The Chances for a Double Dip

I believe that the probability that we will have a double dip in the economy, a second recession following on the Great Recession, is relatively small and growing smaller all of the time.

The reason that I would give for this is that economies only change directions when there is some kind of shock to expectations. To use the words of one famous pundit with respect to an uncertain future, we just don’t know when something will change with respect to an “unknown” unknown. Even in the cases of “known” unknowns, we know where a change might occur; we just don’t know the magnitude of the change.

A liquidity crisis occurs when something happens in a market, generally a financial market, and the buyers on the demand side of the market decide it is best if they just go out and play a round of golf until the market settles and they know where prices will stabilize. The job of the central bank is to provide liquidity to the market so as to achieve this stabilization of prices. The length of a liquidity crisis is usually no more than four weeks.

A credit crisis occurs when something happens in a market, generally a financial market, and the holders of assets must significantly write down the value of their assets. Banks and other financial organizations may go out of business during the credit crisis because they don’t have sufficient capital to cover all the write downs that must take place. The job of the central bank is to provide stability to the financial markets so that the financial institutions can take their charge-offs in an orderly fashion so as not to cause multiple bank failures. The length of a credit crisis can extend for several years as the financial institutions work off their problem loans and those organizations that have to close their doors do so with the least disruption to “business-as-usual.”

In both cases, something unexpected happens and expectations about asset prices have to be adjusted. Extreme danger exists as long as bankers and investors persist is retaining the old expectations about prices and fail to make the moves necessary to adjust their thinking to a more realistic assessment of the situation. However, as these bankers and investors adjust to the “new reality”, they become more conservative and risk-averse in their decision making and work hard to get asset prices into line with the new financial and economic environment they have to deal with.

As the adjustment to the “new reality” takes place, things remain precarious, but, as long as no new surprises come along, the process of re-structuring can continue to lessen the problem and even strengthen the recovery. This is the state in which the United States is in right now.

The thing that needs to be avoided is a “new surprise”. What this can be of course is “unknown”…an “unknown” unknown.

In the 1937-1938 depression, there was an “unknown” unknown in the form of a policy change at the Federal Reserve System that is credited with “shocking” the financial and economic system into the second depression of the 1930s. The shock here was an increase in the reserves the banking system was required to hold behind deposits in banks, an increase in reserve requirements. The argument given for the increase was that there were a lot of excess reserves in the banking system and for the Federal Reserve to be effective at all during the time, the excess reserves had to be removed: hence the increase in reserve requirements.

The problem was that the banks wanted the excess reserves and with the increase in reserve requirements the banks became even more conservative causing another massive decrease in the money stock. This, of course, has been given as a reason for the “double-dip” that took place in the 1930s.

There are, as is well known, a lot of excess reserves in the banking system at the present time, almost $1.2 trillion in excess reserves. The Federal Reserve knows that they are going to have to remove these reserves from the banking system at some time. Hence, it has developed an “exit” strategy.

Banks and investors know that the Federal Reserve is going to have to remove these reserves from the banking system at some time. How the Fed is going to accomplish its “undoing” is, of course, the big unknown!

The fact that these reserves are going to be removed from the banking system is a “known” unknown!

But, how and when the reduction in reserves is going to take place, not even the Fed knows. Bernanke and the Fed have worked hard to keep the banking system and the financial markets aware of the “undoing” so that although there are still many unknowns connected with this undoing, the fact that the “undoing” is going to be done is a “known.”

The effort here is to avoid a policy “shock” coming from the central bank as in the 1937-1938 experience.

There are a lot of things going on in other sectors of the economy and the world, but these all seem to fit into the category of “known” unknowns: like the problems in Greece and the other PIIGS, Portugal, Italy, Ireland, and Spain. There are the problems of states, California, New York, New Jersey, and so on, and municipalities, like Philadelphia and others, but these are also “known”.

There are over 700 commercial banks on the problem list of the FDIC. But these are “known” and are being worked off in an orderly and professional way that seems to be the model of the world. (See the article by Gillian Tett, “Practising the last rites for dying banks,” http://www.ft.com/cms/s/0/00b740a2-350e-11df-9cfb-00144feabdc0.html.) The FDIC closed seven banks last Friday bringing the total for the year to 33. This is right on my projection of closing at least 3 banks a week for the next 12 to 18 months.

And, what about the United States deficit? Well, I would contend that this is a “known” unknown as well. The deficits over the next ten years or so are projected to be in the range of $9-$10 trillion. I believe that they will be more around $15-$18 trillion, but that is just a minor difference. But, the deficits are “on-the-table” even if the amounts are not quite certain. The deficits will be large and this will be a problem, but they are not going to be a surprise.

This is one reason, I believe, why the Obama administration made the effort they did to talk about the budget deficits publically, particularly with regards to the health care initiative. They are talking about the budget, whether one agrees with their projections or not.

And, just the passage of the health care legislation, I believe, will change the temper of things. This thing has been done and I think just this fact will change the environment…for the better.

There are always “unknown” unknowns lurking. There could be a blow up in the Middle East leading to a full-scale war…or in the east. There could be a political move to boost the price of oil. There could be a lot of things. But, as far as the economy itself and the financial markets: I believe that things are being worked out and things will continue to improve. Thus, the probability of a Double Dip has lessened.

Credit Market Debt: Why Is So Much Going to Bank Holding Companies?

Credit market debt increased by only 3% from the end of the second quarter of 2008 to the end of the quarter of 2009, a total of roughly $1.5 trillion. Of course, the primary story concerns the shifts in borrowing that took place during this time. The data used in this analysis is from the Flow of Funds accounts from the Federal Reserve.

One should note that the only two really substantial increases in credit market debt during this time period were the Federal Government and bank holding companies. Bank holding companies?

The Federal Government is easily identified as one of the primary borrowers during this time period as the debt of the government rose 36% or a total of $1.9 trillion. This is the largest year-over-year increase, dollar-wise, in history! But, this is not a surprise for we knew this was coming.

Note, that this increase does not include other sources of government debt extension in what are called “Funding Corporations” that include the creations of the Federal Reserve System to fund AIG and so on. This source of government funding reached a maximum of $445 billion in the fourth quarter of 2008 and dropped off to only $224 billion by the end of the second quarter of 2009.

One thing that has interested me is the performance of the commercial banking industry. The commercial banking industry, as a whole, has increased its use of credit market debt by a little more than 23%, although U. S. chartered commercial banks have actually reduced its reliance on this source of funds by about 6%. Note, too, that the credit market debt of the whole financial sector declined by about 1%.

The difference has come in the dramatic increase in the use of credit market debt by bank holding companies. Bank holding companies increased their use of this source of funds by 50%, an increase of $365 billion. In the process, the bank holding companies reduced their reliance on commercial paper by $78 billion and raised a net of $443 billion in corporate bonds. Thus there was not only a substantial increase in the funds bank holding companies raised during this time period, there was also a lengthening of the liabilities of these institutions.

One should call attention to the fact that Goldman, Sachs and Morgan Stanley became bank holding companies during this time period. How much of an impact this fact had on these aggregate numbers is hard to tell, but one should be aware of this movement. These two organizations became bank holding companies on September 22, 2008 and the bank holding numbers did not really increase appreciably during the third or fourth quarters of the year. Although total financial assets in bank holding companies rose modestly from the end of the second quarter to the end of the fourth quarter, actual credit market liabilities decreased. The numbers really began to jump upwards at the end of the first quarter of 2009.

