Deficit Reduction: An Absence of Leadership

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.

Please Listen: The Problem is Too Much Debt

For the past two years or so, my prediction for the cumulative debt of the United States government over the next ten years has been in the $15 to $20 trillion range.  This would more than double the current amount of government debt outstanding.

Since the events of the past few days in Washington, D. C., my prediction for the cumulative debt of the United States government over the next ten years is still in the $15 to $20 trillion range.

The most descriptive characterization of the “debt deal” that I have heard is that Congress (and the President) has just “kicked the can down the road.”

In this, the United States government seems to be in the same league as their “kin” in the eurozone.  One has to look hard to see any evidence of leadership. (See my post http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

As far as the Obama administration is concerned, in my mind, this “team” has observed the creation of three “camels” on its watch.  The first camel was the health care bill.  The second was the Dodd-Frank financial reform bill. (See my post http://seekingalpha.com/article/281090-the-future-of-banking-dodd-frank-at-one-year.)

The third camel is, of course, the just passed “debt deal”. 

The general comment about all three is that at the birth of all three, people were very unhappy with them. 

Never can I remember, except maybe under President Jimmy Carter, a President that exhibited less leadership in such important areas.  President Obama presented no “plan” to Congress in any of these efforts.  People say that the administration was responding to the “health care plan” rebuff experienced by the Clinton administration in the 1990s and wanted to involve Congress more from the start of any legislative attempt.  I believe that this was a gross mis-reading of the events surrounding the Clinton initiative. 

However, this strategy of holding back and letting Congress take the lead in proposing and disposing resulted in something more like chaos or anarchy than leadership.  And, this strategy has produced three camels that nobody really likes. 

And then people worry about jobs and the state of the economy.  How can you create smaller deficits through cuts in government spending without causing further danger to the health of the economy?

It seems like we are in some kind of situation in which everything that is proposed contradicts everything else.  President Obama, after the passage of the “debt deal” stated very clearly, that the issue now becomes one about jobs.  
In fact, the President plans a bus trip in the Midwest the week of August 15 as part of his new jobs push.  Whoopee!

To me, there is only one thing that ties all the different problems we are experiencing together.  It is the fact that there is just too much debt outstanding today…and, this debt load extends throughout the nation (and throughout Europe).  Consumers are still burdened with too much debt.  So are many businesses.  So are state and local governments.  And, so are sovereign nations. 

“Consumer Pullback Slows Recovery,” we read in the Wall Street Journal (http://professional.wsj.com/article/SB10001424053111903520204576483882838360382.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj).  Why are consumers not spending?  They are saving…they are paying back debt…to get their balance sheets in line.  They are not buying homes because of the problems with bankruptcies and foreclosures (http://professional.wsj.com/article/SB10001424053111904292504576482560656266884.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj).

Many businesses are not borrowing because of a decline in their economic value and the increased pressure this puts on the amount of liabilities they are carrying on their balance sheets.  (See my post http://seekingalpha.com/article/279506-debt-deflation-and-the-selling-of-small-businesses.)

And, the state and local governments are also getting headlines about their budget problems.  What about the city in Alabama that is declaring bankruptcy?  And the municipality in Rhode Island?  And, what about the problems in Harrisburg, Pennsylvania?  And, California?  And so on and so on?

This is the scenario called “Debt Deflation”.  Debt deflation occurs after a period of time in which credit inflation has dominated the scene.  Credit inflation eventually reaches a tipping point in which the continued inflation of credit can no longer be sustained.  Once this tipping point is reached, people, businesses, and governments see that they can no longer continue to operate with so much debt and so they begin to reduce the financial leverage on their balance sheets. (See my post http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation.)

This process is called “Debt Deflation” because it is cumulative.  As these economic units begin to reduce their financial leverage, it becomes obvious to them that they must reduce this leverage even further than first imagined.  Whereas “Credit Inflation” is cumulative and leads to people adding more and more debt to their balance sheets, the reverse process is also cumulative.

The only short-term way to avoid this debt deflation from taking place is to create the condition called “hyper-inflation.”  This is exactly what Mr. Bernanke and the Federal Reserve System has tried to do.  I say short-term because all hyper-inflations come to an end sometime.

