Mase: Economics and Finance

Mr. Bernanke Gets His Way

2012-01-27T03:36:00.000-08:00

Well, Mr. Bernanke has moved the Federal Reserve to a position of greater transparency.

We now have projections of interest rates out until the end of 2014. It is now believed by most members of the Fed’s Open Market that the Federal Funds rate will remain close to zero until the end of 2014.

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the first six months of 2014?

In my mind, zero or close to it!

What is the probability that the Federal Funds rate will be close to zero for the last six months of 2014?

You guessed it!

And, so on…

Seems like I don’t have a lot of confidence in these forecasts.

What are these forecasts for, then?

I have already written my answer to this question. These forecasts are to make Mr. Bernanke feel better. (http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence)

Mr. Bernanke doesn’t want to be misunderstood. Apparently, in the past, Mr. Bernanke feels that he has been misunderstood. Now, with the “new transparency” there should be no doubt where Mr. Bernanke and the Fed stand…and Mr. Bernanke should feel justified.

This is the first time in my mind that the Federal Reserve has done something of this magnitude so as to make the Chairman of the Board of Governors feel better.

I hope it achieves its goal because as far as I am concerned this new transparency program does absolutely nothing for me in terms of understanding where interest rates are going to be for the next two to three years. It does absolutely nothing for me in terms of understanding what the monetary policy of the Federal Reserve is going to be for the next two to three years.

If anything this new transparency program will assist, in the shorter-term, speculators in making lots of money. George Soros, and others like him, loves a situation in which a government says it is going to maintain a price for as long as it can. This type of government activity creates “sure thing” bets.

The economy is in the condition it is in because there is still a lot of insolvency around. By keeping short-term interest rates as low as they are helps financial institutions and other private or public organizations remain open hoping that they will be able to work themselves out of their insolvency.

According to a report released Wednesday put together by the American Bankers Association and State Bankers Associations, thirty percent of the commercial banks reporting were under some form of written agreement with regulators. A total of 1000 banks responded to the survey, so the study should be fairly representative. Extrapolating this to the total number of banks in the banking system we would get some 1,900 banks under some kind of agreement with the regulators.

This is when there are still some 864 commercial banks on the FDIC’s list of problem banks, which we know does not include all the banks under some kind of agreement with the FDIC.

Many home owners still find the market values of their homes below the amount of the mortgage that exists on the property. Commercial real estate loans are still defaulting at a very rapid pace and many businesses are declaring bankruptcy or are near filing for bankruptcy, especially small ones.

It is understood that the Federal Reserve must continue to protect against further economic deterioration and must continue to protect those individuals and institutions that are insolvent or near insolvency.

Because of this and the consequent slow pace of economic growth the Fed must continue to keep the economy excessively liquid.

I don’t know that publishing interest rate forecasts for the next three years will convince us any more that the Fed is attempting to protect the banking system and the economy. I guess it must help Mr. Bernanke to sleep better to know that he is releasing all this information even if it does little or nothing for anyone else.

European Defaults: Portugal is Next After Greece

2012-01-26T06:27:00.000-08:00

It ain’t over until it’s over…

The yield on the 10-year Portuguese government bond closed above 14.80 percent yesterday, a new record for the euro-era.

“The markets are pricing in a Portuguese default with 10-year bonds trading at about 50 percent of par, a deeply distressed level in the eyes of many investors.” (http://www.ft.com/intl/cms/s/0/49916f7a-468a-11e1-89a8-00144feabdc0.html#axzz1kTbnc8Yy)

“Friday the 13^th may be an unlucky omen for Portugal. On that day, almost two weeks ago, Standard & Poor’s became the last rating agency to downgrade Lisbon to junk, marking the moment for many investors when default looked inevitable for Portugal as well as Greece.”

For more on this see my post on blogspot “Credit Downgrades and Europe” for January 16, 2012. (http://maseportfolio.blogspot.com/).

The downward spiral in defaults will continue as long as Europe fails to honestly face its problems. (See my post on blogspot for January 25, 2012 titled “How Long Will Europe Continue to Lie to Itself”: http://maseportfolio.blogspot.com/.)

In the past, analysts, including myself, tried to explain what officials in Europe were doing by casually remarking that their actions amounted to “kicking the can down the road.” Basically, the actions of the European officials were an effort to postpone dealing with the real issues, hoping that by delaying what was needed to be done the situation would eventually correct itself.

Now, it seems that the days of “kicking the can down the road” are reaching a climax.

European officials hope to reach a deal on the Greek debt situation by the end of this month. The current write down seems to be somewhere around 50 percent of face value, but there still remain issues to be decided like whether or not the European Central Bank will have to write down the Greek debt it has on its books.

Bond markets have responded to this reality by dumping Portuguese debt. Note that the yield on the ten-year government bond was about 10.40 percent (compared with 14.80 percent yesterday) around the middle of November, a time when it still seemed that maybe the European Union might be able to pull things together and avoid a Greek default.

As the officials of Europe finally seriously travelled down the path to restructure Greed debt, the price of Portuguese debt started to weaken. The price declines accelerated, as the possibility of a Greek write-down became more of a reality. Today, the yield on the 10-year bond was around 15.00 percent.

I know that governmental officials hate to give in on these write-downs because they hate to concede to the “bond markets” and “speculators”.

It is hard for governmental officials to admit that maybe the “bond markets” and the “speculators” might be right.

It is a very difficult lesson for governmental officials to accept the fact that they cannot continue to cater to their constituencies with jobs and other benefits ad infinitum. Over the longer-run, either taxes have to be raised or money has to be printed because the bond markets will not continue to underwrite debt that will be repaid, both principal and interest, by the issuance of more debt.

The economist Hy Minsky referred to this kind of debt financing as a “Ponzi” scheme.

“Ponzi” schemes come to an end and the end cannot just be blamed on the “bond markets’ and the “speculators”. In fact, the governments just line the pockets of the “bond markets” and the “speculators” by extending their uncontrolled spending until the collapse of the market becomes a “sure thing.”

So the charade continues and Portugal seems to be next.

Who will follow Portugal? Spain…or Italy…who knows?

Yet, this is not the only concern that many of these officials are facing. The austerity programs enacted by governments throughout Europe are not setting well with the people. There is “discontent” and “upheaval” arising in many countries.

“The only consistent messages seem to be that leaders around the world are failing to deliver on their citizens’ expectations and that Facebook, Twitter, and other social media tools allow crowds to coalesce at will to let them know it. That is not a comforting picture for the 40 heads of state or leaders of governments who are attending the World Economic Forum (in Davos, Switzerland)…” (http://www.nytimes.com/2012/01/26/world/europe/across-the-world-leaders-brace-for-discontent-and-upheaval.html?_r=1&scp=1&sq=across%20the%20world,%20leaders%20brace%20for%20discontent%20and%20upheaval&st=cse)

The situation is quite uncomfortable. But this is what happens when you fail to deal with a problem…when you continually try to “kick the can down the road.” The situation does not go away and the delay in dealing with the situation often turns out messier than if the situation had been dealt with earlier.

The only way for the officials to resolve a condition like this is to get in front of it. I don’t see anyone around in a position to do this. The only real possibility is Merkel but the resentment that already exists against Germany makes it that much more difficult for her to achieve what is needed.

If no leader arises then the defaults will continue…and the austerity will grow…as will the “discontent” and the “upheaval.”

“Europe risks being handicapped if it doesn’t deal decisively with this challenge to democracy.” Thought provoking way to end the New York Times article.

How Long Will Europe Continue to Lie to Itself?

2012-01-25T06:00:00.000-08:00

“Bank Seeks To Avoid Taking Loss On Bonds.”

So reads the headline for the New York Times article on the dilemma of the European Central Bank. (http://www.nytimes.com/2012/01/25/business/global/eu-officials-continue-to-press-for-a-quick-deal-on-greek-debt.html?_r=1&ref=business)

“European leaders have begun discussions with the European Central Bank on several options that might keep it from having to take a loss on its 55 billion-euro portfolio of Greek bonds.”

“The deal could address what has long been one of the more vexing questions in reaching a broad agreement on reducing Greece’s mountain of debt: how to get the central bank, the largest holder of Greek bonds, to participate in a debt restructuring without having to take a large loss that would have to be covered by European taxpayers, German ones in particular.

Private sector investors, including large European banks and hedge funds, have complained bitterly—and in some cases threatened legal action—over the central bank’s insistence that its 55 billion euros in Greek bonds were exempt from the loss that the private sector is facing, which some have estimated at 60 cents on the euro.”

The European Central Bank cries, “You can’t hold me responsible for my actions!”

There are articles all over the place on this issue.

For example, on the front page of the Financial Times: “IMF urges ECB to take a hit on 40 billion-euros in Greek bond holdings.” (http://www.ft.com/intl/cms/s/0/74d2b31a-46b2-11e1-bc5f-00144feabdc0.html#axzz1kTbnc8Yy)

Greek debt will be written down…finally.

But, will people still be avoiding reality in some affected areas?

And, remember, this is all voluntary to avoid kicking off the credit default swaps outstanding…what a crock!

Still on the list of lies…Portugal…Spain…Italy…

Lies have a long life and can come back to haunt you in many…often, unfortunate…ways. Just ask people up at Penn State these days.

The resolution of a situation in which people cover up and try to avoid the truth never ends well. The leaders (and I use this term lightly) of Europe that are perpetuating this comedy continue to draw it out as long as possible.

The problem is that the European dilemma will continue to exist until it is dealt with. For more on this see my blogpost “Credit Downgrades and Europe” posted on January 16, 2012 on my blogspot site (http://maseportfolio.blogspot.com/).

The Outlook for Mergers and Acquisitions in 2012

2012-01-20T07:29:00.000-08:00

The key issue in the area of mergers and acquisitions in 2012 is still uncertainty. There seems to be a lot of anticipation that the activity in this area could pick up during the year, but, like last year, there may be little to come of it. (http://www.ft.com/intl/cms/s/0/a29392 10-41d0-11e1-a1bf-00144feab49a.html#axzz1jqA4rKTp)

Many corporations still seem to have a “ton” of cash around. Furthermore, the corporate bond market is flush; companies “sold $44.2 billion of both high- and low-rated corporate bonds this year, the highest on record for the time period….” Investors are “snapping up bonds…pushing the cost of borrowing for some issuers to record lows.” (http://professional.wsj.com/article/SB10001424052970203750404577171341742782200.html?mod=ITP_moneyandinvesting_3&mg=reno-secaucus-wsj)

“The yield on below-investment-grade, or ‘junk’ bonds fell to 7.93% Wednesday, the lowest since August 5 according to a Barclays Capital index. An index for investment-grade bonds, which are of a higher credit quality, was at 3.62%. In comparison, on Thursday the 10-year Treasury note yield rose to 1.972%.”

