When Debt Loads Become Too Large

Debt loads become unsustainable when people, businesses, and governments have to make choices…when they cannot just “have it all”.

A case in point comes from a story about the world famous philosopher Winnie-the-Pooh.  In this particular story, Winnie-the-Pooh is presented with the choice: “What would you have, Bread or Honey?”

To this Winnie-the-Pooh replies, “Both!”

During the earlier periods of credit inflation, people, businesses, and governments are able to reply “Both” to all choices and are able to get away with it because the credit inflation “buys” them out of the implied limitation on resources.

Credit inflations are cumulative because choosing almost all alternatives and financing them with debt just builds and builds the expansion.

The problem with credit inflations is that they one day come to a halt…that is the cumulative build up of debt becomes unsustainable and choices have to be made.  “Both” is not a viable answer any more.

The only possible means of extending the period of credit inflation once the debt loads become unsustainable and a “tipping point” is reached is for the monetary authorities to take the credit inflation to another level, a level that might be called “hyper-inflation.”  Hyper-inflations, however, do not have happy endings

Many governments, as well as individuals and businesses, have reached the point where decisions have to be made.  Budgets cannot just continue to be “wish lists” where all parties are satisfied.  Governments cannot create across-the-board job programs because of the need to substantially reduce their budget deficits.  In addition, raising taxes to cover these “wish lists” is just another effort to achieve a “both” outcome.

Keynesian stimulus plans are built on the presumption that the government can harmlessly attain “both” of the consequences of such policies: issuing unlimited amounts of debt and economic vitality.  This type of credit inflation can only succeed for a period of time and then the accumulation of debt catches up with the government.  In the case of the United States it seems as if the successful period of accumulation lasted for about 50 years.

And, we see that governmental hands can be tied in other ways.  President Obama was not able to commit much in the way of resources to the situation in Libya.  He dropped the ball to NATO.  And, the Libyan battle drags on.  And, President Obama cannot get caught up in the conflict in Syria.  In fact, American foreign policy is finding itself short on resources in many cases, a situation not faced by this county in the post-World War II period.

In addition, many state and local governments have promised way beyond their capacities on pensions, water projects, and other large capital expenditures and now face the dire prospect of not being able to cover their commitments.  We are seeing situations over and over again where debates about pension plans were put into arbitration in order to reach a settlement and those deciding the case had the sole objective of getting people back to work as soon as possible.  Thus, generous pension plans were put into place and the governmental unit could justify the “largesse” of the plans by passing on the responsibility for the decision to the arbitration panel.

People in Europe and the United States are now experiencing the very difficult position of having to choose.  And, as we see, having to choose is very painful.  As we are observing every day, politicians and governments will do almost anything they can to avoid having to make a decision. 

The consequence of such behavior?  Decisions get postponed into the future. 

The feeling: “Maybe if we postpone things long enough the problems will go away.”

The world, unfortunately, does not allow you to postpone the day when decisions have to be made indefinitely.  In most cases, if decisions are not made, the time comes when the crisis becomes so bad that decisions “have” to be made.

And, the problem with this is that the burden of the adjustment becomes even greater on those that can least bear them at the “crisis” date than the burden would be had the decisions been made at an earlier time. 

Politicians, however, are too concerned about their own re-electability to worry about this later time.  But, this is true of executives and their teams and of individuals and families.  People have a tendency to cling to the past and put off taking hard decisions.   

So the battle becomes a “war” between those that want to preserve as much of the “wish list” as possible,like Winnie-the-Pooh they want "both" or "all" of the choices, and those that claim that priorities have to be set and decisions have to be made.   

All to often the decision-making is postponed and postponed and postponed…until it becomes necessary to choose. 

The consequence of this in the financial markets…is volatility.  The uncertainty created by the postponement of resolving the situation is the extreme movement of market prices as traders are moved this way and that way by the most recent information. 

Value investing takes a back seat in such an environment for the achievement of long-term objectives requires extreme confidence and patience.  The draw of short-term trading returns is heady…yet extremely risky.      

Right now, there is very little hope for us to see a much better future.  To see an improvement in the future would require some real leaders to emerge from the crowd and I don’t see anyone yet that fits that description. 