We have had fifty years of government economic policy based on the Keynesian assumption that fiscal deficits and the consequent credit inflation that results from the deficits are good for employment and the economy.  This assumption has, to me, been disproved given that the compound rate of growth of the economy has averaged only slightly more than 3 percent over the last fifty years, about what was expected in the 1960s, and the amount of under-employment in the economy has gone from less than 10 percent of the workforce in the 1960s to more than 20 percent of the workforce, currently. 

Furthermore, the income/wealth distribution in the country has become more skewed than ever toward the wealthy during this time period.  This is because the wealthy can protect themselves against inflation and even position themselves to take advantage of it.  The less wealthy do not have similar opportunities.  And, in the current situation, some, the more wealthy, are doing fine because they are not as indebted as others and so can continue to prosper during these difficult times of excessive debt burdens.

Getting back to my projections for the cumulative federal deficit over the next ten years and the “debt deal”: I really don’t see a fundamental change in the underlying economic philosophy of the Obama administration (which includes Mr. Bernanke) and/or Congress.  They seem to see the current problems as a “temporary” aberration from the existing “Keynesian” credit inflation philosophy that underlies all that they do.  They seem to believe that once this “period of discomfort” is passed that business will continue on as usual. 

Until this attitude is changed, I see little reason to change my prediction for the cumulative federal deficit over the next ten years.

Washington Going Nowhere: Dollar Hits New Lows

For fifty years, the United States government has followed a policy of credit inflation.  And, I am blaming both parties…the (Keynesian) Democrats and the (“we’re all Keynesians now”—Richard Nixon) Republicans. 

The current discussions going on in Washington, D. C. don’t really give me much hope for the future.  Congress and the White House may talk about reducing deficits now, but both sides of the talks don’t seem to have any idea about creating a sustainable government policy with respect to the creation of federal debt.

As I have reported before, since January 1961, the public debt of the United States has increased at a compound rate of growth in excess of 8 percent per year.  This has resulted in the public debt now being in the neighborhood of $14 trillion. 

Over the past two years, I have argued that in the next ten years, the federal debt will at least double from its current level.  If we cut the deficit by $4 trillion…or $3 trillion…or $2 trillion…figures that have been tossed around in the current debates…we will still add massive amounts to the existing debt levels. 

This amount of debt, I don’t believe, is sustainable even after these cuts. 

Why has the United States government amassed so much debt during this time period?

The reason is that the number one goal of the government’s economic policy has been to achieve high levels of employment…low levels of unemployment.  

As I have written elsewhere, the achievement of this goal is impossible.  And, all the government’s efforts to attain this objective have just resulted in making the employment situation worse.  Not only has the official unemployment rate been greater than the target unemployment rate for this period, the level of under-employment in the United States has risen to the point where about one in five people of working age are underemployed…either unemployed, employed part time but want to be employed full time, or have dropped out of the labor market. 

So, the federal government has followed a policy of credit inflation for fifty years and has not only not achieved its goal but has made the employment situation much worse.

In addition, the policies of the federal government have resulted in a tremendous skewing of the income/wealth distribution in the United States away from those earning the least and in favor of those earning the most.  This was certainly not something desired by the perpetrators of these policies.

Wasn’t there any indication that something was wrong? 

In my view there was some very clear evidence that something was wrong.  The value of the United States dollar against other currencies in the world has been an indicator that investors throughout the world thought that the economic policies of the United States government were not sound and that there was little or no hope that the United States government would re-establish any discipline over its budgeting process.  The feeling was that as long as the United States continued to pursue the effort to achieve full employment, fiscal discipline would be ignored.

My argument is that the United States has followed an explicit policy of credit inflation since the early 1960s.  The period began with the value of the United States dollar pegged against gold.  However, the credit inflation of the 1960s brought this to an end as President Nixon took the dollar off the gold standard on August 15, 1971 and floated the dollar in the foreign exchange market. 

Since then, the trend has been downward.  This is shown in the following chart. 

There are two exceptions to the downward movement in the value of the dollar.  The first is the Volcker monetary tightening coming in the early 1980s which resulting in the short term peak in the value of the dollar in February 1985.  The second is the Rubin fiscal tightening that took place in the late 1990s with the near term peak in the dollar’s value occurring in July of 2002. 