Funds are available.

Corporate breakups are likely to continue or even accelerate in 2012. Economic growth is not picking up speed. Europe looks as if it is in another recession and this does not bode well for the rest of the west. Companies are finding that the conglomerate structures they built up in recent are not very helpful in times like these, especially for those organizations that are suffering under the burden of too much debt.

The western world is re-grouping from the excesses of the past ten to twenty years. Those that still have the time to adjust are downsizing…laying off employees and discarding non-central businesses. Those that don’t have this time are attempting to sell outright.

Those looking for deals have the ammunition to pull off these deals and they know that this is a “buyers” market with depressed valuations available. They have the capability of being aggressive. Whether or not they activate this aggressiveness is another question.

This is because a cloud remains over the M & A market, a cloud that kept many firms on the sidelines in 2011. First off, a great deal of uncertainty exists with respect to the future of the economy. Government stimulus policies, both monetary and fiscal, have not worked to any degree and it is debatable whether or not any additional actions will achieve much more.

In addition, Europe appears to be in recession right now and, given its sovereign debt crisis and the state of its banks, any recovery seems to be some way off. It is uncertain how the situation in Europe might play out in the United States. (http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe)

Second, there is the upcoming election in the United States. The uncertainty surrounding the policies of the American government with respect to business and finance over the past three years has been enormous…and largely uncalculable. At this time, we just don’t know how much the uncertainty in this area has retarded the recovery of American business and economic growth.

Further uncertainties exist with respect to the impact of other actions of the federal government in areas like health care, the environment, and foreign affairs. Some people are just learning about the expenses they are going to have to absorb with respect to Medicare, doctors fees, and health insurance. As people learn more and more how their budgets are going to be affected, adjustments will be made to spending patterns and they won’t be up.

Third, in addition to the uncertainties created by new financial regulations and the complexity of these new regulations, there appears to be a growth in the government’s application of the anti-trust laws. The recent treatment of the AT&T/T-Mobile merger is a case in point. The government, ‘feeling its oats’ from this action, will probably step-up its aggressive behavior in this area, leading to even greater uncertainty relative to M&A activity.

Early in 2011, it looked as if there might be a big pickup in merger activity for the year. Many of the same conditions we see today existed at that time. And, what happened?

M&A activity did pick up in 2011 from previous years but we did not see the ‘big jump’ that many of us expected. Instead of buying companies, many firms used their cash on hand or their ability to borrow at ridiculously low interest rates to buy back their stock. This, of course, helped stock prices but it did not help the economy.

But, even a pick up in M&A activity will not do a lot to help the economy, especially in the short-run. Buying companies outright or buying pieces of companies will initially result in efforts to achieve greater corporate efficiencies, higher levels of productivity, and will mean more reductions in employment. This is a part of the “creative destruction” of a market economy.

And, this should not be surprising. The American economy has been subject to fifty years of credit inflation. In such a time, among other things, businesses come to focus more on finance rather than production, they acquire other businesses that are not related to their core operations, and they hoard labor.

The other side of the business structure created by credit inflation is the need to unwind and restructure what was built earlier. That is what we face now.

Let’s hope the boom in M&A business does take place. Let’s hope that the corporate cash and corporate borrowing do not go just to corporations buying back their own stock. Let’s hope that the unwinding and restructuring takes place because that is one prerequisite for business to get back to the capital investment activities that do drive economic growth.

What's to Like About the United States Banking System?

2012-01-19T08:40:00.000-08:00

I really don’t see much to like in the United States banking system.

With interest rates so low across the board, commercial banks have very little interest rate spread to work with.

With Congress and the regulators so screwed up and yet so anxious to pass laws and regulate, the “regulatory risk” and the “complexity risk” facing the industry is enormous.

There is still plenty of evidence that commercial banks have a lot of unrecognized overvalued assets on their balance sheets. (http://seekingalpha.com/article/320370-bank-stress-tests-a-substitute-for-mark-to-market-accounting)

There seems to be growing interest in suing banks that are alleged of “making misleading public statements as the property market crumbled in 2007 to hide internal downgrades of loans from investors” (http://professional.wsj.com/article/SB10001424052970203735304577169360314402158.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj) or for other reasons that banks failed to appropriately disclose their financial condition. There are also other settlements coming related to bank lending practices in the 2000s.

Bank earnings are a mixed bag, at best. The larger banks are not performing well because trading profits and profits on many non-traditional banking operations are off. (See JPMorgan and Citigroup) The returns to trust banks (BNY Mellon, State Street Corp. and Northern Trust Corp.) are sagging because these institutions have taken a “defensive position” with respect to the financial markets and shifted a substantial amount of funds into cash and ultra-safe assets. (http://www.ft.com/intl/cms/s/0/140b9e70-41da-11e1-a586-00144feab49a.html#axzz1jqA4rKTp)

Only the banks that have stayed pretty much as traditional banks (like Wells Fargo, U. S. Bankcorp, and PNC Financial Services Group) have held up, profit-wise, in recent periods. This performance seems to be connected with some minor pickup in loan growth.

Even in the case of loan growth, analysts are relatively pessimistic about the future. “It appears that much of the commercial loan growth we have seen at the large cap banks is coming from large corporate syndicated lending. Not all banks are players in this market.” This from Christopher Mutascio at Stifel, Nicolaus & Co. Note that Mutascio is expecting “total loan growth and commercial loan growth” to slow in 2012. No bounce here. (http://professional.wsj.com/article/SB10001424052970204555904577168510658669178.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

In my most recent blog I discussed the effort of BankUnited, a Florida-based bank, to sell itself because of the condition of the banking industry, especially in Florida. BankUnited wanted to grow and yet could find no other banks to acquire…and they had looked at about 50 banks in the Florida region and elsewhere. Because of the state of the banks available to acquire, BankUnited decided to sell.

Well, yesterday, BankUnited pulled itself “off the market”. The bank had attempted to set up an auction for itself but only Toronto-Dominion Bank and BB&T Corp. submitted preliminary offers. These offers did not come up to the price of that BankUnited received when it went public last year. Thus, the bank withdrew its offer to sell. (http://professional.wsj.com/article/SB10001424052970203735304577169400198108514.html?mod=ITP_moneyandinvesting_1&mg=reno-secaucus-wsj)

Some of the banking statistics reflect the stagnant nature of the banking system as a whole. For example, total commercial banking assets in the United States rose by about $700 billion last year.

Note, however, that cash assets at commercial banks rose by about $515 billion! That is, almost 75 percent of the growth in bank assets came from an increase in the cash holdings of the banks.

Also, note that about 80 percent of this increase in cash assets at commercial banks in the United States occurred at foreign-related financial institutions.

Furthermore, these foreign-related financial institutions increased their commitment to Net Deposits Due to Foreign-related offices by almost $650 billion. Thus, these foreign related institutions took U. S. dollars and shipped them off-shore! Thank you Federal Reserve System!

In all, the share of United States banking assets going to foreign-related financial institutions rose from about 11 percent to almost 15 percent from December 2010 to December 2012. The largest twenty-five domestically chartered banks in the United States continue to account for almost 60 percent of the banking assets in the country. The smallest domestically chartered banks (about 6,300 of them) continue to shrink as a proportion of banking assets.

The American banking system is welcoming more foreign-related financial institutions to the ownership of its assets…note that one of the two bidders for BankUnited was Toronto-Dominion Bank…and is also seeing more and more of its assets being held by larger banks.

Right now, the commercial banking system seems to be going nowhere, just restructuring.

This is just a very, very tough time for the banking system. It is a time of transition. The whole industry is changing. (http://seekingalpha.com/article/319449-the-banks-they-are-a-changing) But, then, the whole world seems to be going through a period of transition.

Bank Stress Tests: A Substitute for "Mark-to-Market" Accounting?

2012-01-18T06:57:00.000-08:00

“The FDIC Board yesterday issued a notice of proposed rulemaking that would require FDIC-insured state nonmember banks and state-chartered savings associations with more than $10 billion in total consolidated assets to conduct annual capital-adequacy stress tests. As of Sept. 30, 2011, the FDIC regulated 23 state nonmember banks with more than $10 billion in total assets.   The Dodd-Frank Act-mandated proposal defines the term “stress test”; establishes methodologies for conducting stress tests that provide for three different sets of conditions, including baseline, adverse and severely adverse conditions; establishes the form and content of a stress-test regulatory report; and requires covered banks to publish a summary of stress-test results.   The proposal is similar to one the Federal Reserve published in December.” (Daily Newsbyte release of the American Bankers Association, January 18, 2012)

The commercial banking industry has not wanted to adopt “mark-to-market” accounting. There are several reasons bankers do not want to do so, but, in my mind, the most prominent reason is that they don’t want to be accountable for taking on risk…both credit risk and interest rate risk.

Remember, I have been a banker for a large part of my professional life.

Generally, you hear bankers complain about mark-to-market accounting after-the-fact. That is, they complain when the value of their assets have declined. The decline in the value of an asset has either come because the asset has “gone bad” (for whatever reason), or, because interest rates have risen and the price of a security has declined.

In the first case, the argument forthcoming from the bankers is that either the asset needs time for the economy to recover or the asset needs time for the bank to help “work out” its problems. In the second case, bankers argue that they will hold the asset to maturity so that no capital loss will need to be realized on the asset.

Thus, the bankers have put on assets that have higher than average credit risk or long term assets that possess interest rate risk and have not had to account for any increase in the over all riskiness of bank assets until they either write off the asset or sell the asset for a price that is below its purchase price.

But, that can mean that there are a lot of “over-valued” assets on the books of the banks.

Because banks do not have to mark their assets to market, the banking system can have lots of “zombie” banks around, banks whose financial condition is unknown to their investors or depositors. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The presence of these banks, and not just the largest banks, can be noted in the Wall Street Journal article about Florida’s BankUnited. (http://professional.wsj.com/article/SB10001424052970203735304577167241414198390.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) The BankUnited situation is unique in that it is a bank that was acquired by an individual, John Kanas, and a group of private-equity firms. BankUnited was a failing bank that was purchased from the FDIC and made into a profitable organization, one that is well capitalized and growing.