Mr. Bernanke and the Fed Don't Know What is Going On!

Recently, the Federal Reserve has held 43 meetings around the country on the financing needs of small business. These meetings began February 3, 2010. Yesterday, Mr. Bernanke hosted a forum on small business lending at the offices of the Board of Governors of the Federal Reserve System in Washington, D. C.

The conclusion of all these meetings about the financing needs of small business?

“Mr. Bernanke’s remarks,” on Monday, “suggested that the Fed was not sure why lending had contracted.” (See “Small-Business Lending is Down, but Reasons Still Elude the Experts,” http://www.nytimes.com/2010/07/13/business/economy/13fed.html?_r=1&ref=business.)

Now there’s a confidence builder.

The Federal Reserve and its Chairman don’t know!

And, they held 43 meetings around the country plus the one on Monday and they haven’t a clue?

I have been writing about the decline in business lending at small banks (in fact at all banks) for 18 months now. Did the Fed just become aware of this fact early this year and are now just trying to understand what is going on?

Go back to your equations, Mr. Bernanke!

The Federal Reserve, the federal government, most economists like Mr. Bernanke, and politicians don’t understand debt. Their models don’t include debt and their thinking doesn’t include debt. They seem to believe that debt is something that can be issued without fear of having to pay it back and if one does get into trouble because of the debt that was issued in the past then they can just issue more debt and that will get them out of their problem.

The banks, particularly the 8,000 banks that are smaller in size than the largest 25 domestically chartered banks in the country, face three factors that are particularly troublesome. First, many of these banks have troubled assets on their balance sheets, especially commercial real estate loans that must be re-financed over the next 18 months or so. Debt can go bad and those that hold the debt must reduce their net worth, their capital, when they write the debt off.

Second, the business environment, both in the United States and in the rest of the world, is very uncertain. The future is very unpredictable and this makes balance sheets extremely fragile. This situation makes banks very unwilling to commit to create more debt on their balance sheets and it also makes businesses, very reluctant to add more debt to their balance sheets. In fact, there are plenty of incentives for these organizations to actually reduce the amount of debt on their balance sheets.

Third, banks need capital, not more debt. About one out of every eight banks in the United States is on the list of financial institutions that are facing severe problems as determined by the Federal Deposit Insurance Corporation. My guess is that maybe three other banks in eight in the United States need a capital infusion. And, with new financial reform legislation about to be enacted, commercial banks will be facing higher capital ratios and a more diligent examination of bank capital positions. Banks are going to be very careful about creating more additional debt that place them in a precarious position relative to the new capital requirements.

What is there not to understand?

And, the headlines read, “Bernanke in call for banks to lend more,” (See http://www.ft.com/cms/s/0/c40445b2-8e07-11df-b06f-00144feab49a.html.)

The Federal Reserve is keeping its target rate of interest between zero and 25 basis points and has injected $1.0 trillion of excess reserves into the banking system! This is to provide incentives to banks to lend.

And, the fundamentalist preacher Paul Krugman shouts at the top of his lungs about “The Feckless Fed” who is “dithering on the road to deflation.” (http://www.nytimes.com/2010/07/12/opinion/12krugman.html?ref=paulkrugman)

Krugman and his whole fundamentalist crowd not only believe that additional spending and more debt on the part of the government is needed at this time but that we need the forgiveness of consumer debt so that consumers can start borrowing and spending again, and we need the Fed to force commercial banks to support more borrowing on the part of businesses so that they can invest in inventories and plant and equipment. Then we inflate the real value of the debt away so that issuing debt is not so painful.

Isn’t this just the attitude that got us into the situation we are now in?

Unfortunately, this attitude seems to have prevailed in history as arrogant governments over time have lived off of issuing more and more debt and then inflating their way out of their responsibility to pay it off. On this issue see the books by Rogoff and Reinhart, “This Time is Different,” (http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff) and Niall Ferguson, “The Ascent of Money,” (http://seekingalpha.com/article/120595-a-financial-history-of-the-world).

There was another time, in the spring and summer of 2008, when Mr. Bernanke and the Federal Reserve didn’t seem to know what was going on. The consequence of this ignorance has been pretty severe.

