Deficit Reduction: An Absence of Leadership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Post QE2 Federal Reserve Watch: Part I

Should there be a QE3 or not?

This seems to be the debate now going on given the sluggish performance of the United States economy.  Not only have most of the recent statistical releases been relatively weak, the government also released revised figures for real growth during the two years of economic recovery since July 2009 that were revised downwards from the previously released mediocre data. 

There is no joy in Mudville. 

President Obama is talking up jobs and infrastructure investment and business innovation, but his “room to maneuver” given the debt wars going on is “little” or “none”.  And, the White House is not feeling really good going into the re-election season.

Only a small minority seems to be calling for substantial fiscal stimulus at this time and they do not even seem to be a part of the current discussions going on.  They are like “voices calling in the wilderness” but few are listening. 

Thus, attention is focusing once again on the Federal Reserve and its increasingly unpopular Chairman Ben Bernanke.  Mr. Bernanke seemed to be the savior of the financial system at one time but now seems to be talking about a different world than the one most people live within.  His efforts at stimulating economic growth have achieved very little with the exception of providing liquidity for world commodity markets and stock markets in emerging countries. 

Yet, people keep looking for more “guns” or “tools” to address the economic malaise that we are now going through.  The FED seems to be the only game in town.  So, are we going to get QE3?

QE2 ended on June 30, 2011.  In the first six months of 2011, the Fed caused Reserve Balances with Federal Reserve Banks to increase by $642 billion reaching a total of $1.66 trillion on July 6.  (Just a note: on August 6, 2008, before the deluge, Reserve Balances with Federal Reserve Banks totaled less than $4.0 billion.)

As we know, most of these reserve balances were held as excess reserves, the growth of bank lending in the United States over this time was non-existent.

In July, the Federal Reserve “backed off” from its program of aggressive security purchases with almost all purchases of United States Treasury issues going to offset the run-off of Federal Agency issues and Mortgage-backed securities from its portfolio during the month. 

The only real activity that took place at the Federal Reserve in July was “operating” transactions, basically balance shifting between Treasury accounts and commercial banks.  These “operating” transactions generally “netted” out close to zero and did not result in much change in reserve balances with Federal Reserve banks. 

So, we watch and wait and listen. 

Will the Federal Reserve do anything more?  And, if they plan to do anything…what will it be?

In my analysis, so much of the county has too much debt that people, businesses, and state and local governments are attempting to de-leverage their balance sheets.  Too many financial commitments have been made relative to cash flows that there is a substantial effort increase savings and re-structure balance sheets. 

This is why people, businesses, and governments are not borrowing…and are not spending. 

The efforts of the Fed to stimulate bank lending has failed to this point because the banking system is, itself, still retrenching, financial institutions are still going out-of-business in a steady stream, people aren’t borrowing to buy houses, small- and medium-sized businesses are not hiring and are not borrowing to expand their operations, and state and local governments are downsizing and trying to keep themselves solvent. 

The economy is not growing because too many are trying to get back on their feet, they are trying to keep from drowning, and adding on more spending and more debt is not on their agenda.

Here is where the paradox comes in.  The massive shift in the income/wealth distribution in the country has put a huge burden on the less wealthy while those with more wealth can continue on.  We hear that the “expensive” stores are doing very well…and the dollar stores are not doing all that well.  We hear that there is a pickup in the sales of the more expensive homes, yet sales in the rest of the market continue to decline.  And, so on and so on.

In such an environment of “debt deflation” for a large proportion of the population (see http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) it is extremely difficult for the government’s economic policy to overcome the drag on spending created by the restructuring of balance sheets. 

Keynes interpreted such a situation as a “liquidity trap”, a situation where the central bank could not drive interest rates any lower because people would just as soon hold cash as hold interest-bearing debt. See David Wessel’s column in Saturday’s Wall Street Journal: http://professional.wsj.com/article/SB10001424053111903454504576490491996443926.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj.

Wessel presents one case for getting out of this trap…a period of (hyper)inflation that would substantially lower real interest rates.  This, one could argue, is what the Fed (unsuccessfully) tried to do in QE2 and it is what would be the objective of following QE2 up with QE3.  But, the strength of QE3 would have to be great enough to get over the “debt deflation” efforts of the people, businesses, and governments that are trying to get their balance sheets back in order. 

Wessel writes, “Failure to arrive at the correct diagnosis, in economics as in medicine, prolongs the illness; so does refusing the remedies. There's a reason the Great Depression lasted for more than 10 years.”  But maybe the correct diagnosis is that the problem is not a liquidity problem but is a solvency problem.  And, the people of a society may take a long time to deleverage their balance sheets when it took fifty years of credit inflation to get them in their current position.
If this is true, having the central bank create a policy of (hyper)inflation will not really resolve the issue but only postpone it for another day…something politicians are very good at.
And, as we contemplate the possibility that the Fed will engage in another round of monetary easing, word comes that the European Central Bank (ECB) is going to engage in the purchase of the sovereign debt of several European nations so as to support eurozone commercial banks and the newly proposed severe budgetary policies of Italy and Spain.  The ECB announcement came after several European commercial banks wrote down the value of the Greek debt on their balance sheets everywhere from 21 percent to 50 percent. 
To the ECB, it seems, the situation in Europe is still a liquidity problem.  But, if this is the incorrect diagnosis, as it may be for the United States, the ECB may have the same success as the Fed’s QE2 had.  Keep watchin’.  

Please Listen: The Problem is Too Much Debt

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Obama Debt Machine

My estimate for the cumulative deficit over the next 10 years before the Obama budget was announced this week: in excess of $15 trillion.

My estimate for the cumulative deficit over the next 10 years after the Obama budget was announced this week: in excess of $15 trillion.

I see no leadership coming from this administration (or the Congress) to achieve anything different in the future. There is no evidence of the will to take leadership on the United States economic ship.

