Debt Ultimately Leaves You With No Good Options

The economies of Europe are hurting, unemployment is too high, and the social nets are under attack.  The economy of the United States is hurting, unemployment is too high, and the social net is under attack.

Options for the governments in each area are decreasing and despair is growing. 

This is exactly what piling on the debt eventually does to you.

I sympathize with the unemployed.  I sympathize with the under-employed.  I sympathize with the labor unions…public sector and private sector…that are losing members and popular support.  I wish there were more for everyone.

Taking on debt, in the beginning, looks like it frees one up…provides opportunities to do more things…own more things…live a better life. 

Eventually, debt does exactly the opposite…limiting your options…constraining your life style…and exerting pressures that are unwelcome.

I sound like a preacher from the early part of the twentieth century…don’t I?  This is exactly what they used to say. 

Except this is just what we are seeing. 

Taking on debt in the early stages of financial leveraging does allow you to do some things that you cannot do without debt.  And, in these early stages, more debt can seemingly “buy” you out of difficulties. 

As we have seen, more debt then becomes the solution to the problems created by debt.  And, it works for a time.

The thing that people don’t see in continually using debt as a panacea for their problems is that the more and more debt they add to their balance sheets, the fewer and fewer options they have. 

Finally, the obligations created by the debt result in a reduction in the options leaving the debtor with very few choices…and, with most of the choices undesirable ones.

So, the government of Greece is faced with selling assets, and tightening up its budget even further, reducing government employment, and cutting social services. 

Portugal is now under the knife although it believed for a long time that it would escape the “cure”.

And, who are becoming the hard-nosed critics that are pushing these governments to take on more radical solutions?

Spain…and Italy…and Belgium….

Why?  Well, because these latter countries are now feeling the potential for the “contagion” to spread in the European continent. 

Spain, who seemed to be getting its house in order, observed a massive shift in voting on Sunday as the long ruling socialist party was basically removed from office.  There is great fear that the accounting in regional governments has been understating the debt of the country and this will have to be recognized and dealt with by the incoming governments.  Whoops!

Italy has a national debt equal to 120 percent of its gross domestic product and is experiencing sufficient economic dislocations that its future was called into question by a bond rating agency.

Belgium is now also coming up on the radar screens of the investment community.  The interest spread on 10-year Belgium debt over 10-year German debt jumped to a near term high on Monday.  Belgium, too, is looking anxiously at what Greece…and Portugal…do to avoid becoming one of the falling dominoes.

Yet there are still calls for these countries to increase their spending and create more debt to solve the employment and social services problems for the countries experiencing such suffering.

Foremost among those calling for more spending and more debt is the fundamentalist preacher Paul Krugman.  To him more debt seems to be the solution to any problem an economy faces. 

Yes, people are hurting, but, as he seeks to achieve a reduction in the “official” unemployment rate, some of us see the increase in the under-employment of our workforce throughout the past fifty years, the period of credit inflation, as the consequence of those, like Krugman, who profess the gospel of governmental deficit spending as the way to put people back to work in their legacy jobs.

Krugman criticizes those concerned with the massive debt levels achieved by  European governments…and by the United States government…and claims that those worrying about these debt levels are like some that are claiming that the end of the world is near.

Yet, Krugman, himself, sounds like a profit of doom, when he claims that the world as we know it will end if governments don’t increase spending and create more debt!

The problem we now face is one in which there seems to be very few choices left for us.  The amount of debt that people and nations have created is acting like a noose around our neck that is getting ever tighter.  We can do as Krugman suggests, and goose up stimulus spending some more creating more debt, but, as we have seen, the outcome of this would be to provide us with even fewer choices in the future.  The noose will just get tighter.

Eventually, the options will run out, leaving us no choices.

It seems to me that we must deal with the choices that are now available to us, even though they may not be very pleasant ones, and act in a way that will allow us more and better choices in the future.  If reducing the debt outstanding at this stage is the only way we to increase our options, then it seems as if this is the way we must go. 

Given the limited choices that are available to us at this time…I would hate to see our options become even more constricted.         

