I read Martin Wolf’s column in the Financial Times this morning and was taken aback by what I read there. (See “Why America is going to win the global currency battle”: http://www.ft.com/cms/s/0/fe45eeb2-d644-11df-81f0-00144feabdc0.html.)
Here are two quotes:
“There is no limit to the dollars the Federal Reserve can create”;
and,
“In short, US policymakers will do whatever is required to avoid deflation. Indeed, the Fed will keep going until the US is satisfactorily reflated. What that effort does to the rest of the world is not its concern.”
In other words, “the US must win” the currency wars!
This sounds something like the fundamentalist preacher Paul Krugman who, seemingly, will never see a federal government deficit that is big enough to satisfy his tastes.
This argument is countered by Allan Meltzer, a historian of the Federal Reserve System.
“The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes.” (See “The Fed Compounds Its Mistakes,” http://professional.wsj.com/article/SB10001424052748704696304575538532260290528.html?mod=ITP_opinion_0&mg=reno-wsj.)
“We don’t have a monetary problem, we have 1 trillion or more in excess reserves so it’s literally stupid to say we’re going to add another trillion to that.” (This can be found at http://www.bloomberg.com/news/2010-10-12/further-fed-easing-could-alarm-bond-market-hawks-historian-meltzer-says.html.)
Meltzer argues that the end to this will come through the marketplace. He states in the Wall Street Journal article:
“The market’s response to the talk about renewed bond purchases includes a 12% or 13% decline in the value of the dollar against the euro. This depreciation occurred despite a weak euro, beset by potential crises in Ireland, Greece and Spain. The dollar’s decline is a strong market vote of no confidence in the proposed policy.”
And in the Bloomberg article
“Sooner or later the bond market hawks are going to say, ‘How are they going to get rid of that $2 trillion of excess reserves?’ and the answer is they don’t know.”
The question is, in my mind, how long can the Washington policymakers hold out against the pressure of the international investment community?
In my professional experience…the international investment community always wins…it is just a matter of time!
I know that Robert Rubin is not much in favor these days, but I still believe that he was absolutely correct as the Secretary of the Treasury in the Clinton administration when he argued that the United States could not continue to create large fiscal deficits because the bond markets would not continue to support government debt issues if the deficits were continued.
President Clinton accepted Rubin’s arguments and moved to reduce the budget deficits. The result was a decline in United States interest rates and a huge run-up in the value of the United States dollar.
Rubin sensed the threat the bond market and the foreign exchange market represented to the ability of the United States government to continue along in an un-disciplined fashion.
I see no one in the United States government now that accepts the conclusion of the foreign exchange market.
My experience in business, both in running financial as well as non-financial companies, is that one ignores what the market is trying to tell you at enormous expense. I don’t know how many chairmen, presidents, and CEOs I have heard that claim that “the market just doesn’t understand what we are doing.”
Guess what?
The market does understand what you are doing and that is why it is moving against you.
I find it scary for someone to say,
“There is no limit to the dollars the Federal Reserve can create”;
and,
“What that effort does to the rest of the world is not its concern.”
The voices of the dogmatists are getting “shrill” now. The world is not behaving according to their model. Let’s just hope that a government that does not see things going its way does not do anything rash out of desperation.
The recovery is taking place. However, it is taking place at a much slower pace than anyone wants. Maybe, just maybe, the healing needs to take its time so that a solid recovery can be attained. Quick fixes may do more damage to the patient over time than making sure that the recovery really heals the illness.
Showing posts with label Martin Wolf. Show all posts
Showing posts with label Martin Wolf. Show all posts
Wednesday, October 13, 2010
Wednesday, September 22, 2010
The Long View of China
“Spend enough time with Chinese officials and economists, and you will hear a story about the Japanese yen in the 1980s.” So writes David Leonhardt in “The Long View of China’s Currency” (http://www.nytimes.com/2010/09/22/business/global/22leonhardt.html?ref=business).
A few years ago, I heard something similar, only it went like this, “Spend enough time with Chinese officials and economists and you will hear a story about Russia opening up its economy and suffering large bouts of social chaos.” Here the fear on the part of the Chinese was that opening the economy up too quickly could bring on social unrest similar to that observed in Russia, when Russia began to open up its economy.