We have arrived at this position through the actions of both Republicans and Democrats. There is no evidence that this condition will change in the near future.

Everything is the same, with one exception: we are heading full steam into the 2012 presidential election.

Our history: We have had 50 years of credit inflation that has brought us to this position.

Forecast: credit inflation will continue for the foreseeable future.

The U. S. Budget Deficit: It's Time to Get Serious!

The United States budget deficit will reach $1.48 billion in the 2011 fiscal year, according to the Congressional Budget Office.

The response: everyone seems to be pointing fingers at everyone else.

The President, on Wednesday evening in his State of the Union address, indicated that something needed to be done about the budget deficit.

Yesterday the CBO released its figures.

The evening news reported that the White House had some general things to say about the projection but would not come out with more specifics because they were waiting for the Republican response that they knew was coming.

There’s leadership for you.

No one in the top leadership positions in the country seem to be staking out a firm position on this. Like Health Care 1, the President is asking Congress to do something, but is not willing to step down from his intellectual tower to set out a path. As a consequence, like HC1, no one in the country really knows where he stands on containing and controlling the deficit.

As a consequence, no one really seems to be serious about the deficit.

The current estimate was constructed assuming that all current law will be used as the basis for the projection. If, for example, all the Bush tax cuts are allowed to expire, as is now the law, this will result in the budget deficit climbing to about 76% of GDP in 2020.

However, if Congress does not allow these tax cuts to expire and if Medicare programs are held constant, along with other spending and taxing programs, the budget deficit will rise to about 97% of GDP in 2020. This would place the cumulative total of deficits at around $12 trillion over the next ten years.

For the last 12-18 months, I have been arguing that the cumulative budget deficit for the next ten years will come in at least around $15 trillion, given the current attitudes about the budget deficit in Washington, D. C.. In my mind, Congress, given current attitudes, will not rescind the programs that are now in place, and, like always, will add more that will only cause the cumulative deficit to rise from current projections.

It seems as if the Congressional Budget Office is coming toward my forecast as time goes forward.

And the Gross Federal Debt continues to climb: the year-over-year rate of increase is now close to 20%. The compound rate of increase in the Gross Federal Debt between 1960 and 2007 was in slightly above 7% which some of us felt was excessive.

Since it took until fiscal year 2009 for the debt of the United States to approach $12 trillion, the idea that this figure would be doubled in the next ten years seems “unreal”. Yet, that is the way things look.

And, there are three major “holders” of this debt…Japan, China, and the Federal Reserve. Going forward it seems almost surreal the proportion of the new debt the Federal Reserve may have to acquire. There is, of course, the $900 billion that the Fed is intending to acquire as a part of QE2. But, what will the Fed have to do after that? With so much government debt coming on board it is frightening to speculate.

Why am I so pessimistic? Well, we really don’t know how much the health care program is going to cost us. We don’t know what military challenges we are going to be facing. The world is very unsettled now and I don’t see how commitments are really going to be lessened over the next ten years given all the turmoil taking place around the globe. We don’t know how the budget crisis affecting state and local governments is going to work out. Many are saying that the federal government will not play any role in state or municipal bailouts, yet, can you imagine the federal government not playing a role? And, what about the housing market and the government agencies called Fannie Mae and Freddie Mac? How much is this area going to impact the federal budget? One last unknown here is the cost of getting the commercial banking system back to full solvency. No one knows what these costs might be.

The problem with debt is that the more you have the fewer choices you have. Debt reduces your room to maneuver. And, as with Europe, it seems to me that the options are running out.

The other thing about creating more and more debt is that the options become less and less desirable.

That is why you don’t want to get yourselves “head-over-heels” in debt…you want to be able to make your own choices and you want the alternatives available to you to be desirable ones.

Right now, the choices are not good! And, we don’t seem to have any real leaders around in positions of authority that will step up to the table to take charge.

Funny, but the two Presidents that did take a leadership role in budget containment were George H. W. Bush (Bush 41) and Bill Clinton. Bush 41 made some decisions with respect to taxes that arguably cost him a second presidential term. But, Bush’s efforts set the stage for the Clinton era of strong economic growth and shrinking federal deficits.

There just is no leadership on this issue coming from the places that should be exercising leadership. To be more specific, in my experience, the top person, the CEO, the person where “the buck stops”, must take a leading role in getting something done or it just does not “get done” right. Secretary of the Treasury Robert Rubin was a major force behind the Clinton move on the budget, but the effort would have gone nowhere without Clinton getting on board and taking the lead.

As with the health care bill, people are not seeing Obama carrying the flag. Oh, he talks and talks, but where does he really stand? Tim Geithner has all but disappeared. The only real spokesperson for the administration on economics and finance seems to be Ben Bernanke and his “talk” has been getting lost in all the attention being given to other members of the Board of Governors of the Federal Reserve System.

The deficit problem is not going to be brought under control immediately. But, the lesson we can learn from the situation going on over in Europe is that someone eventually must take the lead. If no leader steps out in front of the crowd, the misery just drags on and drags on. The debtors just keep banging on the door. And, what happens during periods like this? Well, you lose focus.
I have seen this doing business “turnarounds”. When things start going downhill in a business and the debtors, or regulators, keep banging on the door, you stop doing what you should be doing in order to run a good business. You just have to “put out fires.” Thus, your organization continues to go downhill.

Likewise with a government: if the focus of the government is diverted from doing what it should be doing in order to resolve budget and debt issues, the government continues to experience problems in areas it should be focusing on.

It is past time to “get serious” on the federal government’s deficit problem. Are there any leaders in the room?

The Real Reason for Fed Easing? Debasement Inflation?

