Friday, December 30, 2011

"In the Real World Creditors will Always Have the Whip Hand with Debtors"

The lesson that never seems to be learned in the real world: “In the real world creditors will always have the whip hand with debtors.” (

John Plender writes in the Financial Times, “From the wreck of the sovereign debt crisis Germany has unquestionably emerged as Europe’s pre-eminent power.  And a central tenet of the German solution to the crisis—for it is primarily a German solution—is that other eurozone members must be recast in their mold of fiscal orthodoxy and financial conservatism.”

He concludes his essay, “So Germany rules and southern Europe should prepare for austerity, followed by deflation, unemployment and, eventually, civil strife, if the eurozone holds.”

Europe…and the United States…have experienced roughly fifty years of Keynesian-type credit inflation.  The public debt in these areas expanded at a pace at least double the rate at which the real economy has grown.  Private debt in all of these areas grew at even faster rates than did the public sector debt. 

During this period of credit inflation, risk-taking increased, financial leverage exploded, and financial innovation and financial engineering accelerated at a pace never before seen. 

And, in the end, the weight of all these developments proved to be unsustainable.

While it was going on, the credit inflation was delightful…especially in the country owning the reserve currency of the world.  Oh, there were cyclical swings during this time period, yet, all-in-all, everyone grew together.

Where was the pain connected with being a debtor?

Well, until the music stops, everyone, especially the debtors, keeps dancing and everyone has a pretty good time. 

There were some undercurrents of pain.  Underemployment in these Europe and the United States more than doubled from the 1960s to the 2000s.  Income inequality increased dramatically as the more astute or wealthy took advantage of the credit inflation whereas the less wealthy could not. 

But, as “Chuck” Prince, the Chairman and CEO of Citigroup, put it: “As long as the music is playing you have to get up and dance.”

And, what about the financially prudent?

Well, they had to bend to the times…for they had to dance as well.  If the way to increase or maintain ones return on equity comes from assuming riskier assets, increasing financial leverage, or financing long-term assets with short-term liabilities, the prudent had to play the game to some degree or face the real fact that money was going to move to those producing the greater return.

Even Germany played the game! 

As Plender points out, “Germany was the first in the European monetary union to break the stability and growth pact rules on deficits and debt.”

But, the Germans pulled it together…and now they are in the driver’s seat.

And, we see this to be true in the banking sector…and in the manufacturing sector…and with individuals and families.  When the bubble bursts, those with their balance sheets in the best shape control the future. 

“In the real world…”

Those that did not get their act together face the pain…and, they even come to resent…and dislike…those that did get their act together.  This is where civil strife can come into the picture, where the discontented can attempt to “occupy” the other.

The lesson for the new year…and for every new year…is that one needs to be careful about the debt one accumulates.  Too much debt can always come back to haunt you.  I know that the phrase “too much debt” is only relative, but, it seems that over time, having less debt than others can be to the benefit of the prudential. 

Remember, the general rule for winning the Super Bowl is to have the superior defense!

Happy New Year!

Wednesday, December 28, 2011

Capitalism is Capitalism Because It Changes and is Never the Same

There is an interesting lead editorial in the Financial Times this morning: “Capitalism is dead; long live capitalism.” (

The basic conclusion of this piece is that “Capitalism will endure, by changing.”  It has in the past.  Capitalism will change in the present circumstances.  And, it will change in the future.

The argument: “the market economy is not…unchangeable…It is successful not because it stays the same, but because it does not.

Two centuries ago there was no limited liability, no personal bankruptcy, little central banking, no environmental regulation and no unemployment insurance. 

All these changes occurred in response to economic or political pressures.  All brought with them new solutions and new challenges.

At a time of ongoing financial shocks, this need for adaptation has not ended.  On the contrary, it is as important as ever.”

The argument presented in this editorial is aimed at a “straw man”.  That “straw man” apparently believes that capitalism is an ideal system that can function in total independence of changing technology, changing institutional arrangements, and changing flows of information. 

The “straw man” believes in the “general equilibrium” model of the theoretical economist, a model that only includes profit maximizing and utility maximizing economic units…such units, by the way, are all exactly the same.