Otherwise we have the following results:

Measured from January 2, 1973, the value of the dollar has declined by around 37 percent to the present;

Measured from the its peak value in February 1985, the value of the dollar has declined by about 54 percent;

Measured from its peak value in July 2002, the value of the dollar has declined by almost 40 percent;

Measured from the “flight to quality” peak value during the recent financial crisis in March 2009, the value of the dollar has declined by over 20 percent.

Although the value of the dollar rose during the first European sovereign debt crisis in 2010, it has declined almost constantly during the most recent problems.

International financial markets don’t think much of the economic policies of the United States government.  And, the basic reason the United States has been able to get away with this total lack of discipline has been that the United States currency is the reserve currency of the world.

Now, I am not one that believes that the budget of the United States government has to be balanced at all times or even over time.  I do believe that fiscal discipline must be established so that credit inflation is kept under control.  Over the past fifty years, the real compound growth rate of the United States has been slightly more than 3 percent.  If the government could constrain its budget so that the public debt and the economy grew at no roughly in line with one another, I think the country could live with that and credit inflation would not be a major problem.

However, I don’t see our current crop of politicians capable of exhibiting such discipline.

The Future of Banking: Dodd-Frank at One Year

Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.    

Bank Re-regulation Forgot to Consider Google and Twitter

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

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

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

We are seeing a concentration on the past in dealing with state and local government problems, problems with pensions, bargaining power, and employment. The law just passed in Michigan giving the state government broader powers to intervene in the finances and governance of struggling municipalities and school districts…” has been fought by those that argue that the law “undermines collective bargaining and threatens to subvert elected local governments.” (http://professional.wsj.com/article/SB10001424052748704360404576206603444375580.html?mod=ITP_pageone_1&mg=reno-wsj.)

Times have changed.

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

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

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

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

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

And, what about debt?

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

And, now people have not really been borrowing. The real question is, should they start borrowing again? I have addressed this in my post “Does Getting Out of Debt Mean that People Should Start Spending More?” (See http://seekingalpha.com/article/257772-does-getting-out-of-debt-mean-people-should-start-spending-more.)

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

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

GET OUT OF DEBT! ALL OF IT!

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

GET OUT OF DEBT!

Pass that message on to Chairman Bernanke.

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

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

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

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

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

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

And, there is more!

But, this is not the point.

The point is: the times have changed!

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

Who has the credit inflation of the last fifty years really helped? The financial industry. And, I have asked the question, who is the “Bernanke Credit Inflation” going to help? This time, will the financial industry just dance alone? (See http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone.)

How Much Should the United States Cut the Deficit?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Real World Lessons of the Obama Administration

There are two things that some of President Obama’s base is finding out. First, you just cannot walk away from war. Before you are “in the office” you can say all you want about ending wars or not getting into wars, but once “you get the seat” just being against war is not a sufficient policy. There are dumb wars and there are smart wars; there are well run wars and there are stupidly run wars; but wars are always present in one way or another. To many of President Obama’s supporters, President Obama is not walking away from war, and they don’t like it!

The second thing is that powerful nations need a healthy business sector. Regardless of how important you feel the role of government is in a society, without a strong economic system that is performing well your government will always be weak relative to other countries that have strong economic systems that are performing well.

I addressed this point from a different perspective in a recent post: see “Emerging Markets and the Future”, http://seekingalpha.com/article/214661-emerging-markets-and-the-future. One can deduce a similar point from Floyd Norris in today’s New York Times, “How to Tell A Nation Is at Risk,” http://www.nytimes.com/2010/07/16/business/economy/16norris.html?_r=1&hp.

Norris writes: “Which governments will not be able to pay their bills?

The ones with private sectors that are not doing well enough to bail out the government.

That should be one lesson of the near default this year of the Greek government. Government finances are important, but in the end it is the private sector that matters most.

If so, those who focus on fiscal policy may be missing important things. Spain appeared to be in fine shape, with government surpluses, before the recession hit. Now Spain is being downgraded and has soaring deficits.”

The take away from these two pieces: You need to have a strong, vibrant capitalistic system in place, even if it is a state driven capitalism like that of China. The exception is those despotic nations that have a monopoly on a natural resource like Venezuela or many of the middle eastern fiefdoms, but these situations have their own problems. Economic weakness and slow growth lead to waning economic power. Check out much of Europe.