Well, one of my major arguments made it to the op-ed page of the Wall Street Journal today, but I didn’t write it: Andy Kessler, a former hedge-fund manager wrote it. I agree with most of what Mr. Kessler says in his piece, “ What’s Really Behind Bernanke’s Easing?” (See http://professional.wsj.com/article/SB10001424052748704648604575621093223928682.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj.)

I have been arguing for more than a year that the real concern of the Federal Reserve is the solvency of the banking system. The Fed’s given arguments for pumping so much liquidity into the banking system is that the economy is weak and the level of unemployment is unacceptable. The Chairman of the Board of Governors of the Federal Reserve System cannot say just say out loud that “the banking system is at risk.” Nor can any other Federal Reserve figure say this out loud.

My concern over the past year of so has constantly been that the economic and financial situation did not warrant the injection of all the Fed was throwing at it. See my post “Bernanke’s next round of spaghetti tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.) A recent post continues to exhibit my belief that the justification for the Fed actions has been the solvency of the banking system and not just the health of the economy: http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks.

But, the behavior of the central bank not only represents concern for the commercial banks, but also for the real estate market. Elizabeth Warren, in Congressional testimony earlier this year, indicated that 3,000 commercial banks were threatened over the next 18 months or so, especially in loans in the area of commercial real estate. Plus, we have a massive problem in the municipal bond markets concerning the solvency of our state and local governments. The pension programs of these entities loom large over the financial markets and many individuals I know that work in this sector are scarred silly.

The efforts of the Fed, therefore, are attempts at “debasement inflation”. This was uttered by William Browder, who now runs an investment fund in London. (In the morning New York Times: http://dealbook.nytimes.com/2010/11/18/from-russia-expert-a-gloomy-outlook/?ref=todayspaper.) “Emerging markets went through more than a decade ago in the Asian Financial crisis what developed markets are experiencing now.” Browder added, “you want to own hard things that can’t be printed.”

But, these efforts extend beyond the borders of the United States. Given the fluidity associated with funds flowing throughout the world, the additional liquidity extends to the situation related to many Euro-nations in terms of their sovereign debt. Writedowns are going to occur in Ireland, Portugal, Greece, and possibly Spain and Italy. Even France is feeling some of the heat. International financial markets also need liquidity.

The question here is whether this concern over sovereign debt will extend to the United States. Browder goes on to say that there are limits to how much governments are able to borrow. And, investors move from one weak market to another. Eventually, these investors work through to even the “strongest” of the fiscally challenged states. When it gets to this stage, he argues, the only thing these governments can still do is print money.

Where are the hard assets? Real estate. Commodities. Companies.

These are the areas that will attract a lot of the money going around.

The prices of commodities have already experienced a significant bounce. This will continue.

Big money will also eventually be made in real estate and the merger and acquisition business of corporations. The prelude to this is the massive buildup in the cash holdings at many of the largest companies in the world, in the largest commercial banks in the world, and in hedge funds and other private equity funds. And, really, the move has already started in a very selective way.

I continue to believe that over the next five years of so we will see a substantial acquisition of assets, across the board, of a size we can barely imagine now.

The objective of the Federal Reserve is to keep things as stable as possible so that the FDIC can continue to close banks as smoothly as it can; that mergers and acquisitions can occur in an orderly fashion so that weaker institutions can be removed from the scene; and that more and more money will move into the real estate area so as to eventually put a floor under real estate prices.

All this may be done, but it may not exactly take the path that Mr. Bernanke would like it to take. Furthermore, all of this activity may not achieve the goals that President Obama would like to achieve.

Mr. Kessler argues that, in his view, the stock market will not view these developments as favorably as they have received earlier efforts at spaghetti throwing. He claims that this attitude has been shown by the recent behavior of stock prices. In addition, bond yields have backed up (prices of bonds have fallen) not what quantitative easing was devised to do. Both of
these outcomes are “exactly the opposite of what Mr. Bernanke was trying to achieve.”

In the case of mergers and acquisitions and the acquisition of real property, the early results are indicating that the bigger organizations are getting bigger, both financial and non-financial institutions, and the wealthy are getting wealthier. These outcomes are exactly the opposite of what President Obama was trying to achieve.

Mr. Browder spoke to students at the Columbia Business School several weeks ago. He argued that “the high-inflation scene” described above “could be another lucrative opportunity” similar, although not as great, to one he made so much money in while in Russia.

In such a situation, therefore, the emphasis in investing should be on what companies or assets can be acquired that will benefit from the credit inflation. Caterpillar, for example, moved into the mining equipment field, one reason being that mining will benefit from the surge in demand coming from emerging nations like China and Brazil. So, one is looking for “targets” and not long-term value creation.

One has to be careful, however, in buying into acquiring companies. Not all companies are good acquirers. History shows that many acquirers have to “unwind” their acquisitions within five years or so because the purchases are done for the wrong reasons or the managements cannot effectively integrate the properties they have obtained. However, there may be some very good “buys” amongst the acquirers.

For example, the value of the Caterpillar stock went up after the acquisition was announced. There is the feeling that the Caterpillar management can effectively put the two companies together to the benefit of the shareholders.

The Federal Reserve is creating a lot of opportunities with its new policy stance. However, the beneficiaries of the policy may not be the people it wants to help: the unemployed and the less-well-off.

Why Future Bubbles Can Be Expected

We have been told for at least two years now that the problems in the banking sector are liquidity problems. But, liquidity problems are of short-term nature and need to be resolved within a relatively short period of time. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

The policies that are used to combat a liquidity crisis are also of a short-term nature. These policies are based upon the need to supply the market with liquidity so that asset prices will stop dropping.

Given this interpretation, the Federal Reserve, under Chairman Bernanke’s leadership, has supplied liquidity…and more liquidity…and more liquidity to resolve the issue.

This is a sign that the model being used by Bubble Ben and the Fed is inappropriate for the particular situation that they face.

