Thursday, March 31, 2011

Federal Reserve QE2 Watch: Part 5.0

On March 30, 2011, reserve balances with Federal Reserve banks, a good proxy for the amount of excess reserves in the commercial banking system, almost reached $1.5 trillion!

This total is approximately $450 billion more than was on the Fed’s balance sheet on September 1, 2010 which was soon after Chairman Ben Bernanke announced the advent of Quantitative Easing 2, or QE2, at a Federal Reserve conference in Jackson Hole, Wyoming.

The Fed’s basic plan was to purchase $900 billion in United States Treasury securities during QE2, $600 billion of the purchases were to be a net addition to the Fed’s portfolio of securities held outright and $300 billion were to replace maturing Mortgage-backed securities and Federal Agency securities.

Between September 1, 2010 and March 30, 2011, the Fed has achieved a net addition of about $550 billion to its holdings of Treasury securities which has resulted in a net addition of around $360 billion to its securities held outright. About $190 billion has run off from the Fed’s portfolio of Mortgage-backed securities and Federal Agency securities.

The plan was that the Fed would add about $2 in bank reserves to it’s balance sheet for every $3 it purchased in U. S. Treasury securities. Since September 1, the Fed has added about $3 for every $5 in Treasuries it has purchased.

However, over the past four weeks, the Fed has added about $4 for every $5 in Treasuries it has purchased.

In the first three months of this year the Fed has added, on average, approximately $100 billion in United States Treasury securities to its balance sheet every month.

However, securities purchases are not the only thing changing on the Fed’s balance sheet. Since September 1, 2010, the Fed’s net purchases of securities have supplied almost $325 billion in reserve funds to commercial banks.

The other $125 billion of the total $450 billion increase in reserve balances has come from the other side of the balance sheet. Here the primary contributor to the increase in reserve balances has been a $195 billion decrease in the Supplementary Financing Account of the United States Treasury.

In effect, the Treasury had $200 billion in deposits at the Fed in this account on September 1, 2010. The Treasury has withdrawn $195 billion of this $200 billion and when the Treasury spends out of its account at the Fed it creates bank deposits…or reserve balances at the Fed.

About $70 billion of this decrease has been offset by an increase in currency in circulation which draws funds out of commercial bank accounts and an increase in the Treasury’s General Account at the Fed. Currency in circulation rose about $55 billion since September 1 and the General Account of the Treasury rose by about $15 billion.

After about two years of almost total turmoil, the Federal Reserve’s accounts have settled down and are very open and straight forward. About all that is going on at the Fed right now is the activity related to QE2. And, the Fed is doing exactly what it said it was going to do.

The reason for QE2, we are told, is that the Fed is creating this excessive amount of liquidity to spur on bank lending in order to get the economy growing at a faster pace.

We are told that QE2 will be over by the end of June, 2011.

The average year-over-year growth of real Gross Domestic Product over the past three quarters has been 3.0 percent. Analysts have predicted that economic growth will probably end up around 3.0 percent for the whole year of 2011. Usually the American economy comes out of a recession at a faster rate of growth than this, but this rate of growth is very consistent with the compound rate of growth of real GDP over the past fifty years.

The point is, the economy is growing. It is not a spectacular rate of growth but it shows that the economy is growing at a rate that is close to its long run average. The growth rate is not rapid enough to cause a dramatic decrease in the unemployment rate, but this may be a result of the fact that the United States economy needs to restructure and restructuring a large economy takes time.

Does the fact that the economy is only growing around 3.0 percent warrant the injection of $1.5 trillion in excess reserves into the banking system? Will all this liquidity really cause economic growth to accelerate and with this acceleration bring down the unemployment rate?

It is here, I believe, that we have a disconnect between the story the Fed is trying to tell and the way that the economy is performing. To me, the facts just don’t seem to mesh with the urgency of the Fed’s expressed concern. And, this disjunction of words and economic behavior is made even muddier by the contradictory statements made by members of the Fed’s own Open Market Committee this past week.

But, Chairman Bernanke is going to make things exceedingly clear in the future by holding a press conference after four future meetings of the Open Market Committee.

The results of QE2 to this point: in terms of the purchase of U. S. Treasury securities, the Federal Reserve is doing exactly what it said it was going to do; in terms of economic activity, the economy is behaving just about the way it was behaving at the time QE2 was introduced.

Lots of activity on the part of the Fed and little or no reaction on the part of the economy.

In terms of understanding what the Fed is doing and what it hopes to accomplish…confusion.

Up to this point, the walk and the talk just don’t seem to coincide. My problem is that I was taught to watch the hips…not the lips. What the hips are doing, in this case, however, don’t make a lot of sense.

Why Bet on Treasury Securities?

First Warren Buffet and now Bill Gross, of Pacific Investment Management Company, have publically stated that buying United States Treasury securities is not a good bet. (See

Gross wrote, in his most recent monthly investment outlook, that Treasuries “have very little value.”

One could couch this in other terms: “What is the probability that long term interest rates will go up over the next twelve months?”; and “What is the probability that long term interest rates will go down over the next twelve months?”.

How many people do you know that believe that the higher probability can be applied to the second of these two questions?

Most people I know and respect are arguing over whether the probability that long term interest rates will go up is 75% or 80% or higher.

The only significant argument I hear about falling interest rates on long term Treasury issues is that the Eurozone might collapse and there will be a “run to quality”, a run to United States government securities. Almost all other arguments go the other way.

The economic recovery, however weak, is continuing. The banking system (and the housing industry) is not going to collapse even though the banking industry is going to continue to grow smaller and smaller in terms of the number of commercial banks that are in the system while the biggest banks, including large foreign banks, are going to control more and more of the banking industry itself. The Federal Reserve will continue to keep money flowing into the banking industry so as to keep banks open while the FDIC makes sure that the banking industry shrinks in an orderly fashion.

Are we going to get QE3? Depends upon the rate at which insolvent banks can be closed without disrupting the financial system. The strength of the economic recovery is not the issue. The issue, to me, depends upon what the FDIC can achieve.

The federal government is going to continue to add more and more debt to the total already outstanding.

There just is no credibility in Washington, D. C. concerning the reduction in the cumulative deficits over the next ten years or so. I still believe that the government will add another $15 trillion or more to the federal debt outstanding over the next ten years.

The Libyan situation is a case in point. The federal government is so over-extended fiscally that other demands on its resources are just going to stretch budgets even further and keep the cumulative deficits at near-record levels. Then the government ends up doing two things, neither desirable: the government is limited in what it can do in very important situations; and even if the government cannot do much, whatever it does will increase the cumulative deficit.

Then there are other issues, like the boom in commodity prices worldwide, the acceleration of the merger and acquisition business in America, Europe, and the emerging countries, and currency speculation throughout the globe.

As a consequence, I see no reason to back off my earlier thoughts on the future of the interest rate on long term U. S. Government securities. See This post was written when the yield on the 10-year Treasury security was 3.48 percent, roughly two months ago at the beginning of February. Yesterday the 10-year Treasury closed at about 3.46 percent.

At that time I claimed that a forecast of 5.00 percent to 5.50 percent was not out of reason for a Treasury security of this maturity somewhere in the next 12 to 18 months.

The basic reasoning for this: my estimate of the expected long run “real” rate of interest is roughly 3.00 percent, (Similar, I found out, to the belief of the Wharton School’s Jeremy Siegel.)

I further believe that investors will come to build in a premium for inflationary expectations in longer term interest rates in the neighborhood of 2.00 percent to 2.50 percent.

How strongly do I feel about this prediction? I believe that the odds are in the neighborhood of 3- or 4-to one that rates will move into this range over the next 12 to 18 months.

Thus, I would have to agree with Bill Gross (and Warren Buffet) that Treasuries “have very little value” and are not a good “buy and hold” at this time.