The Euro is "Bad News" for Spain!

Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)

It’s that Trilemma thing again!

The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.

Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.

Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.

If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.

The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.

This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.

That leaves one prong of the Trilemma hanging…independent economic programs.

This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.

And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.

Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.

Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.

What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?

The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.

Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.

Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.

Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!

Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”

America can create debt and inflate its currency all it wants to and no one else can do anything about it!

Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”

Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.

Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)

Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.

The conclusion to this story is far from over.

"There is no limit to the dollars the Fed can create"

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.

Why Krugman Is Wrong!

Talk about a fundamentalist preacher! Paul Krugman continues to rely upon his inerrant interpretation of the dogmatic Keynesian worldview as he condemns those “sinners” that have followed another path from the one he draws strength from.

Krugman’s New York Times column on Monday chastises those that take an alternative view: “More and more, conventional wisdom says that the responsible thing is to make the unemployed suffer.” (See “The Pain Caucus”, http://www.nytimes.com/2010/05/31/opinion/31krugman.html.)

He goes on: “What’s the greatest threat to our still-fragile economic recovery? Dangers abound, of course. But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.”

Amen, brother! Alleluia!

Right out of the creed! When you need to protect your economic doctrine, bring out unemployment and the unemployed. This goes back in history at least to Keynes and the Paris Peace Conference in 1919 when there was a fear about the spread of the Bolshevik revolution throughout Western Europe. (See my book review from October 25, 2009 of “John Maynard Keynes and International Relations”, http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

To support his argument, Krugman claims that America would be creating a situation not unlike that of Japan in the 1990s if the United States followed the “conventional wisdom” he disdains. “We are, however, looking more and more like Japan….[Recent data] suggests that we may be heading for a Japan-style lost decade, trapped in a prolonged period of high unemployment and slow growth.” (See the article by William Galston, “the Case Against Keynes (With Some Questions for Krugman, Too)” at http://www.tnr.com/blog/william-galston/75228/the-case-against-keynes-some-questions-krugman-too.)

The problem is that Krugman (and other fundamentalist Keynesians) interprets the Japanese situation—and the current situation in the United States—and the current situation in Europe) as “a rare real-world example of Keynes’s famous ‘liquidity trap’ in which monetary policy loses its effectiveness.” (See the Galston article.) The Keynesian solution to such a dilemma is to engage in “pump-priming” government expenditures that, through a cumulative multiplier effect that substantially increasing private demand, initiates a self-sustaining process of economic recovery.

The difficulty with this is that it does not take into account the huge amounts of debt that may have been accumulated through the earlier credit inflation that caused people and businesses to increase their financial leverage and risk taking. It was this credit inflation that ultimately led to the financial collapse that put the economy into the current situation. The other side of a credit inflation is a debt deflation.

The problem? People and businesses (including commercial banks) may find themselves so in debt with loan and interest payments far in excess of their own cash flows that they stop spending because they must repay or write-off large chunks of debt. They choose to become as liquid as possible because they must continue to live and finance their daily needs as much as they can through any wealth they may have accumulated. They do not become liquid because of they are afraid or unwilling to commit to the purchase of investment goods. They become liquid to survive.

Within such an environment, the Keynesian solution of pump-priming which leads to credit inflation becomes the only real response because it leads to inflation. To Krugman, Galston argues, “The root of the Japanese crisis is deflation, and the only remedy is a credible shift to a long-term inflationary policy.”

Although not stated in the “liquidity preference” arguments for such a policy, inflation reduces the debt burden because it reduces the real value of the debt. Inflation is always a way to get out-of-debt. The problem is, inflation encourages more financial leverage and more financial risk taking. This is what we in the United States have been doing for the last fifty years. And, ultimately it does not prevent the problem of a financial correction, it just postpones it.

Getting ones financial books in order is not necessarily a bad thing. It appears that Ireland is pulling out of its crisis situation after enduring “one of the worst recessions of any developed economy since the Great Depression.” (See the Bloomberg article: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_gxU5nfACkg.)

