Federal Reserve Report: No Need for QE3

I keep reading that some people want to have the Federal Reserve begin a new round of quantitative easing…QE3.

I see nothing in the financial figures that calls for more quantitative easing.

For one, there seems to be no pressure on interest rates.  Looking over the last 13-week period the yield on the 10-year US Treasury (constant maturity) has remained relatively constant.  The weekly average for the week of November 4, 2011 was 2.07 percent: for the week of January 27, 2012 the weekly average was 2.01.  And, the market yield on 10-year Treasuries has been below 2.00 percent all of this week.

The European sovereign debt situation has certainly contributed to this weakness in yields.  Hence, there does not seem to be any demand pressure on interest rates at this time.

Economic growth continues to be modest and consequently is not adding any demand pressure on rates.

The commercial banking system is quiet and even though bank closures average around 2 per week adjustments are being made smoothly and with little or no disruption to the industry. 

Excess reserves in the banking system have fluctuated around $1.5 trillion over the past three months indicating little or no pressure on the financial system on the loan demand front.  This, too, is consistent with the modest economic growth.

Overt Federal Reserve actions have been absent over the past 13-week period indicating that the Fed is allowing operating factors to work themselves out without undue disturbance to the monetary system. 

The big change on the Fed’s balance sheet has to do with the European debt crisis.  Central bank liquidity swaps have risen by a little more than $100 billion since November 2, 2011 as the Fed moved to assist central banks in Europe.  It appears as if part of this increase went to take pressure off the market for Reverse Repurchase agreements with foreign official and international accounts.  The account recording this activity fell by about $41.0 billion over the same time period.

This has resulted in a net increase of about $53 billion in Reserve Balances at Federal Reserve banks but this has had little or no immediate impact on the United States banking system.

Actually, Reserve Balances at Federal Reserve banks declined by $7.0 billion over the past four-week period.  The increase in central bank liquidity swaps was just about totally matched by the decline in reverse repos with foreign official and international accounts as other factors removed reserves.

In terms of Federal Reserve open market operations, the securities account at the Fed actually declined in both the latest 4-week and 13-week periods.  Securities bought outright dropped by a little more than $11.0 billion since November 2 and by a little more than $5.0 billion since January 4. 

Over the past 13 weeks, about $20.0 billion in federal agency issues and mortgage-backed securities ran off in the portfolio.  The Fed only replaced this runoff by a little more than $8.0 billion.  In the latest 4-week period, the runoff in securities was across the board.

The conclusion I draw from the latest Federal Reserve statistics is that the Fed has had a relatively peaceful 13 weeks.  Money continues to flow into the United States Treasury markets seeking a “safe haven” from what is going on in Europe.  This, along with the mediocre economic growth in the country, has taken pressure off the Fed to buy more securities in order to keep interest rates low.  The fact that the securities portfolio at the Fed has declined over the past 13 weeks indicates that the Federal Reserve is letting market forces keep interest rates low and, for a change, is staying out of the market. 

If these conditions continue, I see no justification for any talk about another round of quantitative easing.

The money stock numbers are continuing to maintain excessive growth rates.  The year-over-year rate of growth of the M1 measure of the money stock for the week ending January 24, 2012 is 18.7 percent; the M2 measure of the money stock is growing at 9.7 percent.

Over the past three years I have been arguing that the reason that these money stock growth rates are so high, given the fact that commercial banks did not seem to be lending and that the reserves being pumped into the system by the Fed were going into excess reserves, is that the dire economic conditions have caused individuals and businesses to move their funds from interest bearing assets to transaction assets like currency and demand deposits.  The very low interest rates on the interest bearing assets also contributed to this movement.