Wednesday, March 30, 2011

Merger Trend Heats Up

For the last 18 months or so, I have believed that one of the most important factors affecting the American (and world) economy would be a growing number of mergers and acquisitions. Individuals at Credit Suisse Group AG estimate that “The value of global takeovers may increase 15 percent to 20 percent this year, extending a 27 percent rebound in 2010.” ( Not only is the economy growing (however modestly) but the better off corporations have lots and lots of cash assets, borrowing costs are exceedingly low, and there are lots of other corporations that are not so well off and whose best outcome is to be acquired by someone larger and healthier. Last week the AT&T and T-Mobile deal was announced. Recently we have also had deals announced by Duke Energy Corporation and Deutsche Boerse AG. And, yesterday, Canada’s Valeant Pharmaceuticals International put out a hostile offer for Cephalon, Inc. General Electric has engaged in a string of acquisitions, the most recent one was just announced, a $3.2 billion deal for GE to acquire the French company Converteam. And, there are many others. Deals are also taking place in the commercial banking industry. Although there were 157 banks closed in 2010, the number of banks in the industry fell by 310 indicating that lots of acquisitions were going on behind the information relating to the regulatory closures taking place. And, the big companies are getting bigger. The prices of an acquisition are rising. In the first quarter of this year, the price of an acquisition reached the highest level since before the collapse of Lehman Brothers Holdings, Inc. There are three aspects of this activity that are important for our future. First, consolidations are taking place across virtually all industries. There are many targets “out there” and companies with lots of cash and lots of borrowing power are “on the prowl.” This activity will have two effects on economic growth. In the short run, consolidations slow down economic growth because they lead to a rationalization of industry where plants and offices are closed and people are let go. Over the longer run, productivity increases as organizations become more efficient and effective producers of goods and services. Second, companies that have built up too much debt are in the process of deleveraging and, at the same time, are spinning off some of the subsidiaries they acquired with the debt. Thus, firms are getting back to more manageable levels of debt in their capital structure and they are also returning their operational focus to their core businesses. Both of these moves will also tend to keep economic growth from speeding up in the near future. The reduction in the debt of these companies will not be replaced in the near future and this will moderate the increase in bank lending and other corporate borrowing. Furthermore, the return of companies to their core businesses tends to result in the closing of plants and offices and the reduction in the number of people these companies employ. Third, investors will have the opportunity to participate in the restructuring of the economy that is now taking place. However, investors must be careful because not all acquiring companies are equal and not all acquisitions will turn out well. The current merger and acquisition boom is still in its early stages. As such, premiums received by selling companies are low, “the lowest since the third quarter of 2007.” Premiums are always low at the start of an M&A boom! Yet, not all deals are attractive to investors. Whereas AT&T stock has climbed 7.6 percent since it disclosed the T-Mobile deal and Valeant Pharmaceuticals stock jumped 15 percent late yesterday on the news of its bid for Cephalon, other transactions have not fared so well. If there is a chance to participate in this investment swing, it is now, when the purchase premiums are low. These will rise, and in the typical cycle, the rise will approach a level in which all new M&A deals are suspect. How soon the rise will occur is, of course, problematic. With so much cash on company balance sheets and the Federal Reserve holding market interest rates so low, one could imagine that the bidding could become pretty hot. But even if the bidding becomes “hot” this will not do much good for the economy in the short run because consolidations and the rationalizing of companies will result in plant and office closings and the laying off of people. It will also result in big companies (and big banks) getting bigger.

Friday, March 25, 2011

Who Needs $1.4 Trillion in Excess Reserves?

On August 27, 2010, Fed Chairman Ben Bernanke gave the world the first news about QE2. (See my post, “Bernanke in the Hole”,

His explanation left something to be desired.

I had just made the comment:

"The Federal Reserve has two basic problems right now. First, those running the Fed don’t know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period. (Details here.)"

Guess what?

Things really haven’t improved.

Guess what again?

The Fed is now going to hold a press conference on a regular basis, four times each year after selected meetings of the Fed’s Open Market Committee, the committee that sets monetary policy for the nation.

The purpose of these press conferences? To explain monetary policy to the nation and to make things “more clear” about what the Federal Reserve is trying to do.

This, to me, would be really funny if the Fed did not have such a crucial role to play in our lives.

Why don’t we just let Alvin and the Chipmunks sing four times a year after meetings of the Fed’s Open Market Committee?

Why does the banking system need $1.4 trillion in excess reserves?

In August 2010, the banking system averaged a little more than $1.0 trillion in excess reserves.
So, excess reserves have gone up about $400 billion.

Since August 25, 2010, two days before Bernanke’s Jackson Hole speech, the Fed has added a net of $520 billion of Treasury securities to its Treasury securities portfolio. The Fed’s portfolios of Federal Agency issues and Mortgage-backed securities has declined by $183 billion.

Thus, the Fed has added a “net” of $337 billion to its “total” securities holdings since just before the speech. This compares with the proposed “net” increase in Treasury purchases of $600

Overall, “Reserve balances with Federal Reserve Banks”, a proxy for excess reserves in the commercial banking system, has increased by $358 billion over this time period to $1.4 trillion.

So, operationally, the Federal Reserve has done exactly what it said it would do.

By the end of June, therefore, excess reserves in the banking system should be between $1.6 and $1.7 trillion.

And, bank loans? Usually when the Fed puts reserves into the banking system, bank loans increase.

Loan and leases at commercial banks in the United States has declined by roughly $130 billion during from the time from August to the early March.

Although Commercial and Industrial (business) loans have increased slightly (about $18 billion), Real Estate loans have dropped precipitously by almost $95 billion. Consumer loans have also decreased by a little more than $65 billion.

In the real estate area, the big drop has been in commercial real estate loans which fell by almost $75 billion. Revolving home equity loans declined by another $20 billion with residential loans remaining roughly constant on bank balance sheets.

Again, one can ask the question, why does the banking system need $1.4 trillion (going to $1.7 trillion?) in excess reserves?

In explaining the reasoning for “throwing so much spaghetti against the wall” we are told that the Fed is acting in this way to spur on economic growth.

Are four more press conferences per year going to throw any more light on the rationale for these Fed actions than we already have?

Let me just reiterate something I said in the early blog post: “Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.”

My take on the story? See my March 24 post, “Banking and Real Estate Loans: the Problems are Still There” ( I believe that the banking statistics presented above capture a part of this story. I am not sure it justifies a banking system with $1.7 trillion of excess reserves. But, then, maybe those banks smaller than the 25 biggest banks in the country are more insolvent than I believe they are. But, the Fed isn’t telling us this and four more press conferences a year is not going to shine, in my mind, any more light on the issue.

Thursday, March 24, 2011

State and Local Governments and Real Estate: The Problems are Still There

“Moody’s Investors Service, the ratings agency, said in a report last week that many states ‘are increasingly pushing down their problems to their local governments.’ The Moody’s report warned that this would be “the toughest year for local governments since the economic downturn began.” (See “States Pass Budget Pain to Cities,”

“The state budget squeeze is fast becoming a city budget squeeze, as struggling states around the nation plan deep cuts in aid to cities and local governments that will almost certainly result in more service cuts, layoffs and local tax increases.”

Homes, over the last fifty years, served as the piggy-bank for the middle classes and the working classes as the rising price of houses during this time served as the major source for these people to increase their wealth. We are learning more and more that the inflated values of land and commercial real estate and the growing wealth of these classes also served as a piggy-bank for other sectors of the economy, such as state and local governments.

And, this piggy-bank was the source for increasing employment, rising wages, and other benefits in the public sectors of the economy.

Now the piggy-bank is broken and state and local governments are feeling the pain as have home owners, small commercial banks and small businesses over the past three years. (See my post

People are learning that those that “live” by inflation, “suffer” by deflation.

Ben Bernanke and the Federal Reserve are trying as hard as they can to create inflation once again so as to preserve the banking system, the housing market, and, now, state and local governments.

The economy, however, may not be responding as the Fed might want it to.

In a real sense there are two economies. There are the better off, those that benefitted from the credit inflation of the last fifty years, the people that learned how to use inflation and who have the resources to protect themselves against changes in prices. Then there are the others, those who can’t protect themselves from changing prices.

One result of this is that the income distribution in the United States is skewed more toward the wealthy than ever before in the history of the country.

The history: in the early 1960s, there were many intellectuals and policy makers who believed that inflation was beneficial to the worker because a little inflation was not a bad trade off for higher levels of employment. This trade off was captured in something called the Phillips Curve.
Although the Phillips Curve was intellectually contested by the end of the 1960s, the myth of the Phillips Curve lived on in many official circles and some still believe in it to this day.

Yet, the credit inflation that was supposed to be a ‘boon’ to the blue-collar worker and the middle class resulted in a withering of American manufacturing capability in steel, autos, and then other industries. It resulted in substantial amounts of under-employment for working age people. It decimated the housing industry. It has made many of the smaller commercial banks in the United States insolvent. And, it has now bankrupt the American system of local government.