Also, the United States in the 1990s presents an example fiscal prudence which contributed to a period of sustained economic growth. The Clinton administration pulled off a very successful policy of deficit reduction which was accompanied by the longest post-World War II period of economic expansion on record. So it can be done.

Other countries around the world are showing the fruits of fiscal discipline in the face of the economic slowdown of the past three years. Even with the turmoil in Europe, manufacturing seems to be recovering around the world, in the U. S., in the U. K., in Canada (where the Bank of Canada just raised interest rates yesterday over concerns about its robust economy), and in Australia, Brazil, China, India, and Japan.

The lingering problem connected with the buildup of debt is the “debt overhang” that remains once the peak of the credit cycle has passed. Yes, there may be liquidity problems connected with reversing out of the expanding economy into an economy that is contracting. Any reversal of direction will experience a dislocation of markets. But, the liquidity problem is a short-run phenomenon. Once the short-term problem is eradicated, the issue becomes one of getting the balance sheets of individuals, businesses (including commercial banks) back into a more conservative structure. And this can take time and can hinder the strength of the recovery.

But, unless one is inflating the country out of its debt load, this re-structuring of the balance sheets must take place for the recovery to become a healthy recovery. There will be pain during this time. But, living beyond ones means for fifty years creates a situation that is uncomfortable for some. Unfortunately, the people that are hurt are not generally the people that really profited from the credit inflation that caused the excesses.

Perhaps focusing on longer term financial discipline might be better for workers over time rather than concentrating on every little short-term wiggle in unemployment. Certainly, the countries that are paying more attention to longer-run issues (like China) are going to put a lot more economic pressure on those countries that only focus on the short run (like the United States and Europe). For more on this see “How China is Changing the World” http://seekingalpha.com/article/206830-how-china-is-changing-the-world.

Financial Reform Is No Silver Bullet

These days I find it very hard to be on the same side of arguments with Paul Krugman. I must admit that today I am mostly in agreement with what Krugman has written in the New York Times. (“Georgia on My Mind”, http://www.nytimes.com/2010/04/12/opinion/12krugman.html?hp.)

To begin with, Krugman asks the question: “What’s the matter with Georgia?” He raises this question because that Georgia has recorded 37 bank failures since the beginning of 2008 against 206 for the nation as a whole.

Why is Georgia different?

Georgia, he contends, was not a part of the housing bubble that saw home prices soar to the point that upon the collapse of prices, many home owners found themselves in a position of negative equity. Unlike many other states, Georgia had lots of land and few limits on expansion into empty spaces. As a consequence, Georgia, and especially Atlanta, did not see much of a rise in housing prices.

Still Georgia managed to create its own housing problem. Krugman states that “the share of mortgages with delinquent payments is higher in Georgia than in California” and “the percentage of Georgia homeowners with negative equity is well above the national average.”

The problem? “Georgia suffered from a proliferation of small banks.” And, these small banks were anything but conservative. “Actually, the worst offenders in the lending spree tended to be relatively small start-ups…”

These banks did not develop local deposit bases but relied on “hot money” from out-of-area investors. Their lending practices? New mortgage loans, subprime loans, and home-equity loans. Anything they could put on the books to generate fees and cash flows.

The prices of houses did not rise by as much in Georgia as they did in other states, yet the equity that people had in homes fell, and fell, and fell.

Krugman contends that the reason for this was the absence of consumer-protection regulation so that people could use their homes as “piggybanks” and almost continuously extract cash by increasing the size of their mortgages. He contrasts this behavior with Texas that also had lots of land and few limits on the expansion into empty spaces. Texas avoided the mess that Georgia found itself in because, according to Krugman, Texas had consumer-protection regulation.

This is where I differ slightly from Krugman in interpretation. To me the problem is that “Georgia suffered from a proliferation of small banks.” Too many banks were chartered to serve too limited a geographic area. The competition for loans was too great for the area. Real estate construction was expanding because it could get financed. People could continue to borrow because banks needed to push out money. The government was happy because more Americans were owning their own homes.

This was all a part of the general credit inflation of the past twenty years as more and more debt was created to support the movement of into housing. It came from an unlikely place: commercial banks.