This pure economic view of the world has very little basis in reality.  In fact, this economic view of the world is at odds with current work in economics that views the study of economics as the study of incentives…incentives that exist everywhere.  This current view of economics is represented by work of Steven D. Levitt and Stephen J. Dubner in the books “Freakonomics” and “SuperFreakonomics”.

Economics, the study of incentives, is a field that indicates that “things” are always changing because the flow of information is always changing and, as a consequence of this, incentives are always changing.  If incentives are always changing then the behavior of individuals and institutions will always be changing.  And, that is exactly what we see in the world. 

The Financial Times editorial goes on: “At the heart of the renewed debate (about capitalism) are three issues: finance, corporate governance, and taxation.  These are the questions raised by the ‘occupy’ movements which, for all their intellectual incoherence, have altered the terms of the political debate.

The financial sector grew too big, partly because risks were misunderstood and partly because it was encouraged by policymakers to expand. …

Again, corporate management has too often rigged executive compensation in its own interests, rather than that of shareholders.

Finally, a plethora of incentives have allowed many of the most successful people to escape taxation.”

In response to the issue that the financial sector grew too big, I can only agree with the conclusion that “it was encouraged by policymakers to expand.”  Fifty years of “Keynesian-type” government policy aimed at stimulating high levels of employment and home ownership for more and more people in society created an environment of almost continuous credit inflation that encouraged increasing levels of risk taking, greater degrees of financial leverage, and more and more financial innovation.  And, given these incentives, General Electric and General Motors, to take two major manufacturing companies, became major financial institutions by the end of the twentieth century.

Why did the financial sector grow to become such a large proportion of the economy?  The incentives were created in such a way that the financial sector had to become a larger proportion of the economy.

Within an economy that produced almost fifty years of steady credit inflation, things were good: the real economy grew (but not at an exceptional rate), people owned their own homes, they owned TV sets…and cars…and second homes…and so forth.  Debt was readily available for all!  Who really cared if executive compensation was excessive if the prices of homes were rising at close to double-digit rates?  The “piggy bank” of the middle class (the homes that were owned by the middle class) kept growing and growing…so who should be concerned about top management salaries?

And, the Financial Times article explicitly states that “a plethora of incentives” existed to allow “many of the most successful people to escape taxation.”  But, the rising incomes created by credit inflation can itself create higher taxation where a progressive tax system exists, and this, alone, may be an incentive to find ways to evade taxation. 

People respond to incentives.  They always have.  They always will.

What we have found is that “The market economy is the most successful mechanism for creating prosperity humanity knows.  Allied to modern science, it has done more than transform the world economy; it has transformed the world.” 

In other words, if the “right” incentives are in place, a market economy can produce incredible prosperity and “good.”

However, if the “wrong” incentives exist, prosperity will not be as great and many, many people can face stagnation and suffer, as a consequence.

We can look back over the past two centuries and argue that people responded to “right” incentives and, as a result, we put in place limited liability, developed the concept of personal bankruptcy, created central banking and environmental regulation and produced unemployment insurance.  The response to these incentives worked to complement the market economy to bring about even greater prosperity.

Over the past fifty years the credit inflation created by many governments in the developed world produced incentives that have turned out to be harmful, even to the people that the credit inflation was supposed to help.  The consequence has been economic stagnation and human suffering.   

Therefore, one can accuse “Capitalism” of many things and make “Capitalism” the villain in the picture.  But, capitalism is going to continue to exist and the market economy will continue to create prosperity.  What we need to be careful of is the incentives that we create within this “capitalistic” economy and the “unintended consequences” that might result from these incentives.  Ideally, what we really want is a system of incentives that creates opportunities for everyone and the openness and mobility for anyone to take advantage of these opportunities and prosper in them.  These incentives will come from the public sector as well as from the private sector.  But, we must be careful of the incentives that are created and how they are implemented.    

