extraordinary factors are impacting Treasury yields at the present time and have been there for quite some time now. The first of these is the effect that the quantitative easing of the Federal Reserve is having on market rates. The second is the “flight to quality” that has kept the yields on Treasury securities below what they otherwise might be. How do I account for these two factors?

Well, first I start out with a “rough” estimate of the real rate of interest. The base figure that I have used for years has been 3.0 percent.

(I just found out this morning that this is similar to what my former colleague Jeremy Siegel,
Professor of Finance at the Wharton School, UPENN, uses:

This figure, the 3 percent estimate is a “before-the-fact” estimate and therefore is a long term expectation. An “after-the-fact” estimate is often made by taking the nominal rate of interest, say the roughly 3.5 percent mentioned above and then subtracting actual inflation from this figure. This is “after-the-fact” because the numbers used to calculate the real rate have already occurred.

The 3 percent estimate is important because it can be compared to another, so-called, real rate of interest, the yield on inflation-protected securities, called TIPS. Yesterday, the yield on 10-year inflation-protected securities was 1.04 percent at the closing, substantially below the 3 percent estimate.

Siegel, I believe rightly, calls our attention to this discrepancy because he believes that the current yield on inflation-protected securities must rise toward the higher number and this will mean that the holders of these securities may suffer substantial capital losses on the securities because the price of the securities must decline to allow the yield to rise.

Investors are not fully aware that this decline might happen in this area of the bond market.

The difference between the current market yield on these securities and the “before-the-fact” estimate of the real rate of interest represents the impact that the Fed’s quantitative easing along with investor’s “flight-to-quality” is having on the current market yields. If this is true then the nominal bond yields in the market are roughly 200 basis points below where they would be without the Fed’s actions as well as including the international flight to safe United States Treasury issues.

If this is the case then we could argue that the yield on the 10-year Treasury security should be around 5.50 percent rather than 3.50 percent.

If this is the case then the longer-term “inflationary expectations” that investors have built into market yields would be around 2.5 percent.

The question then becomes, is this estimate of inflationary expectations “in the ball park”?
I like to look at the year-over-year rate of change of the GDP price deflator as my estimate of the rate of inflation because I have less concern that this figure is being “messed” with than the more popular Consumer Price Index. Looking at this measure of actual inflation we see that inflation does seem to be picking up.

In this chart we see that the rate of inflation is picking up and is now just below 1.5 percent. We can note that once inflation starts to pick up, it does not reverse itself in the near term. Furthermore, looking at the performance of inflation over the past ten years, an inflation rate of 2.5 percent is not unreasonable for a moderately growing United States economy. And, remember, this 2.5 percent can be interpreted as the compound rate of inflation over the next 10 years, a period far beyond the inflation that might be experienced over the next year or so.

Added to this is the fact that inflation is picking up, not only in the developed countries in the world, but also in the emerging countries. Inflation in the Eurozone is running a little above 2.0 percent, in the UK, a little under 4.0 percent, and in China and India, the rate of inflation is now in excess of 5.0 percent. Thus the trend in the world is for increasing rates of inflation.

My rough estimate that the yield on the 10-year Treasury bond should be around 5.50 percent in 2011 is slightly above the forecast I presented earlier. (See “Long-Term Treasury Yields in 2011: The reason for this change, I believe, is that investors, world wide, are believeing that inflation is becoming a bigger problem than earlier expected. The European Central Bank has ceased its special purchase program of securities because of the rising concern over price increses. The Bank of England has experience similar concerns. The only central bank that does not seem concerned yet is the Federal Reserve.

And, of course, my forecast assumes that the Federal Reserve will, at some point this year, back off from quantitative easing.

But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?