Today’s New York Times was filled with signs that the Obama administration was cognizant of the role the business sector must play in the economy in order to ensure its success and continuation. On the front page of the Times we read of the “Obama Victory” with respect to the financial reform package. This is the coin thrown to some of his supporters.

The real news, to me, is on the front page of the business sector in bold headlines: “Cut Back, Banks See a Chance to Grow: Its fight ended, Wall St. Is Already Working Around New Regulations.” (See http://www.nytimes.com/2010/07/16/business/16wall.html?ref=business.)

Funny, but some of this article seems especially like my recent post “Financial Reform: Ho, Hum”, http://seekingalpha.com/article/213263-financial-reform-ho-hum. The authors of the Times article write:

“The ink is not even dry on the new rules for Wall Street, and already, the bankers are a step ahead of everyone else…

So after spending many millions of dollars to lobby against the legislation, bankers are now turning to Plan B: Adapting to the rules and turning them to their advantage."

The Obama administration and those in Congress that wrote the bill had to have enough in the bill to “declare a win” but many are looking at the legislation as just a cost and an inconvenience. Main street must be given something to justify the possibility of re-electing those currently in office. But, Wall Street must be healthy so that the Administration can stand up to China!

Financial institutions spent a lot to keep a lid on Congress and its “spewing into the gulp” and in this respect have been more successful than BP with its oil spill. But, now that the cap is on in terms of the financial reform bill going to the President, it is time to get back to business. And, really, that is what the administration wants as well.

The third important headline on the front page of the business section (the other two articles were there too) is “With Token Settlement, Blankfein Unscathed”, http://www.nytimes.com/2010/07/16/business/16deal.html?ref=business. The New York Times claims that the deal Goldman Sachs reached with the Securities and Exchange Commission was a “Token”…mere pocket change. The people from the S. E. C. declared this to be a victory. What a joke! Well, now we can get back to business!

Just one more piece of information being shared this morning: Treasury Secretary Tim Geithner seems to be very opposed to Elizabeth Warren becoming the head of the new consumer protection agency created by the financial reform package. She is apparently too strong, too emotional of an advocate for the consumer. It seems as if such a person would rock the boat.

The reality of the situation seems to be that the Obama administration needs a strong, rebounding economy. It needs a strong, rebounding economy to not lose much ground in the elections this November. And, it needs a strong, rebounding economy to give the United States more bargaining power in the world.

The United States is still the number one economic and military power in the world. It is just that at this time, with a somewhat weakened economy, room is given to those large emerging nations to be more assertive in world affairs and to gain confidence in their ability to present their positions in world forums. Again, see my post on “Emerging Markets and the Future.”

The Obama administration is walking a narrow line. It cannot afford to lose the support it has been given in the past by the Independent voter and the middle of the political spectrum. And, it cannot afford to be captive of the sovereign wealth funds of the world that control large amounts of financial capital.

In order to achieve these goals, the Obama administration cannot stifle the United States business engine. The issue it now faces is how to support Wall Street and business without appearing to be abandoning Main Street. The danger the administration runs is that in attempting to walk this narrow line, it might not please anybody.

Ho-hum, the Financial Reform Bill is Going to be Passed

Perhaps the most benign statement about the passage of the United States financial reform bill passed by the House of Representatives last week and whose passage is pending in the Senate comes from Richard Bove, banking analyst at Rochdale Securities: The bill, he states, “doesn’t seem to be terribly onerous.” (See “JPMorgan Brushes Aside Bill Concerns,” http://www.ft.com/cms/s/0/24bcbc8c-8858-11df-aade-00144feabdc0.html.)

In terms of the regulation of swaps, especially credit default swaps, “The once-feared swap provision has become toothless.”

The recent debate in Congress over the financial reform bill: A lot of “sound and fury signifying nothing.”

This legislation, the most comprehensive reform of the financial system since the 1930s, seems be passing into the history books with very little fanfare.

Sure, the financial institutions “huffed and puffed” and spent tons of money to fight Congress “every inch of the way.” But, what else did you expect. Perhaps you need to read a good economics book on “Game Theory”.

And, now?

Can’t you hear the executives at the big banks say, under their breath, “Well, the bill is passed, now we need to get back to business. Sure we spent a lot of money that could have gone elsewhere, but that is now history. In terms of where we are going to focus in the future, we just continue doing what we have been doing, finding the best way to do business and to make money. The bill, itself, will cause some inconvenience in some areas, hurt the smaller institutions more than the larger ones, but will not basically change what we are going to be doing.”