But, this was the policy prescription for the Federal Reserve in the early 2000s when interest rates were kept around one percent for about 18 months. And, what did we get…a pair of asset bubbles.

In terms of fiscal policy, the situation is similar. The “experts” in the Obama administration, led by Treasury Secretary Tim Geithner, have called for more spending…and more spending…and more spending.

In both cases, the reason given why the policy prescription is not working is that the particular stimulus package tried has not been large enough. The solution Ben and Tim have given is to make the policy package larger. More spending…and more liquidity!

This is a sign that something is wrong!

The model and the analysis being used are not appropriate. The model being used to develop economic policy must be changed.

In the financial markets, the problems that exist are solvency problems. Households are declaring bankruptcy in record numbers and foreclosures on homes continue to run at very high rates. Small businesses are also declaring bankruptcy and loan demand coming from small businesses is dropping as of the last Federal Reserve survey. Thousands of small banks are on the verge of insolvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

And, guess what? The monetary policy that the Federal Reserve is following has successfully resulted in the accumulation of massive amounts of cash in the hands of large banks and large corporations. I am just waiting for the acquisition binge to begin once the economy stabilizes a little more. So much for "Main Street"!

In the economy, the “consensus” economic model that has been used over the past fifty years is still contributing to the “more-of-the-same” policies that are being followed by the Federal Reserve and the Treasury Department.

Yet, over these past fifty years the application of this model has produced the following results: the United States has moved from an “under”-employment rate of around 8% of the working population to about 25% in the current environment; these policies have also resulted in the capacity utilization in industry moving from about 93% in the 1960s to about 75% at the present time, constantly eroding throughout the whole time period; and, the distribution of income in the United States over this fifty years has moved dramatically toward the end of the most wealthy.

The foreign exchange markets have signaled to the United States that something is wrong! Over the past fifty years, the value of the dollar has declined by more than 40% in foreign exchange markets. After a recovery in the latter part of the 1990s, the value of the dollar once again tanked until we hit the financial crisis of 2008 and there was a “stampede to quality.” Once this “stampede” was over and markets and economies stabilized, the value of the dollar declined once again. And, after Ben made his remarks in Jackson Hole concerning the forthcoming quantitative easing, the value of the dollar plunged 7% in a matter of weeks.

Paul Volker has written that the most important price in a country is the price of its currency in terms of other currencies. If the value of your currency declines, this is a sign of weakness…weakness in your economy and in your economic policies.

And, here we are. Thursday November 11, 2010, the President of the United States was lectured to by Hu Jintao, the Chinese President, over the United States currency. Other world leaders, from Germany, Great Britain, and Brazil, have also reprimanded the President over the United States currency situation. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)

Furthermore, given the election results in the mid-term elections held last week, the American people seem to have a problem with United States economic policies.

The policy direction in Washington needs to be changed and changed soon.

However, I don’t expect a change to be made in the near future. President Obama seems to be adamant that this policy must be effectively enforced.

Therefore, like the early 2000s I expect bubbles to occur here and there.

The problem is, as we well know…that, sooner or later, bubbles burst!

You Can't Lead Out Of Weakness: The IMF Meetings

With each international meeting it is becoming more and more obvious, the United States is dealing from a weakened hand.

The New York Times makes it very clear: “Despite loud calls from the United States; and more muted appeals by Europe, Japan and other countries, the annual meeting of the International Monetary Fund did not succeed in placing significant pressure on China to allow a prompt and meaningful rise in the value of its currency.” (See “Financial Leaders Decline to Press China on Currency,” http://www.nytimes.com/2010/10/10/business/global/10imf.html?_r=1&ref=todayspaper.)

The language in the concluding statement of the policy-setting committee of the IMF “was benign.” Everything was postponed to the G-20 meeting in Seoul, South Korea in November.

The United States took a strong position on the value of the Chinese currency and the behavior of the Chinese government with respect to this value. The United States Congress made its will known in late September. Treasury Secretary Geithner also spoke out about the need for action on the part of the Chinese. President Obama has even made mention of the issue.

But, policy-makers are “wary about pressuring China too severely.”

Right now, China seems to hold the cards and no one is willing to move strongly against their position.

Most revealing is the fact that the United States seems to be in no position to press its points with its own actions and does not seem to be strong enough to command support among the other nations that might side with it.

Furthermore, the central bank of the United States, the Federal Reserve System, appears to be on the verge of another round of “quantitative easing”, something that world financial markets have reacted to by selling dollars. The world investment community has not given the United States a very good grade in terms of how its government has managed the monetary and fiscal policy of the country over the past eight years or so and sees these additional efforts as just a continuation of the lack of foresight and discipline and will in its economic policymaking.

If this is the prevailing attitude in the world about the economic policy of the United States, then one can only project further declines in the position of this country in the evolving discussions about world financial arrangements.

The United States has dealt itself a weak hand in world economic affairs. Unless it steps back and re-assesses how it got here and what it needs to do to change the situation, it will just continue to further weaken its position. And, it is very hard for a nation to lead when it is continually hurting itself.

It's All About Leadership, Stupid!

I got on a Michael Douglas kick this weekend because his new flick “Wall Street: Money Never Sleeps” was coming out in the theaters. I, of course, took in Wall Street 1.0 again. Among the other Michael Douglas films I reprised, “The American President” caught my attention.

The particular line that got to me was one uttered by Michael J. Fox, who played a sort of George Stephanopoulos character to the President. The scene was set in the Oval Office of the President and the President and his chief advisors were discussing the direction that should be taken with respect to a crime bill. The conflict being addressed concerned whether or not the President should “play politics” and disappoint his friends, including his “girl friend” Annette Bening, or be true to his leanings and go for the environmental package.