Another factor influencing bank holding company debt during this time is the guarantee on bank bonds provided by the federal government. This gave bank holding companies the ability to raise funds relatively more cheaply than they could have raised them otherwise: a good reason to raise funds.

The interesting thing is that the raising of these funds did little or nothing to spur on bank lending or commercial bank growth. Investment in bank subsidiaries by bank holding companies went up by about $112 billion but this certainly doesn’t seem to have gone into bank loans since most of the increase in U. S. chartered commercial bank assets has been in the form of a rise in cash assets and government securities.

Total financial assets at banks rose by about $950 billion from the end of the second quarter of 2008 until the end of the second quarter of 2009. However, cash assets and reserves at the Federal Reserve rose by $430 and Government, Agency and GSE-backed securities rose by $185 billion. The only lending category to show much of a rise was the mortgage category, $233 billion, and this was primarily in commercial real estate. Commercial loans actually declined by about $100 billion. Something called Miscellaneous Assets rose by about $160 billion. Not a lot of lending going on in the banking sector.

However, investment by bank holding companies in nonbank subsidiaries actually rose by about $630 billion and investment in Other Miscellaneous assets rose by about $150 billion!

Thus, bank holding companies invested almost $800 billion in funding nonbank assets.

It seems as if big financial institutions are continuing to behave in the same way that they did before the financial markets started to unravel toward the end of 2007. That is, they put their money into non-bank operations, areas that the regulators did not have a lot of insight into or control over. That is, the banking system is still not relying on the fundamentals of banking to make money these days! They are returning to the areas that proved to be so profitable to them before the crash. And, once again, we seem to be in the dark as to what exactly they are doing.

Even through the credit crisis of 2008 and 2009, the credit markets provided some issuers of debt a substantial amount of funds. However, it seems as if these funds are going into hands that were very similar to the ones that were obtaining funds right before the crisis took place.

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 Citigroup "Rally"

The performance of the stock market today, March 10, 2009, I believe, provides us with a clear indication of what is predominantly on the minds of investors. The major concern of investors is the value of the assets that are carried by companies on their books, and especially on the asset values on the balance sheets of financial institutions.

I say this because Citigroup has been the “poster child” of what most investors feel is wrong with the financial markets and the economy. The perception is that Citigroup is so weighed down by assets that are not performing and that must be written down that there is little or no hope for its survival outside of a full takeover by the United States government.

Focus has been so strongly focused on the “asset problem” that other institutions, like Bank of America and JP Morgan Chase & Co., have also been affected with concerns about the value of their assets. As a consequence, the stock price of these and other financial institutions have declined drastically due to the uncertainty as to whether or not they are solvent.

The stock market took off right from the opening bell this morning. The cause—a memo written by Vikram Pandit, the chief executive officer of Citigroup, to employees of his organization indicating that Citigroup had been profitable for the first two months of 2009 and was likely to turn a profit for the first quarter of the year. If this happens it will be a sharp turnaround in performance for the company, a move to the black after five consecutive quarterly losses.

There was no indication about any special write-offs or credit losses, but the memo gave hope to the idea that Citigroup, even after such write-downs, would post a profit for the first quarter.

The hope that was forthcoming, I believe, is the hope that Citigroup will now be operationally in the black going forward and that this kind of performance would give them the time and cushion to continue to work off bad assets and take more modest charge-offs against profits in the future.

The hope is certainly not that Citigroup is “out-of-the-woods.” That would be too much to hope for. To me, what is captured in the market response is that Citi may still have time and not be forced into some precipitous governmental takeover action.

Now, let me say that this was just one day and just one piece of action released by someone that needs, in the worst way, to give some sort of encouragement to his troops. Tomorrow is another day and there will be more information and more market maneuvering in the future. But, it was a day in which there was a possibility for hope—no matter have small that hope might be.

The problem had been that investors had perceived asset values declining with no bottom to be seen. And, there was no one or no event in sight that might put a stop to this decline.

This is why I believe that the financial markets have not been giving President Obama and his team “good grades” on their efforts to craft an economic policy and a bank rescue bill. The economic recovery plan was proposed and passed by Congress, yet there was no “bounce” in the market due to this program. So far, any bank rescue bill talked about or outlined has been deemed a dud.

It is this latter failure that the financial markets have been reacting to. To the financial markets the concern over asset values has dominated everything else. The recovery plan does not address this issue and so does not provide any confidence to investors over possible bankruptcies and takeovers related to institutions that are insolvent due to the bad assets on their books. Expenditures on infrastructure and education and health care and so on are one thing, but a stimulus package like the one that passed Congress cannot prevent a collapse of the financial system as the value of assets plummet and are recognized.

And, so the memo relating to the two-month performance of Citigroup hit the market and gave investors some encouragement that there might be some possibility that the problem related to asset values maybe…just maybe…could be worked out. And this attitude spread to other companies and other areas in the stock market.

We see that the stock of Bank of America Corp. rose 28 percent, the stock of JPMorgan Chase & Co. rose 23 percent, and the stocks of PNC Financial Services and Morgan Stanley increased by double digit numbers. Of especial interest is that the stock of GE rose by 20 percent reflecting the spillover of the positive attitude given to the banks was also given to GE and the concern over the fate of GE Capital.

Again, all of these companies have seen the price of their stocks decline in the past six months or so because of the concern over the value of their assets.

As mentioned, stocks rose from the opening bell, seemingly responding to the contents of the Pandit memo. But, the market responded to other news that they interpreted in a positive manner.

Fed Chairman Ben Bernanke gave a speech that reinforced the “good news” coming out of Citigroup. In this speech, Bernanke discussed the need for moving onto a new regulatory system. The part of his statement that market participants focused upon was Bernanke’s claim that the accounting rules that govern how companies value their assets needed to be changed. The Fed Chairman was careful to say that he did not believe that the mark-to-market accounting rules should be changed. Still he did talk about how asset values should be treated and investors reacted to this in a positive way. Again, the focus of the market was on asset values and little else.

There was one other bit of news that the financial markets reacted to in a positive way and that was the comment of Barney Frank about the “up-tick” rule. This statement, although important in itself, was only a side-show in the movement of the stock market today. Its just that when the good news is poring in, look out!

The important take away about the performance of the stock market today is that the major focus of the investment community is on the value of the assets on the balance sheets of banks and other organizations in this country. This message should be read loud and clear by the Obama administration. Spending plans are fine, but the recovery of the country depends very heavily on what is done about the value of the assets on the books of banks and other organizations and how losses in value are going to be worked off.

This is important too because of what is on coming in the future. It seems as if the credit problem is going to accelerate as the defaults rise on credit card debt, as interest rates need to be reset on Alt-A and option payment mortgages over the next 18 months or so, and the looming bust in the commercial real estate market. The asset value issue is not going to go away soon.

So, we got a rise in the stock market. We may get several more in the next week or so. I don’t believe anyone can predict the movement in the stock market over the coming six months. There are still too many uncertainties. And, even if the stock market were to rise over the next six months, my bet is that the asset valuation problem is still going to be with us. And, in all likelihood it will still be with us next year at this time.

The Three Problems We Face: Debt, Debt, and Debt!

The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.

As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.

This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.

The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.

The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…

The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.

Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.

As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.

What is the response to the existence of too much debt?

Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.

The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.

Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.

One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.

However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.

And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.

The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?

The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)

The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?

The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.

The Two Major Issues in this Crisis

There are two major issues that have to be confronted in this crisis. First, there is the pricing of assets. Second, there is the issue of capital. In my mind, the two need to be kept separate.

The first concern is that there are many securities that, at present, don’t have a market and hence their prices cannot be determined. This is primarily a short run issue. Typically in a situation like this the Federal Reserve provides sufficient support for the financial markets so that the markets stabilize and trading can once again take place. We are beyond that situation now and so we have to look further into what kind of problem might exist.

The situation we are in now is related to what economists call “the accelerator model”, a way of looking at things that Ben Bernanke is particularly fond of. On the up-side, the accelerator model helps explain what Charlie Kindleberger, an economist at MIT, popularized as the “mania” portion of a bubble. (See Kindleberger’s book, along with Robert Aliber, titled “Manias, Panics, and Crashes…a classic.) The problem with manias…and panics…is that they are cumulative. That is, they build on themselves.

The “accelerator model” in modern terms has a feedback mechanism in it that can create cumulative movements in asset prices. The particular channel this feedback mechanism works through is individual wealth. As the economy expands, asset prices rise. As asset prices rise, the wealth of individuals increase and they spend more out of this increased wealth. This additional spending raises asset prices further, credit grows to support this increase, and this leads to another round in which wealth grows further…an so on and so on.

Adherence to this model helps to explain Bernanke’s fear of inflation before last August.

But, the “accelerator model” works on the downside as well. The downside result has often been referred to as “deleveraging” or as a period of “debt deflation.” Here, as the economy slows or asset prices dip, the wealth of individuals declines. People reduce their spending and asset prices fall further. As asset prices decline, credit is tightened and this exacerbates the drop. This, obviously, is cumulative in behavior.

Just as Bernanke was concerned about the possibility of inflation in the spring and summer of 2007 he became extremely concerned about the possibility of debt deflation a week to ten days ago.

Did Chairman Bernanke panic? Did he over react? Only time will tell.

The issue before Congress now is whether or not they should enact a bailout plan that will help to stabilize the asset prices of a vast quantity of securities. Setting aside $700 billion in funds to help stabilize the market is the primary goal of the proposal.

ASIDE: whether or not the total is $700 billion or $1 trillion or $2 trillion is irrelevant. Supposedly when ask, a Treasury official said that there was no good reason for the choice of $700 billion, it was just that the number had to be quite large. This, of course, did not build confidence for the Paulson plan. However, in my judgment the answer is the correct one. No one knows how big the number needs to be. The crucial thing in a debt deflation is that those that are attempting to get out ahead of the situation need to have a lot of “chips” to play with. Whatever the number was it had to be a big one!

Return to message: is a proposal like this needed? Will such a proposal work? As I said in my Monday post…this is decision making under uncertainty…and this is beyond graduate school!

Another question that is being raised by House Republicans is whether or not this bill is philosophically (or ideologically) correct. The model these members of Congress work with initially cause them to reject such government interference with the market place. They have their arguments and we need to hear them before a final bill is passed. Any bill that is passed must have the general support of all members of Congress.

The second issue has to do with capital adequacy. It is argued that many financial organizations do not have sufficient capital to absorb the losses that exist on their balance sheets and will find it extremely difficult to continue business as usual if they are under-capitalized.

This issue is completely different from the first issue discussed above.

There are two choices here…either the market is allowed to work in the re-capitalization of these institutions or we allow the government to “invest” in these firms and become “owners”. The latter solution would mean that these institutions would be nationalized and we would, explicitly, socialize the financial system.

I guess we could call a combination of the two a possibility, but this would really be just bastard socialization…once you start this you have a socialized system regardless of how much of the system is in private hands.

To me there is no choice. I argue that the market should be allowed to determine who stays and who goes. What this will mean, however, is that more and more capital for American institutions will come from off shore. That is, the “wonderful” support for United States debt that has been accelerating in recent years, along with the decline in the value of the dollar, will lead to more and more foreign ownership of America’s assets.

Given this scenario, the major reason that might be given for a socialization of American finance is to keep it under American ownership, even if that ownership is coming from the government.

These two issues are the most important ones being faced in the current crisis. All the other things, to me, are secondary and should not muddy the waters of the debate going on.

ANOTHER ASIDE: I cannot agree with those that believe that this crisis was caused or exacerbated by “mark-to-market” accounting. I firmly believe in “mark-to-market” accounting because it increases the transparency of an institution’s decisions. Yes, it the market is moving around a lot there will be a lot of changes recorded on the balance sheet of a company, but, it was the management’s decision to have acquire such assets and the affect of these decisions should be obvious to shareholders and others. Riskier assets will require more marking to market. That is the choice of management. That choice should not be hidden.

Earning the Trust of the World

It is difficult for an individual or an organization to earn the trust of the market. Although market participants may want to give an individual or an organization the ‘benefit of the doubt’, especially when a person or the leadership of an organization is new on the job, trust has to be earned and trust is not gained overnight. But, trust can be quickly lost and once it is lost it becomes even harder to earn it back..

There seems to be very little trust in the Bush administration these days and to hear members of “the team”, including President Bush, out in public talking up a strong dollar seems a little bit absurd and surreal. From time-to-time, the Bush administration has spoken about a strong dollar, but has never seemed to do anything about it. And, this charade has gone on for seven years or so.

Now, when this administration is in its waning days, when it can do little or nothing in the way of implementing appropriate policies, when it is subject to internal questioning of what it has done, “talking the good talk” just highlights how incompetent and how out-of-touch the Bush administration really is. The President has never really had much of an interest in economic policy making and has failed to appoint or listen to quality advisors. The results that have been achieved only point up these failures.

The internal questioning is another issue. Individuals that have been members of the Bush administration have given us their impressions about economic policymaking after they have left the administration, but now we have people within the monetary wing of the team expressing doubts and concerns in the public square. (See my post of June 6, 2008, The Bermuda Triangle?” which was posted on Speaking Alpha on June 10 with the title “Fed Policy and U. S. Economic Turmoil”.) Fed Chairman Ben Bernanke has spoken out three times in the past week to argue for a strong dollar and to waylay worries about the jump in the unemployment rate. (see:http://online.wsj.com/article/SB121305516121159161.html?mod=todays_us_page_one.) Yet, one worries about the leadership within the Federal Reserve System with so many governors and district bank presidents speaking out. This is coupled with the fact that the Board of Governors only has three confirmed governors plus one who resigned a week ago. Where is the source of any confidence here?

But, let’s look to the future, to the presidential candidates. Polls inform us that the state of the economy is, by far, the most important issue on the menu of voters concerns. The two candidates are contending that economics is the big issue that they will fight over in the upcoming election and that they stand miles apart in terms of what they would do.

Yet, what do the participants in international markets hear? They hear discussions about tax cuts…tax cuts for middle-income families and retirees…tax cuts for corporations and upper-income families…and expanded unemployment aid…and subsidies for state relief programs…and enlarged coverage of health care…and help for families facing foreclosure on their homes…and so on, and so on.

How will these be paid for? By letting the Bush tax cuts expire…by cutting back on other programs…by the reduction of support for the military through redirecting the use of resources…by taxing corporations like those in the oil industry…by better management of programs…by efficiencies…and so on, and so on.