The article cited above states it all. JPMorgan acquired a large energy and metals trader last week. How will the financial reform bill impact this deal? After all, “Commodities are among a handful of derivatives still targeted…” by the bill.

The author of the article writes: “Blythe Masters, head of commodities at JPMorgan, said the bank already traded most energy through an affiliate and the law would ‘not substantially’ affect business.”

I have been arguing for months that the large banks had already moved beyond the reach of the regulations being discussed in Congress and that anything enacted by the legislators would be DOA, “dead on arrival.” The large banks started to reform and restructure themselves soon after the fall of 2008 when the financial crisis was at its peak! By the spring of 2009 these banks were well on the way to the future.

Congress, on the other hand, was mired in the past.

JPMorgan, to my mind, is one of the organizations leading us into the future. See, for example, my blog post “Follow the Dimon,” (http://seekingalpha.com/article/212236-follow-the-dimon). But, there are many others that are also out there pushing finance into the future.

Similar discussion are taking place in all areas of the finance field. Just this morning, the Wall Street Journal contained the article “What’s a ‘Prop’ Trader Now?” relating to the proprietary trading that many of the largest financial institutions engage in. (See, http://online.wsj.com/article/SB10001424052748703620604575349161970563670.html?mod=ITP_moneyandinvesting_0&mg=com-wsj.) The article addresses issues like, “What are ‘Prop’ traders?” and “How are banks redefining ‘Prop’ traders?” and “Where are ‘Prop’ traders located within the organization?”

The answers to these questions will help the larger financial institutions “churn out” billions of dollars in profits. Thus, the banks are willing to spend millions of dollars in hiring “the best and the brightest” lawyers and financial experts to come up with the answers. Congress is just not capable of matching the resources available to these publically-traded firms and so will lag behind what is going on in the private sector. To me, the information “gap” between the public sector and the private sector has never been larger.

The problem is that Congress is attempting to achieve “outcomes”. They want to keep banks from becoming “too big to fail” and to keep banks from taking on too much risk. Historically, we see that laws and regulations that seek “outcomes” are bound to fail because, specifying “outcomes” tells those being regulated what they have to “get around”, what they have to “evade.”

In this Age of Information, it has become exceedingly easy to “get around” laws and regulations and “evade” the restrictions imposed by the legislators and regulators. (See the series of posts I began on January 25, 2010, “Financial Regulation in the Information Age”: http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.)

Laws and regulations work better when they are aimed at processes, the way that the regulated firms do business. These kinds of rules and regulations have to do with information flow (corporate disclosure and transparency), how trades are made, how trades are constructed, margin requirements, and so forth. One can see successful examples of “process” oversight in the creation of the Financial Futures Market and the Options Market in the latter part of the 20th century.

A proposal for overseeing the assumption of risk by financial institutions has been put forward by Oliver Hart, an economics professor at Harvard, and Luigi Zingales, an economics professor at the University of Chicago, in the Spring 2010 copy of National Affairs, titled “Curbing Risk on Wall Street,” (http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street). I have threatened several times to present a critique of this proposal in one of my posts. Hopefully, I will accomplish this soon for the Hart/Zingales proposal, I believe, offers a lot for people to consider.

So, the world goes on. The financial reform package will be passed. Banking and finance will continue to thrive. Big banks will get bigger and there will be fewer and fewer small banks. Hedge funds and venture capital funds will, in general, continue to do what they do well. And, sometime in the future there will be another financial crisis.

Things are not different.

End note: for a “good read” check the lead article in the business section of the New York Times on Sunday about Ken Rogoff and Carman Reinhart and their book “This Time Is Different”: http://www.nytimes.com/2010/07/04/business/economy/04econ.html?_r=1&scp=1&sq=ken%20rogoff%20and%20carmen%20reinhart&st=cse.

I Beat You By 200 Milliseconds, So Sue Me!

The future of finance is wrapped up in information technology. First because the technology deals with information and secondly because the technology is rapidly improving, even as I write this sentence.

In lectures I have given around the country on how information technology is going to impact the future I tell my audiences to keep their eyes on two groups of people and what they are doing with computers. First, check out what large governments, like the United States are doing about computers, because in order to keep their position in the world they must continue to be better than anyone else at killing people.