One of the best insights given to me has been the one a friend of mine gave about the future of China. He said, “The Chinese believes that they need to move in the direction of a more capitalistic society. They also believe that moving too quickly in this direction could result in societal disruption that could derail their efforts. Furthermore, the Chinese think in decades whereas Americans think within a two- to four-year horizon. Consequently, Americans will become very impatient with what the Chinese are doing.”
Just a side note: Martin Wolf, in explaining how China is achieving its remarkable growth, makes the statement that, China “is, in a sense, the most ‘capitalist’ economy ever.” This is because it is putting so much emphasis upon investment to achieve a 8-10 percent a year growth rate. However, this is a pretty dramatic generalization. (See Wolf’s column, “How china must change if it is to sustain its ascent,” http://www.nytimes.com/2010/09/22/business/global/22leonhardt.html?ref=business.)
Leonhardt makes two important points I would like to give my on. First, he writes that China and the United States aren’t the only two countries in the world producing products. But, “The entire value of the product counts toward the trade deficit between the United States and China.”
China is making itself felt in many, many parts of the world. Again, we see the article this morning, “Chinese Business Gains Foothold in Eastern Europe,” (http://www.nytimes.com/2010/09/22/business/global/22chinaeast.html?ref=todayspaper). And, we are constantly hearing about the initiatives of China in South America, and Africa, and the Middle East. And, this doesn’t fully capture the advances of the Chinese Sovereign Wealth Fund that is even buying physical assets in the United States.
China has a long term plan to obtain supply sources and build influence throughout the world. They are doing this quietly, peacefully, and continuously.
The United States is mired in the current value of the renminbi and the current trade deficit. In the meantime, the strength of the United States economy continues to slide. There have been numerous assessments recently about where the United States stands in the world economy and they have not been very favorable to the relative strength of America’s economic performance.
One of the standard arguments for a rise in the value of a nation’s currency, or, a decline in the value of a nation’s currency is that such movement will correct trade imbalances. This is only true if the relative quality of the goods produced by the countries remains the same.
The international investment community has been especially concerned about the performance of the United States economy and the economic philosophy of the United States government since the 1980s. This concern has been reflected in the continued secular weakness of the United States dollar (see my post “The Dollar and the Fed,” http://seekingalpha.com/article/226286-the-dollar-and-the-fed).
The decline in the value of the United States dollar will not automatically correct America’s trade balance problems. The problems go much deeper.
And, this gets me to Leonhardt’s second point: we should not “view the exchange rate as a cure-all” because “economies, like battleships tend to turn slowly.”
China will continue to maintain a long-term view of where it is going. The United States will continue to focus on the short-term. As a consequence, the specifics of United States policy will vary this way and then it will vary that way, attempting to maintain high levels of economic growth and high levels of employment. The thing we have learned over the past fifty years is that such a short-run focus eventually fails to achieve either higher levels of economic growth or high levels of employment. Such policies have led to one out of every four individuals of employment age being under-employed, the capacity utilization of American industry hovering under 80%, and continued growth in income inequality.
Business is in a “funk” right now concerning the future. Uncertainty about future economic policy is high. Few people place much confidence in where the Obama administration is going policy-wise and even more people have much confidence that the Federal Reserve knows what it is doing.
The Chinese have taken the road to economic power that Germany, Japan, and the United States have taken in the past. This path relies upon becoming an exporter and reaping the advancements that come from successfully becoming an important part of world trade. Now comes the hard part, building up “a thriving domestic economy. Leonhardt argues that China is now moving slowly to achieve this.
My belief is that the Chinese will continue to travel along this path. Some of the bumps along the road, however, are going to come from sources like the United States that have created their own problems and now want others, like the Chinese, to bail them out from the weaknesses they have created for themselves. This situation will not change until the United States stops pointing fingers at others and takes a very hard look at itself.
A few years ago, I heard something similar, only it went like this, “Spend enough time with Chinese officials and economists and you will hear a story about Russia opening up its economy and suffering large bouts of social chaos.” Here the fear on the part of the Chinese was that opening the economy up too quickly could bring on social unrest similar to that observed in Russia, when Russia began to open up its economy.