Tuesday, December 27, 2011

U. S. Businesses Shop Europe

“As Europe struggles with its debt crisis, American businesses and financial firms are swooping in amid the distress, making loans and snapping up assets owned by banks there—from the mortgage on a luxury hotel in Miami Beach to the tallest office building in Dublin.” (

Where in our current understanding of macroeconomics does it indicate that a sovereign debt crisis might end up with foreign interests owning large chunks of a country’s physical assets?  How much of Ireland will United States interests buy?  How much of Spain will Middle Eastern countries end up owning?  And, how much of Italy will China possess?

Macroeconomics just cannot pick up the complexity of real economies.  Too much of the reality of an economy takes place at the micro-level and cannot be comfortably incorporated into the simple structures of the aggregate models of the economy. 

Macro-models just cannot include all of the incentives that are created within the total economy that lead to results that can even produce contradictory outcomes to what the macro-economists had been predicting. 

One of the most egregious results of the past fifty years is the prediction of the macro-economist that inflation can help the working classes and the middle classes.  Yet fifty years of credit inflation in the United States produced exactly the opposite effect in that the income/wealth distribution in the U. S. became highly skewed toward the wealthier in the society.

For one, the economists used aggregate models to show that there was a favorable tradeoff between employment and inflation.  The policy implication: if a little more inflation can be created then more people will be hired and unemployment will decline.

These models did not pick up micro-behavior that indicated that the “less wealthy” could not protect themselves from credit inflation whereas the “more wealthy” could not only protect themselves from credit inflation but could actually benefit from it.

Furthermore, these models did not include the fact that the credit inflation would provide incentives for manufacturing companies to move more into financial services while shifting their focus away from their historically productive enterprises.  Who would have thought in the 1960s that General Electric and General Motors would, by the end of the century, be earning more profit from their financial wings than from their manufacturing capacities?

Another macroeconomic idea that I have repeatedly used in discussing international financial arrangements has been that of the “trilemma”.  The “trilemma” analysis concludes that a country can only achieve two of the following three policy objectives: a free international flow of capital; a fixed exchange rate; and the ability to follow an independent economic policy.

Since 1971 when the United States went off the gold standard, many countries floated the value of their currencies in foreign exchange markets.  This had to occur, the argument went, because in the 1960s, capital began to flow freely throughout the world. 

Therefore, if governments wanted to gain the favor of those that worked in manufacturing and the labor unions by conducting a policy of credit inflation to keep unemployment low and, in many countries, housed in their own home, they had to be able to conduct an independent economic policy.  Within this effort, popular pension programs were also expanded to encourage people to retire earlier and governments became a large supplier of jobs to the economy.   

Thus, the value of the currency could be allowed to decline as governments created massive amounts of debt often financed by foreign interests.  Governments were able to keep the pedal to the floor during this period by generating a relatively steady flow of credit to their economies.

And, what was the micro-impact that the “trilemma” models did not pick up?  It was the declines that occurred in labor productivity that made many nations uncompetitive in world product markets. 

Here we see Greece…and Spain…and Ireland…and Portugal…and Italy…and, others...

And, corporate interests in the United States…and elsewhere…have lots of cash available…either on their balance sheets…or through financial markets that have been generously supplied by the Federal Reserve.

“At Kohlberg Kravis (Roberts), Nathaniel M. Zilkha, co-head of the special situations group, is expanding his London team to eight, from two, and hoping to take advantage of opportunities in Europe.  The firm is even considering potential investments in the country where the crisis began, Greece, despite headlines warning of a default by Athens or the possibility that Greece may withdraw from the eurozone…

Besides Greece, Kohlberg Kravis bankers have also been looking for deals in Spain and Portugal, where private companies are having a similarly hard time winning new credit or extending existing loans.”

As we see over and over again, the excessively loose monetary policy of the Federal Reserve is not helping the “working people”, those 20- to 25-percent of the labor market that are under-employed.  The Fed’s largesse is going to those that can use the money to “do the deal”.  Now, it seems that the flow of funds is going into the acquisition of assets formerly owned by Europeans.  Earlier, we saw Fed injections creating bubbles in commodity prices and in the stocks of emerging markets.   Even earlier than that, we saw Fed injections creating bubbles in the U. S. housing market and in U. S. stocks. 