He, at the time, chooses to “play politics”, and is taken to task for it by Michael Fox. The line that stuck with me was this:

“People want leadership and in the absence of leadership they’ll listen to anyone who comes to the microphone.”

This statement really resonated with me because I believe that is the situation we are in now in the United States. People want leadership, but they are not getting it.

Leadership starts with the CEO, the Chief Executive Officer.

There is no way others within or without the organization can exhibit leadership and set up the tone and the culture of the organization. But others try, especially opponents.

And, if the leader does not take charge, people will “listen to anyone who comes to the microphone.”

President Obama speaks. He is constantly speaking. Something small comes up and he goes out and makes a speech about it. Something large comes along and he goes out and makes a speech about it. The problem is that he is just speaking…not leading.

One of my firmest beliefs is that CEOs and their teams need to listen to the market and try and discern what the market is attempting to tell them. The “market” may be wrong, but, to me, the wisest action is to listen to the market and only claim that the market is wrong after a serious and thorough study attempting to support the fact that the market is correct.

What is the market saying right now?

Well, who is dominating the airways and printing presses these days? John Boehner. Christine O’Donnell. Stephen Colbert. Jon Stewart. Rush Limbaugh. Nancy Pelosi. Carl Rove. The Tea Party movement. The Party of “NO”. And, so on.

President Obama spoke at the United Nations this week…and it was just another of his many speeches. Who really listened to him?

President Obama is visiting homes trying to establish the “common touch.” Where is the leadership?

Obama is speaking a lot, but, people seem to be listening to other people who are grabbing the microphone. Conclusion: people do not feel that Obama is leading the nation.

A health care bill was passed on the watch of President Obama. But, the view of the voters is that Harry Reid and Nancy Pelosi and Congress did all of the work.

There is a new financial reform package the Chris Dodd and Barney Frank crafted. Where was Obama?

And, the earlier stimulus bill. The public perception was that the Obama administration turned this over to the Congress, fully supporting a bill that contained a lot of old programs that benefitted the interests of members in Congress. All Obama just praised the fact that a stimulus bill was passed.

The market perception seems to be that President Obama, himself, did not send up any bills to Congress in these areas; he turned the tasks over to Congress, urged them along, and accepted whatever Congress produced and sent to him.

The market does not see President Obama as “the” leader in any of these initiatives. His absence, then, has allowed the microphone to be dominated by others.

This lack of leadership has particularly been felt in the areas of economics and finance. No one seems to know where the administration is going or what the administration is going to do. What about another stimulus program? What about the Bush tax cuts? What about foreclosures? What about the big banks? What about the consumer protection agency? What about the insurance companies that are raising rates? What about the credit card companies that are raising fees? What about the Chinese currency? What about the government’s 61% ownership in General Motors? What about how GMAC pursued its foreclosure efforts? What about…you name it?

Talk about a free market!

If there is no leadership, then anarchy takes over.

There was the cry against big banks. But, the Obama administration (including the Fed) seems to be doing everything it can to help the big banks at the expense of the smaller ones. The administration talks about the United States being strong economically, yet its policies are just accelerating the re-positioning, economically, of China and Brazil, Russia and India, and other emerging nations. The administration talks about helping out the middle class and blue collar workers yet its policies promote the bifurcation of the work force, lessened capacity utilization in industry, and greater income inequality.

And, this is why people, other than the President, are dominating the microphone.

The Michael Douglas President finally did make a stand and began to tell the people where he really stood. The Michael Douglas President became a leader. Although this change came right at the end of the movie, it was the turning point of the movie. And, you knew what the President was going to do in the future, nothing more needed to be said in the movie. In taking this turn, the President began to dominate the discussion again.

Do you think this might happen in the real world? In the United States? Do you think it might happen in the near term?

Federal Reserve Non-Exit Watch: Part 1

Last month I presented Part 13 of my exit watch of the Federal Reserve. In the summer of 2009, the Fed stated that it was going to remove reserves from the banking system to reverse the massive injection of reserves that took place in late 2008 and early 2009.

The Federal Reserve really did not “exit” over this 13 month period. In fact, bank reserves and excess reserves actually increased during that time period. From my post on
August 10, 2010 (see http://seekingalpha.com/article/219717-federal-reserve-exit-watch-part-13):

“Here we are 13 months into the “exit watch” and there has been ‘no exit’ of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.”

Over the past month, the Federal Reserve has backed off from this policy of removing reserves from the banking system because of the concern over the fragile condition of the smaller banks in the United States and the failure of unemployment to fall. Chairman Bernanke has spoken about the need for the Federal Reserve System to focus on the economy while “the FOMC will do all that it can to ensure continuation of the economic recovery.” This is from the speech he gave at Jackson Hole, Wyoming on August 26 (see my post http://seekingalpha.com/article/222704-bernanke-in-the-hole).

Thus, the “Federal Reserve Exit Watch” becomes the “Federal Reserve Non-Exit Watch.”

There are two areas to focus on in this “Non-Exit Watch.” The first relates to all of the “innovations” the Federal Reserve created to bailout various financial institutions (like Bear Stearns and AIG that “blew up” the Fed’s balance sheet) and to engage in “liquidity swaps” with other central banks throughout the world. The plan is for these accounts to decline incrementally as assets are worked off or that the need for central bank liquidity swaps declines.

Over the last four weeks ending September 1, 2010, these Federal Reserve accounts that were created during the financial crisis have declined by $16.4 billion. Central bank liquidity swaps have fallen to almost zero and the other “crisis” portfolios the Fed maintains continue to run off. Still the Fed’s balance sheet maintains more than $150 billion in assets that are connected with the financial upheaval.

Over the past 13-week period these accounts have dropped by a little more than $22 billion. These accounts should continue to decline in the future, but the pace of decline will not be large.