One of the best insights given to me has been the one a friend of mine gave about the future of China. He said, “The Chinese believes that they need to move in the direction of a more capitalistic society. They also believe that moving too quickly in this direction could result in societal disruption that could derail their efforts. Furthermore, the Chinese think in decades whereas Americans think within a two- to four-year horizon. Consequently, Americans will become very impatient with what the Chinese are doing.”
Just a side note: Martin Wolf, in explaining how China is achieving its remarkable growth, makes the statement that, China “is, in a sense, the most ‘capitalist’ economy ever.” This is because it is putting so much emphasis upon investment to achieve a 8-10 percent a year growth rate. However, this is a pretty dramatic generalization. (See Wolf’s column, “How china must change if it is to sustain its ascent,” http://www.nytimes.com/2010/09/22/business/global/22leonhardt.html?ref=business.)
Leonhardt makes two important points I would like to give my on. First, he writes that China and the United States aren’t the only two countries in the world producing products. But, “The entire value of the product counts toward the trade deficit between the United States and China.”
China is making itself felt in many, many parts of the world. Again, we see the article this morning, “Chinese Business Gains Foothold in Eastern Europe,” (http://www.nytimes.com/2010/09/22/business/global/22chinaeast.html?ref=todayspaper). And, we are constantly hearing about the initiatives of China in South America, and Africa, and the Middle East. And, this doesn’t fully capture the advances of the Chinese Sovereign Wealth Fund that is even buying physical assets in the United States.
China has a long term plan to obtain supply sources and build influence throughout the world. They are doing this quietly, peacefully, and continuously.
The United States is mired in the current value of the renminbi and the current trade deficit. In the meantime, the strength of the United States economy continues to slide. There have been numerous assessments recently about where the United States stands in the world economy and they have not been very favorable to the relative strength of America’s economic performance.
One of the standard arguments for a rise in the value of a nation’s currency, or, a decline in the value of a nation’s currency is that such movement will correct trade imbalances. This is only true if the relative quality of the goods produced by the countries remains the same.
The international investment community has been especially concerned about the performance of the United States economy and the economic philosophy of the United States government since the 1980s. This concern has been reflected in the continued secular weakness of the United States dollar (see my post “The Dollar and the Fed,” http://seekingalpha.com/article/226286-the-dollar-and-the-fed).
The decline in the value of the United States dollar will not automatically correct America’s trade balance problems. The problems go much deeper.
And, this gets me to Leonhardt’s second point: we should not “view the exchange rate as a cure-all” because “economies, like battleships tend to turn slowly.”
China will continue to maintain a long-term view of where it is going. The United States will continue to focus on the short-term. As a consequence, the specifics of United States policy will vary this way and then it will vary that way, attempting to maintain high levels of economic growth and high levels of employment. The thing we have learned over the past fifty years is that such a short-run focus eventually fails to achieve either higher levels of economic growth or high levels of employment. Such policies have led to one out of every four individuals of employment age being under-employed, the capacity utilization of American industry hovering under 80%, and continued growth in income inequality.
Business is in a “funk” right now concerning the future. Uncertainty about future economic policy is high. Few people place much confidence in where the Obama administration is going policy-wise and even more people have much confidence that the Federal Reserve knows what it is doing.
The Chinese have taken the road to economic power that Germany, Japan, and the United States have taken in the past. This path relies upon becoming an exporter and reaping the advancements that come from successfully becoming an important part of world trade. Now comes the hard part, building up “a thriving domestic economy. Leonhardt argues that China is now moving slowly to achieve this.
My belief is that the Chinese will continue to travel along this path. Some of the bumps along the road, however, are going to come from sources like the United States that have created their own problems and now want others, like the Chinese, to bail them out from the weaknesses they have created for themselves. This situation will not change until the United States stops pointing fingers at others and takes a very hard look at itself.
Thursday, October 29, 2009
More Talk About Credit Bubbles
Bloomberg put up a headline this morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says”, http://www.bloomberg.com/apps/news?pid=20601110&sid=a.YErMIwMYKA. Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”
We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.
“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”
“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”
According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.
Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.
How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?
In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.
Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)
Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.
According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.
A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)
Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.
Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”
This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.
Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.
We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.
“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”
“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”
According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.
Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.
How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?
In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.
Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)
Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.
According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.
A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)
Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.
Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”
This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.
Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.
Friday, October 23, 2009
Breaking up the Banks?
Mervyn King, Governor of the Bank of England, gave a speech the other night and set off somewhat of a storm…at least across the pond. It is a discussion that needs to be heard here in America. (For a full text of the speech: http://www.bankofengland.co.uk/publications/speeches/2009/speech406.pdf.)
Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see http://www.ft.com/cms/s/0/7056b56a-bda8-11de-9f6a-00144feab49a.html.
Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see http://www.ft.com/cms/s/0/0a8a6362-bf3d-11de-a696-00144feab49a.html). Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.
I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.
In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.
The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.
In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.
The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.
Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.
What changed?
Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.
This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!
Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.
Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.
Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.
As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.
The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!
Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.
Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see http://www.ft.com/cms/s/0/7056b56a-bda8-11de-9f6a-00144feab49a.html.
Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see http://www.ft.com/cms/s/0/0a8a6362-bf3d-11de-a696-00144feab49a.html). Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.
I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.
In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.
The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.
In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.
The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.
Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.
What changed?
Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.
This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!
Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.
Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.
Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.
As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.
The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!
Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.
Wednesday, October 14, 2009
A Word on the Dollar from Mr. Wolf
Another commentary on the state of the dollar, well worth reading, is that written by Martin Wolf and presented by the Financial Times this morning (see “The Rumours of the Dollar’s Death are Much Exaggerated”: http://www.ft.com/cms/s/0/9165b8b0-b82a-11de-8ca9-00144feab49a.html.)
Wolf begins by stating that “It is the season of dollar panic.” He then specifically lists two, gold bugs and fiscal hawks that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”
I presume that Mr. Wolf would classify me as a “fiscal hawk”, but I do not believe that “Hyperinflationary collapse is in store.”
I do believe that the dollar will remain weak as long as the fiscal stance of the United States government remains as it is, so that the trend in the value of the dollar will continue to be downward. I do not believe that a “hyperinflationary collapse” is imminent.
The reason I believe that this will be the case is that the international investment community will continue to be on the sell side of the dollar as long as the United States government continues to run the size of deficits that it is now running and has no credible plan to bring future deficits under control.
I believe this for the same reason that was stated by Robert Altman, former deputy US Treasury secretary, in his commentary in the Financial Times yesterday (see “How to Avoid Greenback Grief”: http://www.ft.com/cms/s/0/8bdc802e-b675-11de-8a28-00144feab49a.html.) Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies.
And, this response on the part of international investors was a common thread in the latter part of the 20th century. France, as well as a dozen or more other countries can provide similar stories.
And Altman argues that “the dismal (US) deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”
I support Wolf’s reading of the recent decline in the value of the dollar. He states: “In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar's fall is a symptom of success, not of failure.”
Note, however, Wolf’s statement, I believe, that the mother, the United States, “did so much to cause the crisis” through “her mistakes” needs to be clarified. What he doesn’t say is that United States monetary and fiscal policy contributed a decline in the value of the United States dollar of about 40 per cent ending in July 2008! I agree with Wolf that the jump of 20 percent came about due to the fact that “In the recent panic the children ran to their mother.”
The subsequent decline in the value of the dollar, in a perverse way, is therefore “a symptom of success” because through the actions of the United States government (as well as many other governments throughout the world) the financial panic ended and so “failure” was avoided.
To me, the return to a declining value for the dollar is nothing more than a return to the pre-crisis situation in which the world investment community is concerned with the huge deficits being produced by the United States government and the fact that there is really no credible scenario being presented by the leaders of the government that these will be in any way reduced in the future. The connected concern with this fact is that, historically, governments cannot contain the underwriting of these deficits by the nation’s central bank over the longer haul. It’s not the fact that the international investment community sees hyperinflation coming down the path, just that historically the evidence is not in place to have a strong belief that an independent monetary authority will be able to offset the substantial increases in debt that are forecast.
I also agree with Mr. Wolf’s assessment that nothing, at the present, can replace the dollar. Whereas I don’t have the space in this post to go into the very cogent discussions that are presented by Mr. Wolf on this issue, I can come out where he does, without having travelled exactly the same road that he has followed.