The macroeconomic models are becoming less and less useful because the world works at a more micro-economic level.  It is at this micro-economic level that we can really observe the complexity of human behavior and also see how markets can self-organize and emerge to take on a life of their own.  Until governments become more sophisticated in their analysis of economic problems, they will continue to create opportunities that the wealthy and the better connected can take advantage of.  And, a Fed guarantee that short-term interest rates will remain at levels that are close to zero only exacerbates the situation.      

Thursday, December 15, 2011

How to Solve the European Sovereign Debt Crisis

“It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.” 

That is what is needed to resolve the European sovereign debt crisis.  So says Christine Lagarde, the managing director of the International Monetary Fund. (

Need one say more?

But, she stated, the world economic outlook “is quite gloomy” with a pervasive downside risk.

So, the international community must work together. 

Working together means that, starting at the core…the European countries…economic and fiscal union must be achieved.  This would be attained through fiscal solidarity and risk-sharing around the globe. 

Unfortunately, one has to ask…is this “actually facing the issues…accepting the truth…accepting reality...” or is it just another way to postpone what needs to be done for a while longer?

My blog yesterday discussed the underlying economic dilemma faced by the European nations.  Over the past ten years or so, unit labor costs in Germany have increased 20 percent to 30 percent less than in other eurozone countries. (  That is, German labor has consistently become more productive than non-German labor.

And, the non-German countries, in an attempt to keep their labor as fully employed as possible given the divergence in labor productivity, engaged in programs of fiscal stimulus which created a credit inflation that was unsustainable.  Hence, the sovereign debt crisis.

Since the eurozone is subject to a single monetary authority and a common currency, fiscal budget tightening, at this time, can only bring on the “pain and suffering” of a recessionary restructuring.

The problem is that countries within the European Union have been allowed to get “out-of-line” with one another, economically.  And, in a union of countries like this, nations cannot “paper-over” the differences in labor productivity by the creation of lots and lots of debt.  In fact, such behavior only can exacerbate the problem.

The countries in the European Union are facing a need for a massive restructuring of their economies, their labor markets, and their industrial structure.  Yet, “fiscal solidarity and risk-sharing” will not do this job. 

As I mention in my blog post yesterday and Alan Blinder states in his op-ed piece in the Wall Street Journal ( we have reached the stage where the only possible solution may be a substantial change in how people do things.

According to Blinder, the only path left may be debt deflation. The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

A possible response to this, however, is social unrest.  We have already seen protests in Greece, and Spain and Italy and France…  But, protests have become a worldwide phenomenon.  We have protests in Russia.  These movements are also seen as a kin to the events of the Arab spring.  Furthermore, there are the “Occupy” efforts…in the United States…and in other parts of the world that cannot be totally divorced from these other events.  Modern information technology is being felt everywhere.

It is difficult to see how the protests and unrest in the non-German countries of the eurozone are going to resolve the situation.  Just as with the idea of “fiscal solidarity and risk-sharing”, a movement that does not address the fundamental misallocations that exist within these societies will not come up with viable alternative solutions.   

The issue is that many countries are “out-of-line” economically.  German labor productivity exceeds that of other European nations.  The industrial structure of Germany is more competitive than the non-German eurozone countries in the global marketplace.

I am not in favor of returning to a world of mercantilism, as I mentioned in yesterday’s blog.  But, as many emerging nations have recently managed their economies so as to improve their relative position in the world, those developed countries that have focused just on buying off labor unrest over the past fifty years, may have to alter their approach to how their economies are managed.  “Soft” solutions will only enlarge the gap they face with more competitive nations.   

Remember, one conclusion about the internal management of a nation’s economy within the framework of world trade is that a country can only choose two of the following three alternatives available to them: the nation can have a fixed exchange rate; it can have a free flow of capital internationally; or it can conduct an economic policy independent of all other countries.  This problem is referred to as the “trilemma.”

Well, the countries within the eurozone have a fixed exchange rate and they have a free flow of capital internationally.  Therefore, they cannot conduct their economic policies independently of the rest of the world.