Now, however, it seems as this re-arrangement of liquid asset holdings has slowed down.  This is something I think we want to keep our eyes on, for it could be that households and businesses have done all they can do to “be liquid” in bad times.  Thus, we will either see a slow-down in money growth measures (the rates have dropped since the first of November from a 20.0 percent year-over-year rate of growth for M1 and a 10.0 percent rate for M2) or we will see spending starting to increase as these transactions accounts are being used to actually buy things.  It will be interesting to see what happens here.

If people and businesses do speed up their expenditures, this fact would be another reason why another round of quantitative easing would not be necessary.  The Fed would have done enough.   

European Defaults: Portugal is Next After Greece

It ain’t over until it’s over…

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So the charade continues and Portugal seems to be next. 

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

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

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

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

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

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

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

Where Does Sovereign Credibility Come From? The European Sitaution

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

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

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

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

But, the limits must be enforced.

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

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

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

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

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

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

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

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

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

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

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

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

The issue is one of credibility. 

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

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

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

How to Solve the European Sovereign Debt Crisis

“It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.” 

That is what is needed to resolve the European sovereign debt crisis.  So says Christine Lagarde, the managing director of the International Monetary Fund. (http://www.bloomberg.com/news/2011-12-15/imf-s-lagarde-says-escalating-european-crisis-requires-more-cooperation.html)

Need one say more?

But, she stated, the world economic outlook “is quite gloomy” with a pervasive downside risk.

So, the international community must work together. 

Working together means that, starting at the core…the European countries…economic and fiscal union must be achieved.  This would be attained through fiscal solidarity and risk-sharing around the globe. 

Unfortunately, one has to ask…is this “actually facing the issues…accepting the truth…accepting reality...” or is it just another way to postpone what needs to be done for a while longer?

My blog yesterday discussed the underlying economic dilemma faced by the European nations.  Over the past ten years or so, unit labor costs in Germany have increased 20 percent to 30 percent less than in other eurozone countries. (http://seekingalpha.com/article/313888-the-problem-is-germany)  That is, German labor has consistently become more productive than non-German labor.

And, the non-German countries, in an attempt to keep their labor as fully employed as possible given the divergence in labor productivity, engaged in programs of fiscal stimulus which created a credit inflation that was unsustainable.  Hence, the sovereign debt crisis.

Since the eurozone is subject to a single monetary authority and a common currency, fiscal budget tightening, at this time, can only bring on the “pain and suffering” of a recessionary restructuring.

The problem is that countries within the European Union have been allowed to get “out-of-line” with one another, economically.  And, in a union of countries like this, nations cannot “paper-over” the differences in labor productivity by the creation of lots and lots of debt.  In fact, such behavior only can exacerbate the problem.

The countries in the European Union are facing a need for a massive restructuring of their economies, their labor markets, and their industrial structure.  Yet, “fiscal solidarity and risk-sharing” will not do this job. 

As I mention in my blog post yesterday and Alan Blinder states in his op-ed piece in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj) we have reached the stage where the only possible solution may be a substantial change in how people do things.

According to Blinder, the only path left may be debt deflation. The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

A possible response to this, however, is social unrest.  We have already seen protests in Greece, and Spain and Italy and France…  But, protests have become a worldwide phenomenon.  We have protests in Russia.  These movements are also seen as a kin to the events of the Arab spring.  Furthermore, there are the “Occupy” efforts…in the United States…and in other parts of the world that cannot be totally divorced from these other events.  Modern information technology is being felt everywhere.

It is difficult to see how the protests and unrest in the non-German countries of the eurozone are going to resolve the situation.  Just as with the idea of “fiscal solidarity and risk-sharing”, a movement that does not address the fundamental misallocations that exist within these societies will not come up with viable alternative solutions.   

The issue is that many countries are “out-of-line” economically.  German labor productivity exceeds that of other European nations.  The industrial structure of Germany is more competitive than the non-German eurozone countries in the global marketplace.