The markets are interpreting this debate as promising more and more government debt. They have heard these arguments before. More benefits for the electorate…paid for through reductions in government or better management of programs. International markets are just hearing “more of the same”. And, when they look at the advisors to these candidates they see one candidate who admits that he doesn’t know much about economics and has two old friends, Phil Gramm and Jack Kemp, as his primary advisors. (“Back to the Future” Part VII or VIII.) The other candidate…well, that remains to be seen…we are told that the overall plans will be forthcoming this fall. Not much of a confidence builder here.

What about monetary policy? The bet is still on that United States monetary policy will help to underwrite the government debt. The first concern is with the leadership of the Federal Reserve System. Disarray within the body is not a good sign. The absence of so many principals it also not a good sign. And, the monetary authority is still strapped with the assignment to pursue both economic growth and low inflation...something that is very, very difficult to do. Furthermore, with a credit crisis still at hand…the Lehman earnings report did not help nerves at all…and the possibility of a recession…unemployment up, car sales and retail sales down and the housing market still in the tank and so forth…along with high oil and food prices…the best bet is that the Fed will support policy actions to lower unemployment and spur on economic
growth. It is currently the American way to inflate oneself out of problems.

Not only is this the way of the government, it is also the way of the people. A timely article on this point is the David Brooks piece in the New York Times of June 10, 2008: http://www.nytimes.com/2008/06/10/opinion/10brooks.html. I have also presented some points on this: see my blog of June 4, 2008, “Economic and Financial Power and Leverage”. Discipline does not seem to be a word to be found in the American vocabulary these days.

One of the problems is that we have to get rid of the Keynesian idea that monetary policy has a responsibility for high levels of economic employment. For one, statistical research has shown that monetary policy has very little, if any, influence over the unemployment rate over time. So, empirically, the relationship between monetary policy and employment is a weak one. Secondly, the Keynesian model was developed to provide a foundation for government spending policies at a time when greater national autonomy in economic policymaking was desired to achieve higher levels of employment so as to avoid social revolution. (See Donald Markwell, “John Maynard Keynes and International Relations, Oxford University Press, 2006.) These times have passed, yet, as Keynes himself argued, the ideas of economist long dead still influence the making of economic policy. The monetary authority needs to focus on inflation as its primary responsibility and not some dream about achieving high employment.

The difficulty that the United States is facing is exacerbated by other institutions within the world that are earning the trust of international financial markets. The European Central Bank (ECB) is one such institution and the Bank of England is another. The ECB has, as its main function, the goal of low inflation. It is determined to crush inflation. (See http://www.ft.com/cms/s/0/42ffd73e-3688-11dd-8bb8-0000779fd2ac.html.) The Bank of England is also taking a strong stance against the rising tide of inflation. Nations within the world community cannot ignore what is going on in the rest of the world and conduct economic policy independently of everyone else. History seems to side with the nations and institutions that establish and maintain the trust of others within the world community. To this end, participants in international financial markets are leery about placing any trust in the current leadership of the United States and are not comfortable with what they are hearing from the potential future leadership.

The future of the value of the dollar? Right now, it is hard to be bullish. There will be recoveries and rebounds…there always are. But, aside from these short-term swings, what is there to be confident about in terms of the future of the economic policies of the United States. Candidates have to get elected…and the candidates have to tell the electorate where they stand in terms of what they would do if elected. The policies and programs that are being proposed almost assuredly will not be enacted within the next two or three years. America must get its act together. That is the only way that the rest of the world will come to trust this country again. What needs to be done, however, will take time and patience. And, with time, trust can be re-earned. Until then, I believe the value of the dollar will remain soft.

The Bermuda Triangle?

Is the United States flying into a period of economic turmoil that one can only describe as a Bermuda Triangle? Financial institutions are not out-of-the-woods yet in terms of cleaning up their balance sheets. The economy has surprisingly remained stronger than expected, yet there are layoffs in the airline industry, the car industry, the housing industry, and other industries that are bound to contribute to future weakness. And, there is talk within central banking circles that interest rates may need to be raised in upcoming months.

Furthermore, there seems to be some uncertainty among the pilots flying the monetary ship in the United States. After leading the Federal Reserve through a period of historically massive reductions in the Fed’s target Federal Funds rate, the introduction of major innovations in the way the Fed conducts its monetary policy, and after intervening into areas of the financial sector in ways that are reminiscent of the Great Depression (of which he is a major academic scholar), Chairman Bernanke has stated that maybe the Federal Reserve better look out after the decline in the value of the United States dollar.

But, now several other members of the Federal Reserve leadership have expressed doubts about how the Federal Reserve has acted in recent months. On June 5, Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond has come out and expressed concerns about the Federal Reserve lending to major securities firms. Charles Plosser, the president of the Federal Reserve Bank of Philadelphia has also spoken out defining more clearly the boundaries of what the Federal Reserve System can and should do. Both raised concerns about whether or not the Fed should actually be doing these things.

But, these are not the only voices that have expressed concern. Two other presidents of Federal Reserve banks have expressed similar thoughts. Gary Stern, president of the Federal Reserve bank of Minneapolis, discussed, in April, the expansion of the Fed’s authority, while Thomas Hoenig, president of the Kansas City Federal Reserve bank discussed the threat of moral hazard in the financial system due to the Fed’s actions.

On the other side, Ben Bernanke, vice chairman of the Board of Governors of the Federal Reserve System, Donald Kohn, and Timothy Geithner, president of the Federal Reserve Bank of New York, have defended the recent actions taken by the Fed.

I cannot remember a time when there has been so much discussion, in public, about what the Federal Reserve is doing or has done by the individuals within the Federal Reserve System that have responsibility for making the policy decisions that the Fed executes. The Federal Reserve does no usually “wash its dirty linen” for the whole world to see. Just what is going on here?

One final point: the timing of the departure of Governor Frederic Mishkin to return to his teaching position at this time raises a question mark. This is a very delicate time for the Federal Reserve System because the departure of Mishkin will reduce the number of openings in the ranks of the Governors to four…out of seven. This, of course, is not Mishkin’s fault because the administration has made appointments for the other three positions. It is just that the Democratically controlled confirmation process has held up the confirmation on these other three appointments for over a year. But, Mishkin’s resignation is tremendously awkward at this time. I don’t want to make too big a point out of this, but the timing, given the internal debate within the Fed and with the shortage of Governors on the Board, the timing of the departure is curious.

But, let’s return to the other points mentioned above. First, the condition of the financial system. Foreclosures remain high and will probably continue to rise. Bankruptcies have increased and probably will increase. Charge offs of credit card debt are high and rising. There remains the question about further charge offs at major financial institutions. And, if the economy is going to get softer, delinquencies and other financial dislocations are going to increase. The question still remains…how stable are the financial institutions of the United States, particularly if short term interest rates need to rise?

Second, the state of the economy, although it has been stronger than expected, shows signs of growing weakness. It is kind of like watching this whole thing evolve in slow motion. The bad news piles up, yet the economy seems to be hanging in there. However, the unemployment figures are up and the impacts of the higher oil and gas prices seem to be spreading to more and more major industries. The unexpected strength in the economy has allowed Chairman Bernanke to express concern about the weakness in the value of the United States dollar, but one really wonders about how much can be done in this election year to actually combat its falling value if the economy gets softer and financial institutions remain in a tenuous state.