The only thing left for these countries to do is to create an environment in which the productivity of their labor and capital become more competitive within world markets.  If not, the most productive capital and labor will move on to other nations. 

This solution has little to do with “fiscal solidarity and risk-sharing.”

The labor and capital utilization within the countries that are not doing so well…must be restructured.

As managing director Christine Lagarde stated, “It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

I’m not sure she is there yet…but neither are a lot of other people.  

Tuesday, December 13, 2011

The Problem is Germany

Last Friday, December 9, I ended my post with this concern: “So much was made of the role that Angela Merkel was playing in the effort to get a more comprehensive solution to the European problems that concerns were raised about the possibility of German dominance of the European Union. I even saw articles that made the following assertion: ‘What Germany could not achieve by military might may be obtained through financial strength.’

If this is true then it appears that Europe is still fighting the old battles. As long as Europe continues to operate on the basis of prejudices established years ago it will not move itself into the 21st century. If this is true, the European financial crisis still has a long way to go.” (

Tuesday, in the Wall Street Journal, Alan Blinder lays it on the line: “the eurozone has a big, visible Greek problem, which is a result of failure.  But, it also has a far bigger, though less visible, German problem, which is a result of success.” (“The Euro Zone's German Crisis: Blame Teutonic efficiency for what ails Europe. The other countries just can't compete”: (

“When it comes to productivity, Germany has simply pulled away from the pack…Since 2000, German unit labor costs have risen about 20 to 30 percent less than unit labor costs in the other euro countries.  That gap has left Germany with a large intra-Europe trade surplus while most other countries run deficits.”

The referee could blow the whistle and call a foul…Germany is guilty of mercantilism!

On Wikipedia, mercantilism “is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy…from the 16th to late-18th centuries.”

But, mercantilism has not been an overt policy of the German government.  In fact, over the past decade or so, Germany has been trying to get its act together, dealing with putting two separate nations together as well as dealing with the newly constructed common currency area. 

But, Germany is Germany with a strong work ethic and a desire to pull things together with “thorough-going-labor reforms in the last decade.” 

It has not conducted a mercantilist economic policy, but the results have been roughly the same. 
Besides being ahead of most of the rest of its eurozone partners in terms of labor productivity, Germany also had the lowest rate of inflation.  The highest?  Well, of course Greece…and Spain…falling off to France, who had the second lowest rate of inflation.

The way out of this for the non-German eurozone countries?  Debt deflation!

The eurozone countries have one currency, so there can be no adjustment of individual currencies to revive some competitiveness among the nations. 

The eurozone countries have one central bank, so the individual countries cannot use monetary policy to correct their individual situations.

And, the eurozone countries in trouble have foolishly created so much debt in order to build up their economies through credit inflation that this avenue of spurring on economic growth has been closed.

According to Blinder, the only path left is debt deflation.  The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

Blinder closes, “Sadly, this may be the most likely way out.”

We knew it…the whole situation has been caused by those damn Germans!  They couldn’t get what they wanted by military means so they resorted to trickery…they worked hard, they innovated, they reformed their labor laws, and they didn’t issue too much debt.  Damn them!

If we blame the Germans, however, as I reported above, we…the Europeans…are just living off the same prejudices and wars that were fought in the past. 

Again, to quote Stephen Covey once more…”if we believe the problem is out there, that is the problem.”

This situation may be an uncomfortable one and the resolution of it may be “incredibly difficult and painful…and protracted.” 

Maybe that is what we need to work with.  Maybe the non-German countries need to get their budgets under control, get their labor laws reformed, get their educational systems up-to-speed, and move into the twenty-first century

Maybe the eurozone countries need to actually resolve the sovereign debt crisis, create a fiscal compact, and get on with these other problems that really need to be addressed.  

One final note…the United States is still benefitting from the role it plays as the country with the reserve currency of the world.  United States Treasury securities are still the place to go when there is a “flight to quality” and international investors become overly concerned with risk. 