I am not in favor of returning to a world of mercantilism, as I mentioned in yesterday’s blog.  But, as many emerging nations have recently managed their economies so as to improve their relative position in the world, those developed countries that have focused just on buying off labor unrest over the past fifty years, may have to alter their approach to how their economies are managed.  “Soft” solutions will only enlarge the gap they face with more competitive nations.   

Remember, one conclusion about the internal management of a nation’s economy within the framework of world trade is that a country can only choose two of the following three alternatives available to them: the nation can have a fixed exchange rate; it can have a free flow of capital internationally; or it can conduct an economic policy independent of all other countries.  This problem is referred to as the “trilemma.”

Well, the countries within the eurozone have a fixed exchange rate and they have a free flow of capital internationally.  Therefore, they cannot conduct their economic policies independently of the rest of the world.

The only thing left for these countries to do is to create an environment in which the productivity of their labor and capital become more competitive within world markets.  If not, the most productive capital and labor will move on to other nations. 

This solution has little to do with “fiscal solidarity and risk-sharing.”

The labor and capital utilization within the countries that are not doing so well…must be restructured.

As managing director Christine Lagarde stated, “It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

I’m not sure she is there yet…but neither are a lot of other people.  

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

“European leaders’ blueprint for a closer fiscal union to save their single currency left the onus on central bankers to address investor concerns that Italy and Spain would succumb to the two-year-old financial crisis.” (http://www.bloomberg.com/news/2011-12-09/euro-states-to-shift-267-billion-to-imf-as-focus-shifts-to-deficit-deal.html)

In other words, the so-called leaders of the European Union did not lead! 

In place of action, they asked the European Central Bank to cover for them.

 

“Nineteen months since euro leaders forged their first plan to contain the debt turmoil, the fifth comprehensive effort added 200 billion euros ($267 billion) to the war chest and tightened rules to curb future debts. They sped the start of a 500 billion-euro rescue fund to next year and diluted a demand that bondholders shoulder losses in rescues.”

The biggest winner: Nicholas Sarkozy.  The “second best” award went to Angela Merkel. 

In other words, we still have not resolved the European sovereign debt crisis. 

And, what else was occurred?

The major loser award was given to Britain’ David Cameron.  Cameron refused to agree to a full change in the treaty for all 27 members of the European Union if there were no special safeguards for the financial services of the United Kingdom…more specifically, protection for the financial industry in London.  In taking such a stance, Cameron basically isolated himself from the proceedings of the summit.

The response of Financial Times editorial writer Wolfgang Münchau: “So we have two crises now. A still-unresolved eurozone crises and a crisis of the European Union.” (http://blogs.ft.com/the-a-list/2011/12/09/the-only-way-to-save-the-eurozone-is-to-destroy-the-eu/#axzz1g2glnIN4)

To Münchau, “The eurozone may, or may not, break up. The EU almost certainly will. The decision by the eurozone countries to go outside the legal framework of the EU and to set up the core of a fiscal union in a multilateral treaty will eventually produce this split.”

In other words, the inability of the officials of Europe to resolve the sovereign debt crisis is leading to additional difficulties that must be dealt with going forward.

The problem with not dealing with problems is that the problems tend to multiply and grow.

And, what about the threat made by Standard & Poor’s?  Will Standard & Poor’s downgrade the debts of the eurozone countries? 

The initial feeling is one of uncertainty.  It may be that Standard & Poor’s will not move right away…but, the European sovereign debt crisis is not over and the downgrade will probably come in the very near future. 

But, this raises another question…what about the European banks who hold so much of the sovereign debt of these nations?

Yesterday, the European Banking Authority declared that European banks needed to add 115 billion in euros to their capital base by next June.  New stress tests have indicated that the banking system, especially Germany’s, has a much bigger shortfall of capital than earlier thought.  Without the capital the EBA is concerned that the banks will be able to handle the continued financial stress in European capital markets. 

European officials, once again, fail to get their arms around the situation.

Perhaps one should not be surprised at this.