Yet, the desire was for the bank to grow more, and grow by acquisition, but this has not been possible because “other Florida banks are either too sick or too expensive…“Mr. Kanas’s team has examined more than 50 potential targets in the past few years but pulled the trigger on just one.”

The banking system is still not healthy and when “outsiders”, like Mr. Kanas and his team, actually get to review the assets of a bank during a due diligence, they find out just how fragile the banking system is.

The original acquisition of BankUnited was done in an assisted deal that “The FDIC estimates that the failure will ultimately cost its deposit-insurance fund $5.7 billion.” Deals are still being made for “failed” or “troubled” banks, (there are still about 850 banks on the FDIC’s list of problem banks) but the efforts to complete them and the frustration connected with “the regulatory red tape that is increasingly gripping the industry” are costly and tiresome.

Mr. Kanas is in the process of selling BankUnited and is leaving the industry. “’He is just tired,’ said a person who knows Mr. Kanas well.”

It seems to me that the imposition of “stress tests” on the banks with more than $10 billion in assets is a way to for the regulators to “mark-to-market” the assets of these banks! The regulators are to see what happens to the value of the assets of a bank under “three different sets of conditions, including baseline, adverse and severely adverse conditions.”

These “stress tests” are just simulations, but, the purpose of the tests are on to determine how vulnerable banks are to changing market conditions. In other words, are the banks sufficiently capitalized to withstand detrimental movements in financial markets.

This exercise basically “marks-to-market” the loans and securities held by a bank under different scenarios. And, the exercise is conducted by the bank regulators and not by the banks themselves. Furthermore, the Dodd-Frank mandate “requires covered banks to publish a summary of stress-test results.” That is, the results of these tests cannot be hidden.

Because the commercial banks would not reveal their risk exposure voluntarily and of their own making, the regulators will now design the tests relating to the risk exposure of the banks and will force the banks to reveal the results of the tests publically.

One just wonders how long it will take for the regulators to extend these “stress tests” to all financial institutions with assets of $1.0 billion or more. And, then...

I hope the bankers are happy with the consequences of their failure to disclose!

Credit Downgrades and Europe

2012-01-16T17:41:00.000-08:00

The problem is the free flow of capital throughout most of the world.

When capital flows freely you cannot escape the consequences of your actions.

What is called the “trilemma” problem of international economics makes this very clear. The “trilemma” problem states that a country can only choose two of the following three options. The three options are to be a part of world capital markets where capital flows freely; have a fixed exchange rate; or, be free to run an independent economic policy.

If there is a free flow of capital internationally, then the choice is reduced to just one of the two remaining options. But, there are consequences to either choice.

First, if a country choses to run its economic policy independently of all other nations, then it must let it currency float in the foreign exchange markets. Generally, a nation that wants to run an independent economic policy has particular domestic economic goals it wants to achieve and so wants to be able to choose an independent economic policy that supports these goals.

The goals most often chosen in the latter part of the twentieth century have been full employment and social welfare programs like government jobs, early retirement, substantial amounts of vacation, and high pension levels. The means of achieving these goals has often been a policy of public sector credit inflation.

If a country chooses the path of credit inflation then the price of its currency in foreign exchange markets must be allowed to float. And, if credit inflation becomes extreme, the value of the currency in the foreign exchange markets will decline. And, this will bring on other problems.

This is one reason John Maynard Keynes wanted restrictions on the international flow of capital in the 1920s and 1930s. (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell) A limited flow of capital internationally was a reality when Keynes helped to craft the Bretton Woods agreement that created the rules for the post-World War II international monetary system. This agreement also included fixed exchange rates between the currencies of the participant nations.

The purpose of this system was to allow member countries to follow their own economic policies aimed at achieving high levels of employment in their own country. Therefore, a policy of credit inflation could be followed in each country without disrupting changes in foreign currency rates.

The Bretton Woods system fell apart as international capital markets opened up in the 1950s and 1960s and the credit inflation created in the United States in the 1960s resulted in a situation where the United States could not maintain its fixed exchange rate. On August 15, 1971, President Nixon choose to float the value of the U. S. dollar.

A second choice, given the unrestricted flow of capital internationally, is to choose a fixed exchange rate. But, if a nation chooses a fixed exchange rate then it must give up its sovereignty with respect to running an economic policy that is independent of other nations.

This is what the European nations did when they choose to form a monetary union based on a single currency, the euro: in essence, they choose to have a fixed exchange rate between member nations. But, the nations forming the union did not want to give up their sovereignty with regards to the formation of their government budgets.

Oh, they allowed for budget deficits to be run, but they were to be limited in scope. This, they felt, gave the included nations some flexibility in creating their budgets, but, they were not supposed to exceed the set limits. The problem was that these limits were unenforceable.

Which brings us to the current time. Budget limits have been grossly exceeded and the nations forming the European currency union and these eurozone nations are unable…or unwilling…to give up the sovereignty of running their own economic policy or abiding by the rules of the union.

The “trilemma” analysis states very clearly that in circumstances like this the monetary union must be broken up and the countries must form a central budgetary unit or must once again establish their own currency units whose price will be floated against the other currencies of the former eurozone countries.

The ultimate cost of running independent economic policies and trying to run a single currency monetary union will be the destruction of the sovereign political bodies as we know them in Europe or the euro, as we know it now, will have to become history.

Current events now relate to the break down of solvency talks, which had been taking place between the Greek government and private investors in Greek debt. An “unrealistic” proposal has been rejected by the debt holders.

Furthermore, the credit downgrades of France and other nations, which took place over the past week, were expected, yet no one really exhibited any sense of urgency. Now that the downgrades have taken place a downward spiral seems to be starting.

“Both events are important because they show us the mechanism behind this year’s likely unfolding of events. The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.” (http://www.ft.com/intl/cms/s/0/987fd2fe-3ddc-11e1-91ba-00144feabdc0.html#axzz1jd5VycTs)

The European Financial Stability Facility has also been downgraded and this means that its effective lending capacity has been reduced. The ability to “bailout” distressed countries has declined. And, the European Central Bank cannot resolve the longer-term issues. There is very little still available to the European officials to “kick the can down the road” any more.

I just do not see the European countries at this time getting over their resistance to form “a strong central fiscal authority with power to tax and allocate resources across the eurozone.” Hence, I don’t have much confidence for the continued existence of a common currency for Europe, except maybe, on a much more limited scale. Right now, I don’t see alternatives to the downward spiral mentioned above.

The bottom line is that the conditions of the “trilemma” problem seem to hold. Given that capital is flowing freely throughout the world nations cannot just totally ignore the consequences of their choice of economic policy. And, if the consequences of that economic policy are not realized immediately, the evidence shows that they will be realized sooner or later. This is a lesson in macroeconomic decision-making that all countries need to take into account when determining what economic policy they should be following. Are you listening America?

The Banks, They Are A Changin'

2012-01-13T06:21:00.000-08:00

The banking system is going through massive changes. The morning papers are filled with stories about what is happening in the banking area, although they cover only a minor portion of what is going on in the industry.

The Wall Street Journal trumpets, “Bank of America Ponders Retreat.” (http://professional.wsj.com/article/SB10001424052970204409004577156881098606546.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj) The current Bank of America represents, perhaps as well as any organization the excesses of the financial institutions over the past twenty years or so. Currently selling at 33 percent of book value, the Bank of America can be potentially classified as one of the “Zombie” banks that now meander through the environment. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The Journal article does not give us much faith that management has a firm grasp on the situation…or, at least, is not revealing to us the reality that they face. “Bank of America Corp. has told U. S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen…”

The crucial hedge word is “if”.

Commercial banks have to recover from the binge that has taken place in the banking industry over the past fifty years. This binge has seen commercial banks grow to enormous size and many have become “too big to fail.” It has resulted in a massive shift in employment in the United States as the proportion of people working in the manufacturing trades has declined substantially relative to those working in the financial industry. It has resulted in a huge shift in risk-taking in the industry, a move to more and more financial innovation, and a substantial increase in the amount of financial leverage used in the industry.

Several of the articles in the morning paper discuss the reductions that are taking place employment. For example, yesterday the Royal Bank of Scotland Group PLC announced that it will be laying off 3,500 people. Cutbacks have also been announced by UBS AG and UniCredit SpA and well as Credit Suisse Group AG and many other major players. The reductions in staff of the smaller institutions do not get as much publicity and play in the press.

Some have argued that the industry is going through a cyclical shift that generally happens after a downturn in the economy but more and more industry analysts are claiming that they see a more permanent shift taking place. And this is true of other parts of the financial industry than just the commercial banks. “It isn’t just the lackluster business environment that is prompting banks to rein in their lofty investment-banking ambitions. A realization is sinking in among securities-industry executives that because of the huge potential losses they are exposed to in bear markets, the business just isn’t as attractive as it once seemed.” (http://professional.wsj.com/article/SB10001424052970204409004577156833880721736.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The fifty year period of credit inflation bought out over time many of the bad decisions and allowed the banks to go merrily on their way. As “Chuck” Prince, former CEO of Citigroup expressed it…”As long as the music continued to play, people had to keep dancing.”

But, this continual pressure to grow and expand and take on more risk resulted in a massive change in the banking industry itself. Going from around 14,000 commercial banks in the 1960s the commercial banking industry now contains less than 7,000 banks. My forecast is for this number to drop below 4,000 in the next several years.

And, the banking industry is bifurcating: almost two-thirds of the assets in the banking system are owned by the largest 25 banks in the country. That leaves just one-third of the assets in the hands of about 6,300 banks. More and more wealthier personal banking relationships are being handled by firms that cannot be considered to be community banks. The products and services in these banks are many and the electronic interchange and access between financial assets and transactions are seamless and almost instantaneous.

One could imagine a banking system in which the wealthier people worked with institutions like these and the less wealthy “banked” at non-profit credit unions, the non-profit institutions being the only ones that could provide the products and services needed without having to achieve a competitive return on shareholder’s equity.

The last factor producing major changes in the banking industry is the advances taking place in information technology. Finance is nothing more than information. That is, finance can ultimately be just a recording of 0s and 1s. Thus, as information technology advances, so does the innovation in the financial industry.

And, don’t think of how you use banking services right now…think about the electronic gadgets that your children or your grandchildren are using. This is where you will see what financial institutions are going to need to provide for in the coming years. What goes on in “electronic stuff” is real to these children and will become a part of the financial system as electronic finance becomes ubiquitous in the future.

Furthermore, as advances in information technology has allowed “finance” to become more innovative, my guess is that for the future…we haven’t really seen what financial innovation can do.