But, let me just say that the world is becoming more competitive.  There are other countries in the world that may be less generous, more mercantilist.  There are other countries in the world that may be honing their productivity, their economic strength, their currency strategy to establish trade balances in their favor in order to change the relative power structure of the world. 

The United States is going to feel this is the future and needs to take a lesson from what is happening in the eurozone.  The unfortunate thing is that unless something is done the United States is not going to be in the position in the world that Germany now finds itself within the EU.    

Monday, December 12, 2011

Recent Monetary Policy and the Growth of the M1 Money Stock

Since the end of June 2011, excess reserves held by commercial banks have declined by about $107 billion. (Remember in August 2008 when excess reserves in the banking system totaled only $2.0 billion…for the whole banking system!) For the two-week period ending November 30, 2011, excess reserves averaged almost $1.6 trillion.

Reserves balances held at Federal Reserve banks dropped by about $110 billion over the same period of time. On December 7, 2011, reserve balances were slightly under $1.6 trillion.

Excess reserves held by the banking system and reserve balances at the Federal Reserve tend to move in the same direction and in about the same magnitude.  The reason for focusing on reserve balances held at Federal Reserve banks is that this number comes from the Fed’s balance sheet and can be related the movements of line items that appear on the balance sheet.

This decline in reserve balances has not been overtly driven by Federal Reserve actions.  In fact, three factors have dominated this decline, and each of the three is independent of what the Federal Reserve might be overtly doing. 

The first two factors relate to components of the Federal Reserve’s portfolio of securities.  After the Fed’s holdings of U. S. Treasury securities, the largest part of the portfolio is made up of mortgage-backed securities.  From the end of June through the current banking week, the amount of mortgage-backed securities on the Fed’s balance sheet dropped by $82 billion and represented maturing securities. 

The Fed’s holdings of Federal Agency securities also feel by almost $11 billion during this same time period again from the run-off of maturing issues. 

The third factor that helped to decrease reserve balances was a $31 billion increase in currency in circulation outside the banking system.  That is, when currency is drawn out of the banks and moves into the hands of individuals, families, and businesses, bank reserves go down…unless these outflows are offset by other actions of the Federal Reserve. 

Just these three factors alone resulted in a $124 billion reduction in bank reserves.  Some open market operations as well as other operating factors offset this decline, but the net result, as mentioned above, was that overall excess reserves in the banking system decline by more about $110 billion over this time period.

While these excess reserves were declining, however, we observed during the same time period, a sizeable change in the speed at which the money stock was growing.  For example, in June, the year-over-year rate of growth of the M1 measure of the money stock was about 6 percent.  In July, the rate of growth increased to 16 percent, in August it was slightly more than 20 percent where it has stayed. 

The M2 measure of the money stock did not show such dramatic increases, since the M1 measure is a subset of the larger total, but it, too, increased during this time period.  In June, the year-over-year rate of growth of the M1 measure was about 6 percent.  In July the growth rate of this measure rose to 8 percent and then jumped to 10 percent in August where it has remained. 

In July and August, the banking system experienced huge gains in demand deposits while in June, July, and August savings deposits at depository institutions rose dramatically. 

These movements along with the continued strong demand for currency in circulation can still be used as evidence that the economy remains very weak.  The $31 billion increase of currency in circulation mentioned above has resulted in the currency component of the money stock measure showing a year-over-year rate of growth by the end of October of almost 9 percent, which is a very high figure historically.  

The movements taking place in the money stock figures point to the weak economy in two ways.  First, with people under-employed, with people trying to stay away from debt, and with businesses trying to build up large stashes of cash, the demand for currency and for transaction balances at financial institutions rises.  Weak economies cause economic units to keep more of their wealth in a form that is readily accessible and spendable.

The second piece of evidence, however, is the extremely low interest rates associated with the weak economy.  With interest rate so low, it just does not pay for people to keep funds in interest-bearing accounts. Over the past five months, savings deposits at financial institutions have dropped by almost $75 billion and funds kept in institutional money funds have dropped by $160 billion over the same time period.  A large portion of these funds has apparently gone into currency and transaction balances.   