However, one question still lingers in my mind.  So much was made of the role that Angela Merkel was playing in the effort to get a more comprehensive solution to the European problems that concerns were raised about the possibility of German dominance of the European Union.  I even saw articles that made the following assertion: “What Germany could not achieve by military might may be obtained through financial strength.” 

If this is true then it appears that Europe is still fighting the old battles.  As long as Europe continues to operate on the basis of prejudices established years ago it will not move itself into the 21^st century.  If this is true, the European financial crisis still has a long way to go.

How Do You Cover Up Your Failure: the Greek Case

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

The situation: “the debt mess in Europe.”

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

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

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

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

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

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

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

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

Just ask Penn State University officials about this!

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

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

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

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

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

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

Hello, Occupy Wall Street!!!  

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

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

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

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

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

Something is Missing...

The Dow-Jones Stock Index dropped almost 400 points today. European stocks also dropped substantially…the FTSE 100 dropped by over 4 and one-half percent. 

European sovereign debt continues to grab headlines a the interest spreads on ten year bonds of troubled countries versus the yield on ten year German bonds remained near peaks. 

Today, the Economic Union moved to speed up the recapitalization of banks that did not show well in the recent stress tests administered to more than 90 banks.  “The move would affect mostly mid-tier banks. Seven are Spanish, two are from Germany, Greece and Portugal, and one each from Italy, Cyprus and Slovenia.” (http://www.ft.com/intl/cms/s/0/49d6240e-e527-11e0-bdb8-00144feabdc0.html#axzz1Yj4RAJ9F)  But, there is little confidence that this move will resolve things because the stress tests were such a joke!

Moody’s downgraded Bank of America, Wells Fargo, and Citigroup…and a couple of days ago a few European banks…that passed the stress tests. 

And, the top officials in the European Union continue to argue over this issue and they continue to argue over that issue and resolve little…but still hope to kick the can down the street a little further.  No one seems to be facing the real issues because their solutions appear to be so painful.   

In the United States, Ben Bernanke and the Federal Reserve attempt to grasp another straw in the wind as they continue to throw “stuff” against the wall, hoping that some of it sticks.  For three years now the Fed has thrown “stuff” against the wall but it must be too wet…for very little is sticking to the wall.  The Fed’s current monetary policy is to make sure that they throw all the “stuff” they have against the wall so that no one writing future history books can accuse them of not leaving any unused “stuff’ in the …

And, President Obama has come up with his new economic re-election platform disguised in the form of a jobs program, which includes new proposals to finance the program with various tax increases.  Since this combination is a part of the re-election campaign it must contain a little of this and a little of that to appeal to different parts of his voter base.  The problem with something like this is that it just makes the tax code more complex and provides incentives for the more heavily taxed…in the words of George Shultz, the former Secretary of the Treasury, ”the wealthy and General Electric”...to find ways to avoid bearing the burden of the tax. (See my post from Tuesday, September 20, “The Case Against the Obama Taxes”, http://maseportfolio.blogspot.com/.)   

Something is missing!

My answer has been and continues to be, that the something that is missing is leadership!

The problem is that there are no easy answers…no painless answers. 

People in Europe and the United States have been living high for fifty years.  The goals of high levels of employment and income re-distribution through the spread of home ownership have produced their consequences…excessive amounts of debt in households, businesses, national, state, and local governments. 

The economic policy of almost consistent application of credit inflation for the past fifty years has produced, in the United States, an 85 percent reduction in the purchasing power of the dollar, an under-employment rate of at least 20 percent, and the widest skewing of the income/wealth distribution in recent history.  If this is what credit inflation achieves…I don’t want it. 

Continuing to apply the policies of the past fifty years to the current situation will only exacerbate things.  We are facing an extended period of economic stagnation, at best, and a double-dip recession, at the worst.  Little or no growth in this situation will be accompanied with continued increases in the under-employment rate.  And, of course, continuing with all this stimulation with little of no economic growth will result in even more decline in the purchasing power of the dollar.