This has tremendous implications for the regulatory efforts going on in the United States and the world. I have argued for three years now that the efforts of the United States Congress and others throughout the world have been to create a regulatory system that will prevent a 2007-2008 financial collapse. To me, the commercial banks in the United States are way beyond this system already. Oh, the banks fight Congress and the regulators all along the way. But, how much of this is real and how much of this is a smokescreen.

Throughout my professional career…and I have run three banks…the banks have always been ahead of the legislators and the regulators in terms of what is going on in the banking system. I am no less confident now that the banks are still far ahead of legislation and regulation and will continue to be so into the future.

I can’t imagine what banking will be like in five years…but, it will be something substantially different than it is now. It will be more electronic, it will be more innovative, and it will be harder to control. The only way we can hope to keep up with what is going on is to increase the openness and transparency with which the banking system operates.

There Still Are "Zombie" Banks Around

2012-01-12T09:01:00.000-08:00

In Europe, “On average the 31 companies in the Euro Stoxx Banks Index (SX7E) trade for 39 percent of common equity, or book value, according to data compiled by Bloomberg. France’s Credit Agricole SA (ACA) trades for 23 percent of book. Yet somehow the European Banking Authority last month concluded it had no capital shortfall.

The situation in the U. S. is better, but not good. Bank of America Corp. (BAC), for example, trades for 33 percent of book and insists it doesn’t need to sell new common shares, in spite of the markets’ contrary verdict.” (See http://www.bloomberg.com/news/print/2012-01-12/financial-frankness-is-a-bad-dream-for-a-bank-commentary-by-jonathan-weil.html.)

“Zombie” banks are banks that have substantial amounts of worthless assets on their balance sheets but are afraid to write them down. In essence, the financial markets are doing the “writing down” for them.

Bankers are reluctant to write down assets in the first place. First of all it is an admission of a failure…of underwriting, of intuition, of forecasting, of lax behavior. The bankers that are holding your deposits don’t like to admit that they have made a mistake.

I know this is true…I have completed three (successful) bank turnarounds in my career…so I have seen the other side of the asset acquisition process in commercial banks.

Furthermore, bankers don’t like to write down assets way after the time in which they should have written them down.

Bad assets accumulate and the longer that bankers “paper over” their bad asset problems the problems tend to grow and “the eventual clean up” becomes even worse. Rather than admitting that a problem exists and allocating resources to “clean up” the problem at an early stage, the bankers postpone devoting enough effort to resolving these issues and, in consequence, they find that the difficulties of their job increases in a non-linear fashion as the number and complexity of bad assets grow and multiply.

The problem now is that most of these “zombie” banks want to raise more capital to satisfy the new, higher regulatory requirements for capital but find that their stock prices are so depressed that raising additional capital can be extraordinarily expensive.

The author of the Bloomberg piece, Jonathan Weil, discusses this in the above quoted article. He focuses on UniCredit, the Italian bank that took a large writedown in the third quarter of 2011, which resulted in a 10.6 billion euro loss. On top of this the European Banking Authority determined, after the latest stress tests, that UniCredit had an 8 billion euro capital shortfall.

As of September 30, 2011, UniCredit had 950 billion euros in assets and only 52.3 billion in euros in common shareholder equity on its balance sheet. The stock market value of the bank is 14.8 billion euros. Something doesn’t add up here.

And, that is where the concern over the other European (and American) banks comes in.

With bank valuations in the range of those mentioned in the first two paragraphs of this post, the financial markets seem to be indicating that many of these banks have substantial amounts of questionable assets on their books that they have failed to publically acknowledge. And, this is one of the problems financial markets face…if the institutions they invest in are not brave enough…nor honest enough…to reveal this to the marketplace…then investors just have to guess at how serious the problems are.

In times like these, the guesses will tend to be on the negative side. And, this certainly doesn’t help the bankers to raise the capital they need to get back onto a solid capital footing.

Are there still a lot of “zombie” banks “out there”?

I believe there are. Although the FDIC only closed 92 banks in calendar year 2011, the number of banks in the United States shrunk by more than double this number. In the third quarter alone, only 26 banks were closed yet a total of 61 banks left the banking system. While the number of banks closed in the 12-month period ending September 30 was around 100 in number, the banking system had 271 fewer banks. So for 2011 it seems as if the number of banks leaving the banking system were two- to three-times the number of banks that the FDIC actually closed.

There was cheering when the number of banks listed on the FDIC’s problem list fell in the third quarter to 844 banks, down from 865 banks the quarter before. But, this means that although the problem list dropped by 21 banks, 61 banks, most of them troubled in one way or another, dropped out which means that maybe around 40 new problem banks got added to the FDIC’s list.

(For more on this see my post http://seekingalpha.com/article/310644-while-small-banks-disappear-big-banks-get-bigger.)

My point here is that I don’t believe that either Europe or the United States is finished with its banking problems.

I still contend that one of the major reasons that he Federal Reserve pumped so much money into the banking system was to keep banks liquid enough so that they didn’t have to write off bad assets at too fast a pace, so that the banks had more time to try and work out these bad assets, and so that the FDIC had sufficient time to either close these banks as smoothly as possible or arrange for acquisitions to eliminate a substantial number of the “bad” banks.

Sooner or later, however, the bad assets on the balance sheets of banks are going to have to be recognized.

The problem is still sufficiently severe so that these “zombie” banks are unwilling to admit to the world that they remain troubled. For a more realistic valuation of their assets we will just have to look at market values.

But, these banks are not out of the woods yes, for in Europe the “next” recession seems to be in progress. How this recession will play in the United States is, of course, unknown. (See my post, http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe.)

How much better it would have been for these banks to “recognize” and “claim” these bad assets earlier and to have fully disclosed them and then set out to work to correct the situation than to postpone recognition and “paper over” the problems which, in the end, creates major difficulties.

Bankers vociferously fight mark-to-market accounting and the timely writing down of “worthless assets” after-the-fact, that is, after the damage has been done. The problem is that mark-to-market accounting and the timely writing down of “worthless assets” are aimed at getting bankers to do their jobs before the financial crisis occurs. The hope is that the early proper recognition of the problems will lead to earlier resolution of them thereby avoiding major cumulative collapses.

Where Does Sovereign Credibility Come From? The European Sitaution

2012-01-09T06:58:00.000-08:00

As usual, when Bob Barro of Harvard writes something it usually contains some provocative ideas. In the Monday morning Wall Street Journal, Barro writes about how Europe might get out of the Euro. (http://professional.wsj.com/article/SB10001424052970203462304577134722056867022.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

What interested me most in Barro’s piece was the emphasis he placed on the credibility of the organizations that issue a currency.

In essence, as I read the article, Barro argues that the credibility of the Euro comes from those within the eurozone that are fiscally sound and carry those that are not fiscally sound, the “free riders”, along with them.

This credibility is maintained for as long as the “free riders” conduct their irresponsibility within limits. In fact, this is what the original charter of the eurozone called for…limits to how irresponsible the “free riders” could be.

But, the limits must be enforced.

“Greece…has been increasingly out of control fiscally since the 1970s. But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.”

The bailouts have become serial, as bailouts have also been given to Portugal, Ireland, Italy, and Spain.

Thus, the only way credibility can be maintained is for Germany to continue to be fiscally strong while the union continues to provide bailout packages that will carry the “free riders” along for as long as possible.

Meanwhile, the internal effort of the members of the eurozone has been to create a stronger “fiscal” bond within the zone itself…ultimately moving to a “centralized political entity” that will oversee the fiscal and currency policy of the whole eurozone.

Europe, to achieve such a “centralized political entity”, would have to overcome many, many issues that have existed on the continent for a long time. For one, the internal rivalries that have existed for centuries would have to be overcome. Already the resentment against Germany has grown as Germany has become a more demanding partner within the union. Even statements like “Germany is achieving through economics what it could not achieve militarily at an earlier date” demonstrate some of the underlying emotions that exist on the continent. Then you have the cultures, languages, and other hurdles to overcome to achieve the needed unity.

Even so, Barro continues, in the shorter run, the credibility of the nations is vitally important because of the sovereign debt that has already been issued by the governments of Europe and that rest on the balance sheets of the banks within the eurozone. This is the reason there is rush to achieve the near term austerity in the budgets of Italy, Spain,…and France…among others.

Greek debt is now yielding more than 34 percent on its ten-year bonds. Portuguese bonds are yielding more than 13 percent. The debt of Italy is yielding more than 7 percent. And Spanish bonds are above 5.5 percent. These rates are unsustainable!

French debt is yielding around 3.5 percent and the rating agencies are soon expected to remove their AAA rating.

The status of this debt is important because, “the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on. Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany, and elsewhere.”

Credibility is lacking because “it is unclear whether Italy and other weak members will be able and willing to meet their long-term euro obligations.”

Not only is the banking system threatened by this lack of confidence, the uncertainty that exists surrounding the future structure and performance of this area does not contribute to the achievement of stronger economic growth. If anything, this uncertainty works to reduce growth.

Only as independent nations with their own currencies would these countries be able to meet their own obligations and achieve the credibility a nation needs to function within the global economy. “This credibility underlay the pre-1999 system in which the bonds of Italy and other eurozone countries were denominated in their own currencies. The old system was imperfect, but it’s become clear that it was better than the current setup.”

The issue is one of credibility.

Right now, Germany seems to possess credibility. But this credibility is based on its maintaining the position of fiscal responsibility it has already achieved. And, this is just what the Germans seem to be doing. (“Germany Resists Europe’s Plea to Spend More,” http://www.nytimes.com/2012/01/09/business/global/germany-resists-europes-pleas-to-spend-more.html?_r=1&ref=business)

As long as the current economic structure exists for the eurozone, the credibility of the eurozone will depend upon it’s ability to provide sufficient “band aides” to piggy-back on the credibility of Germany. My guess is that it will become harder and harder for financial markets to buy-into this piggy-back arrangement.

Credibility requires the provision of actions that backup promises. Barro is suggesting that the only way that the fiscally irresponsible will become credible is for them to be “out-on-their-own” again where they will have to be totally responsible for their own actions. Unless this happens, there is too much historical baggage carried by the eurozone that will not be overcome.

Monetaray Policy in 2011: Looking Back

2012-01-06T08:01:00.000-08:00

Total reserves in the banking system rose by almost 50 percent in 2011 to average around $1.6 trillion. The increase during the year was slightly more than $511 billion. (Remember in August 2008 when total reserves in the banking system averaged less than $45 billion?)