We have had a bailout of the steel industry. We have had two bailouts of the auto industry. Labor unions in the manufacturing industries are so week that union leaders are now training people to go into other countries and build up labor unions there. We have had a bailout of the banking industry. We are now going through a workout and possible bailout of state and local governments.

Labor unions in the public sector, teachers unions, are now acting in much the same way as did the auto unions and the steel unions before them, as the economic base for their benefits have faded away.

People and organizations can only live beyond their means for so long and credit inflation can create the “good days” for only so long. And, when the good days are over, people must return to a more controlled and disciplined life style. The pain of the ‘return’ is not easy to bear.

The efforts by Mr. Bernanke and the Federal Reserve to create another round of credit inflation is, unfortunately, producing a further bifurcation of American society.

While the middle class and the blue collar workers continue to suffer and continue to restructure their budgets and balance sheets, those who have more are taking advantage of the Federal Reserve’s actions to further strengthen their position.

Large commercial banks are bigger than they were when they were “too big to fail” in 2008. Payrolls and bonuses at financial institutions are exceeding earlier years.

Large corporations are sitting on “tons” of cash and possess immense borrowing power at miniscule interest rates. And, we see one large merger taking place here and another large merger taking place there: AT&T and T-Mobile; Deutsche BÅ‘rse and the NYSE Euronext; Warren Buffet and Lubrizol, and Caterpillar and Bucyrus. The projection is for more of this to take place in America...and in the world.

And, the wealthy? Consumer spending is picking up but the strength is not at the lower end of the value chain. Manufacturing is picking up but for higher end goods. Overall, the pickup is just modest because it is not supported throughout the income spectrum.

I raised the question earlier, in such an environment “Will the Financial Industry Dance Alone?” ( The answer to this question seems to be “No, the financial industry will not dance alone. Big corporations will dance along too as will the wealthy.” There was concern in the 2000s that the benefits of the economic growth at that time were not spread evenly throughout the economy.
My feeling is that you haven’t seen anything yet.

The efforts by the Federal Reserve to inflate the economy are not going to be spread evenly throughout the economy. State and local governments are going to have to re-structure and downsize. The people in these bodies are going to have to lower their expectations as well as the people that have been served by them.

Similar to the situation with the smaller banks, one hopes to get through this adjustment period without major disturbances. That is, government officials and regulators are working overtime to keep a lid on things so that insolvencies and bankruptcies do not overwhelm the system. The efforts to contain these problems seem to be having some success. Ever Meredith Whitney, the financial analyst who predicted massive defaults in the municipal bond area still contends that there will be a large number of defaults although not as many as she first feared.

Still, things are changing and will my guess is that in many areas of the society we will not return to the “plush” years experienced in the last half of the twentieth century.

Wednesday, March 23, 2011

Banking and Real Estate: The Problems Are Still There

Fed Chairman Ben Bernanke just informed Congress that people were not anxious to buy homes. He commented that “there’s no demand for construction to build homes and so the construction industry is quite reduced.”

As a consequence, the Fed will continue to purchase Treasury securities up to some $900 billion, $300 billion to replace maturing mortgage-backed securities that have rested in the Fed’s portfolio and an additional $600 billion to expand reserves in the banking system.

My feeling has been that this injection of reserves into the banking system has been to protect the banking system, especially the smaller banks, and keep failing institutions open for as long as possible so that the FDIC can close these insolvent banks in an orderly fashion.

This, of course, is different from what the Fed has been telling us. The Fed has argued that their reason for the injection of liquidity into the banking system has been to help spur on bank lending and help accelerate economic growth.

The data that continues to come in from the real estate sector does nothing to convince me that the Fed’s statement is the correct one.

Data coming in from the real estate sector, I believe, continues to support my contention that the loan portfolios of many smaller financial institutions remain seriously underwater.

The median sales price of a house sold in February, the Commerce Department has just reported, was $202,100, down from $221,900 a year earlier. This is a drop of almost 9%.

Just one added piece of information: last month’s price was at it lowest level since December 2003 when the median sales price stood at $196,000.

This just exacerbated the problem of “underwater” mortgages. CoreLogic, Inc., reported in early March that about 23%, or roughly one out of every four, mortgages in the United States had outstanding balances that were higher than the reported value of the secured properties.

In addition, a record 2.2 million homes were in foreclosure in January of this year. The number of homes in foreclosure had slowed down in the last half of 2010 because of all the fuss being made about how banks had not used proper methods to foreclose on many properties. This slowdown seems to have ended.

Furthermore, the purchases of new homes declined to the slowest pace on record.

Housing starts dropped in February to an annual rate of 479,000, the lowest level since April 2009.

And, construction permits slumped to a record low.

The commercial real estate sector is now getting hit with a new phenomenon…state governments and municipalities that are under tremendous budget pressures are downsizing and cutting back on office space. As a consequence, a lot of commercial office buildings are standing empty and their owners, who are not the states or municipalities, are faced with the task of trying to fill up the empty space.

The banking system holds the paper on a lot of this real estate.

The question is, how big a write-down is the commercial banking system going to have to take…and how fast is it going to have to take it.

The credit inflation the Federal Reserve is trying to create, I don’t believe, will cause housing prices to turn around any time soon in the magnitude needed to save their asset values.

Sooner or later these asset values are going to have to be written down.

Therefore, the efforts of the Fed are just allowing banks to stay liquid enough so that the assets do not have to be written down precipitously. In that way the regulators can control the situation and close the banks that must be closed in an orderly fashion.

But, this raises another question. This question pertains to the length of time the Fed will need to continue to provide liquidity to the financial markets? That is, how long will QE2 be maintained?

The original plans of the Federal Reserve were to call an end to QE2 in June. But, will we need to add on QE3?

My guess is that the Fed will need to continue some kind of program to maintain the “peace and quiet” on the banking front for an “extended period.”

This is a “good news” and “bad news” situation. The “good news” is that events in the banking sector are relatively quiet. The FDIC continues to close banks in an orderly fashion.

The “bad news” is that events in the banking sector are relatively quiet. The Fed must continue some kind of financial support to the banking industry because there are so many real estate related assets in the banking system that are troubled and are in need of a “write down.”

It would seem that as long as there are problems like the ones described above in the real estate sector, there will continue to be problems in the banking sector.

And, as long as there are problems in the real estate sector and the banking sector of this magnitude, the desired pickup in the economy will not be forthcoming.

Tuesday, March 22, 2011

Bigger is Happening!

AT& T and T-Mobile. The strategic merger activity of 2011 and 2012 continues.

As I have argued for a long time, the environment for a crucial restructuring of the economic world is right in front of us.

There is lots of cash around.

Interest rates are ridiculously low.

There are a lot of people, businesses, and governments “defensively” in debt.

There are a lot of companies that are “behind”, technologically and culturally, that have “good” products or good market niches.

And, there are a lot of nations in the world, like China for example, that have a lot of United States dollars that want to buy United States companies.

What about the anti-trust aspects of strategic mergers like AT&T and T-Mobile?

First, I don’t think the executives at AT&T and T-Mobile would try a combination like this if the probability of getting the deal approved were low.

Second, we are in a period of time when the “limits” of what can be done are going to be pushed. Thus, we will see more and more deals “push the edge.”

Third, if it ain’t AT&T and T-Mobile, it will be someone else and, I believe, the crucial issue is going to be how far the regulators are behind-the-times and out-of-date rather than the fact that they are enforcing some coherent program or policy.

Fourth, this is more “global” than it is “local” United States. Regulators, attempting to live up to some historical norms of anti-trust behavior, can stifle deals and leave the United States lagging in world competition. If the members of Congress and the regulators want to continue to fight “past” wars, as they tend to do, then so much the worst for us.

The thing is that Congress and the regulators have already “taken their eye off the ball.”

A report released just the other day indicated not only that banks are big and doing much of what they did before the financial crisis, the large banks are actually bigger and doing even more things than they did before the financial crisis.

The meltdown in the financial system came in the fall of 2008. I was posting blogs in late Spring of 2009 that the large commercial banks were not only getting bigger, but they were far ahead of the Congress and the regulators writing new rules and restrictions for them.

Now the large banks are even further ahead of the government than they were back in the spring of 2009.

But, this is the scenario for the future.

And, the people creating the environment for such a development are…

You guessed it…Ben Bernanke, Tim Geithner, Barack Obama, Barney Frank, and so on and so forth!