If you would go back in history and ask bankers from the 1960s whether or not commercial
banks should hold more than 60% of their loan portfolios in real estate loans, you would have gotten an overwhelming vote of “NO!”

If one looks back at the 1960s, one finds that, for example, all domestically chartered banks held only 25% of their loan portfolios in mortgages or other real estate loans. Looking at the same figures for 2009 we find that all domestically chartered banks held 61% of their portfolio of loans and leases in mortgages or other real estate loans.

Commercial banks used to lend primarily to businesses. That is why they were called “commercial” banks.

Now domestically chartered commercial banks hold three-quarters of their loan portfolios in real estate loans and consumer loans.

We get a split according to size as well. Small commercial banks now hold almost 70% of their loans and leases in mortgages and real estate loans. The largest 25 domestically chartered commercial banks in the United States hold roughly 55%.

The largest banks hold 17% of their loan portfolio in consumer loans whereas the loan portfolios of smaller banks only contain about 9%. Adding the two numbers together results in both the big banks and the smaller banks holding around 75% of their loans in these categories.

Commercial banking has changed!

Since the 1960s, the mortgage market has become the place where commercial banks play. This is even more so for the smaller banks! And, Georgia represents our extreme example of this.

How did we get to where we are? A picture of this transition from the 1960s to now is presented by Michael Lewis in his book “Liar’s Poker”. The first mortgage pass-through security was issued in 1970. By the middle of the 1980s the mortgage market was the largest component of the capital markets worldwide. Lewis describes this part of the capital markets in his book.

I do agree with Krugman that some consumer-protection regulation is important in this world. But, it is not a panacea. And, along with other regulation of financial institutions it is not a “silver bullet” that will keep the United States from another financial crisis in the future.

We are hearing almost daily the things that the larger commercial banks are doing to avoid future regulation. Plus, it is my contention that these banks have moved well beyond what Congress is now working on to resolve financial crises. Furthermore, we are constantly bombarded by headlines like the one that appeared in the Financial Times this morning, “Banks seek to exploit new rules,” http://www.ft.com/cms/s/0/b6e57828-4588-11df-9e46-00144feab49a.html.

And, as Krugman argues, “The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.” Of the 8,000 small- to medium-sized banks in United States, about one in eight is seriously in trouble. This certainly is not the major part of the pie as these 8,000 or so banks make-up only about a third of the assets of domestically chartered commercial banks in the United States. The largest 25 banks control two-thirds of the banking assets in the country.

Conventional regulation is not going to do the job in this information age. (See my comments on this beginning with http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) I have found a regulatory scheme I believe will work better than the ones currently being proposed. I will write on this scheme later this week.

Why Should China Change?

Paul Krugman takes on China in his column this morning: “Taking on China”: http://www.nytimes.com/2010/03/15/opinion/15krugman.html?hp=&adxnnl=1&adxnnlx=1268654957-6LHafkNf0eW6a/enaOOFeQ. He begins, “Tensions are rising over Chinese economic policy, and rightly so” because it “has become a significant drag on global economic recovery.”

Why should China change direction at this time?

There was a time when the United States could do just about anything it wanted to. It was, by far, the strongest economy in the world. It had, by far, the most powerful army on the planet. It provided, by far, the best education anywhere. In essence, it could get away with about anything.

In fact, there are quite a few nations now in addition to China, such as Brazil, India, Russia, Canada to name a few, that can ask the same question, “Why should we change direction at this time?”

The gap has closed. There has been more and more talk about this diminishing gap. One of the more prominent books on the subject is by Fareed Zakaria titled “The Post-American World and another is by PIMCO’s Mohamed El-Erian’s “When Markets Collide.” The problem arises, not because the United States has been replaced at the top. No, the United States will remain the world’s number one power, economically and militarily, for many more years.

The problem is that the relative gap has changed putting the nations mentioned above relatively closer to the United States and this, consequently, gives them a stronger position is how things are played out. We see this in the shift to the G-20 rather than some other G-something. We see this in discussions around the World Bank and the International Monetary Fund. We see this in the growing influence of these other countries around the world.