The first modern computer, the Eniac, was funded by the government in order to be able to better track the flight of artillery shells so that the army could be more accurate in hitting their targets. The Quantum Computer is going to be built because the government must be able to keep secrets and Quantum Computers are so fast that current coding systems are inadequate relative to the speed at which these new computers will be able to calculate. Also, these computers will be so fast that the ability to attack targets far away and the ability to simulate battles before they happen will be an overwhelming tool for the military. Obviously, America cannot afford to be second in the race to build the Quantum Computer.

Second, I suggested, watch what the kids are doing. If you want to know what is going to be “ubiquitous” in a few years, check out what that eight year old in your family is doing with electronic gadgets. And, by-the-way, in terms of stimulating battles and what kids are doing, read “Ender’s Game” by Orson Scott Card. In this book, a set of children are being trained to repeal an invasion of earth. The invasion is simulated by computer games with “faster than light” communications. After much practice, another game takes place. However, as we learn, it is an actual invasion and the only thing protecting the earth is these kids!

Great book…you should read it if you haven’t already read it. Actually, put “Ender’s Game” on your bookshelf right there along with “The Quants”! (See my review: 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 important thing, however, is that this book is hugely popular, it is what young people are familiar with, and it presents a picture of what they believe the technology of the future will be like. And, the book was written in 1985!

What does this have to do with finance?

The Wall Street Journal this morning contains the article “Fast Traders’ New Edge.” (See http://online.wsj.com/article/SB10001424052748703340904575285002267286386.html#mod=todays_us_money_and_investing.) “Some fast-moving computer driven investment firms are getting an edge by trading on market data before it gets to other investors…The firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers.” Although these moves may only produce pennies, if one multiplies the pennies by thousands of trades, “big profits” can be made.

“The ability to estimate price moves ahead of the national best bid and offer price can give traders an advantage of about 100 to 200 milliseconds over investors who use standard market tools.”

This practice is called “latency arbitrage” and, of course, those investors that are not into it at the present time are searching for ways to protect themselves. Of course, the first thing you do is see whether or not you can compete electronically. Obviously, if you can’t compete electronically then you ask for regulation.

But, this is the world of the future. This is “Ender’s Game” only it is beyond the simulation exercises, it is the real thing. It is also a part of that netherworld that includes high frequency trading and dark pools.

My point is that advancements in computer technology are not going to slow down. If anything, these advancements will speed up. And, with the possibility that Quantum Computers will become a reality within the next decade or so the ‘speed up’ will tend to be exponential and not linear. Furthermore, the generations that will follow us expect this ‘speed up’ to happen and will look on these capabilities as just another part of their ‘normal’ lives.

If we do not comprehend this future, if our elected officials and regulators do not comprehend this future, then we will not be prepared for the economic and financial systems that are on the horizon. Hence, we will all make mistakes.

The “Quants” made mistakes this last time around. But, they are alive and well, and, I believe that it is a very safe bet to say that they have learned from their mistakes and have already modified their systems to take advantage of the most recent information available to them. Many “Quants” are trained in Information Theory, the study of the messages that are contained in strings of data, even though these strings may seem to be random in nature. Their systems are now more robust than they ever were in the past.

This is how humans become better decision makers. They adapt their models and systems so that they can make better predictions of the future in order to make better decisions or solve more difficult problems. This process is part of being a human and humans will not cease to put it into practice.

The discussion so far has been at the “top of the pyramid,” so to speak. But what about the “bottom of the pyramid”? How is technology playing out there?

This morning there appeared in the Financial Times a description of how banks in the South African Township of Tembisa are using mobile phones to develop their customer base. (See “Banks find potential in mobile phone growth,” http://www.ft.com/cms/s/0/0f6fad92-6f28-11df-9f43-00144feabdc0.html.) Banks have changed over the past decade because “as the spending power of low-income groups increases, more and more banks are competing for the business of the 15m adult South Africans who had previously been excluded from the financial system.” And they are using information technology to do it!

And, the players are not small. “In South Africa, Capitec and African Bank pioneered the drive…” and Vodafone, the British telecoms company, “launched one of the most celebrated mobile banking initiatives.” “Instead of opening an expensive branch network, many of these new operations work with agents such as shops or bars.” Mainstream banks are following suit.