Finally, there is the reality that the United States is “out-of-step” with the rest of the world in terms of where it is policy wise. On June 5, the European Central Bank and the Bank of England, both left their target interest rates at their current levels, but, especially Jean-Claude Trichet, the president of the European Central Bank, they both stated that there was a strong possibility that these target interest rates would need to be raised in the future. The focus of these central banks on inflation remains firm in spite of weakening economies. These central banks are earning their reputation for trying to keep inflation in their areas under control.

The direct effect of this effort has been to cause renewed weakness in the value of the United States dollar and a rebound in the price of oil. And, this points up the main dilemma facing the United States government and the Federal Reserve. Policy wise, the United States is in a different place than is much of the rest of the world. The “go-it-alone” attitude of the Bush administration which thumbed its nose to the international community in foreign relations as well as in its economic and financial policies has now left it at odds with much of the rest of the world and isolated it in terms of what it needs to do. Whereas the United States seemingly cannot act to protect the value of the dollar because of the fragility of its economic and financial system, other major players in the world now are indicating that they, in all likelihood, will raise interest rates in the future. If others do raise interest rates this can only put the United States in a more difficult position because if the Fed does need to act to further protect the economy or even if it does not move from the targets it now has, the weakness in the value of the dollar will only continue. The actions of others will place the dollar in a relatively worse position than it is now

Once again, we see the problem of a major nation going off on its own path. Now, when the United States is reaping the consequences of its past actions, the only way others can contribute to helping it resolve its difficulties is to weaken their own discipline and act in a way that is not consistent with the long term welfare of their own people. The future direction of the United States economy and the health of its financial system is heavily dependent upon what others might have to do to maintain the health and welfare of their countries. We have already seen the United States president “beg” for relief on the oil front. Will he also need to “beg” for other relief?

Foreign Central Banks and the Dollar

There is continual talk that, if not in the short run, at least in the longer run, foreign central banks, especially the European Central Bank, should cut interest rates. My question right now is “Why should they?” They have played by the rules. The United States hasn’t. For the past seven years, the United States government has gone it alone…in foreign policy…and in economic policy. It is not in the interest of other central banks to ease up on the disciplined monetary policy they have worked so hard to establish. There is also some resentment they must get over caused by the ‘go-it-alone’ policies of the United States.

Since 2001 the value of the dollar has declined against the Euro by more than 7% per year. This certainly should have been a signal to the US that the rest of the world thought something was wrong with its economic policy. But, the Bush Administration did nothing about it. Now, the chips associated with globalization and the absence of an energy policy are coming home. The rest of the world is strong enough economically and financially that the United States cannot act independently anymore.

The current activity is exactly why world markets react against the monetary and fiscal policies of a country that are not sound and disciplined and sell that country’s currency. Sooner or later that country is going to have to monetize more and more of its outstanding debt. That is what the Bush Administration is now doing. No wonder the value of the dollar continues to decline and the price of gold rises along with the price of oil. The United States is paying for its lack of discipline. However, the rest of the world is also concerned about the price it will pay for the past behavior of the United States.

Markets and Uncertainty

This is not the best time to be recommending books to people. But, I thought that, given all the turmoil around, it would be worthwhile for us to remember some relatively recent works that might help us to regain some perspective on markets (financial and otherwise) and guide us back to the fundamental issues we have to deal with during times like these. It is all too easy to get caught up in personalities or specific situations and that, in my mind, is exactly what we don’t want to do. For example, Paul Krugman’s Op-ed piece in the New York Times on March 10, 2008, is an example of emotional reporting and needs to be tempered with a review of the basics on which market participants need to concentrate: http://www.nytimes.com/2008/03/10/opinion/10krugman.html?hp.

I have great admiration for former Treasury Secretary Robert Rubin and have found his book (written with Jacob Weisberg) titled “In An Uncertain World: Tough Choices From Wall Street to Washington (Random House: 2004) to be helpful in the sense that Rubin has apparently systematically applied the techniques of decision making under uncertainty to both business and governmental situations. (I, like a lot of other people, are waiting for his next book in which he will discuss his role in the recent events at Citibank.) In terms of dealing with uncertainty there are two important ‘take-aways’ from this book. The first is that uncertainty in pervasive in human decision making. The thing that differentiates one situation from another is whether greater uncertainty or less uncertainty applies. The second pertains to the methodology used: the decision maker must be try to identify all of the possible outcomes related to the decisions that are available to her or him; and the decision maker must, in some way, assign probabilities to each of the possible outcomes.

Of course, the methodology that Rubin proposes is not an easy one to apply, particularly when one is under stress and is having to deal with markets that can move quite rapidly. Difficulty, however, is no excuse for not attempting, even in a simple way, to deal with the uncertainty that the individual is facing. We must do our research, we must read a lot and listen to many different opinions, and we must then make the best effort we can. There are no objective criteria for determining a comprehensive list of possible outcomes and the probabilities to assign to each outcome: everything is ‘subjective’. Intuition and experience are important factors alongside knowledge and skill.

Another book that is helpful in understanding the process of decision making under conditions of uncertainty is that of Michael J. Mauboussin titled “More Than You Know” (Columbia University Press, Updated Expanded Edition: 2007). There are several ‘take-aways’ from this book that should be remembered in dealing with uncertain markets. One of the first is that people tend to consider too narrow a range of potential outcomes. Thus, it is always relevant for people to expand their perspective and give attention to the possible outcomes they might otherwise exclude. It is a good discipline to force yourself to consider outcomes that you think only have a small probability of occurring. In doing so, you protect yourself from unintentionally eliminating outcomes that you might ordinarily dismiss from careful consideration.

A second thing that Mauboussin discusses which might be important in our analysis of uncertain situations is that all analysts and commentators will not be correct all of the time. Thus, we must not rely on one or just a few individuals for their view of the market. However, we should pay more attention to those analysts and commentators that have a higher ‘batting average’ than others. Even though we know that all will be wrong some of the time, those with a higher’ batting average’ will tend to have more ‘streaks’ of being right and longer ‘streaks’ than those whose ‘batting average’ is much lower. Thus, there are some analysts and commentators we should review more than others even though we know that they will be wrong a fair percentage of the time.

A third relevant factor is that individuals, according to the research that Mauboussin cites, do not always act in a completely rational way. For example, they may weigh possible losses more heavily than gains in their decision making. However, even though individual participants in the market may not be completely rational, if these participants generally act independently of one another, markets will ‘tend’ to be priced appropriately. This is because that, when aggregated into the whole market, the deficiencies of the individual decision makers seem to cancel out and the resulting prices tend to be a relatively adequate reflection of all the information that is available to the market at that time.

The time when this will not be true is when individuals do not behave independently of one another. At these times, the market becomes unbalanced because opinion tends to congregate on the buy side of the market or on the sell side and people act more like a ‘herd’ than independent individual decision makers. These are the times when the markets become ‘disorderly’ and present the greatest problem to policy makers. We have given special names to some of these disorderly situations such as ‘liquidity crisis’ or ‘credit crisis’ or ‘market collapse’.