The world has changed and we in the United States have not accepted the fact.

Why should China change direction at this time?

China is growing stronger and stronger. The United States, and most of the rest of the west, is in a weakened state. The United States, and most of the rest of the west, has gone through a very severe financial crisis and the worst recession since the 1930s. The United States, and most of the rest of the west, is beginning to recover, although the pickup has been very weak up to the present point.

Krugman is arguing that those big bad Chinese are hurting us when we are weak, when we are least able to defend ourselves.

Well, we got ourselves into this situation. We, the United States, created an inflationary environment which resulted in the purchasing power of the dollar declining by about 85% over the past fifty years or so. We, the United States, produced an environment that fostered, even celebrated, the creation of debt. We, the United States saw the value of our currency in international markets decline steadily, with a few exceptions, over the past fifty years. The only respite experienced recently has been that the dollar and U. S. Treasury securities have become a haven for risk-averse investors throughout the world.

Now, the United States is suffering through the consequences of this lack of discipline and is pointing its finger at the big bully that is taking advantage of the situation.

But, the big bully is pointing his finger back at the United States and even accusing the United States of not playing fair itself. (See “Chinese Leader Defends Currency and Policies”, http://www.nytimes.com/2010/03/15/world/asia/15china.html?ref=world.) China is even playing international economics against the United States (see China Uses Rules on Global Trades to its Advantage”, http://www.nytimes.com/2010/03/15/business/global/15yuan.html?hp.) and continues to acquire natural resources, companies, and trade ties throughout the world (see “CNOOC in $3bn Bridas deal”, http://www.ft.com/cms/s/0/c9636dba-2f63-11df-9153-00144feabdc0.html.)

Imagine the nerve of these people!

In the end, the lack of fiscal discipline comes back to haunt one, whether it be a person, a family, a business, or a nation. On the upside, the ride can be great. However, once the bubble bursts, there are no good choices available to one. There is pain regardless of what one does.

Now, however, there are other players in the game and this lack of fiscal discipline can really hurt. The economy of the United States, and the rest of the west, is weak, budget deficits are projected to go on forever, and the dollar is expected to weaken again as international investors become less risk-averse. We need everyone to cooperate with us so that we can bail ourselves out of our past behavior.

Unfortunately, that is not how the world works. And, it is human nature to sense weakness in others. The United States, and the rest of the west, is in a weakened state right now. It will not always be so, but it is for the time being. Thus, others have an opportunity to increase their relative position within the world.

My guess is that China does not plan to overdo it for they have more to gain in the future if trade is more open than not. One piece of advice someone gave me several years ago about the Chinese has proven to be very perceptive. They said that whereas people in the West have very short time horizons, generally in the three to five year range or less, the Chinese have a much long perspective of history. They think in decades rather than years.

I believe that the Chinese know that they will be better off over the longer run if world trade is more open rather than more restricted. Hence, they will not go far so as to create a trade war that will be detrimental to achieving a more open world trade. China’s investments in natural resources and companies throughout the world underscore this bet.

However, the United States is in a weakened position. Thus, the Chinese can achieve more now by taking advantage of this weak position and still achieve the longer-term goal of more open trade. The United States is in no position to resist this and will not be in a position to resist this for some time. And, it would hurt us more to act aggressively at this time to introduce more trade protection than it would China. Hence, advantage China.

Quite a few other countries are also in a position of strength relative to the United States at this time. Brazil seems to be following a more and more independent line. India is acting more in tune with its own interests. Russia, except for its athletics, is also stepping out here and there. And, so on and so on.

It is interesting to see people from the school of economics that led the United States into the position it is in, like Krugman and Joe Stiglitz, begging for help from others in the world that are taking advantage of the weaknesses created by the application of the policies forthcoming from that school. The lack of discipline has consequences. Why should we expect or depend upon others to bail us out of the conditions that we ourselves have created? Why should China change

Bank Failures Are Up: Way Up!