The second area relates to the securities portfolio of the Fed. As a part of its support of financial markets, especially the mortgage market, the Federal Reserve bought substantial amounts of mortgage-backed securities and federal agency securities. A part of the “exit” strategy of the Fed was to let these securities “run off” as they matured thereby helping to reduce the excess reserves held by the commercial banking system.

It appears as if the “non-exit” plan is to replace the maturing mortgage-backed securities and federal agency securities with outright purchases of United States Treasury issues. In this way the Fed will keep funds in the banking system so as to encourage bank lending and economic growth but will reduce the role that it has played in specific sub-sectors of the financial markets.

It appears as if the Fed began this program within the past four-week period. Between August 4 and September 1, the volume of mortgage-backed securities at the Fed dropped off by $14.5 billion and the amount of federal agencies on the books of the Fed fell by $2.9 billion.

United States Treasury securities “held outright” by the Federal Reserve rose by $9.3 billion so that the volume of all securities held by the Fed dropped by only $8.1 billion. Note that this action was concentrated in the last four-week period for this behavior was not observed in the nine earlier weeks of the last 13-week period.

Overall, reserve balances with Federal Reserve banks fell by $27.2 billion over the last four-week period. Part of the drain from the Fed was the seasonal rise in both currency in circulation and bank needs for additional vault cash during the summer to handle the vacation pickup in the demand for currency. These movements result in an increase in factors absorbing reserve funds which reduces reserve balances at Federal Reserve banks. As a consequence, the excess reserves in the banking system remained relatively constant. There are always these “operational” factors occurring that the Fed must take account of in order to help the banking system function as smoothly as possible.

Given what Bernanke and others at the Federal Reserve have said, we must keep our eyes on what the Fed does with its securities portfolio. The Fed does not seem to want to maintain its mortgage-backed securities portfolio or its federal agency portfolio at the levels achieved earlier this year. It appears that the Fed will allow the volume of these portfolios to decline naturally as they mature and run off. The thing to watch is whether or not the Fed replaces this run-off with the acquisition of United States Treasury issues.

The good thing I see about this is that in “normal” times the Federal Reserve has primarily conducted its monetary policy using the Treasury market, either through outright purchases or through the repurchase market. Thus, to reduce the amount of mortgage-backed securities and federal agency securities in its over-all portfolio and to increase the proportion of Treasury securities is, to me, a good thing.

However, even though the Federal Reserve, over time, is going to have to withdraw the excessive amount of reserves it has pumped into the banking system, this is not going to happen in the near term. There was a lot of “bad” economic news that came out in August. This “bad” news had a very negative impact on the polling statistics of the President and created a very dark picture for Democratic politicians looking forward to the November elections. Within such an environment, the Federal Reserve and its officials must appear to be working to accelerate the economic recovery and help put more people back to work.

Thus, the Fed is not likely to allow reserves to decline by much in the banking system, although I doubt that they really want to increase reserves much throughout the fall. For the time being, it looks as if the best bet is that the Fed will let the runoff continue in mortgage-backed and federal agency securities, replacing them with purchases of Treasury securities. This will take place while the Fed allows the “crisis” assets to continue to decline as they are resolved. The only deviation from this picture would occur if the economy or the banking system took a turn for the worse.

The Problem is "Out There"! It's China!

The quote of Stephen Covey that continues to resonate with me is "As long as you think the problem is out there, that very thought is the problem."

With all the fuss over the movement by the Chinese to allow the value of their currency to rise we hear, once again in the background, that the real problem is that the imbalances in the world are really a consequence of “an entrenched savings excess” in China. (See the article by George Magnus, “We Need More from China than a Flexible Renminbi,” http://www.ft.com/cms/s/0/4f19ced4-7d4a-11df-a0f5-00144feabdc0.html.)

There we have it!

And, the support for this theory goes as far as Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, who came up with this idea to provide Alan Greenspan with an excuse to keep interest rates excessively low in the earlier years of the 2000s.

The problem is “Out There”!

Those Chinese just save too much! Let them be like the Americans who reduced their savings to close to around one percent of disposable income earlier this decade. The Chinese bought a large proportion of the bonds going to finance the huge deficits of the United States government and this kept interest rates so low that the Federal Reserve could reduce their target interest rates to levels that created a bubble in the United States housing market.

As Magnus writes, the Chinese do have an unreformed rural sector, an immature social security and financial system and a one-child policy. But, China is transforming. It is just not doing it at the pace that the Western world would like it to in order to reduce or eliminate the imbalances that exist internationally.

The Chinese, however, are not going to change their social policy overnight. This is one of their “no-no’s”! They saw what happened in Russia and Eastern Europe as the social order unraveled when the Communist governments in these areas fell. They vowed to keep a lid on things, culturally, as China modernized. They will not back off this controlled approach as they move toward a state capitalism and a society that is more open to the world.

But, this is not what created the huge government budget deficits in the United States. The total amount of United States debt outstanding rose at a compound rate of over 7% from early in the 1960s through the end of 2008. This was not the fault of the Chinese!

Nor is it the solution to the low personal savings rates in the United States and the huge government budget deficits going forward. The personal savings rate in the United States stayed above 7% for most of the period between the late 1950s into the late 1980s. It exceeded 10% at times!

What eventually got to the American saver was the steady erosion of the real value of the savings put aside during this time. And, as the American saver moved into the 1990s, the personal savings rate began to fall and continued to fall into the 2000s. Consumer prices in the United States rose at a compound rate of around 4% from January 1961 through the summer of 2008. The purchasing power of a 1961 dollar dropped during this time to about $0.15.

If anything may accelerate the decline in the personal savings rate in China it may be the rising rate of inflation that is being experienced there. If the real value of savings takes a precipitous drop, even the rural Chinese may begin to adjust their behavior.