There are two other books on markets and uncertainty that provide a good deal of insight into the world of decision making under uncertainty. Both of the books are by Nassim Nicholas Taleb: the first of these is titled “Fooled by Randomness” (Random House, 2005); and the second is “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007). Both of these books contribute to our understanding of the point made by Robert Rubin that there are, at most, only a limited number of situations in life that are not subject to uncertainty. Uncertainty comes from not having all the information we need in order to make a decision or to solve a problem. The idea that we have complete information on every situation we face in life is just a fantasy. The tendency to narrow the range of possible outcomes we consider in any specific case is related to our desire for greater certainty in life: humans tend to act as if they had complete information. Taleb presents us with example after example of the absence of complete information in our decision making or problem solving.

One additional fact is emphasized by both Mauboussin and Taleb: the probability distributions that apply to most uncertain market situations are not normal distributions. Although the probability distributions used should all conform to the general rules of probability theory, it has been shown that the tails of these probability distributions are ‘fatter’ than those of a normal distribution. That is, extreme events should have more probability assigned to them than would be the case if the probability distributions were normally constructed. Thus, these extreme events may not be very probable, but the expected impact of their occurring can be more substantial than might be thought. This conclusion is not meant to frighten, but only to serve as one more piece of information that will help us to understand the performance of the markets in which we operate.

Recently in a talk, Federal Reserve Governor Fred Mishkin indicated how uncertainty can impact price relationships within a market. The case that Mishkin discussed related to the calculation of inflationary expectations measured by the difference between the yield on the10-year Treasury bond and the yield on the 10-year inflation protected Treasury securities, TIPS. This differential has been increasing since the first of the year and the general interpretation given the increase is that financial market participants now expect more inflation over the next 10 years than they had expected last fall. Mishkin argued that the increase in this differential was not due to an increase in inflationary expectations but was due to an increase in the ‘uncertainty’ of what inflation will be. In this respect, uncertainty can affect markets. But, we must deal with uncertainty as analytically as possible, for that is the best way to make decisions because it tempers the impact of the more dramatic events that we generally see in the headlines.

What About Inflation and the Dollar?

Paul Volcker, former Chairman of the Federal Reserve System, has written that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity.” (Paul Volcker and Toyoo Gyohten, Changing Fortunes, Times Books, New York, 1992, page 232.) If “a nation’s exchange rate is the single most important price in its economy” one really has to be concerned that the United States has allowed the value of the dollar to decline so precipitously over the past six years or so. Volcker alludes to all kinds of things that can happen to the nation that lets its exchange rate decline, but he doesn’t even mention one other possibility, a situation that has arisen since he wrote the quotation presented above, and that is the situation, like the one that has arisen, in which a country’s assets become so cheap that foreign interests can acquire them at historically low prices.

It is important to see just how badly the United States Dollar has declined in value to get some appreciation for the problem. From the year 2001 through the year 2007, the Dollar has declined at a compound rate of over 7% per year to the Euro. In terms of the British Pound, the Dollar has declined at a compound rate of over 5.5% per year. The same is true of an index of major currencies against the Dollar as compiled by the Federal Reserve System. An index that includes a broader range of currencies produced by the Federal Reserve shows a more moderate rate of decline of about 3.3% per year. However you measure it, though, the United States Dollar has not fared well in world markets during much of the Bush Administration.

These market results are important because they indicate how world financial markets are betting on relative rates of inflation in the different countries. If one works with what is called the Purchasing Power Parity (PPP) Theory for exchange rates in its pure form, one can argue that the change in any nation’s currency against the currency of another nation can be represented by the difference in the expected rates of inflation between the two countries. In this were the case, it could be argued that the difference in expected rates of inflation between the United States and England is in excess of 5.5 percentage points. That is, whatever the market expects the rate of inflation to be in England, they expect the rate of inflation in the United States to be 550 basis points higher.

Since the PPP Theory does not work exactly, we cannot just extrapolate the figures presented above and apply them to differences in expected rates of inflation. However, we don’t need to do this. We can just argue that the differences presented above provide some ballpark ‘guesstimate of anticipated relative rates of inflation. If one argues in this way, the conclusion can be drawn that, whatever the real estimates are, participants in world markets believe that inflation in the United States is much worse than it is in other countries or areas in the world. If the differences were just 1% to say 1.5%, it could be argued that the differences were non-existent or too small to worry about since the PPP Theory was not exact. However, at the magnitudes that have existed over the past six years, the differences, I believe, cannot be ignored. Market participants believe that inflation is expected to be much worse in the United States than it is in other areas of the world! The only country that is not listening to this is the United States.

Why is this happening to the value of the United States Dollar?

Let’s step back for a minute. At one time it was assumed that the United States government could run any kind of economic policy that it wanted and not have to pay for it to any degree in world financial markets. The reason for this was that the United States was a ‘big’ country and was not subject to the same pressures that ‘small’ countries were. Much of International Macroeconomic Theory relates to ‘small’ countries, but theorists and practioners, historically, have generally argued that because of its dominating size, the United States could act in a way that the ‘small’ countries of the would could not. They could get by doing what they wanted to do without much regard to international financial markets.

What happens to the ‘small’ countries when they try and do this? Well, they were kept in hand by that amorphous, unidentifiable, shady group of people called ‘international bankers’. If a ‘small’ country conducted its fiscal policy in a way that ran substantial deficits (for that county) and did not have an independent central bank, thereby increasing the possibility that the inflation rate in the country would rise, these ‘international bankers’ would sell the currency of that country in the foreign exchange markets, the foreign exchange rate would decline and the government would have to back track and reduce or eliminate the deficit and make its central bank independent of the national government.

The argument was put forward that this clandestine band of ‘international bankers’ usurped the sovereignty of nations so that the nations could no longer run their own economic policies. During this time we saw leaders, like Francois Mitterrand of France, a militant socialist, back off from combating the ‘international bankers’. They made their central banks independent of the government and began to conduct a more conservative fiscal policy. For example, Mitterrand freed the central bank of France making it independent of the national government. And, in the 1990s and the early 2000s, many other nations followed suit, making their central banks independent and mandating inflation targets for the conduct of monetary policy. But, these were all ‘small’ countries.

Now we come to the United States. After balancing the Federal budget, the United States Government, under the leadership of President George W. Bush, created massive Federal deficits through the implementation of major tax cuts and the expenses related to fighting a foreign war. In addition, the Federal Reserve System, led by Alan Greenspan, acted as a complacent component of the Federal Government and kept its target for the Federal Funds rate below 2% for over two years and at 1% for approximately a year during this time. In the past, the United States government could ignore the ‘international bankers.’ No more!
Just like any ‘small’ country in a similar situation, the international bankers’ began to sell Dollars and continued to sell them as the large deficits persisted. Yet, the Federal Reserve remained seemed to ignore the decline. The result? The United States does not seem to be a ‘large’ country anymore! Globalization has come back to hit the United States!

Still the price indices produced in the United States do not reflect this perceived inflation…at least up to this time. But, there are those that believe these price indices understate the true rate of inflation. See, for example, the perceptive article “Inflation May Be Worse Than We Think” by David Ranson of H. C. Wainwright & Co.: http://online.wsj.com/article/SB120407506089695263.html?mod=todays_us_opinion. Furthermore, we see in the commodity markets that wheat, oil and gold have all hit new highs. And, the Euro rose above $1.50 for the first time. Maybe the United States needs to put aside ideology and listen to what the market is telling us.