Excess reserves in the banking system rose by about $490 billion from December 2010 to December 2011 to a total of about $1.5 trillion. (Remember in August 2008 when excess reserves in the banking system averaged less than $2 billion?)

The Federal Reserve continued to pump reserves into the banking system in 2011 and about 95% of the reserves going into the banking system went into excess reserves.

Bank loans fell during the year by approximately $50 billion. There was a pickup in business loans (commercial and industrial loans) of about $122 billion, but real estate loans (primarily commercial real estate loans) fell by $150 billion and consumer loans dropped by $22 billion.

Note that the pickup in business loans was predominately located in the largest 25 domestically chartered banks in the United States. The increase here was approximately $95 billion.

One can conclude from this that the reserves that the Fed pumped into the banking system did not, on balance, go to support an increase in lending.

Yet, the growth rate in both measures of the money stock rose during the year. For the M1 measure of the money stock, the year-over-year rate of increase rose from 7.5 percent in December 2010 to 19.1 percent in December 2011. (This is using the 13-week average of the measure.) The year-over-year rate of growth of the M2 measure of the money stock rose from 3.3 percent in December 2010 to 9.8 percent in December 2011. (Again using the 13-week average.)

The increase was highlighted by a whopping 45% rise in demand deposits!

But, this increase in demand deposits did not come from an increase in bank lending because the bank lending that might have resulted in an increase in demand deposits and hence the M1 money stock actually declined!

The reason for the huge increase in demand deposits seems to be that people are moving assets from short-term investment vehicles to demand deposit accounts.

For the past two years or so I have been arguing that this movement into demand deposits is coming for two reasons. The first reason is that interest rates on short term investments are so low that people do not believe that it is worthwhile to keep their money in interest bearing assets rather than demand deposits. (For example, Federal Reserve data record a drop of almost $90 billion in Institutional Money Funds over the past year.)

The second reason is that many people are still is difficult financial condition. Hence, they are keeping what funds they have in transaction-type accounts so as to pay for necessary living expenses. Additional information that supports this argument is that the currency component of the money stock rose by more than 9 percent this last year. This is, historically, an extremely high number. People in tough economic situations also hold more cash.

The evidence from the banking system is not very encouraging with regards to a pickup in economic activity.

How did the Federal Reserve inject more than $500 billion reserves into the banking system this last year?

First, the Federal Reserve increased its holdings of securities by roughly $442 billion. Actual acquisitions of Treasury securities amounted to about $640 billion but these purchases were offset by a $43 billion decrease in the Fed’s holdings of Federal Agency issues and a $154 decline in the Fed’s holdings of mortgage backed securities.

One should also note that there was a net decrease in funds associated with the bailout actions of 2007 and 2008 of approximately $140 billion. Also, primary borrowings from the Fed’s discount window declined by $36 billion. One generally assumes that these “operating” factors are offset by the Fed’s purchase of securities. Thus the “net” addition of funds from the increase in the Fed’s outright holdings of securities totaled about $266 billion.

Second, the United States Treasury also played a role in the increase in bank reserves. At the end of 2010, the Treasury held almost $200 billion in something called the U. S. Treasury Supplementary Financing Account. (I have mentioned the use of this account many times in 2010…here is one post: http://seekingalpha.com/article/256497-qe2-watch-version-4-0-fed-is-tone-deaf-and-spaghetti-tossing.) These funds were injected into the banking system this past year…the full $200 billion of them. This can be added to the $376 billion mentioned in the previous paragraph to account for $466 billion of reserves going into the banking system.

Third, the currency being demanded by the public mentioned above is supplied to the public by the Federal Reserve “on demand”. That is, the Federal Reserve generally replaces the currency flowing out of the banking system into general circulation, dollar for dollar. This past year, currency in circulation rose by about $93 billion. Thus the $466 billion of the previous paragraph drops to $373 billion.

Fourth, the Federal Reserve has “pumped” dollars into the European banking system due to the sovereign debt crisis in Europe. For example, Central bank liquidity swaps have increased by about $100 over the past year, most of the increase coming in the past six months. This is not the only way the Fed influences what is going on internationally as the Fed holds other assets denominated in foreign currencies and also engages in reverse repurchase agreements with “foreign official and international accounts”. If one roughly nets out the accounts associated with all of these type of transactions, we can say that the Fed roughly added another $104 billion to bank reserves which brings the total injection to $477 billion

One final operating factor influences this total figure, payments into and out to the general account of the United States Treasury. This fluctuates with tax payments and actual government expenditures. The year-over-year drop in this account is about $28 billion and this brings the total increase in “reserve balances at Federal Reserve banks to $505 billion, which matches very closely with the $490 increase in excess reserves mentioned in the second paragraph of this post. (The difference is due to minor operating factors that we do not need to discuss.)

In summary, the Federal Reserve (and the U. S. Treasury) put a lot of reserves into the banking system this past year. As usual, the Fed needs to take care of other operating factors that constantly impact the banking system, but in general, the injection of reserves came from the securities the Fed purchased as a part of the QE2, the dollars being advanced to European central banks to help relieve the pressures of the sovereign debt crisis, and the injection of funds into the banking system from the fiscal activities of the United States Treasury.

As of this time, the reserves going into the banking system have not been lent out…they are just sitting on the balance sheets of the commercial banks. The extraordinary increase in the money stock measures are the result of the low interest rates that people can earn on their money balances and the need of people who are economically distressed to hole transaction accounts.

The efforts of the monetary authorities are not being felt, yet, by an increase in economic activity.

What the Federal Reserve is Risking

2012-01-05T08:16:00.000-08:00

There are two articles in the Wall Street Journal today that I believe are very important responses to the announcement of the Federal Reserve that it will release interest rate projections for several years out.

The first of these by Kelly Evans says a mouthful: “Boosting Transparency, Fed Puts Its Reputation on the Line.” (http://professional.wsj.com/article/SB10001424052970204331304577141034029100316.html?mod=ITP_moneyandinvesting_5&mg=reno-secaucus-wsj)

I love the quote that Evans leads the article with…it is from Abraham Lincoln: “it is better to remain silent and be thought a fool than to open one’s mouth and remove all doubt.”

First of all, to produce projections of interest rates three years into the future? Come on…

And, to release the forecasts from all 17 members of the Federal Reserve’s open-market committee…

This is to produce credibility?

Come on…

Furthermore, the projections are to “make monetary policy more effective by lowering volatility and uncertainty in the market around the path of future rates.”

Formerly, those in the Federal Reserve believed that some uncertainty should surround its goals because this allowed markets to move incrementally due to the fact that market participants had to search for where the Fed was moving. At least this was the way it was when I worked at the Fed.

Knowing what the target will be results in markets that take discrete leaps…up or down…as market participants jump to the place where the wizards at the Fed now presume interest rates should be.

But, two points on this. The first one is that making everything depend on the Fed’s prognostications and the persistence with which the Fed holds onto the projections, can lead to “sure-thing” bets on the part of market participants. There are plenty of examples around in which “the market” bets against the ability of a government or a central bank to hold onto a desired “goal”. As the pressure builds up, the probability that the government or central bank will have to adjust to the reality of the situation can approach 100 percent.

The second point is that the Federal Reserve may actually be the cause of the volatility and uncertainty it is attempting to reduce. As the very actions of the Fed become less recognizable and as, as Evans states, the forecasts “differ significantly from reality” the authority of the Fed decreases and this, in itself, creates “volatility and uncertainty.”

I would argue very strongly that the actions of the Federal Reserve over the past four years…if not longer…have been a large part of the uncertainty it abhors and this has resulted in the increase in market volatility that it would like to reduce. But, this increase has not been due to a lack of “transparency” on the part of the Fed but has been due to a lack of understanding on the part of the Fed. And, this lack of understanding has been transmitted from the Fed to the financial markets.

This is where the other article in the Journal comes in: “Fed Rate Outlook to Bite Traders.” (http://professional.wsj.com/article/SB10001424052970203471004577141182345031606.html?mod=ITP_moneyandinvesting_3&mg=reno-secaucus-wsj) In this piece, Cynthia Lin argues that “With its push to provide a clearer policy road map, the Federal Reserve is about to give bond traders one less reason to like medium-term bonds as it pins down yields that already are at historic lows.”

Ms. Lin quotes Kent Engelke, chief economic strategist at Capitol Securities Management as saying, “The short end of the (yield) curve is dead.”

Ms. Lin goes on, “Some investors even are suggesting that the new policy may give little reason to trade bonds maturing as late as 2019.”

Doesn’t someone at the Fed understand this possibility?

I have always assumed that volatility was a function of the depth and breadth of the market. If the policy of the Fed has the result that it will tend to reduce the number of traders in the market, then it would seem to me that this is a movement will have the wrong consequences for the market.

As I stated yesterday, I believe that the move made by Mr. Bernanke and the Fed to achieve greater “transparency” of Federal Reserve operations is more an effort to justify what Mr. Bernanke and the Fed have done over the past four years or so. (See “Bernanke “Transparent about his lack of self-confidence,” http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence.)

Furthermore, I believe that what has been done to the Fed over the past decade has changed central banking in the United States more that we can possibly imagine at this time. And, as most of you know that have read my blog over the past, almost four years, I am not convinced that the movement has been in the right direction. Unfortunately, I believe that we will be paying for this movement, in one way or another, over the next four or five years.

Bernanke "Transparent" About His Lack of Self-Confidence

2012-01-04T07:29:00.000-08:00

This post is about the Fed’s latest effort to build confidence in the financial system by “providing the predictions of its senior officials about their own decision, hoping to increase its influence over economic activity by guiding investor expectations.” (http://www.nytimes.com/2012/01/04/business/economy/fed-to-start-publicly-forecasting-its-rate-actions.html?_r=1&ref=business)

“The inaugural forecast will show the range of predictions made by Fed officials about the level of short-term interest rates in the fourth quarter of 2012, 2013, and 2014…. It will also summarize when they expect to start raising short-term rates….”

To me, this is Ben Bernanke’s latest effort to justify himself and what he has done. It is Mr. Bernanke’s cry to financial markets: “please understand me.”

But, the more Mr. Bernanke cries for understanding, the more he digs a hole for himself with respect to the future. For one, who can believe that anyone can forecast short-term interest rates for a three-month period let alone for a three-year time frame? The record of the people at the Fed is no better than that any other group of forecasters.