The real problem in this picture is the massive amount of United States debt that is outstanding. And, the amount of debt that is outstanding is the fault of no one but the United States. But, this problem puts a lot of pressure on other countries, especially on China.

China holds about 70 percent of its foreign exchange reserves in dollars, mostly in United States Treasury securities. This accumulation began in the 1990s and accelerated into the 2000s. The United States dollar was the reserve currency of the world and United States Treasury securities were the most secure investment around in terms of risk.

I remember working with a group from China in the early 1990s that represented Chinese pension funds. This discussion took place at the University of Pennsylvania. I was not teaching at the time, I was the president and CEO of a bank.

Chinese pension funds had a very large amount of money, yet because they could only invest on Mainland China they had limited capabilities of earning a decent return on their monies and were very limited in terms of their ability to diversify their investment holdings. This group was investigating investing pension fund monies “off-shore” and they were interested in foreign exchange risk and how this risk could be hedged. And, these discussions were a part of the general discussion going on in China at the time about investing more and more of their monies and international reserves in the rest of the world.

The point is that the early 1990s represented a time in which China was opening up and investigating how it could participate in global financial markets. Being very cautious, the Chinese were learning about how to diversify into the world but keep its risk exposure low both in term of credit risk and foreign exchange risk. I don’t see much of a change in this attitude at the present time.

Magnus mentions, in his article, that because of China’s creditor status it must play a role in helping to fix the global financial imbalances. Specifically, he argues that China cannot “back away” from these world imbalances—as the United States did in the 1920s and the Japanese did in the 1980s—because, in the end, backing away will neither help the world, or themselves.

My guess is that the Chinese will not “back away” and “dump” United States Treasury securities. This is one of the reasons why the Chinese do not want to see the value of the Yuan rise too rapidly. A “quicker revaluation would act as a stealth monetary tightening not only in China but also the US.” This is because it would have a negative effect on US equity prices and also result in higher US interest rates. (See the Lex column in the Financial Times: http://www.ft.com/cms/s/3/9db857ea-7d45-11df-a0f5-00144feabdc0.html.)

However, President Obama’s administration and the United States Congress continues to press for China to change the behavior of its government and the savings habits of its people. Yet, many of the major imbalances in the world today result from the undisciplined behavior of the United States over the past fifty years or so. The huge amounts of United States government debt outstanding are not the result of the government of China or the Chinese people. Why, then, should the Chinese bear the brunt of any adjustment that is to take place?

As long as the United States government and the people of the United States think the problem is out there, the problems and imbalances will not be resolved. The only one we can control is ourselves, so if anything is going to be accomplished, we are going to have to do it…not the Chinese.

Washington Still Doesn't Get It!

The President and Congress just don’t get it!

Financial reform is in the air! The bad guys did it and they need to be brought to account! Protect Main Street and go after those that are on Wall Street!

Unfortunately, this is not going to produce the results that the President and Congress want.

Unfortunately, we are not going to get helpful results until the President and Congress develop an understanding about finance and what their current philosophies about economic policy are doing.

Unfortunately, I don’t see this happening in the near term.

Just two points this morning, but points that I have made before.

The first point pertains to the understanding…or misunderstanding…of what finance is all about. This misunderstanding is captured in the lead editorial in the New York Times this morning titled “After Goldman” (http://www.nytimes.com/2010/04/22/opinion/22thu1.html?hp). In this editorial we read: “The Goldman deal was nothing more than a bet on the mortgage market…WITHOUT ‘INVESTING’ ANYTHING IN THE REAL ECONOMY.”

Guess what? That is what finance ultimately is. Finance is nothing more than information and millions and millions of people operate with this kind of information every day.

What is your dollar bill? A piece of paper…a piece of information.

Well, but it is legal tender!

Right, according to the government you have to accept a dollar bill in payment for debt. What has this got to do with THE REAL ECONOMY?

And, what about the demand deposit account you have at your commercial bank? It is just 0s and 1s in some computer. What has this got to do with THE REAL ECONOMY?

By the way, you are betting that you will be able to access that money when you need it? Is it safe?

Well, you say, the deposit account has insurance on it, doesn’t it? The Federal Government has guaranteed that you will not lose these funds and will not be inconvenienced by a delay in access to them. You have a promise! But, what has that got to do with THE REAL ECONOMY?

What are loans? Well, they are cash flows. Say, an initial cash outflow to the borrower and then a series of cash inflows back to the lender. Just 0s and 1s through bank accounts.

But, I put up a house to back the loan, didn’t I? The house is a real asset.

Yes, but the loan agreement is in terms of cash flows and the house is there for security in case you don’t pay the returning cash flow. Furthermore, that house is 25% underwater now, another piece of information, so how does this impact the cash flows?

Furthermore, it was the government that showed us how to “slice and dice” cash flows in order to tailor cash flows so that potential purchasers would find those “new” cash flows more attractive and purchase them. The first mortgage-backed security was issued by the Federal Government in 1970. The mortgage market went from playing a zero role in world capital markets to becoming, by the middle of the 1980s, the largest component of world capital markets. (See Michael Lewis’ “Liar’s Poker”.)

Thank you Washington for teaching us that cash flows are just bits of information! No real world
here.

Now Washington wants to bring the herd of cats it has unleashed under control. Good luck!

The second point has to do with government policy and how it creates the environment for all else that goes on in the economy. Some of this discussion can be related to the David Wessel’s column in the Wall Street Journal this morning, “Mapping Fault Lines of Crises,” (http://online.wsj.com/article/SB20001424052748704133804575198080507492968.html#mod=todays_us_page_one). Wessel, in his column, discusses the work of Raghuram Rajan, a professor at the University of Chicago and former chief economist at the International Monetary Fund.

Rajan argues that “The U. S. approach to recession-fighting and its social safety net are geared for fast recoveries of the past, not jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume that the government will keep money flowing and will step in if catastrophe occurs.”