To think that people can say that Mr. Bernanke and the Federal Reserve don’t know what is currently going on in the banking system they oversee and regulate is downright scary. The American people deserve better!

Why Krugman Is Wrong!

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

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

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

Amen, brother! Alleluia!

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

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

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

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

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

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

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

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

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

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

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

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

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

Inflation is in the News

There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” http://seekingalpha.com/article/188351-doesn-t-anyone-understand-inflation. The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.

This morning we see an opinion piece by Wolfgang Münchau in the Financial Times, http://www.ft.com/cms/s/0/9776aeb0-1ef2-11df-9584-00144feab49a.html; an article by Sewell Chan in The New York Times, http://www.nytimes.com/2010/02/22/business/22imf.html?ref=business; and another article by Jon Hilsenrath in the Wall Street Journal, http://online.wsj.com/article/SB20001424052748704511304575075902205876696.html#mod=todays_us_page_one. All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.

The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”

In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.

The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!

It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.

The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.

Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.

The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”

The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.

The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.

Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.

Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.

The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.

I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.

The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.

This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.

The Debt Problem Poses a Two-Sided Threat to the Fed

There are two numbers I can’t get out of my head. The numbers are $1.84 trillion and $1.26 trillion. These are estimates of what the deficit of the United States government is going to be for the fiscal year ending in September 30, 2009 and the fiscal year ending in September 30, 2010. (Note that revised estimates for the fiscal year were supposed to be put out in July, but the Obama administration postponed their release until sometime in August.)

It was announced today that the budget deficit in July reached an all time record of $180.7 billion and this brought the year-to-date deficit to $1.27 trillion.

Some simple calculations show that if the estimated number for fiscal year 2009 is to be hit, the budget deficits for August and September will have to average $285 billion per month.

This would mean that the deficits would be $100 billion more a month than the record deficit that was posted in July! This is not a good trend.

Some analysts are predicting that the current year deficit will actually top $2.0 trillion while the 2010 deficit will reach $1.5 trillion. With the deficit for next year at $1.5 trillion, the monthly deficits would only average $125 billion, a figure that would look pretty good given the July, August, and September figures presented above. But, is this realistic given all of the proposals and programs that are in the federal pipeline.

Gross federal debt held by the public increased by more than 28 percent, year-over-year, at the end of the second quarter of this year. That is up from 24 percent at the end of the fourth quarter of 2008 and 15 percent at the end of the third quarter of 2008. With the forecast figures for the deficit, these numbers are going to continue to be at relatively high rates in the near term.

According to the Congressional Budget Office’s alternative fiscal projections, the public debt of the United States could rise from 44 percent of GDP in 2008 to 87 percent of GDP in 2020.
Adding this much debt to the world is going to place a tremendous burden on financial markets!

The Federal Reserve announced today that it was going to continue on its path to purchase the $300 billion in Treasury securities that it had already committed to, but would extend the program through October rather than ending it in September. The Fed will also retain its plan to buy as much as $1.45 trillion of housing debt by the end of the calendar year. By August 5, 2009 the Fed had purchased $543 billion in mortgage-backed securities.

Numbers like these only cloud the picture of what an “exit” strategy might look like for the Fed. In fact, it does not look like an exit strategy at all.

But, this is just one side of the coin. The other side has to do with existing bad assets. Elizabeth Warren, the chair of the Congressional Oversight Panel that is monitoring the bank bailout effort appeared on Joe Scarborough’s “Morning Joe” program today and stated that the “toxic assets” on bank balance sheets that got us into this financial mess are still there. And, they are going to have to be dealt with at some time in the future. For the near term she warned of a looming commercial mortgage crisis, one that will require more federal money, especially for smaller banks.

Oh, and about commercial mortgages, what about the problem the Fed faces with the commercial mortgages that it already has on its balance sheet. This morning in the Wall Street Journal there was an article about how the Fed has to deal with some debt it inherited from the Bear Stearns failure. (See “Fed Grapples with Extended Stay,” http://online.wsj.com/article/SB125003659369724401.html#mod=todays_us_money_and_investing.) On the balance sheet of the Fed there is a line item dealing labeled Maiden Lane related to the Bear Stearns sale to JPMorgan Chase. Included in this line item is a $900 million debt that the Extended Stay Inc. chain of hotels owes to the Federal Reserve among others. Extended Stay is in bankruptcy now and the issue is how the Fed is treated among other debtors and the deals that have been made between Extended Stay and some of the lenders. It is messy. But, this comes with doing the deals that the Fed has been doing.