No wonder the income distribution in the United States gets skewed more and more toward the wealthy. The wealthy could not have written a better script for their advancement than that being written by the liberals and the progressives!

And, the more these people try and help their “constituencies” the more and more they hurt them. Paul Krugman, stand up and take a bow!

The best investments in the next year or so, I believe will be made in the companies that are best positioned to make “deals” that will help them expand markets, expand into slightly larger product spaces, and move to restructure industries and markets.

I wouldn’t always argue that this is a good strategy, but the world has changed and we are moving into that future. There are many companies that are well positioned, they are operating very effectively in their “core” products and markets, they don’t have much debt, and they have lots of cash.

Furthermore, prices are low since there are many more companies that are not well positioned, companies that are not operating very effectively, companies that are into too many products and markets, and companies that have way too much debt.

And, we are in that part of the cycle where sound economic deals can be struck. In a year or two, premiums will start to rise as people look back and see the transactions made in 2010 and 2011 and as these people move to try and skim some of the icing off the cake themselves.

This always happens as the euphoria in the market picks up due to the previous successful deals that were cut.

So, keep your eyes open and look for the action taking place. Look not only at the companies that are operating very well and have lots of cash and/or borrowing power but look at the nations that have United States dollars and are looking to play a bigger role in the world. Look for executives that do not buy companies too different from the ones they operate now.

Also, look for the leaders that are starting to make a name for themselves in terms of “prudent” yet aggressive deals. Who is going to take on the mantel of the next Jack Welch?

Friday, March 18, 2011

Bank Re-regulation Forgot to Consider Google and Twitter

One of the clearest comments I have heard recently about the financial reform actions of Congress and the regulators is that those passing the new laws and establishing the new regulations completely ignored the fact that something like Google and Twitter had been created.

In other words, times have changed and those in Congress and in the regulatory bodies have kept their focus just on the past.

Financial regulation, however, is not the only thing that is falling victim to a backward looking focus.

We are seeing a concentration on the past in dealing with state and local government problems, problems with pensions, bargaining power, and employment. The law just passed in Michigan giving the state government broader powers to intervene in the finances and governance of struggling municipalities and school districts…” has been fought by those that argue that the law “undermines collective bargaining and threatens to subvert elected local governments.” (

Times have changed.

The years of inflation which began in the early 1960s has reached a tipping point in many areas. The days of inflated state and local government budgets, of passing on the fiscal impacts of lucrative union bargaining agreements in the form of higher property taxes, and of using the accounting gimmicks that postponed dealing with pension obligations is over. Adjustments must be made

But, that is not how people deal with the unpleasantness of current dislocations.

The inflation benefit for labor unions in manufacturing industries gave out years ago.
Manufacturers of cars and steel and so forth could neither pass on lush labor agreements to the public nor hide the increasing labor costs is limited technological advancements in their products or the production of their products.

And, the labor unions that still exist in these areas of manufacturing have shrunk, both in numbers and in terms of bargaining power.

State and local governments are now having to deal with this phenomenon.

And, what about debt?

The taking on of debt thrives in periods of credit inflation and Americans have had at least fifty years to get on this bandwagon.

And, now people have not really been borrowing. The real question is, should they start borrowing again? I have addressed this in my post “Does Getting Out of Debt Mean that People Should Start Spending More?” (See

What has this debt done for people? If the number of foreclosures and bankruptcies over the last few years and the number of foreclosures and bankruptcies pending or near the edge are any indication, many people may not want to jump right into the “debt circus” again any time soon.

What accounts for the popularity of the finance guru Dave Ramsey? Take a peek at his new book, “The Total Money Makeover: A Proven Plan for Financial Fitness.” And, what is his recipe for financial fitness and greater happiness?


This advice doesn’t apply to just families. It applies to small businesses, and medium-sized businesses, and others.


Pass that message on to Chairman Bernanke.

And, what is the solution of Chairman Bernanke and other leaders in Washington, D. C.?

Let the presses role! Start the credit inflation once again!

The question is, will this new round of credit inflation succeed. It seems as if over the past fifty years that every time we entered a new round of credit inflation, some things got worse.

For example, capacity utilization in manufacturing continued to drop since the 1960s. That is, every subsequent peak in capacity utilization during this time period was lower than the previous peak. Furthermore, after almost two years of economic recovery, capacity utilization still remains just a little over 75%.

Underemployment has continually risen over the last fifty years and now about one out of every five individuals of working age in the United States is underemployed.

In addition, the inflationary environment of the last fifty years has benefitted the wealthy who can either take advantage of the inflation or protect themselves against it and has been exceedingly costly for the less wealthy, who cannot protect themselves. As a consequence, we have the worst skewing of the income distribution toward the wealthy in United States history.

And, there is more!

But, this is not the point.

The point is: the times have changed!

If we do not accept this fact in financial regulation, in the management of state and local governments, in our own finances, and in the federal governments budgetary policy, we will all be the sorrier for it.

Who has the credit inflation of the last fifty years really helped? The financial industry. And, I have asked the question, who is the “Bernanke Credit Inflation” going to help? This time, will the financial industry just dance alone? (See

Thursday, March 17, 2011

FDIC Bill for Loan Losses at Failed Banks to Reach $30 Billion

The good news is that the FDIC payments to those organizations and institutions buying failed banks during the present crisis are smaller than the regulatory officials anticipated. The FDIC has paid out $8.89 billion to “cover losses” at 165 banking institutions that have failed during the recent financial crisis. (See Wall Street Journal article:

The reason for this good news, I believe, is the monetary policy followed by the Federal Reserve over the past three years, now captured in the quaint symbol QE2. Excess reserves pumped into the banking system by the Fed now total around $1.3 trillion.

I have argued for at least a year-and-a-half now, that the Federal Reserve is pumping all these reserves into the banking system to help the FDIC close banks in an orderly manner. The basic premise is that if the Fed can provide sufficient “liquidity” to the financial markets in order to maintain the value of financial assets it wil give the FDIC breathing room to close banks as rapidly as they can without causing major disruptions to the many other troubled banks in the system.

The Federal Reserve has argued that it has pumped all these reserves into the banking system to help stimulate the economy. The economic recovery has almost reached its two-year anniversary, although there is general dissatisfaction with the speed of the recovery, and looks likely to extend beyond this milestone.

However, the recovery seems to have taken place without the Fed’s help except for the argument that there have not been further disruptions to the recovery due to major cumulative banking failures. Certainly, one cannot argue that the Fed’s actions have provided banks with the incentives to increase their lending activity for they have not. Commercial banks are still sitting on the money.

This is exactly my point! The policy of the Federal Reserve has been to support the FDIC and allow the FDIC to close insolvent banks in an orderly manner.

Thus, the monetary policy followed by the Federal Reserve over the past three years has succeeded.

Added evidence that the policy of the Federal Reserve has been successful is that reported above: the FDIC payments to those acquiring banks have been “smaller than FDIC officials anticipated.” Without the market liquidity, results would have been much worse.

The Wall Street Journal even reports: “Some executives at U. S. banks that bought failed institutions using the FDIC lifeline agreed that losses on the troubled loans aren’t piling up as high or as fast as they previously anticipated.”

The bad news?

“FDIC officials expect to make an additional $21.5 billion in payments from 2011 to 2014. More than half of that total is predicted for this year, followed by an estimated $6 billion in loss-share reimbursements in 2012, according to the agency.”

According to my calculations, $21.5 billion is almost two-and-one-half times the $8.89 billion the FDIC has already paid out during this cycle of bank failures!

This would bring the total of FDIC payments up to more than $30 billion!

It also seems to mean that we have a lot of bank failures that still have to be resolved!

The banking system now has less than 8,000 banks in it. Over the past year or so, I have argued that this number will drop to less than 4,000 by 2015.

I see nothing inconsistent between my forecast about the number of banks that will be in the banking system and the estimates made by the FDIC, itself, concerning the amount of payments it will need to make to those that acquire banks to cover loan losses.

Bottom line: there are still a massive amount of bad loans that still reside on the balance sheets of commercial banks!

Consequently, there are still a lot of commercial banks that need to be closed!

And, what does this mean for the Fed and QE2? The Fed claimed on Tuesday that the economic recovery is picking up. However, QE2 will need to continue, as planned, through June. Also, the Fed will maintain its interest rate targets at current levels for “an extended period”. NO CHANGE IN MONETARY POLICY!