This philosophy of government was first incorporated into government policymaking in the early sixties and has continued as the foundation for economic policy ever since. A consequence of this has been that the purchasing power of the dollar has gone from $1.00 in January 1961 to $0.15 in 2010. And, as we know, a sustained inflationary environment is one that produces massive debt creation and increasing financial leverage along with extensive amounts of financial innovation.

This leads us to another part of Rajan’s argument: “As incomes at the top soared (in the last half of the 20th century), politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes, politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.” And, Wessel states, Rajan goes back in history to support the fact that this is not an atypical reaction.

The latter move not only contributed to general inflation, but eventually led to asset price bubbles in specific sectors of the market which could not be sustained. Hence the financial crisis!

Finance has never really been connected to THE REAL ECONOMY. Take a look at Niall Ferguson’s book “The Ascent of Money.” (See my review, http://seekingalpha.com/article/120595-a-financial-history-of-the-world.) This is especially true since the growth in finance and financial innovation, historically, has been connected with government’s financing of wars and, in the 20th century, the social system.

Furthermore, finance, in the future, is going to be even more connected with the idea of information and the exchange of information. For example, see the book “The Quants” (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson). And, this concept is spreading beyond financial markets. An amazing amount of research efforts and publications are connected with “Information Markets” which are not related to financial markets. Bob Shiller of “Irrational Exuberance” has produced a lot in this area: see his books “Macro Markets” and “The New Financial Order.”

The point is, again, that the President and Congress are fighting the last war. But, the last war is history!

Mr. Geithner Goes to China

Treasury Secretary Tim Geithner will meet Thursday with Wang Qishan, the Chinese Vice-Premier responsible for economic affairs. The agenda of the meeting is unknown. At least one probable subject of discussion is the exchange rate policy that has been followed by China in recent years.

The word of the street is that China may widen the daily trading band for their currency and allow the renminbi to trade over a wider range. This could allow the currency to gradually appreciate against the dollar, present China as a cooperative partner in global trade, and help to build for more open world trade going forward.

It is reported that “The Chinese foreign ministry would adhere to three principles on currency policy: any change must be controlled, it must be Beijing’s own initiative and any shift must be gradual.” (See “Geithner heads to Beijing for talks”: http://www.ft.com/cms/s/0/64c4bd04-4193-11df-865a-00144feabdc0.html.)

This points to the fact that the major issue here is a political one, not an economic one. China is on the upswing in the world and is playing out its options “close to the vest.” It is bargaining for the long run, and those that see the world only as a series of “short-runs” fail to understand the Chinese mind.

In a recent post, “Why should China Change,” http://seekingalpha.com/article/193689-why-should-china-change, I wrote: “One piece of advice some people 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.”

As a consequence of this the Chinese do not want to rush into anything, any new arrangement, without a full consideration of the implications of what they are about to do. Again, from my earlier post, “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. 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.”

And, the United States? “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.”

Yet, China does not want to “overplay” its hand.

The meeting this Thursday is a positive sign. The word is that “The secretary and the vice-premier have been working together to find an opportunity for some time,” according to a spokesperson for Secretary Geithner. Geithner, being right next door in India, found it very convenient to arrange a side trip for such a meeting.

As stated above, no agenda was reported for the meeting and there is no expectation that a statement will be issued when the meeting ends.

Still, leaders at this level don’t just agree to meet unless there is something going on. Furthermore, in recent months “conciliatory gestures” have been made by both sides. And, there was the April 2 telephone conversation between the presidents of China and the United States, a conversation that “reached an important new consensus” between the two parties according to the Chinese minister for foreign affairs.

Stephen Green, an economist with Standard Charter in Shanghai, was reported by the Financial Times to have said that “Some grand bargain between the US and Beijing appears to be in the works, if it hasn’t already been struck.”

As a prelude to the meeting, Geithner stated on television on Tuesday that the decision to revalue the renminbi was “China’s choice”. He also added that he believed that China would see that it was in their long run interest to work with a more flexible exchange rate policy in the future.

So, it seems that the pieces are in place and the meeting is at hand.

The bottom line is that it is in the interest of the United States to take a longer run view of things. For the past fifty years or so, the emphasis of the United States economic policy has been on the short run. As a consequence, the United States has focused undue attention on current levels of unemployment, short-run growth projections, and temporary fixes to markets and industries and, in the process, has established an inflationary-bias to monetary and fiscal policies that has produced more than an 80% decline in the purchasing power of the dollar. Individuals and families found that in such an environment the best way they could save was to buy a home and watch the value of the house appreciate. They didn’t need savings because their net worth was rising with the price of their home.

This short-run focus produced mounting deficits that had to be financed off-shore since Americans, themselves, were not producing the savings necessary to fund them. Thus, the rest of the world helped to finance the inflationary binge and now we in the United States have to bear the burden of this myopia.

We can see now that a nation with a longer-term focus can trump a nation that just focuses on the short-run. If the United States is going to match up with China, and with other rapidly emerging nations in the world, then it, too, will have to lengthen its perspectives to the longer-run. Perhaps we are seeing this change in the progress that has been made leading up to this meeting.

And, maybe this gives us another picture of the underlying operating process of the Obama administration. In the current issue of Time magazine, Jon Meacham comments on “The New Book on Barack Obama,” titled “The Bridge” by David Remnick, the editor of the New Yorker. Meacham writes that Obama has a recognition that “politics (and life) is in the end more about the journey than the destination, since no destination is ever really permanent.” And, he argues, the president is “a patient man because journeys require patience” and this “helps explain his understated doggedness.”

If this administration is truly working from a longer-run perspective, maybe this is one reason that many of his critics, who have just a short-term myopia relating to policy and achievements, are so unhappy with him. We shall see.