Second, by telegraphing the Fed’s intention, the Fed will be setting itself up for financial markets to “bet” against it. This is always a possibility when central banks or governments explicitly state their policy goals. And, the “bet” many times can become a “sure thing.” Perhaps the best, most recent example of this is the Soros “bet” against the British government in the 1990s about the value of the pound.

Ultimately, to me, this effort at “transparency” is a sign of Mr. Bernanke’s real lack of self-confidence in his ability to lead the Federal Reserve through this difficult time. He can’t understand why people don’t understand what he is doing and so he tries, harder and harder, to create this understanding. His steps to gain greater “transparency” over the past six months is just evidence of his struggle.

I will admit that I am not, nor have I ever been, a fan of Ben Bernanke as the Chairman of the Board of Governors of the Federal Reserve System. I was in favor of him being the Chair of the Economics Department at Princeton University…but not Chair of he Fed.

I was against Bernanke’s re-appointment as the Chairman (http://seekingalpha.com/article/151474-exit-strategy-an-argument-against-bernanke-s-reappointment) and disappointed in President Obama for actually re-appointing him (http://seekingalpha.com/article/158762-bernanke-s-disappointing-reappointment).

In reviewing Bernanke’s record since being a member of the Board of Governors, I see nothing but a competent academic, out of his element and over-his-head in the deep water of a twenty-first century whirlpool.

In more peaceful times when he was just a member of the Board of Governors (August 5, 2002 – June 21, 2005) he was a lackey of the then Fed Chairman Alan Greenspan, developing the argument for Greenspan’s defense of recent monetary policy that used the savings of China and the Middle East to finance U. S. Treasury debt.

He was a strong supporter of Greenspan’s effort to keep the Federal Funds rate at one percent in the 2003-2004 period to combat the possibility of the economy going into a deep recession. This effort helped to underwrite the “bubble” that took place at this time in the U. S. housing market.

Then, once he was became Chairman of the Federal Reserve on February 1, 2006, he was a firm advocate of pushing the target rate for the Federal Funds rate to 5.25 percent and keeping it there into August of 2007 so as to combat the possibility that inflation might get out-of-hand.

The Fed move was in response to the financial market meltdown of “Quant” financial firms that took place in August 2007. (See book review on “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)

The recession in the United States began in December 2007.

The next episode of Bernanke’s “steady hand on the tiller” came in the fall of 2008. I have characterized Bernanke’s reaction to the Lehman Brothers failure as one of panic. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

But, what Bernanke and the Fed did next has been the basis for the claim that Mr. Bernanke saved the United States from a second Great Depression. The Federal Reserve acted to increase its balance sheet from slightly less than $900 billion is assets to more that $2.0 trillion in assets by the beginning of 2009. Through various stages of Quantitative Easing (QE), the Fed’s total assets now amount to more than $2.8 trillion.

This injection of funds into the banking system has resulted in around $1.6 trillion in excess reserves on the balance sheets of U. S. banks. It has created little in the way of bank lending or economic growth.

However, many people have given credit to Mr. Bernanke for saving the country and this may be an appropriate gesture on the part of a grateful country. My concern has been that this policy is nothing more than a policy of throwing sufficient “stuff” against the wall to see what would stick. As a consequence, monetary policy in the United States has become a tool of ignorance, not of professional competence.

And, that is exactly where we are today. That is why there is so little confidence in the Chairman of the Federal Reserve System in world financial markets.

Thus, that is why the Chairman of the Federal Reserve System is struggling to reach out to the financial markets to justify what he has done…and is doing.

This effort, in my mind, will achieve little or nothing…and could do much harm.

No. 1 Issue of 2012: Recession in Europe

2012-01-03T10:15:00.000-08:00

I believe that the number one economic issue for 2012 will be a recession in Europe. I don’t see how this will be avoidable.

The sovereign debt crisis in Europe has not ended and a lot of the debt is turning over this year and must be financed in the face of greater scrutiny by the rating agencies.

The solvency problems in the European banking system has not been resolved and with more severe capital requirements and a rising level of troubled loans on their balance sheets, commercial banks are not going to be in the mood to increase lending levels.

And the governmental austerity programs of Greece, Italy, and Spain are just beginning to hurt. The pain will only rise over the next year or two.

Furthermore, the lack of leadership on the European continent (and elsewhere) is astounding! How do you resolve a difficult situation when there are no leaders around to realistically deal with the problems embedded within the situation?

A European recession has a high probability of occurring, but the depth of the recession is still to be determined. On the surface, one might think that the recession would be relatively shallow, but there are other factors one must filter into the picture that adds to the uncertainty of how deep the recession might be.

Given this picture as the most likely leading scenario for 2012, I believe that we must further focus our sights on two other factors.

The first of these is how the recession might spread to other nations. Contagion is obviously the biggest concern here. If a recession hits an area as large as the eurozone, even if it is a modest one, the effects of that recession will spread to others. The exports of non-European nations will drop. And there will be financial markets consequences.

It is highly unlikely that a European recession will be contained just to the continent. And, since many of Europe’s trading partners are already facing economic expansion that is modest, at best, the repercussions could spread to a relatively large part of the world.

The second factor is even more disturbing. If we have a European recession in 2012, given the austerity programs that are being embedded in the economic policies of eurozone states, the likelihood that social unrest in these nations will accelerate both in the current year and beyond.

We have already seen outbursts of social unease in 2011 and with the increasing information on greater income inequalities, higher levels of unemployment, lower pensions, and so forth, that will be in the news, social unrest can only increase.

But, these protests will have the examples of the Arab spring to build upon. As was seen in 2011, the use of modern information technology can only strengthen the capability of protesters to organize and to disrupt. What happened in 2011 has not been lost on the discontented of the developed world.

And, what happens if a European recession spreads to other areas of the world. The seeds of protest have already been planted in many areas, including the United States. Just mention the word “occupy” and you will get your response.

Which leads me to one final point. I believe that modern society is now going through a period of substantial transition, and, like most periods of substantial transition there will be a lot of suffering as the “new world” emerges and there will be a substantial period of uncertainty as we grapple with the issues and move into this “new world.”

Of course, this will be one of the major problems we have to face…the problem of identifying what needs major changes and what needs only minor adjustments.

With certainty, however, I will argue that the evolving information technology is going to play a huge role in whatever results. People are going to be dealing with more and more information and they will have this information is “real time.” There will be much greater connectivity between people. Due to this there is going to have to be greater openness and transparency in life and this is going to force major changes on the way we do things and the speed at which people react. Governments are going to have to respond to this. Corporations are going to have to respond to this. And, whole societies and their social structures are going to have to respond to this.

Changes in the availability of information have resulted in major upheavals in the world from the use of mobile type in printing which occurred around 1450 CE and resulted in societal changes like the Renaissance and the Reformation…and the Enlightenment…to the creation of the typewriter, the telephone, the telegraph, the radio, and television.

In a very real sense, I believe that a worldview is passing. A recession in Europe during 2012 would accelerate changes that are already in motion. If I am correct, this conclusion does not present a real comfortable picture for the next five to ten years but in terms of the human suffering that will result and in terms of the needs involved in adapting to the changes.

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

2011-12-30T06:42:00.000-08:00

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.” (http://www.ft.com/intl/cms/s/0/f05edd3e-27ee-11e1-a4c4-00144feabdc0.html#axzz1i1eGuNp3)

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!

Capitalism is Capitalism Because It Changes and is Never the Same

2011-12-28T07:59:00.000-08:00

There is an interesting lead editorial in the Financial Times this morning: “Capitalism is dead; long live capitalism.” (http://www.ft.com/intl/cms/s/0/2dd6f264-2d6c-11e1-b985-00144feabdc0.html#axzz1hq4siSP2)

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.

U. S. Businesses Shop Europe

2011-12-27T08:32:00.000-08:00

“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.” (http://www.nytimes.com/2011/12/26/business/us-firms-see-europe-woes-as-opportunities.html?_r=1&scp=2&sq=nelson%20schwartz&st=cse)

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.

How to Solve the European Sovereign Debt Crisis

2011-12-15T17:06:00.000-08:00

“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. (http://www.bloomberg.com/news/2011-12-15/imf-s-lagarde-says-escalating-european-crisis-requires-more-cooperation.html)

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. (http://seekingalpha.com/article/313888-the-problem-is-germany) 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 (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj) 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.

The Problem is Germany

2011-12-13T16:34:00.000-08:00

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 21^st century. If this is true, the European financial crisis still has a long way to go.” (http://seekingalpha.com/article/312920-initial-verdict-on-european-summit-the-can-got-kicked-further-down-the-road)

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”: (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“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.

Recent Monetary Policy and the Growth of the M1 Money Stock

2011-12-12T02:57:00.000-08:00

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. (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility) 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.

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

2011-12-09T06:08:00.000-08:00

“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.” (http://www.bloomberg.com/news/2011-12-09/euro-states-to-shift-267-billion-to-imf-as-focus-shifts-to-deficit-deal.html)

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.” (http://blogs.ft.com/the-a-list/2011/12/09/the-only-way-to-save-the-eurozone-is-to-destroy-the-eu/#axzz1g2glnIN4)

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 21^st century. If this is true, the European financial crisis still has a long way to go.

A Leading Indicator: Corporate Stock Buy-Backs

2011-12-08T06:05:00.000-08:00

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.” (http://www.ft.com/intl/cms/s/0/546f97ec-1231-11e1-9d4d-00144feabdc0.html#axzz1fwprkyNi)

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 (http://seekingalpha.com/article/312223-the-focus-should-be-on-underemployment-not-unemployment) 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.

The Focus Should Be On Under-Employment Not Un-Employment

2011-12-06T05:42:00.000-08:00

The president, the press, and the political pundits focus on the unemployment rate in November as it dropped to 8.6 percent of the workforce, a drop from 9.1 percent in October.

However, under-employment still remains in the 20.0 to 25.0 percent range as it has for the past several years.

Under-employment includes those people that are working part time but would like to work full-time. This component did decline by more than 4.0 percent in November from a month earlier but was down by only about 5.0 percent year-over-year.

Under-employment also considers people that are not working but say that they would like to be. This includes discouraged workers and those who cannot work for reasons like ill health. The number included in this classification increased by about 6.0 percent over the last year. Does this capture the movement from part-time employment to discouraged workers?

These figures indicate that there are long-run factors at work in the labor market that cannot just be solved by short-run fixes or election-year accusations and verbal confrontations.

My argument is, and has been, that fifty years of credit inflation has left the United States with a substantial dislocation of economic resources, like labor, and a vast redistribution of income toward the wealthy. These dislocations are not subject to the “quick fix”.