On Friday, bank failures for the year reached 77. In January or March of this year people started projecting that we may make 100 by the end of the year. I think that is as sure a bet as you can get these days. Now, we are seeing forecasts of over 200 more bank failures in the next 18 months.

The headlines over the past several days have been eye-catching. On Bloomberg.com, we saw “Toxic Loans Topping 5% May Push 150 Banks to Point of No Return.” On Reuters Blogs, we saw ”Citi’s Dirty Pool of Assets,” which reported that Citigroup had identified $39.5 billion that represented deep problems on its pool of subprime mortgages, of which it has only incurred $5.3 in looses leaving another $34 billion to go. Citi also faces problems in it CDO portfolio some of which it has hedged its exposure with credit default swaps. And, Jonathan Weil, in an article titled “Next Bubble to Burst Is Banks’ Big Loan Values” on Bloomberg.com, argues that the change in mark to market accounting early this year has covered up huge losses on the books of the biggest banks that were reported in the fourth quarter of 2008 but have since disappeared.

The good news in all this is that most of the troubled assets in banks have been identified and the regulatory bodies, particularly the FDIC, are fully aware of the most troubled banks. These individual insolvency cases are being worked out on a case-by-case basis. We got headlines in the newspapers this week because of the sell-off of Colonial BancGroup Inc. which was the largest bank to fail in 2009 and one of the most costly bank failures ever. But, this bank had been identified a long time ago and it has been systematically handled. The other four that failed this week did not claim headlines. This is good because the banking sector is staying relatively quiet. (See my post of August 10 on this http://seekingalpha.com/article/154998-banking-sector-stays-quiet.) Most bank failures over the next year or so will not get major headlines. (Our most optimistic wish is that none of the bank failures coming in the next year or so will warrant headlines.)

We are in the part of the credit or debt cycle where things are relatively calm: we are way past the phase of the cycle where liquidity was the primary issue. The problem now is not that financial institutions need to and want to get rid of assets as quickly as they can. We are in the “work out” phase of the cycle. Historically, the time it takes to “work things out” depends upon the depth of the collapse in asset values. The betting now seems to be that this time around, the “work out” phase of the cycle will be a relatively long one.

If we still have to go through 125 to 150 more bank failures in the next 18 months or so, the banking system as a whole is not going to be too aggressive in putting new loans on its books. And this will not result in a strong economic rebound going forward.

In addition, the amount of debt that is still outstanding in the economic system will remain a major drag on the banking system. The uncertainty pertaining to the future repayment of loans to the banking system, in the areas of commercial real estate loans, of credit cards, and because of another wave of residential loans that will be repricing over the next 12 months or so, is still a concern. This uncertainty will further restrain banks from being too aggressive in making new loans. (See my post of August 12, “The Debt Problem Poses a Two-Sided Threat to the Fed,” at http://maseportfolio.blogspot.com/.)

And, those who have borrowed will be reluctant to spend giving the uncertainties about the state of the economy, unemployment, foreclosures, and other economic dislocations. Even Paul Krugman has recognized the role that debt plays in spending. In a recent lecture Krugman discussed why the Great Depression did not re-start after World War II when almost all economists expected it to do so. He argued in this talk that by the end of World War II the private sector of the economy, households and businesses, had worked off most of the debt that it had taken on in the 1920s, but had not been able to eliminate in the 1930s. The private sector had deleveraged by the 1950s and was now ready to spend. Krugman contends that the private sector will not begin to spend again coming out of the current recession until it has deleveraged itself from the current buildup of debt.

The financial system and the economic system are working themselves out of their recent problems. Let us hope that things stay quiet. That means, we need to avoid any more surprises. If we don’t have surprises, there is a good chance that the recovery will start and will continue. This doesn’t mean that it won’t take a long time for the banks, households, and businesses to work through their current problems. It will. And, it doesn’t mean that other problems with respect to long term interest rates and the value of the United States dollar may not worsen because of the huge and increasing load of federal debt.

This “quiet” does give us some hope that we are moving in the right direction. There will continue to be bank failures, and foreclosures, and bankruptcies, and more. But, they can be worked through if we don’t get too impatient.