People are still getting out of short-term assets and placing their funds, more and more, in transactions-type accounts.  This is a sign of the weak economy and not of economic growth or a successful monetary policy. 

This is “debt deflation” type of behavior. ( It is a type of behavior that the Federal Reserve has not yet been able to over come. And, having the Fed toss more “stuff” against the wall does not seem to be the policy to turn things around.

Federal Reserve officials keep talking about up the fact that they have not run out of things that they can do to continue to try and stimulate the economy.  Unfortunately, it seems to me that fewer and fewer people are listening to their pleading. 

With a banking system that is still much weaker than the authorities are willing to talk about; with a consumer sector and business sector that, for the most part, are still trying to reduce their debt load; and with a public sector that is sorely out-of-balance and doesn’t seem to know where it wants to go; people are confused and uncertain about their future and about what to do.  

In this kind of environment, people want to hold onto what they have and want to avoid as much risk as they can.  They don’t want to borrow if they don’t have to and they want their assets to be as liquid as possible.

This is what the Federal Reserve is facing. 

Friday, December 9, 2011

Initial Verdict on European Summit: the Can Got Kicked Further Down the Road

“European leaders’ blueprint for a closer fiscal union to save their single currency left the onus on central bankers to address investor concerns that Italy and Spain would succumb to the two-year-old financial crisis.” (

In other words, the so-called leaders of the European Union did not lead! 

In place of action, they asked the European Central Bank to cover for them.
“Nineteen months since euro leaders forged their first plan to contain the debt turmoil, the fifth comprehensive effort added 200 billion euros ($267 billion) to the war chest and tightened rules to curb future debts. They sped the start of a 500 billion-euro rescue fund to next year and diluted a demand that bondholders shoulder losses in rescues.”

The biggest winner: Nicholas Sarkozy.  The “second best” award went to Angela Merkel. 

In other words, we still have not resolved the European sovereign debt crisis. 

And, what else was occurred?

The major loser award was given to Britain’ David Cameron.  Cameron refused to agree to a full change in the treaty for all 27 members of the European Union if there were no special safeguards for the financial services of the United Kingdom…more specifically, protection for the financial industry in London.  In taking such a stance, Cameron basically isolated himself from the proceedings of the summit.

The response of Financial Times editorial writer Wolfgang Münchau: “So we have two crises now. A still-unresolved eurozone crises and a crisis of the European Union.” (

To Münchau, “The eurozone may, or may not, break up. The EU almost certainly will. The decision by the eurozone countries to go outside the legal framework of the EU and to set up the core of a fiscal union in a multilateral treaty will eventually produce this split.”
In other words, the inability of the officials of Europe to resolve the sovereign debt crisis is leading to additional difficulties that must be dealt with going forward.
The problem with not dealing with problems is that the problems tend to multiply and grow.
And, what about the threat made by Standard & Poor’s?  Will Standard & Poor’s downgrade the debts of the eurozone countries? 
The initial feeling is one of uncertainty.  It may be that Standard & Poor’s will not move right away…but, the European sovereign debt crisis is not over and the downgrade will probably come in the very near future. 
But, this raises another question…what about the European banks who hold so much of the sovereign debt of these nations?
Yesterday, the European Banking Authority declared that European banks needed to add 115 billion in euros to their capital base by next June.  New stress tests have indicated that the banking system, especially Germany’s, has a much bigger shortfall of capital than earlier thought.  Without the capital the EBA is concerned that the banks will be able to handle the continued financial stress in European capital markets. 
European officials, once again, fail to get their arms around the situation.
Perhaps one should not be surprised at this.
However, one question still lingers in my mind.  So much was made of the role that Angela Merkel was playing in the effort to get a more comprehensive solution to the European problems that concerns were raised about the possibility of German dominance of the European Union.  I even saw articles that made the following assertion: “What Germany could not achieve by military might may be obtained through financial strength.” 
If this is true then it appears that Europe is still fighting the old battles.  As long as Europe continues to operate on the basis of prejudices established years ago it will not move itself into the 21st century.  If this is true, the European financial crisis still has a long way to go.