And, there is one piece of anecdotal evidence that maybe needs to be mentioned. In the early 1920s, John Maynard Keynes wrote about the ‘profit inflation’ that existed in England. This was a situation where profits had risen but the real wages of the worker had not. He was concerned with the restlessness in the country that had arisen due to the resulting redistribution of incomes. What I would like to point out is that all of the major candidates campaigning to become the Democratic nominee for President of the United States have taken a more and more populist position on economic policy as the campaign has progressed. Ohio is a prime example of how this message has resonated with a fairly large portion of the population. The question therefore is…has inflation really been a problem for the United States over the past several years? The magnitude of this inflation has not yet surfaced in the statistics, but it may have been experienced and felt by participants in the financial markets and by workers and by households.

Bad Policies Eventually Catch Up With You!

There were the headlines, right on the front of the February 26 Wall Street Journal: “U. S. Pushes Sovereign Funds to Open to Outside Scrutiny.” We are told that “Seeking to head off a political backlash against huge investments in Western companies by Asian and Middle Eastern government-run investment funds, the U. S. is prodding two of the biggest funds to embrace a set of promises that they won’t use their wealth for political advantage.” The request: Please don’t act in your own interest.

The economic policy of the previous seven years, the Bush/Greenspan version, has come home to haunt us and the U. S. is now pleading with offshore interests to “be gentle with us.” The monetary and fiscal policies of the past seven years have resulted in an almost constant decline in the value of the U. S. dollar. American assets have never been available at such cheap prices and, due to other policies, such as those related to energy, offshore interests have the wealth to scoop up these assets. Furthermore, the same governmental policies that resulted in the weak dollar also helped to underwrite inflationary financial relationships. As a result, not only is the dollar weak, but many of our major institutions are weak so that they ‘need’ the infusion of funds from offshore to keep them healthy.

It is interesting to hear the candidates running for President of the United States talk about all that they are going to do economically when they are elected. Much of what they are promising, I believe, will have to be put on the shelf for a later time until some balance is restored to our basic monetary and fiscal policies.

The Solvency Issue

Something new seems to be happening in this current period of financial dislocation. It appears to me that banks and other financial institutions are responding to their portfolio problems more rapidly this time around than they did in the past. If this is true, in my estimation it is all to the good! The reaction may result in a sharper reduction in lending in the short run than would occur otherwise, but it will mean that the system will be moving onto the future more quickly. Within such a scenario, the concern is that if all adjustment takes place at relatively the same time, financial markets could be overwhelmed. I am not expecting this…just pointing out the downside concern.

In the past, banks and other financial institutions have responded relatively slowly to problems in their portfolios primarily because many of the problems occurred in loans and other debt arrangements that were just between the banks and their customers. The assets under consideration were not market related. In the present case, many, if not most, of the financial assets that are having problems are market related. That is they are securities connected with subprime loans, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs) among other things. In most cases the institutions holding these assets did not originate them but in some way acquired them from a third party.

Why does this make a difference? Loans and other debt relationships that are directly made between two parties and where the lender holds the paper on their balance sheet as an asset generally have no ‘market’ in which the asset can be traded and a value can be determined. Since the relationship is a direct one, when the borrower runs into some kind of operational difficulty in which the terms of the loan cannot be fully met, the lender and the borrower attempt to work things out. Lenders are not under a great deal of pressure to ‘pull the plug’ on the relationship and admit that the asset on the books may be overvalued. In fact, the tendency is for borrowers to take an optimistic view of things and believe that things will work themselves out. Thus, it may take a sometime before the seriousness of the situation to be recognized and accepted. Of course, the examination of assets by regulators or accountants may speed this process along but this only takes place with a lag.

In an environment like the one just described the truth about a portfolio comes out slowly and charge offs may only come in bits-and-pieces over an extended period of time. In situations like this, Presidents and CEOs remain in place as do their management teams with the hope that everyone on board will be able to ride out the storm. But, when management stays in place there is not much incentive to change the way things are done. The status quo is maintained. Keeping things in place and hoping that the assets will begin to perform is the norm.

If things continue to go bad for the institution, eventually the organization will be acquired or a new leader will be retained to do a ‘turnaround.’ The good thing about a turnaround is that by bringing in someone entirely new, there will be no investment in what had previously been done. The goal of the person brought in to execute the turnaround is to get rid of all that is bad, bring in capable new people, scale back to what might be called the basic franchise, and then execute a new game plan built upon solid fundamentals. Since the turnaround person has nothing vested in the old way the company had been run, he or she pretty well can do what is required to change the organization. This is my experience in the three (successful) turnaround situations I have led.

These kinds of turnarounds are usually done with the same ownership. Of course, there are vehicles that have become more important in recent years that can perhaps ‘save’ an institution earlier in the firm’s downward cycle. Although these have not been used frequently with banks or other financial institutions, their methodology is instructive. These are the hedge funds or buyout funds that specialize in buying companies that are not using their basic franchise as well as they could in order to redirect them…and, in the process, make a lot of money. Whereas the turnaround specialist brought in by a troubled Board of Directors does not have the ownership control, the private equity fund or the hedge fund that buys a distressed company has absolute control. They can do what they want…change management, sell assets, close operations, restructure, and so forth. And, the organizations can do these things rapidly because they own the place and there are no governance issues that have to be dealt with.

In the current situation we have seen a much quicker response to asset difficulties in banks and other financial institutions. The reason being that the assets in question have not been originated by the organization that is holding them and there has been some kind of market in which the assets have been traded. The consequence of this, in my view, is that managements have had to recognize earlier than before the problems being experienced in these asset categories and have had to act more quickly. The result has been that the difficulties being experienced by these organizations have surfaced much earlier in the cycle that they have in the past.

In addition, Boards of Directors have not been as passive as they have been historically. The information concerning charge offs have gotten into the press earlier than ever before and the magnitude of the charge offs have made for sensational headlines. Boards could not sit idly by. They, too, had to act and the actions they took were to remove the person in charge of the organization, the CEO. I don’t believe that we have ever seen so many top executives of important companies relieved of their position in such a short time as we have seen over the past three months or so. And, in my opinion…this is good!

There is also a cumulative effect at work in this process. This is because it is easier to do something when many others are doing the same thing. It is easier to recognize losses in asset portfolios if almost everyone else is also recognizing losses. It is easier to be severe in finding losses if almost everyone else is also being severe in their judgments. It is easier for a board to remove its CEO if other boards are removing their CEO. It is easier to make major changes and restructurings as the new CEO if other CEOs are doing the same thing. Of course, one of the dangers in ‘herd’ mentality is that the ‘herd’ will go too far in the direction in which it is heading. Right now, I don’t see this happening.

What does this mean for the current situation? From my experience recognizing and disclosing problems earlier rather than later is a good thing. In a troubled time, it is good to be relatively severe in the analysis of the value of your portfolio. It is also good to replace those that have a vested interest in the current portfolio with people that do not have a vested interest in it. And, it is a good thing to restructure an organization, returning it to its basic franchise so that it can focus on what it does best. To me, the economy goes through more pain for a longer period of time if people are slow to accept that they have problems, move only slowly to correct the problems, and fail to get back to the basics of their business and proceed into the future on a sound fundamental basis. It seems to me that this time we are moving through this stage of the cycle more rapidly than before.