And, apparently the Maiden Lane fund holds about $4 billion in debt backed by Hilton Hotels. Messy, messy, messy.

But, the Fed has also extended money to AIG, and to money market funds, and to commercial paper dealers, and has $543 billion of assets tied up into mortgage-backed securities. The Financial Times reported this last week that the Federal Reserve Bank of New York is hiring like crazy attempting to add positions to its staff as fast as it can, positions that will deal with all the future issues arising from all the new programs that the Federal Reserve System has gotten into over the last year or so. The administrative headaches of these actions are now being felt. (Question: if the Fed exits all of these programs, does the Federal Reserve Bank of New York need to create an exit plan to have a reduction in staff when these programs go away?)

And, the National Association of Realtors released information today that home price declines accelerated in the second quarter and Realty Trac said that foreclosure filings reached a level at which 1 in every 84 U. S. households had received a filing. ForeclosureRadar warned that California was on the verge of a new wave of foreclosure sales as notices of default, the first step in the foreclosure process, rose 12% in July from one year ago. Prime borrowers that were behind on their mortgage payments rose 13.8% between March and June.

On top of this household debt remains at about 130 percent of disposable income and household net worth continues to decline.

Business defaults are above 11 percent and are heading toward 13 percent according to some experts.

As we have reached a relatively calm period in economic and financial markets, more and more people are demanding that the Fed present them with a picture of how it, the Fed, might get out of the position it is in. With all the debt that currently exists and all the debt that is going to be created, the Fed seems to be at a loss about what an exit strategy might look like. In fact, with the growth of federal debt projected to stay in the double digit range for several more years, the realistic answer to the request for the Fed to devise an exit strategy is that there seems to be nothing to exit from.

If we accept this conclusion then we must argue that the problem is not with the Federal Reserve, the problem is with the federal government. The problem is with the Treasury department and with Mr. Geithner. The problem is that there is too much debt outstanding, and the creation of more and more debt by the federal government is not helping the problem, it is only exacerbating it. And, Mr. Geithner only strains his credibility, and that of the administration, when he argues that there is already a plan to reduce the future deficits.

CIT and Getting Out Of This Mess

CIT is an example of the kind of problems still facing the economy. CIT has taken on legal counsel in order to determine whether or not it should go into bankruptcy. The problem, the company has $2.7 billion in debt coming due through year end and its credit-rating has been cut “deep into ‘junk’ territory.” (See http://online.wsj.com/article/SB124744080839729811.html#mod=testMod.) It has been seeking liquidity help from the Federal Government but has not received approval yet.

Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.

The current debt crisis is so severe because of the credit inflation created by the U. S. Government over the last eight years of so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.

In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!

If the credit inflation during a period of economic expansion is not too excessive then the following correction that must take place can be relatively mild and reasonable and the government can come in and re-flate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?

This is what happens in most minor recessions.

An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.

What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.

There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected...no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper inflation going again which is the classic solution for an economy with too much debt.

There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.

A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or it will have to renounce the debt by declaring bankruptcy.

One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could reduce sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?

If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow. Also, on Monday morning investors dumped the company’s stock.

The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.

The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term. There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.

Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?

Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks,” http://online.wsj.com/article/SB124744606526030587.html#mod=todays_us_money_and_investing.) So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?

The State of the Recession--a long way to go

Going into this holiday weekend, we need to take a little time to reflect on the state of the economy and the financial markets. I certainly don’t want what I write below to sound like a “rosy scenario” but I would like to try and put some perspective on where I think we are and what is ahead of us.

First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.

My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System” http://seekingalpha.com/article/129838-the-clogged-banking-system.)

The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.

The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.

There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.

But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.

Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts
http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned and
http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan.)

Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.) which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.

The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.

Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.

In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” http://www.ft.com/cms/s/0/f3f00a48-249c-11de-9a01-00144feabdc0.html.) This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.

This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.

The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.