I believe that over time the global role of the dollar will lessen. I believe with Mr. Wolf that “the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong.” I agree that the reason that a different role for the dollar is needed is because the current role “impairs domestic and global stability.”
I would just like us to get to this new system by a different path than that proposed by Mr. Wolf or by his colleague at the Financial Times, Gideon Rachman (see my post of October 6, 2009: “The G20: Time for a US Attitude Adjustment”: http://seekingalpha.com/article/165088-the-g20-time-for-a-u-s-attitude-adjustment.)
The world has changed and will continue to change. The United States and the United States dollar will continue to be powerful; they just will not be as relatively powerful in the future as they have been in the past. This has to be taken into consideration by the United States government as it goes forward, but the new system must not be negotiated with the United States government reeling and in a defensive position from continued pressure on the value of its currency.
Wolf begins by stating that “It is the season of dollar panic.” He then specifically lists two, gold bugs and fiscal hawks that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”
I presume that Mr. Wolf would classify me as a “fiscal hawk”, but I do not believe that “Hyperinflationary collapse is in store.”
I do believe that the dollar will remain weak as long as the fiscal stance of the United States government remains as it is, so that the trend in the value of the dollar will continue to be downward. I do not believe that a “hyperinflationary collapse” is imminent.
The reason I believe that this will be the case is that the international investment community will continue to be on the sell side of the dollar as long as the United States government continues to run the size of deficits that it is now running and has no credible plan to bring future deficits under control.
I believe this for the same reason that was stated by Robert Altman, former deputy US Treasury secretary, in his commentary in the Financial Times yesterday (see “How to Avoid Greenback Grief”: http://www.ft.com/cms/s/0/8bdc802e-b675-11de-8a28-00144feab49a.html.) Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies.
And, this response on the part of international investors was a common thread in the latter part of the 20th century. France, as well as a dozen or more other countries can provide similar stories.
And Altman argues that “the dismal (US) deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”
I support Wolf’s reading of the recent decline in the value of the dollar. He states: “In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar's fall is a symptom of success, not of failure.”
Note, however, Wolf’s statement, I believe, that the mother, the United States, “did so much to cause the crisis” through “her mistakes” needs to be clarified. What he doesn’t say is that United States monetary and fiscal policy contributed a decline in the value of the United States dollar of about 40 per cent ending in July 2008! I agree with Wolf that the jump of 20 percent came about due to the fact that “In the recent panic the children ran to their mother.”
The subsequent decline in the value of the dollar, in a perverse way, is therefore “a symptom of success” because through the actions of the United States government (as well as many other governments throughout the world) the financial panic ended and so “failure” was avoided.
To me, the return to a declining value for the dollar is nothing more than a return to the pre-crisis situation in which the world investment community is concerned with the huge deficits being produced by the United States government and the fact that there is really no credible scenario being presented by the leaders of the government that these will be in any way reduced in the future. The connected concern with this fact is that, historically, governments cannot contain the underwriting of these deficits by the nation’s central bank over the longer haul. It’s not the fact that the international investment community sees hyperinflation coming down the path, just that historically the evidence is not in place to have a strong belief that an independent monetary authority will be able to offset the substantial increases in debt that are forecast.
I also agree with Mr. Wolf’s assessment that nothing, at the present, can replace the dollar. Whereas I don’t have the space in this post to go into the very cogent discussions that are presented by Mr. Wolf on this issue, I can come out where he does, without having travelled exactly the same road that he has followed.
I believe that over time the global role of the dollar will lessen. I believe with Mr. Wolf that “the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong.” I agree that the reason that a different role for the dollar is needed is because the current role “impairs domestic and global stability.”
I would just like us to get to this new system by a different path than that proposed by Mr. Wolf or by his colleague at the Financial Times, Gideon Rachman (see my post of October 6, 2009: “The G20: Time for a US Attitude Adjustment”: http://seekingalpha.com/article/165088-the-g20-time-for-a-u-s-attitude-adjustment.)
The world has changed and will continue to change. The United States and the United States dollar will continue to be powerful; they just will not be as relatively powerful in the future as they have been in the past. This has to be taken into consideration by the United States government as it goes forward, but the new system must not be negotiated with the United States government reeling and in a defensive position from continued pressure on the value of its currency.
Subscribe to:
Comments (Atom)