This is not the only technological initiative taking place at the “local level” in the world. Electronic finance is here to stay and it is spreading further and further into previously under-served communities every day. Remember, finance is really nothing more than information and the exchange of information.

So the Obama administration, Congress, and the regulators in Washington (and politicians and regulators in the rest of the world) are attempting to prevent the last financial collapse from happening again.

Should I smile…or giggle…or break out in laughter?

Hotshot Traders Leave Street

Jenny Strasburg captures the mood on Wall Street in her article in the Wall Street Journal this morning: http://online.wsj.com/article/SB20001424052748704515704575282982462922628.html#mod=todays_us_money_and_investing.
“The competition is on to scoop up Wall Street traders and portfolio managers increasingly unnerved by the likelihood of sweeping new financial regulation.

Since political momentum began building earlier this year to limit trading for profit at Wall Street firms, traders have been exploring their options, and some have already left. Outside the banks, private investment funds looking for traders have been gearing up for a hot talent market.”

Economics works!

You change the incentives and people change…people move.

With the situation being more mobile than ever, with the technology more available and adaptable than ever, with the future more uncertain than ever…people…and the system…can change more rapidly and in more different directions than ever before.

And, that is what is happening!

This is one thing that Congress (and others) can’t seem to understand. Even after observing fifty years of the most dramatic financial innovation that has ever taken place in the world, the members of Congress seem to believe that they can “freeze” things, return to the past, and prevent the recent financial crisis from ever occurring again.

They also seem to think that the government is blameless from creating any incentives that might have a derogatory impact on the future that they want to create.

People in the Obama administration, as well as members of Congress, seem oblivious to the fact that over the last fifty years the United States government, Republicans and Democrats alike, produced a fiscal environment that created the incentives that led to a burst of innovative activity in the financial sector that produced massive changes in the way people did business and in the composition of the American economy. A brief picture of the environment.

From January 1961 through January 2009, the Gross Federal Debt of the United States rose at a compound annual rate of 7.7%. The monetized portion of the federal debt, the monetary base, rose at a compound rate of about 6.5% from January 1961 through August 2008, just before the Federal Reserve’s balance sheet exploded in response to the financial crisis that took place in the fall of 2008. The M2 money stock grew by more than a compound rate of 7.0% during the time period under review.

Thus, money and credit variables grew relatively in line with one another. Real GDP growth during this time was about a 3.4% compound rate of increase every year.

Prices, as measured by the Consumer Price Index and the GDP implicit price deflator, increased at a compound rate of about 4% during this time period resulting in a decline in the purchasing power of the dollar by around 85%. A 1961 dollar bill could only buy 15 cents worth of goods in 2008!

Inflation breeds financial innovation and the late 20th century with its relatively moderate, yet steady increase in prices, was a perfect environment for financial innovation!

The leader in financial innovation was the federal government itself, confirming what Niall Ferguson argues in his wonderful book, “The Ascent of Money: A Financial History of the World.” Ferguson claims that governments, historically, have been the primary financial innovator because of the need to fight wars. This, he continues, spilled over into the 20th century as governments needed to expand deficit financing to incorporate spending on social programs.

My guess is that in the next five to ten years we will see the biggest change in finance that we have ever seen and this change will be worldwide. I have written a little on this in a recent blog: “Changes Continue to Shakeup the Banking System”. See http://seekingalpha.com/article/200475-changes-continue-to-shake-up-the-banking-system.

The largest twenty-five banks in the United States, who control about two-thirds of U. S. banking assets in the country, are already changing their business. Again, they have already moved beyond what Congress and the administration are doing to regulate the banking system.

More important, foreign banks are changing the banking picture in the United States. Currently, foreign branches control about 11% of the total banking assets in the country. I have already stated that this will increase to 15% to 20% over the next five years or so. We see this expansion taking place before our eyes. Yesterday “China Finds a New Market for Loans: U. S.” (See http://online.wsj.com/article/SB10001424052748703957604575273011917977450.html#mod=todays_us_money_and_investing.) Today, “China Bank IPO, Possibly Biggest Ever, Set for July.” (See http://online.wsj.com/article/SB20001424052748704875604575281690877047522.html#mod=todays_us_money_and_investing.) And, don’t forget the sovereign wealth funds, huge accumulators of money.