Thursday, December 8, 2011

A Leading Indicator: Corporate Stock Buy-Backs

I must admit to being wrong.  I believed that the big cash buildup at corporations would be used to fuel a mergers and acquisitions binge.  I thought that the economic recovery was strong enough that the “better off” corporations would “pick off” all the low-hanging fruit offered by the companies that were not in a very good position coming out of the Great Recession. 

I argued that this behavior would not accelerate economic recovery because the restructuring taking place would result in consolidations and debt reductions that would just make industry more productive somewhere down the line but add very little to economic growth and lower unemployment in the present.

Merger activity has been fairly high this past year but not as great as I thought it would be.    

Where I was wrong…was in the strength of the recovery.  The economic recovery is not strong enough to propel the M&A binge I expected. 

So, what are the cash accumulations and the low borrowing rates leading to? 

Corporations buying back their own stock.

“US companies are on pace to announce buy-backs of more than $500 billion worth of shares this year, according to stock research firm Birinyi Associates, the third biggest year on record.” (

The message is that the economy is not recovering sufficiently to warrant more acquisitions and the stock markets have not been robust enough to provide higher valuations for market shares, so, the companies with the cash or with access to the cash are buying back their stock at prices they believe to be ridiculously low. 

This can have some consequences for firms.  For example, Safeway, Inc., sold $800 million in bonds last week and, the same day, management disclosed that it was buying back $1 billion worth of its own common shares. 

The rating agency, Fitch Ratings, immediately dropped the company’s credit rating by one notch to triple B minus. 

A similar thing happened to Amgen and Lowe’s.  Last month, Amgen sold $6 billion worth of bonds to buy back its stock early in November…and Moody’s Investors Service cut Amgen’s bond rating by one notch while Fitch cut its rating by two notches.  Lowe’s sold bonds in November to buy back stock, which resulted in downgrades by Moody’s and Standard & Poor’s. 

That is, the debt issue followed by the stock buy back increased the financial leverage of these companies and hence make their debt riskier.

Stock buy backs, however, do not increase economic growth!

What is happening?

Long-term interest rates in the United States are being kept down by the actions of the Federal Reserve and the flight of money from Europe seeking a “safe haven” in United State Treasury bonds.  The Fed wants to get the economy going again and has said it will keep rates at historically low levels for another two years or so.  And, “with corporate bonds benchmarked to US Treasuries, whose yields have fallen to historic lows amid strong demand for havens, borrowing costs fro investment grade companies have also fallen.”

So what do we have…low economic growth and credit growth that exceeds the “productive” needs of the corporations. 

In essence this is a picture of credit inflation.  To be sure, we are not seeing the creation of credit raising consumer or wholesale prices at this stage…but, when credit expansion exceeds the real growth rate of the economic sector that the funds are going into we get a “dislocation” that can lead to problems in the future.

That is why, to me, the acceleration of corporate stock buy-backs in this instance seems to me to be a leading indicator of dislocations in the economy that will have to be dealt with at a later time.

“Although bondholders generally do not like these transactions (issuing bonds to buy back stock) because of the risk they pose to companies’ credit ratings, most of the groups buying back shares this year with debt have not seen too much fall-out from the bond markets or from credit rating agencies.”

This is always the case.  Those that move first and move rapidly get the most benefits from their actions.  Only later, when many others attempt the same thing, do markets…and credit rating agencies…move more…or produce greater “fall-out.”

“The deals, then, are likely to continue so long as investors keep buying bonds and pressuring rates.”

And, as the Fed works to keep interest rates so low.

The concern about corporate stock buy-backs being a leading indicator?

If economic growth does not pick up a greater speed ( and if the Fed continues to maintain the excess reserves it has pumped into the banking system and keep interest as low as it has promised to do, then we need to be aware of where the dislocations are forming in the economy. 

And, be assured, if this credit inflation begins to show up in some places…it will also begin to show up in other places as time passes.  That is, fault lines are created in the economy much as Raghuram Rajan has described in his award winning book called “Fault Lines: How Hidden Fractures Still Threaten the World Economy.”  And, fault lines make everything more fragile.