If I am correct the Fed will only change its monetary policy when it…and the FDIC…believe that problems connected with bank closings have receded sufficiently so that more normal operations can be resumed.

Since the Fed…and the FDIC…have never claimed that the excessively loose monetary policy over the past few years has been to assist the regulatory closing of commercial banks, any statements about changing policy will not be worded in a way that ties the policy with the closing of banks.

Maybe it has been just as well for us…that we have not really known how bad off the banking system has been. But, so much for openness and transparency.

Wednesday, March 16, 2011

For Mr. Trichet, the New Rules are "Insufficient"

The European sovereign debt unpleasantness continues.

Muddle, muddle, muddle…

The European finance ministers want automatic sanctions against EU countries that violate the debt levels assigned to the countries…

That is, unless a country has enough allies to be able to avoid the sanctions if they break the rules.

Jean-Claude Trichet, president of the European Central Bank, states that the new rules put into place on Tuesday are “insufficient.”

The next step in the application of these rules involves the approval of the European Parliament. The feeling is that this body, given the position taken by Mr. Trichet, will push for tougher rules.

We’ll see.

Meanwhile, back at the ranch, Moody’s Investors Service downgraded Portugal’s long-term government bond rating.

And, the finance minister of Greece, George Papaconstantinou, indicated that Greece might need additional aid beyond what was in its initial bailout which came in 2010.

Interest rate spreads on European government debt over German government debt rose again yesterday after spreads had fallen on Monday after reports from the weekend meeting of the finance ministers was released.

Financial markets just don’t seem to be convinced that the problems that exist within the eurozone are being faced. Government officials seem to want to return to a previous world and will try any band aid they can construct in order to get things “back to the past”.

At least two governments within the European Union are going to have to write down the value of their debt. Maybe there might be two more that will have to do the same thing.

Then, these nations are going to have to severely limit their future budget deficits.

After this, some of the peripheral nations are going to have to bring their economies into the 21st century. This is going to be the hardest part of this exercise.

The point here is that just getting government budgets back into greater balance is not going to do resolve all the issues of the European Union. One of the fault lines that Raghu Rajan writes about in his award winning book “Fault Lines: How Hidden Fractures Still Threaten the World Economy,” is the one that exists between those eurozone countries that are growing rapidly and those whose growth is lagging behind because they are still trapped in the 20th century.

So, in addition to just the fiscal issue, there are structural issues that some nations are going to have to deal with, and, given the protests and riots we have already experienced, it is obvious that such changes are going to be painful. But, the future of the European Union, as it now stands, depends upon this effort.

How can the European Union hold together when these social, as well as economic, issues that are so divisive must be dealt with? If the budget constraints are held to, the governments that face the greatest amount of change are not going to have the “deep pockets” needed to resolve the social unrest that might result. How can the needed change take place without a lot of economic “safety nets” in place, especially in Europe?

In my view, Europe has a long way to go and the sovereign debt problem is just a bump along the road. But, since the “people” issues connected with making these peripheral countries competitive in the 21st century are so important, the debt of these troubled countries should be written down so that the governments of these countries can get their fiscal houses in order.
Then, these governments can deal with the “safety net” issues that they will be facing.

Trichet is correct, what has been done is “insufficient”, but there is much more to the situation than that.

Tuesday, March 15, 2011

Bring on the Debt Restructuring in Europe

Did you hear the latest one…94% of college professors in the United States believe that they are better teachers than the average college professor! Furthermore, the vast majority of college professors also believe that they are better researchers than the average college professor!

I just thought of this when a quote in the Financial Times this morning. The columnist Gideon Rachman writes of the European leaders: “European leaders do not know whether to be more frightened of the bond markets or of their own voters.” (

In the first case, the European nations do not seem to be able to create any workable plan to bail out the sovereign nations whose debt is under attack by those nasty “speculators” in the bond markets. In the second case, more and more elected officials, like German chancellor Angela Merkel, French president Nicolas Sarkozy, and others, are under pressure from the voters in their countries to adopt “much harder-line policies on everything from immigration to European spending.”

There is a real possibility that Europe could move much more to the right, politically, than has been the case for a long time. Two countries provide vivid examples of this possibility: the Netherlands and England.

The reason I included the little bit of humor in the first paragraph above is that I needed an example of the fact that not everyone can be above average (except in Lake Wobegon). To be honest, there are a lot of horrible college teachers. And, there are a lot of horrible (peer reviewed) research papers written by college professors.

And, not every country (or business or individual) in the world can “pump up” its economy through fiscal deficits and create more and more and more debt.

Someone has to buy the debt and countries and businesses and individuals will not always be available to run fiscal surpluses so as to acquire this debt for their portfolios.

I know this sounds like heresy, but there ultimately comes a day of reckoning for those that issue excessive amounts of debt. I know that the meaning of the term “excessive” is in the eye of the beholder, but, how the financial markets decide what is “excessive” can be cumulative.

That is why we talk of a “debt deflation” and a “credit inflation.” In periods of “credit inflation” the taking on of risk accelerates during the buildup and leverage increases. In a “debt deflation” people cumulatively reduce their exposure to risk and they also de-leverage at such times.

We cannot “average” the amount of debt across nations and say that all these nations just have an average amount of debt outstanding: if we average the amount of sovereign debt in Greece and in Ireland with the sovereign debt of Germany and the Netherlands we cannot say that these countries combined will then have the “average” amount of debt outstanding.

Rachman provides the example of the current Franco-German relationship: “A senior EU official in Brussels says that this is not the old Franco-German relationship that was built on a basis of equality: ‘Germany needs France to disguise how strong it is. And France needs Germany to disguise how weak it is.’”

But, the people of Germany do not seem to be buying this and Ms. Merkel is in trouble. Because of this she has been taking stronger and stronger positions in the negotiations within the European Union. And, Sarkozy seems to be trailing the far right candidate in the buildup for next year’s presidential election and has, therefore, been more of a supporter of Ms. Merkel.

Within such an environment it seems almost impossible that a unified political settlement could be reached that would ultimately satisfy the bond markets in terms of a bail out financing package for EU countries. This would take a political union that I just don’t see happening in the present state of the world.

Some of the weak, like Ireland and Greece, do not appear to be willing to submit to the strong, Germany, in the ways the strong believes the weak must act. Thus, the bond markets will not be satisfied.

But, there seems to be a section of the voting public that are saying that they should not be paying for the undisciplined way others have acted in the past. This body of voters appears to be gaining ground as the coherence of their message grows and the confidence in their ability to succeed expands.

As I said yesterday, there seems to be only one path out of this dilemma: the sovereign debt of the fiscally troubled nations must be restructured. (See

Bring it on!

Monday, March 14, 2011

Are There Any Leaders in Europe?

On March 10, I asked the question, “Is this Europe’s month of reckoning?” (

Well, the answer is no! The result of the meetings held this past weekend at the emergency summit in Brussels: “Not if we can postpone it for a while!”

In essence, however, we got the worst of two possible worlds...a combination of the two.

The leaders came together and seemed to say, “On the one hand we will provide some bailout protection for the nations struggling to right their fiscal distress, but on the other hand in our plan we will not get penalized for the funds we advance because our repayment will stand first in line over any prior claims.”

No real bailout, no real restructuring…which, in the longer run will mean that we will get a restructuring...we just don’t know when this restructuring will take place.

Current holders of Europe’s sovereign debt can now respond to Europe's leaders, “Don’t do us any favors.”

My patience is gone.

Let’s have the European sovereign debt restructuring now and get this thing over with!

The European Union does not seem to be workable in its present form. No one can lead.

I still believe that there should be a Euro, a common currency for Europe, but there needs to be
some other serious governing body behind it.

The current structure is awful!

Get on with it!

Bring on the debt restructuring!

Let’s move on to something else that we might have a chance of resolving!

Sunday, March 13, 2011

Is Bank Lending to Business Starting to Pick Up a Little?

Last month I wrote a post about “Why is most of the Fed’s QE2 Cash Going to Foreign Related Banking Institutions.” (

This month the Fed’s “cash” injection has ended up at the largest 25 banking institutions in the United States. Cash assets at the largest domestically chartered banks rose by almost $160 billion over the past four weeks.

The cash assets at foreign-related banking institutions dropped modestly (about $4 billion) over the last four weeks but is still up approximately $125 billion since the end of last year.