And,  as a consequence of the uncertainty related to the attempt to solve these problems, volatility continues to plague the financial markets.  Experts predict that the volatility of these markets will not subside until things settle down on the policy side and some true leadership is shown amongst our governmental officials and regulators.  That is, the volatility will continue until someone steps up to the plate and initiates a real solution to the existing situation.

The problem is that the main job of politicians is to get re-elected.  It is very clear to most politicians that resolving the debt-situation is going to be painful and many are already hearing the discontent of their constituents.  Riots in the streets of Greece and Spain are just a small indication of the disruptions that the politicians fear.  But, there is the fear that if they do too much they will not get re-elected.  The are caught in the trap of having to do something…but not too much.   

The financial markets…the economy…are getting no clear vision of what the future may look like.  They don’t know what their taxes are going to be.  They don’t know what the rate of inflation will be. 

All the financial markets…and the economy…can do is go up…and go down…

Something is missing and the problem with this is that no one in the financial markets…or the economy…can identify where the leadership is going to come from. 

Can you?

The Debt Crisis: It Ain't Over Until It's Over!

The people in charge, both in the United States and Europe, still believe that the problem we are facing is a liquidity problem.  They, therefore, continue to come up with plans that “kick the can down the road a little further” but fail to come up with any solutions that will allow us to move on into the future.

For three years now, I have been arguing that the problem is not a liquidity problem but a solvency problem. 

There is too much debt outstanding in the world!  People, businesses, and governments cannot carry this debt much further, their debt load is unsustainable. 

This is a solvency problem.

Liquidity problems are short-lived problems.  They have to do with the ability of an asset holder to sell assets into the market place at prices that are near to the value of the assets on the balance sheet of the asset holder. 

Liquidity problems arise because the two sides of a market have different information sets.  The sellers of assets have a different set of information than do the buyers.  Because of this, the buyers generally take a little vacation until they have more information about the asset prices and regain sufficient confidence in the amount of information they have to begin trading again.  At this time the liquidity problem goes away.

Central banks (and other government agencies) may intervene in the market providing a floor to asset prices until such time as the buyers start buying again.  This is the “classic” function of the central banks to provide liquidity to the banking system.

Solvency problems are different.  When solvency problems occur, the holders of assets know that the value of their assets are below that recorded on their balance sheets.  They are reluctant to sell the assets or recognize the value of the assets because any write down of the value of the assets would have to be taken against net worth and this might threaten the solvency of the economic unit that holds the underwater asset.

A solvency problem is a “sell” side problem whereas a liquidity problem is a “buy” side problem.

Economic growth or price inflation may help asset prices regain their balance sheet value.  However, in the absence of either of these forces, market prices may remain below the book value of the asset and this threatens the existence of the household, business, or government.

There is too much debt outstanding in the world!  Whoops, I said that before?

Much of the debt is underwater.  Economic growth or inflation are not coming along fast enough or strong enough to “buy out” this underwater situation.  Hence, the threat of insolvency exists for many people, businesses, or governments. 

Sooner or later asset values are going to have to be written down!

Continuing to postpone the day when they are going to be recognized just creates more and more uncertainty.

The fact that the people running the governments in America and Europe can’t come to grips with this just creates even more uncertainty.   

This uncertainty is the biggest factor in the marketplace right now.  With so much uncertainty in the world, market participants jump this way and that way in response to almost any new bit of information being released. 

And, my guess is that this volatility will continue until people recognize the nature of the problem they are facing.  Until the people running things accept the fact that the crisis they are facing is a solvency crisis and do something about it, this uncertainty and volatility will just increase. 

As Yogi Berra said, “It ain’t over ‘til it’s over.”

Until people realize it is a solvency problem and propose solutions to “get it over with”, the situation will continue. 

Now we know what it is like to live in a world without leaders!