The world of finance is changing because the incentives affecting finance are changing all over the world. I can’t even imagine what this world will look like with instantaneous trading, further ‘slicing and dicing’ of cash flows and other financial information, greater use of information theory to detect trading patterns (see my book review of “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), and more and more information markets popping up around the world (see Robert Shiller’s book “The New Financial Order: Risk in the 21st Century”)!

In the field of Complexity Theory, researchers speak of times like this when systems go through the process they call “Emergence” and “Self-Organization.” It is during times like these that one structural system is transitioning into another structural system. The problem is that no one, before-the-fact, can predict how existing information systems combine with other information to produce the resulting system. Systems just “self-organize” and a new system “emerges” from what was formerly un-organized.

This appears to be what is happening now. The movement of “hotshot” traders is one piece of evidence of this. The restructuring of the big banks is another piece of evidence. The response of hedge funds to the Congressional threat to change how partners are paid is evidence of this. The changes in financial regulations around the world is evidence of this. The growth and increased aggressiveness of Chinese banks is evidence of this. And, so on and so forth.

Congress is just speeding this change along. However, they better be careful about what they wish for because my best guess is that what they get will be nothing like what they are planning for.

The "Sound and Fury" of Banking Reform

Well, the Senate finally passed a banking reform bill. It is said that President Obama wants to sign the final bill around July 4.

All I can really say about the bill is that it represents a lot of “sound and fury signifying nothing.”

The bill will be costly. The bill will result in a lot of inconvenience.

But, banking and finance will recover and will continue on their merry old way!

The reason that I say this is that finance is just information and with the accelerating pace of information technology in the United States and the world, finance will continue to expand and prosper. The regulators cannot control how information is used or transformed!

History has shown that information spreads and although the pace of its spread can be slowed down, it has never been stopped. Just ask all the religious medievalists in our world today that are fighting a losing battle and are defensively striking out at everyone else.

I have stated some of the reasons for my position in a series of posts beginning January 25, 2010: see “Financial Regulation in the Information Age”; http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.

I have also highlighted the place of information in the practice of modern finance in my review of the book “The Quants”: see 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.

Furthermore, attempts to reform and re-regulate the banking system will ultimately do more damage to banks that are not among the 25 largest banks in the country than it will do to those banks that the administration and Congress are really after. And remember, the largest 25 domestically chartered commercial banks in the United States control about two-thirds of the banking assets in the country.

Another factor that I have tried to stress over the past year is that the largest banks have already moved on. The legislation in front of the Congress is aimed at preventing the last financial crisis from occurring again. In my estimation, the largest banks are beyond this feeble effort and are moving into areas we will learn about in the next round of “popular” books explaining what has happened to our financial system.

An example of this was a recent report in the press about how Congress is trying to alter the status of how hedge funds reward their managements so that more of this income is taxable. The response of the industry was to have already hired scores of lawyers to “get around” any legislation about hedge fund fees.

Can you imagine any other kind of response from the financial industry…or, for that matter, any industry?

Reform and re-regulation face a moving target and, consequently, they are aiming their efforts at the past, not the future.

The financial reform package will change the playing field for a limited amount of time. However, in this age of information you can bet that the lag between what “the Feds” do now and how the financial system reacts to these actions will be shorter than ever before.

NOTE: we now have 775 commercial banks on the list of “problem banks” put out by the FDIC, up from 702 banks at the end of 2009. When this latter list was presented, I argued that the FDIC would close between three and four banks a week for the next 12 to 18 months. We have been averaging 3.8 banks closed every week this year through May 14. Using a rough “rule of thumb” my estimate now is that at least four banks will be closed every week through the end of 2011.

I still have grave concerns about the solvency of the 8,000 “smaller banks” in the United States. I define the “smaller banks” as any bank below the top 25 largest banks in the country. These 8,000 “smaller banks” control only one-third of bank assets in the United States. I derive this concern from the actions of the Federal Reserve who continues to subsidize the banking system with extremely low interest rates, and the FDIC. Although the Fed and the FDIC are not “owning up” to this problem, everything they are doing raises questions about how solvent these smaller 8,000 banks really are. I guess the big issue concerns what would happen to the value of bank assets IF interest rates were to rise. Would this result in a “cascade” of “small” bank failures?