According to the Fed’s data on the commercial banking industry, cash assets in commercial banks have risen by about $260 billion over the past nine banking weeks, with around $135 billion going to the largest 25 domestically chartered banks, $125 billion going to foreign related financial institutions and roughly zero going to the other 7,600 domestically chartered small banks.

Other than this fact, the interesting change within the United States banking system itself is that although credit extension at domestically chartered commercial banks declined rather substantially since the end of last year, the loans and leases at the smaller commercial banks actually went up.

Overall, loans and leases on the books of commercial banks declined by about $27 billion over the last four weeks and by $61 billion since the end of 2010.

Interestingly, the smaller banks recorded a $28 billion increase in loans over the last four weeks, with commercial and industrial (C&I) loans rising by $5.5 billion and commercial real estate loans increasing by about $18 billion.

It should be noted that residential mortgages fell by about $11 billion over the same time frame.
Is this a sign that commercial lending is picking up for the smaller banks. This is the first time in the last few years that commercial lending has actually shown any sign of increasing at these smaller institutions, especially in the area of commercial real estate.

C & I loans did pick up at the larger banks over the last four weeks and this dominated the activity in this area during the early part of this year.

However, commercial real estate lending declined at the largest banks by $25 billion, so that this category of loans did decline in total. Also, since the end of last year, commercial real estate loans at these large banks declined by $32 billion so that overall, the commercial real estate sector continued to decline throughout the early part of 2011.

So, the question is, “Is bank lending to businesses starting to pick up a little?”
Really, we only have a little information that it might be picking up. But, it certainly is something to keep our eyes on.

The big mystery still seems to be the placement of the QE2 money being generated by the Federal Reserve system. Reserve balances at Federal Reserve banks have increased by about $280 billion from the end of 2010 to March 2, 2011. This increase in Reserve Balances seems to be roughly divided between the largest 25 domestically chartered commercial banks and foreign-related financial institutions. But, loan at these institutions over this time period have actually gone down. What’s going on?

As for the smaller banks, they do not seem to have participated in this round of quantitative easing. Yet, it has been my belief that one rationale for QE2 has been to provide market liquidity for the smaller banks so that it will ease the strain on those banks that are especially having solvency problems. Given recent data released by the FDIC it seems as if there are still a large number of the smaller banks in the country that are still having major problems staying alive.

Thus, at least part of the purpose of QE2 is to help keep these banks open so that they can be closed by the FDIC in an orderly fashion. Through the first nine weeks of the year the FDIC has closed an average of just under 3 banks per week. This is down slightly from about 3.5 banks a week in 2010.

We continue to wait. Believe it or not, the economic recovery is just about a quarter short of being two years old. There are still areas of the economy that remain of concern like the banking industry, the residential housing market, the commercial real estate market, and state and local finances. And, there still are shocks around the world that threaten to bring everything else down: the unrest in the Middle East and arising oil prices; the earthquake in Japan; and the sovereign debt problem in Europe.

So the bad news is that the economic recovery is just about a quarter short of being two years old and underemployment is so large and manufacturing capacity is so low for this time in the business cycle.

The good news is that the economic recovery is just about a quarter short of being two years old
and the recovery seems to be robust enough to continue to meander along in an upward direction.

It would be nice to have more bank lending to spur the recovery along, but it will be even better if the financial system can continue to function without a disruption to the steady pace of the FDIC closing the banks it needs to close.

Friday, March 11, 2011

Does Getting Out of Debt Mean that People Should Start Spending More?

From the Wall Street Journal this morning:

“U.S. families—by defaulting on their loans and scrimping on expenses—shouldered a smaller debt burden in 2010 than at any point in the previous six years, putting them in position to start spending more.

Total U.S. household debt, including mortgages and credit cards, fell for the second straight year in 2010 to $13.4 trillion, the Federal Reserve reported Thursday. That came to 116% of disposable income, down from a peak debt burden of 130% in 2007, and the lowest level since the fourth quarter of 2004.” (See “Families Slice Debt to Lowest in 6 Years,”

The logic in this is that people reduce debt so that they can spend more. I think that is called a “non sequitur”.

If people (and businesses) get more and more in debt over a fifty year period (as they have since 1960) and this contributes to the worst recession since the Great Depression the objective of these people (and businesses) getting out of debt is so that they can get more in debt once again?

I thought that if people (and businesses) got themselves so leveraged up and so “over-extended” that they found themselves in serious financial trouble and were faced with foreclosure on their real estate and personal (or business) bankruptcy that what they would try and do is bring their debt more in line with their incomes so that they could manage their debt.

I thought that maybe people (and businesses) would become more prudent and try and manage their debt in a way that would allow them more “peace of mind” not having to scramble to make principal or interest payments every month.

And we read that there are 11 million people who find themselves owing more on their mortgages than their home is worth on the market.

And we read that about one out of every four individuals of working age is under-employed.

And, we read that the income distribution is skewed toward the high income end worse than it has ever been in the history of the United States.

And, we read that America is bifurcating more and more based on education and race.

And, we read that many state and local governments can’t meet their pension commitments and can’t balance their budgets so that they are cutting jobs, cutting pensions, and cutting education.

Some people are spending. Some people are using credit again. Some people are buying very nice homes. Some people are paying for very expensive educations.

But, this spending and credit extension is not across the board.

The inflation over the past fifty years created the ideal environment for debt creation. The inflation was not large enough to create a panic. From time-to-time, the inflation was not enough to really see.

Yet, from 1960 to the present time, the purchasing power of the dollar has fallen by 85%. The dollar that could buy a dollar’s worth of goods in 1960 can only buy about fifteen cents worth of goods now.

This was the perfect scenario for the creation of credit, for financial innovation, and for the growth of the finance industry.

This could not have been a better environment for the consumer culture to thrive where people could feed their insatiable appetites for goods and think that things were great.

And, now a substantial part of our economy is mired in this debt and struggling hard to get their heads above water. They don’t need to pile on more debt…they need some stability and consistency to their lives.

Yet, many are pushing to get the “credit machine” going again. The federal government is setting the standard (as it has over the past fifty years) by living way beyond its means and threatening to increase its debt by $15 trillion or more over the next ten years.

The Federal Reserve has pumped almost $1.4 trillion in excess reserves into the banking system in order to get the banks’ lending again.

We want families to be “in position to start spending more” as the Wall Street Journal article stated.

A credit inflation is just what is needed.

Each time we restart the “credit inflation” button again, more and more people seem to be in a position in which they are excluded from its benefits. They are under-employed, substantially in debt, and excluded from benefitting from further increases in prices.

This means each time the “credit inflation” button is pushed again, only a smaller proportion of the population can participate in subsequent expansion.

Maybe this is why it is taking us so long to get the economy “moving again.”

History has shown that this “show” cannot go on forever. The difficulty is in knowing just when the “show” is over.

The government is trying to start the music playing again. And, those that can are supposed to begin dancing. But, maybe this time only the financial industry will be dancing (

Thursday, March 10, 2011

Excess Reserves at Commercial Banks on March 9, 2011

New Federal Reserve statistics just released indicate that the Reserve Balances of commercial banks at that Federal Reserve increased by more than $83 billion this week to come in just short of $1.4 trillion on Wednesday March 9.

Excess reserves in the banking system averaged just under $1.3 trillion for the two banking weeks ending March 9. This figure tends to trail the Reserve Balances number because it is a 14-day average.

The Reserve Balances at the Federal Reserve are up over $360 billion since December 29, 2010 and up about $400 billion since September 22 just after Ben Bernanke warned the world that QE2 was on the way.

Bank Reserves have increased by 41% since that September date.

Note that on August 22, 2008 the total assets held by the Federal Reserve totaled $925 billion so that the increase in Reserve Balance from September 22, 2010 to March 9, 2011 of almost $400 billion represented 43% of what total Fed assets were before the financial crisis in the fall of 2008.

The $1.4 trillion in Reserve Balances are one and a half times the amount of assets held by the Federal Reserve on August 22, 2008.

Is This Europe's Month of Reckoning?

Interest rate spreads on European sovereign debt jumped to new levels yesterday. On 10-year bonds, Greek debt rose to 942 basis points over German bonds of the same maturity. Portugal rose to 436 basis points over the German yields and Spain jumped back up to over 200 basis points.

Is something on the horizon?

A lot it seems. See my earlier post, “Meanwhile Back In Europe” (

The new round of stress tests began on European banks last weekend. And,ever since they started the tests the bank regulators have had to defend themselves, to defend that the tests WERE NOT too soft!