The economy is recovering, but the economic recovery is not doing much…and cannot do much…to create the restructuring that is needed. You cannot try and put an employee of the auto industry back to work in the same job he/she held for the last ten years when the industry has moved on technologically and that job no longer exists.

Another significant indicator of this is that the share of the population in the labor force has dropped to 64.0 percent, the lowest level in decades.

This drop in labor force share is being driven by people retiring early from the labor force. We see this in a lead article in the New York Times this morning, “Many Workers in Public Sector Retiring Sooner.” (http://www.nytimes.com/2011/12/06/us/more-public-sector-workers-are-retiring-sooner.html?_r=1&hp) This is a result of the budget problems being faced by state and local governments, but it is also a result of events taking place in the private sector as well.

Further supporting information comes from the data of the manufacturing sector. Capacity utilization continues to be below the levels attained over the past fifty years.

The latest figure for capacity utilization was 77.8 percent. This is above the level capacity utilization reached in the depths of the Great Recession, 67.3 percent in June 2009, but it is only slightly higher than the level at the trough of the 2001 recession. And, the trend throughout the last fifty years has been down with capacity utilization being near 90 percent in the 1960s.

Over the past fifty years in the United States, under-employment has increased dramatically and capacity utilization has declined dramatically. Note, that this is the time period that the income distribution skewed so dramatically toward the wealthy in the United States.

The economic policies of the United States government, both Republican and Democratic, have produced this outcome over this time period. More of the same will not be helpful.

Economic growth and economic recovery will not be robust unless and until people come to understand that the economic policies of the government must change. And, these economic policies must deal with the structural dislocations that have evolved over the past fifty years as well as put the economy back on a more stable foundation with less reliance on debt and credit inflation.

Credit inflation paints a very pretty picture while it is accelerating. But, the consequences of this inflation is anything but pretty. Just ask the less wealthy, the under-employed, and the manufacturers that cannot use their full capacity.

Central Banks in Liquidity Action...Not Solvency Action

2011-12-01T04:54:00.000-08:00

Here we go again!

The central banks acted yesterday and the markets went wild! Six central banks acted in concert to make sure that European banks…and others…could get dollars if they wanted them.

This is a liquidity action!

It is an act to keep the flow of short-term funds flowing in world financial markets…just as these six central banks did after the Lehman Brothers failure.

Once again, the definition of a liquidity crisis is that there is a short term need for “buyers” in a market because, for the short term, the “buyers” that are usually there are not there. The “sellers” want to sell assets and obtain dollars.

“Buyers” without dollars are not what is wanted. So the central banks are making sure that there are plenty of dollars available so that the “sellers” can sell their assets.

The emphasis, however, should be on the short-term nature of a “liquidity” crisis.

The fundamental problem is still the solvency problem facing several of the sovereign nations of Europe. (See my post from yesterday, “European Debt Must Be Restructured,” http://seekingalpha.com/article/310994-european-sovereign-debt-must-be-restructured.)

Providing liquidity to the market will not resolve the solvency problem. As almost everyone except the officials in Europe know, the efforts of the last two years or so to treat European debt problems as a “liquidity” issue has resulted in the situation we now find ourselves in.

As in the past, central bank action has gotten a favorable response from stock markets around the world. In the past, the quick, dramatic response to the central bank action has been followed by a retreat. If nothing is done on the sovereign debt restructuring need, the stock markets will, in all likelihood, retreat once again.

The word out is that this liquidity action on the part of the central banks gives the officials in Europe some time to deal with the restructuring.

But, the restructuring is also only a short-term response for eventually the eurozone must deal with the whole question of how the fiscal affairs of the eurozone will be handled. The concern is that restructuring of the debt without reforming how the nations of the eurozone discipline their fiscal affairs just creates a situation in which fiscal irresponsibility can survive into the future.

Revising how the eurozone conducts its fiscal affairs, however, cannot be done overnight. Yet, the financial markets must be given some kind of credible assurances that fiscal discipline will be forthcoming before they will really settle down.

This seems to be the unknown…for the single currency framework will not last without the eurozone achieving some kind of fiscal unity. Is this what Germany is holding out for?

So, is the problem going to be resolved now…or, are we just going through another cycle?

I still am not convinced that the Europeans, at this stage, possess the backbone to do what is necessary!

Oh, and once all these dollars get out into world markets…will they be withdrawn once the “liquidity” crisis is over?

Small Banks Are Getting Smaller

2011-11-30T05:36:00.000-08:00

Check out the Wall Street Journal article “Ax Falls at Smaller Banks.” (http://professional.wsj.com/article/SB10001424052970203764804577060752595022804.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) And, the subtitle to the piece: “Cuts at Lenders as Industry Job Growth Slows: ‘There will Be More to Come.”

This article is right in line with my Monday post “While Small Banks Disappear, Big Banks Get Bigger.” (http://seekingalpha.com/article/310644-while-small-banks-disappear-big-banks-get-bigger)

“Smaller U. S banks and savings institutions are cutting jobs in a sign of a deepening financial industry retrenchment that is shaking firms from Main Street to Wall Street.”

“Banks that cut jobs in the third quarter outnumbered those that added jobs by 605, according to data from the FDIC.”

“Overall, banking industry employment rose slightly in the third quarter due to continued growth at the nation’s biggest banks.”

“Small banks are under especially intense cost pressure because they are as a group less efficient than larger rivals.” And, they cannot achieve the economies of scale that larger banks can experience.

“In the third quarter, about 76 cents of every $1 in revenue at banks with $100 billion or less in assets was consumed by expenses…. At the biggest banks, the figure was 58 cents. The efficiency gap has widened by 50 percent in the past decade.”

Many of the smaller banks just cannot compete in today's environment.

And, the recognition of the industry problems continues to grow as Standard & Poor’s “downgraded some of the world’s largest financial institutions.” (http://dealbook.nytimes.com/2011/11/29/s-p-cuts-ratings-on-big-banks/?ref=business)

The line I like best in this article is “This is confirmation that rating agencies are lagging indicators.” These downgrades should have taken place a long time ago. But, I have written about this many times over the past three years and even suggested how market instruments might be used to provide an “early warning indicator” for the purposes of bank regulation.

The banking industry still has a ways to go to regain its health. Until then, the economic growth of the economy will continue to be mediocre…at best.

European Sovereign Debt Must Be Restructured

2011-11-29T06:25:00.000-08:00

A debt crisis for an organization occurs when either its debt repayment cannot be covered by the cash flow being generated by the organization or the outstanding debt of the organization cannot be reduced sufficiently to reduce the debt repayment needs.

In the case of a governmental organization, the cash flow needed to cover the debt repayment requirements comes from economic growth that is large enough to generate governmental revenues that cover the government’s cash outflow.

Or, the cash needed to reduce the amount of government debt outstanding comes from a cash surplus generated by the government’s prudent fiscal budgets.

If neither of these conditions is met, then the government is insolvent and the debt outstanding must be restructured.

What is so hard to understand?

The growth rate of many countries in the eurozone is exceedingly low or non-existent.

The new budgets being generated in these countries do not reduce deficits sufficiently to reduce their ratio of government debt to Gross Domestic Product.

The current efforts of the effected governments produce a cumulative result that just exacerbates the situation. If the deficits cannot be reduced sufficiently, the debt repayment crises continues which puts greater pressure on governments to reduce budget deficits, and so on, and so on. The experience of the eurozone over the past few years just confirms this dilemma.

This reality pervades the bond markets.

But, this reality is still being evaded by eurozone officials.

A movement to enact a “fiscal union” to go with Europe’s “currency union” cannot correct the current situation without a debt restructuring because it ignores the reality of what the current situation has inherited.

A “fiscal union” can only be achieved if, at the same time, a debt restructuring takes place in those nations that are fiscally insolvent. That is, the resolution of the current problems can only be achieved when the fact of insolvency is dealt with AND some form of a “fiscal union” with sufficient power is put in place.

The past must be dealt with and some hope must be established for the future.

A debt restructuring will be costly because of the impact this restructuring will have on European banks…and other banks and financial institutions throughout the world. Any new “fiscal union” combined with a debt restructuring must include some plans to “backstop” banks. This “backstopping” may spillover into other countries, like the United States and the United Kingdom.

And, all of this will have further negative repercussions on economic growth…in Europe, in the Untied States, and elsewhere.

As Milton Friedman warned, “There is no such thing as a free lunch.” Well, it appears as if the “free lunch” we have been trying to live off of is just about over.

Big Banks Get Bigger While the Smaller Banks Disappear

2011-11-28T06:43:00.000-08:00

The FDIC released data on the state of the banking industry last week. And, we see that the size and number of the bigger banks increase while the size and number of the smaller banks continue to decline.

Let’s look at the number of banks in the United States first. The number of banks in the United States dropped by 61 from June 30 to November 30 leaving only 6,352 banks still in existence. Note that the FDIC closed only 26 banks in the third quarter of 2011.

Over the past 12 months, the number of banks in the banking system dropped by 271 banks.

Obviously, if we focus on just the number of banks that the FDIC closed, we are not getting the whole picture as many unhealthy banks that might eventually be closed are being acquired.

The number of banks on the FDIC’s list of problem banks dropped to 844 on September 30, down from 865 on June 30. So, the number of banks on the problem list dropped by 21, the number of failed banks was 26, and the number of banks leaving the banking system was 61. Seems like more banks went on the problem list than left it in the third quarter of the year. Maybe the statistics on problem banks is not as "jolly" as indicated.

Over the past 12 months, however, the largest bank classification, banks with assets in excess of one billion dollars rose by 10. Banks with less that $100 million in assets declined by 176 over the past year and banks with assets between $100 million and $1.0 billion dropped by 105.

Whereas the average size of banks in these last two categories remained about the same over the past year, the average size of banks over $1.0 billion in rose by $1.5 billion to $22.0 billion.

At the end of September 2011, there were 2,208 banks that were less than $100 million in asset size and these banks represented about 1.0 percent of the assets in the banking industry. On the same date, there were 3,626 banks with assets ranging from $100 million to 1.0 billion, and all of these banks just controlled slightly more than 8.0 percent of the assets in the banking industry.

There were 518 banks in the United States that had assets in excess of $1.0 billion, and these 518 banks controlled 91.0 percent of the assets in the banking industry.

In terms of loans, Net Loans and Leases at the smaller commercial banks declined by almost $8.0 million over the past year, by $2.5 million over the past quarter. The Net Loans and Leases at the middle range of banks dropped by a little less that $50.0 million over the past year and by about $4.0 million over the past quarter.