Not a very good beginning to the upcoming events, is it?

How much confidence are we going to have in the results if the regulators are not even “out of the gate” and their methodology is being questioned? It’s just like the United States government saying it believes in a “strong dollar”.

Then again, how good can the tests be if the banks are changing how they do business right in front of the efforts of the regulators to re-regulate them? All sorts of things are going on, in Europe ( and as well as in the United States, and the regulators still seem to be creating an environment to avoid another 2008 crisis.

Oh, well, what else do regulators have to do to keep themselves busy?

And, the politicians still are on the lookout for “speculators”, those dastardly villains that create havoc for nations that don’t seem to have sufficient discipline to manage their fiscal affairs prudently. There are still a substantial number of member states in the European Union that want to ban the use of “uncovered” credit default swaps on sovereign debt. (See
This will stop the speculators!

Most of the distressed European nations that have experienced problems in the bond markets continue to deny responsibility for creating these sovereign debt problems. And, with unrest continuing or even increasing in these countries, governments face substantial internal pressure to place the blame for their problems “out there”, out where the shady “speculators” gather.

These “shady” speculators have taken the place of those “shadowy” international banks that inhabited the 1980s and caused sovereign nations, like France and Mitterrand for example, such incredible trouble.

Readers of my posts know what I feel about people who claim that their problems are “out there”!

One example of such unrest is that which is taking place in Greece. Adding to this is the fact that the unemployment rate in Greece recently hit a historic high.

In the face of all that is going on Portugal was able to issue new two-year debt on Wednesday, albeit at very expensive rates. Wednesday’s offering was for €1, which means that Portugal has raised almost €7 this year; approximately 35% of the year’s total funding need.

But, even this successful offering does not seem to ease the general concern in international financial markets that the overall political solutions to the problems being faced in the Eurozone are going to be resolved. In addition to the increased spreads in the bond markets, the Euro has fallen off in the last couple of days as the traders have worried that the leaders of the European Union will “pass” on reaching strong enough solutions to stem the lingering crisis.

There are still a lot of “unresolved” issues in the world and the existence of these issues points up the difficulties that people, states, and nations have created for themselves.

In my estimation it has taken Europe (and the United States) fifty years to get into the position it now finds itself. Europe (and the United States) has dug a big hole for itself. In many cases, people, states, and nations have not stopped digging the hole deeper!

In some cases, efforts have been made to stop the digging…and in one, possibly two, cases there have even been efforts to start filling the hole up.

No one seems to be really stepping up to really address the bigger problems…the leaders are nowhere in sight.

The international financial markets are indicating a lack of confidence in what is going on. The “stress” tests are too soft. Nations are still looking backwards to develop regulations. And, the leaders of the European Union are not going to come up with anything effective in their deliberations that begin again this Friday.

Kenneth Rogoff, who co-authored the book “This Time is Different," has recently stated that Greece and Ireland will need to restructure their debts. He also suggested that Spain and Portugal may be forced to do the same thing.

A debt restructure may be the only way to really make something happen. Historically, this is often the only way to get things changed when there is a total void of leadership!

Tuesday, March 8, 2011

Trichet: It's All About A Strong Euro

Jean-Claude Trichet, the President of the European Central Bank (ECB), made headlines toward the end of last week by suggesting that the ECB might have to raise its major interest rate in April.

This suggestion raised quite a bit of controversy and also helped the Euro to rise, briefly, to more than $1.40 per Euro. It also, some said, set the stage for the weekend in Europe and the upcoming discussions about fiscal affairs in the eurozone countries. (

Trichet has been as hardnosed as anyone in recent years about keeping inflation in check. And, since 2003 when he became President of the ECB, he has been adamant about maintaining an inflation target as the primary objective of the central bank.

In doing so, he has been relatively successful in allowing eurozone economies to expand while keeping the Euro strong, especially against the United States dollar.

In this chart we see an almost steady climb in the dollar/euro exchange rate from about 2002 until late 2008 when the financial markets began to collapse and there was a “flight to quality” toward the United States dollar.

As market participants moved back into “risk” in 2009 the dollar/euro exchange rate began to rise again, roughly reaching $1.50 per Euro. The sovereign debt crisis in the eurozone resulted in another drop in the exchange rate but the Euro began to rise again once Fed chairman Bernanke started talking up his plans for Quantitative Easing, Part II, for the Federal Reserve in late August 2010.

The strength of the Euro, especially against the United States dollar, should be seen as a source of pride for the President of the ECB. Trichet, a Frenchman, saw how upsetting inflation or the threat of inflation could be in international financial markets when he served in the Treasury Department in France during the time that Francois Mitterrand was the President of the French Republic.

Mitterrand was a socialist and who came to power in 1981. Early in his first term, Mitterrand followed a radical economic program, including nationalization of key firms. The economy developed a serious inflationary problem and money fled France causing a substantial decline in the French Franc. After two years in office, Mitterrand made a substantial u-turn in economic policies. In March 1983 he presented the so-called “Liberal turn”, in which priority was given to the struggle against inflation so that France could remain competitive within the European Monetary System.

The young Treasury Department official took note of this and applied the lessons learned when he became a Governor of the Banque de France, a Governor of the World Bank, an Alternate Governor of the International Monetary Fund and the President of the ECB.

Leading the European Central Bank is one thing, but the ultimate success of Trichet’s efforts to keep European inflation under control is also dependent upon the European Union (EU) getting its fiscal act under control. The sovereign debt issue and its resolution amongst the eurozone countries is crucial to the EU in keeping inflation under control and even whether or not the Euro will continue to exist.

The problem in the eurozone is that the limits or restrictions on independent sovereign nations to conduct their own fiscal policies have not been very effective. The leaders of the EU are going to have to reach some satisfactory solution to this problem or there will be continued attacks on the sovereign debt of the less disciplined countries and this will tend to bring with it attacks on the Euro.

In my view, the EU has two choices. It either moves toward the German model of conservative fiscal control of governmental budgets or it fails to bring sufficient controls on less-disciplined governments which, to me, is basically saying that the EU will err on the side of not offending anybody.

To err on this latter side is to seal the fate of the Euro. If one takes the “weaker” side, if one allows the less-disciplined to get-away with their lack-of-will, then the financial problems of the eurozone will continue and there will be a movement away from the Euro. Over time, the value of the Euro will slowly deteriorate. The Germans will not remain in such a union and the Euro will become “legacy.”

Trichet hopes, I believe, that the Germans will prevail in determining the fiscal parameters of the European Union now being discussed. This, to me, is the only hope for the Euro surviving in the longer run. In this, the Germans win…which a lot of people in Europe…and elsewhere…don’t really want to see.

Ultimately, however, the more fiscally prudent nation will prevail whether or not the Euro does. I believe the Germans don’t want the Euro to become history, but they are not willing to sacrifice their economic strength and benefits to live with the excesses of other governments. It is good to be economically strong!

Thus, to Trichet, it’s all about a strong Euro. He has done his job in setting the stage for the continuing discussions within the EU over the future of eurozone cooperation, fiscal policies, and debt restructuring. For the eurozone to be a strong player in the global economy in the future, the EU must have a strong currency. Trichet has done his job in an effort to achieve this goal.

Monday, March 7, 2011

How Much Should the United States Cut the Deficit?

How much should the United States government cut its budget deficit?

This seems to be the big debate in Congress surrounding discussions/negotiations related to the new fiscal budget.

The problem as I see it is that the United States government is focused on the wrong objective! It is focused on an objective, low levels of unemployment that it cannot achieve without creating all other kinds of distortions in the economy, distortions that produce, in many cases exactly the opposite result from what the government is attempting to achieve.

Let me tell you what objective I believe the United States government should focus upon in determining its economic policy stance, which includes its fiscal budget.

I believe that the primary economic focus of the United States government should be on the value of the United States dollar. I believe that the United States government should attempt to stabilize and maintain the value of the dollar in international currency markets.

The current focus of economic policy in the United States government is employment…or low levels of unemployment. This objective was memorialized in The Employment Act of 1946 which set placed the responsibility for achieving high levels of employment, or low levels of unemployment on the back of the United States government.

In 1978 this objective was re-enforced by a new act, The Full Employment and Balanced Growth Act (known informally as the Humphrey–Hawkins Full Employment Act). This act just made stronger the government’s commitment to the achievement of low levels of unemployment.

The ability of a government to achieve full employment was contested in 1968 by the economist Milton Friedman who contended that continued governmental stimulus to achieve a “hypothetical” level of employment, called “full employment” would only achieve more and more inflation as people came to expect the government’s efforts to stimulate the economy through the creation of credit expansion…credit inflation.

Friedman’s expectations proved to be true as the government continued to promote government deficits and the expansion of government debt in economy.

From 1960 through 2010, the gross federal debt of the country expanded at an annual compound rate of more that 7% per year.

From 1960 through 2010, the purchasing power of the United States dollar declined by about 85%.

From 1960 through 2010, the United States removed itself from the gold standard and allowed the value of the United States dollar to float in foreign exchange markets. The value of the United States dollar has declined by more than 30% since it was floated and expectations are for it to decline further.

From 1960 through 2010 under-employment in the United States has gone from a relatively modest number which was not measured at the earlier date to more than 20% in the current environment.

From 1960 through 2010 manufacturing capacity has declined from about 95% to about 75%. The peak capacity utilization has every cycle since the early 1970s has been at lower and lower levels.

From 1960 through 2010 the income distribution of the United States has become dramatically skewed toward the higher levels of income earned. This is the most skewed income distribution curve ever for the United States.

I cannot see how the United States government can continue to keep “full employment” as a goal of its economic policies. Not only has “full employment” not been maintained, it has generated side effects that, it seems to me, has substantially worsened the life of many Americans.

Why should the government substitute the maintenance of the value of the United States dollar as its primary objective for the conduct of its economic policy?

Here I quote Paul Volcker: “a nation’s exchange rate is the single most important price in (the) economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate.” This quote is from Paul Volcker (“Changing Fortunes: the World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten, Times Books, 1992, page 232.)

Yet “ignore large swings in its exchange rate” is exactly what the United States did and is doing. The consequences of ignoring this value? I have reported those above.

By focusing on the level of unemployment the way the United States government did and pursuing an economic policy of credit inflation, the United States government actually weakened the country and hurt its citizens. The “unintended results of good intentions!”

The United States government should not, and realistically cannot, reduce its budget deficit too rapidly. Markets realize that.

But, the United States government must signal that it is changing the objective of its economic policy and is sincerely pursing a path to reduce or even eliminate the credit inflation it has inflected on its country…and the world…for the last fifty years.

My guess is that until international financial markets see this shift in policy objectives and sense a realistic change in the attitudes of the politicians in Washington, D. C. the dollar will continue to decline in value because participants in international financial markets will just see the government continuing to act in the same way it has over the past fifty years, acting in a way that will continue the policy of credit inflation.

And, if the government continues to act in this way, the economic health of the economy will continue to deteriorate and the standing of the United States in the world will continue to become relatively weaker.

In my view the government does not have to reduce the deficit by massive amounts this year. It does, however, have to signal that it is changing its goals and objectives and then provide enough evidence of this change in focus to convince the international financial markets that it is sincere.

In the current political environment, however, this may be too much to ask.

Friday, March 4, 2011

Federal Reserve QE2 Watch: Part 4.0

The Federal Reserve continues to pump funds into the banking system. Reserve balances at Federal Reserve banks reached $1.3 trillion on March 2, 2011. This is up from $1.1 trillion on
February 2 and up from $1.0 trillion on December 29, 2010.

These balances serve as a relatively good proxy for the excess reserves in the banking system which averaged $1.2 trillion over the two-week period ending February 23, 2011.

As we have reported before, there are two drivers of this increase in bank reserves. The first, connected with the Fed’s program of quantitative easy, is the acquisition of United State Treasury securities.

Over the past four weeks the Federal Reserve has added almost $100 billion to its portfolio of Treasury securities. Only about $18 billion of these purchases were offset by maturing Federal Agency issues and mortgage-backed securities.

Since the end of last year, the Fed has added $220 billion to its Treasury security portfolio. In this case the Fed was replacing a $48 billion decline in the other securities that were maturing.

And, in the past 13-week period, Almost $320 billion were added to the Treasury portfolio, replacing about $80 billion in maturing Agency issues and mortgage-backed securities.

The second driver has been the action surrounding Treasury deposits with Federal Reserve banks. Since these deposits are a liability of the Fed, a reduction in these deposits increases reserves in the banking system. There are two important accounts here, the Treasury’s General Account and the Treasury’s Supplementary Financing Account.

The Supplementary Financing Account has been used for monetary purposes and in the current case, the Treasury has reduced the funds in this account by $100 billion. All of this reduction came in February.

The Treasury’s General Account is used in conjunction with Treasury Tax and Loan accounts at commercial banks and is the account that the Treasury writes checks on. Generally tax monies are collected in the Tax and Loan accounts and then are drawn into the Federal Reserve account as the Treasury wants to write checks. When the Treasury writes a check, it is deposited in commercial banks, so that bank reserves increase.

Over the past four weeks, the Treasury’s General Account has dropped by almost $70 billion. Thus, between this account and the Treasury’s Supplementary Financing Account the Fed has injected almost $170 billion reserves into the banking system in February.

I need to call attention to the fact that funds moving into and out of the General Account can vary substantially. For example, since the end of the year (which includes the February change) this account has only fallen by $39 billion. Over the last 13-week period, the account has actually increased by $4 billion. Tax collections build up toward the end of the year and then are spent during the first quarter of the year preparing for another buildup around April 15, tax collection time.

The bottom line, the Federal Reserve is seeing that plenty of reserves are being put into the banking system. But, the commercial banks seem to be holding onto the reserves rather than lending them out.

Still, the growth rates of both measures of the money stock seem to be accelerating. The year-over-year growth rate of the M1 measure of the money stock was growing by about 5.5% in the third quarter of 2010. The growth rate increased to 7.7% in the fourth quarter and is growing at a 10.2% rate in January 2011.

The M2 measure of the money stock has also accelerated, going from a year-over-year rate of increase of 2.5% in the third quarter to 3.3% in the fourth quarter to 4.3% in January.

On the surface these increases in money stock look encouraging in terms of possible future economic growth. However, we are still seeing the same behavior of individuals and businesses in the most recent period that we have observed over the past two years.

The growth rates of both measures of the money stock still seem to be coming from people that are getting out of short term “investment” vehicles and are placing these funds in demand deposits or other transaction accounts, or in currency.

The first piece of evidence of this relates to the reserves in the banking system. The total reserves in the banking system have remained roughly constant over the past year. Yet, the required reserves of the banking system have increased by 10% year-over-year. This situation could only happen if demand deposit-type of accounts, which require more reserves behind them, were increasing relative to time and savings accounts, which have smaller reserve requirements.

Looking at the individual account items we see that demand deposits at commercial banks rose at a 20% year-over-year rate of growth in January. The non-M1 part of the M2 measure of the money stock rose by only an anemic 3% rate. Thus, the substantial shift in funds from time and savings accounts to transaction accounts continues. There is no indication of a speeding up of money stock growth connected with the reserves that the Fed is injecting into the banking system.

An even more dramatic shift can be seen if we include institutional money funds in the equation and look at what has happened in the banking system over the past nine weeks. The non-M1 portion of M2 increased by $22 billion over this time period. However, funds kept in institutional money funds declined by roughly $40 billion. This means that accounts that Milton Freidman would have labeled “a temporary abode of purchasing power” actually declined by $18 billion since the start of the year.

Demand deposits and other checkable deposits rose by about $21 billion. One could note that currency in the hands of the public also rose by $16 billion.

The public continues to move money from relatively liquid short-term savings vehicles to assets that can be spent by check or cash. This is not the kind of behavior one gets in an economy that is confident and expanding. This behavior can roughly be called “defensive”.

So, another month has gone by. The Fed is aggressively executing its program of quantitative easing. Yet, it still seems to be “pushing on a string.” Why is it I retain the feeling that the Federal Reserve’s effort is just spaghetti tossing, seeing what might stick to the wall?

The longer this policy continues, the less confidence people seem to have in both Ben Bernanke and the Federal Reserve. I shutter to think what Bernanke and the Fed will do to us when the banking system actually does start lending again.

Note that some members of the Fed’s Open Market Committee are suggesting that QE2 end abruptly at the end of June when the current program is slated to expire. (See "Policy Makers Signal Abrupt End to Bond Purchases in June":

Does everyone in the Fed seem “tone deaf” to you? They just seem to act on pre-conceived ideas and have no sense or feel of the banking system and financial markets. Another confidence raiser.