In the larger banks, Net Loans and Leases increased by more than $70.0 million over the past year and by about $36 million over the past quarter.

The bottom line is that commercial banks with assets totaling less than $1.0 billion continue to produce statistics that cause one to question the health of this segment of the banking industry. In addition, given the decline in total assets in these banks, the sector has not observed a consistent reduction in noncurrent assets (past due loans). That is, there has only been a modest reduction in the average amount of noncurrent assets to total assets over this time period.

Consequently, the larger banks are getting larger and becoming more dominant all the time. And, if one looks at Federal Reserve statistics, the largest 25 domestically chartered banks in the country control about two-thirds of all the assets held by domestically chartered banks. Thus, if the largest 518 banks in the country control 91.0 percent of the banking assets, this means that 493 banks that are larger than $1.0 billion in asset size but are not among the 25 largest, control about 24 percent of the assets.

All the statistics show that the small- to medium-sized banks are really becoming insignificant in the United States banking industry and, given the troubles that many of these banks still face, will become even less significant in the future.

An article in the Monday edition of the Wall Street Journal presents research showing that the health of the banking industry is being questioned by the stock markets. Andrew Atkeson and William Simon write that “The recent volatility in bank stocks is a signal that U. S. banks, large and small, are not as healthy as many analysts assume.” (http://professional.wsj.com/article/SB10001424052970204531404577052493270860130.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“The dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy. Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices is back up to levels seen historically only in advance of these two great crises.”

“This extraordinary volatility is not limited to the stocks of large banks but extend to small and midsize banks as well.”

So much has been written about the condition of the banking industry in Europe. Very little has really been written about the condition of the banking industry in the United States. Investors in the stock market seem to have picked up this concern.

And, I have argued for more than two years now that the major reason that the Federal Reserve has pumped so much money into the banking system is that the United States banking industry has severe problems. And, the fact that banks have held onto these funds as excess reserves and have not loaned them out is an indication of the fact that many of the banks are still not solvent. However, the fact that the Fed has provided so many excess reserves to the banking system has allowed the FDIC to either close banks or approve acquisitions of weak banks as smoothly as possible. The Fed and the FDIC have, so far, prevented any panic from occurring.

However, problems remain.

Deficit Reduction: An Absence of Leadership

2011-11-22T04:07:00.000-08:00

I spend a lot of time writing…and talking…about the credit inflation that has taken place in the United States over the past fifty years. In my mind, this period of credit inflation set the stage for the Great Recession of December 2007 through July 2009. It also set the stage for the debt overhang that burdens the United States economy to this very day. It also will account for the mediocre economic growth that the United States will experience for the next four or five years.

Essentially this credit inflation laid the foundation for all the private sector credit expansion that took place during this fifty-year period and for the financial innovation that dominated the country in the latter part of the last century.

Over the past fifty years, the Gross Public Debt of the United States increased at a compound rate of growth of approximately 8.0 percent. Private debt rose somewhere between a compound rate of 10.0 percent and 15.0 percent.

All of these figures exceed the growth rate of the economy, which averaged a compound rate slightly in excess of 3.0 percent.

When credit growth exceeds the rate at which the economy can grow, that is called “credit inflation.” A good portion of this credit inflation has gone into consumer prices, but even more has gone into asset prices, or, has gone offshore.

The Gross Public Debt stands around $15.0 trillion as of this last October. In just the past three years this figure has grown by about $4.0 trillion.

If this pace is continued, the Gross Public Debt will rise by more than $13.00 trillion over the next ten years, slightly below the forecast I have been putting out for the last year or more, which is $15.0 trillion or more. I have argued that, given current attitudes, the government’s debt outstanding will double in the next ten years.

I feel much more comfortable, at this time, arguing that the debt will double in the next ten years than I do that the debt will increase by only 50.0 percent or 75.0 percent.

I have very little faith, at the present time, that much will be done to divert us from the path that we are on. And, just ten years ago we were experiencing a surplus in the government’s budget.

It comes as no surprise, therefore, that I am not surprised in the breakdown in the deficit talks of the Congressional supercommittee. There is no leadership in Washington to bring about a change in direction. The President’s ability to lead the situation is almost non-existent given the evidence of the recent polling data on support. And, Congress is even less able to lead given that polls on the public’s confidence in it are substantially below that of the President.

The problem, as I see it, is that the leadership style of the President is to state, in general, what he would like…a health care bill, a financial reform act, an increase in the debt ceiling, and a deficit reduction plan…and then turns it over to Congress to come up with a plan.

The Republicans in Congress knows that they will not be punished if they stand up and take a very intransigent position. They have become very direct in this in the last two skirmishes, because they knew that there was no way they would be called out. They learned this from the first events surrounding the development of the health care bill and the financial reform act. The Democrats in Congress have just been left out to “hang”. You really don’t hear anything from them anymore. They know they have the weak hand.

So, I continue to predict that the federal debt outstanding will grow…and grow…and grow.

And, as the debt continues to grow, the value of the dollar will continue to trend downward. Over this time period the debt of the United States government has trended upwards.

Since 1971, when the dollar was taken off the gold standard, the dollar has declined in value by about 33.0 percent. Since 1971, the debt of the government has increased by 39 times. The reason that the dollar has not declined by more is that other countries have followed policies that are similar to those of the United States and the U. S. dollar is still the reserve currency of the world.

As the debt continues to grow, the value of the dollar continues to decline. Here is the chart of the value of the U. S. dollar against other major currencies over the last ten years.

The chart begins near the start of the Bush (43) administration. The two years previous to the beginning of the Bush (43) administration, the federal budget was in surplus. As can be seen, the value of the dollar was about 10.0 percent above the level it was at the time the dollar was removed from the gold standard. As federal deficits rose through the last decade, the value of the dollar continued to decline, reaching historic lows earlier this year.

Thus, I continue to be a pessimist about the ability of the United States government to get its budget under control and I continue to be a pessimist about the future value of the dollar. We cannot expect to see the value of the dollar really get stronger until we achieve some control over our fiscal affairs.

Given this view about the future, I continue to be a pessimist about the ability of the United States to maintain its economic lead on the rest of the world going forward. (See http://seekingalpha.com/article/309054-signs-of-the-future-developed-countries-vs-emerging-countries for more on this.) Right now, that is the environment I believe businesses and investors should prepare for.

How Do You Cover Up Your Failure: the Greek Case

2011-11-21T03:30:00.000-08:00

I believe that Gretchen Morgenson of the New York Times has done investors a big favor in writing her piece for the Sunday morning paper of November 20. This article reveals the extent that officials will go to try and avoid the consequences of when they royally “screw up”! (http://www.nytimes.com/2011/11/20/business/credit-default-swaps-as-a-scare-tactic-in-greece.html?_r=1&ref=business)

The situation: “the debt mess in Europe.”

The event: “bankers are pressing Greece’s bond holders to swallow big losses.”

The intended consequence: “Leading the charge is BNP Paribas, the big French bank, which has been hired by the Greed government to help persuade investors to accept a deal that would cut the value of their investments in half.”

The cover-up: “On paper, this restructuring would be voluntary!”

The reason for this behavior: the Credit Default Swaps that are supposed to cover the losses on a write down like this. “If Greece stops paying after the restructuring (the swaps that investors bought as insurance on the Greek debt) are supposed to cover their losses, much the way homeowners’ insurance would cover a fire.”

The effort: if the restructuring is declared voluntary then the “credit insurance may not pay off down the road, because after the restructuring is completed, the terms of the old debt might be changed.”

Who stands to gain: “BNP which stands to profit from the restructuring.” BNP will “generate fees from the exchange” or is concerned about “its own exposure to Greece. A question being discussed is whether or not “BNP Paribas has written a lot of insurance on Greek debt. If so, getting people to unwind such swaps now would be less costly for BNP than having the insurance pay off.”

Most suspicious, an official of BNP Paribas, Belle Yang, is also on the “powerful” International Swaps and Derivatives Association (I.S.D.A.) “determinations committee” that will decide what constitutes a “credit event” both in Greece and elsewhere in Europe.

When you don’t do your job, things happen. And, when things happen and you deny that things are happening, things get worse. And, when things get worse you sometimes do very stupid things in order to keep avoiding what you really have to do.

Just ask Penn State University officials about this!

Politicians in Europe created too much debt in trying to remain in office by paying off their constituents in order to get re-elected. When financial markets started to complain about the excesses of debt created, European officials claimed that the problems were caused by speculators and other “greedy bastards” that were trying to disrupt things for their own gain. When things got worse, officials claimed that there was a liquidity crisis at hand, not a solvency crisis. And, because it was a liquidity crisis, bailouts could resolve the issue by giving governments enough time to get their budgets in order.

This did not work and when these officials finally came to accept the fact that they might have to deal with the insolvency of their countries, they began working on a “new gimmick” that a default really was not a default…if it were voluntary.

And, if the default was just voluntary then contracts written to insure against a default could not really be collected upon!

That is, the legal contracts that were written to insure parties against default are really worthless!

“If investors think debt terms can be changed by fiat, they will flee the market. Ditto, if they find that their insurance can be made worthless.”

“The discussions with BNP Paribas confirm the view of some investors that credit default swaps are not insurance at all, but rather instruments that big banks use to benefit themselves.”

Hello, Occupy Wall Street!!!

My prediction: “the debt mess in Europe” is not going to be cleared up until people stop lying to themselves and really start to address the issues that are outstanding. The problem with this, as I have written about many times before, is that I see no leaders in Europe that are willing to stand up and really discuss the issues that are outstanding. (See my post: “In Europe the Issue is Leadership,” http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

The sovereign debt problems that Europe faces are problems of solvency. How many times does someone have to say this! Until the officials of Europe address this problem “head on” and really try to “get their hands around it” they will continue to come up with “screwball” ideas like the one that Morgenson writes about in the Sunday NYTimes.

Resolving solvency problems are not easy and I’m sure this is why many European officials “put off” going for a real solution. Solving solvency problems are going to cause a lot of hurt and pain…and will take a lot of time to correct.

Unfortunately, there was a lot of hubris connected with the conceit of many European governments, a conceit that these governments could engineer high rates of employment and a social infrastructure that took care of all ills within a world in which there would be no international repercussions for such excessive and undisciplined behavior.

Unfortunately, there are no “good” solutions to living beyond ones means for an extended period of time. If you “screw up” you finally end up paying for it. And, solving the problem can hurt many, many people.