The assets of concern have caused people to address things earlier in this phase of the economic cycle than in the past, but these assets have some problems of their own that are creating other difficulties. One problem of major concern is how to determine the value of the securities in question. The securities themselves are very complex instruments, which mean that there are only a limited number of people that fully understand them. Also, the markets in which these securities are traded are not very active so that prices are not very reliable measures of value. An additional uncertainty is that it has not always been easy to identify the originator of the assets backing the security thereby limiting the ability of either the original borrowers or the ultimate holders of the asset to resolve problems. How these problems will be resolved is uncertain at this time. Stay tuned!

Market evaluation of Inflationary Expectations and Credit Risks

With all that has been happening in the financial markets over the past six months or so, it is worthwhile to check in from time-to-time to see what is happening to market expectations of inflationary expectations and credit risk. During this time the Federal Reserve has substantially lowered its target for the Federal Funds rate and has provided liquidity to the banking system in order to contain a liquidity crisis in world financial markets and perhaps to lessen the magnitude of any economic slowdown that might be forthcoming.

The growth of aggregate monetary and reserve statistics has remained steady. The narrow measure of the money stock (M1) continues to decline by about 0.5% year-over-year and the broader measure (M2) continues to rise at about 6.0% year-over-year. Total reserves in the banking system also continue to decline through January, 2008 at a 0.9% rate, year-over-year. This latter decline reflects the outflow of funds from transactions accounts (reflected in the decline in the narrow measure of the money stock) into time and savings accounts (that are still within the definition of the broader measure of the money stock). So, not much has changed even with all the other things going on in the financial markets.

In terms of expected inflation, little has changed over this time period. The measurement I am using is the difference between the rate on 10-yer US Treasury constant maturity bonds and the rate on 10-year inflation indexed bonds. In August, 2007, inflationary expectations were approximately 225 basis points and toward the middle of February, 2008, inflationary expectations were approximately 230 basis points. The average over this time period was roughly 230 basis points. Thus, even though the Federal Reserve has, arguably, loosened up, the market has not translated the Feds actions as worsening the possibility that inflation will rise in the foreseeable future.

There has been a shift in attitudes toward credit risk over this time period. In August and September 2007 the difference between Moody’s Baa and Aaa bond yields averaged around 85 basis points. In November 2007 this spread started to rise and reached about 120 basis points in January 2008. In the middle of February 2008, the difference has averaged around 130 basis points. Market participants have become more concerned with credit risk over the past six months and this attitude has been built into current yield spreads.

Conclusions: Market participants are not concerned that the recent actions of the Federal Reserve will have much long term impact on the rate of inflation; however, they are increasingly concerned about the credit crisis and the solvency issue.

Can Interest Rates Resolve a Solvency Crises?

In recent weeks, we have heard a lot about something called a Solvency Crises. In this number I discuss is meant by a Solvency Crises and differentiate it from a Liquidity Crises. A central bank has to be concerned about both types of crises, but it has to be able to distinguish one from the other because the monetary authority must respond differently to each kind.

A Liquidity Crises is a short term phenomenon that arises because someone must relieve themselves of some financial assets. The recent example is that of the French bank which had to unwind a securities position that had been established by a trader working at the bank. The bank had to sell off the position in order to minimize any further losses it might have to take. The amount of the securities that were involved in the position was estimated to be around $75 billion, so we are talking about a substantial amount of securities that must be sold within a relatively short period of time.

In normal times for markets that are relatively liquid, the bid-ask spread between what people will buy a security for and what they will sell the security for is relatively narrow. That is, I can buy a security and then turn around and sell the security and will only lose a small amount of money. The narrow bid-ask spread is an indicator that the market is relatively liquid. Less liquid markets experience bid-ask spreads that are more or less wider depending upon the illiquidity of the market.

If the seller of a security has to sell a noticeably larger amount of securities within a relatively short period of time, potential buyers may reduce the ask price somewhat, but the increased discount is not unusually large. If the discount is not large, this is used as evidence of the liquidity of the market. In other words, if a sizeable amount of a security can be sold relatively quickly without much concession in price then the market is termed a liquid market. Liquid markets are, of course, very important for financial (and other) organizations because securities that trade in liquid markets can be used to adjust portfolio positions under normal circumstances with little or no penalty in terms of price concessions to the market.

However, if a large amount of securities must be sold within a very short period of time, even liquid markets can experience liquidity problems. This is what is termed a liquidity crisis. What happens in these cases is that market participants know that the securities must be sold and they know that a large amount of the securities must be sold. Very often market participants will even know which institution has to sell the securities. Under such circumstances the problem becomes one of price.

In a normal situation when a larger block of securities is sold, potential buyers know that this sale is just a ‘bump’ in the market and that the market will return very quickly to the range that this type of security had been trading within. Thus, market participants know where the market is and they are willing to continue to ‘make a market’ in the security.

In a liquidity crisis this is not the case. Market participants know that price concessions must be made but because of the quantity of the securities that must be sold on the market and the short time span over which they must be sold, confidence wanes as to where the market will continue to trade. Buyers become unsure…sellers become desperate! The problem, therefore, switches to the buy side. Buyers don’t want to buy a security, even if the seller is willing to give up a substantial discount, if there is a concern that they, the buyer, will soon be holding a security for which they overpaid. Buyers withdraw…they head for the sidelines…they go and play golf. And, buyers will stay on the sidelines until the markets exhibit some kind of stability and they can become confident about where prices should be.

The job of stabilizing the market in a liquidity crisis is that of the central bank. There are two actions that the central bank can take that are the classical responses of central banks to such a market situation. Putting these responses within the structure of the Federal Reserve System we call them the lender of first resort response and the lender of last resort response. In terms of the former, the Federal Reserve reduces the operating target for the Federal Funds rate, which, in essence means, that the Fed will become a buyer of securities at a set price so that the market knows there will be a buyer for their securities…hence, institutions that need to adjust their portfolios know that they can sell to the Federal Reserve. The latter response has to do with the Borrowing window at the Federal Reserve. In the case of a liquidity crisis, the Fed, for a short time, will throw open the borrowing window so that banks can borrow funds from the Fed and not have to sell securities into a declining market. In both cases, the Federal Reserve, in classical central banking style, provides liquidity to the money markets in order to stabilize markets and keep buyers at their trading desks. This is how a liquidity crisis can be stemmed.

It is time to get back to the problem of the solvency crisis. The problem of solvency occurs when there is a decline in the value of assets that are being carried on the balance sheet of an organization. Solvency can be an issue within the context of a liquidity crisis when the securities on, say, a bank’s balance sheet lose market value. However, the problem becomes of much greater concern if the institution, the bank, experiences a decline in the value of other assets on its balance sheet, say in its loan portfolio. Here the difficulty may be the ability of the borrower to repay the loan that they have outstanding with the bank. In these cases, the bank knows that it will not receive back the total amount of the loan outstanding and, therefore, must write down the value of the loan.

The concern here is that when asset values on a balance sheet are written down the impact ultimately impacts the capital position of the organization. When we write off a loan, for example, we write it off against income reducing profits, which means that the increase in net worth will be less than it otherwise would be, or, it the charge-offs result in a loss, net worth would actually decline. If the capital position of the bank gets too low, then the bank will have to raise more capital, sell itself to another financial institution, or close. When many banks have this kind of problem there is a solvency crisis!

Raising capital is the only long term way to resolve a solvency problem and there are basically two ways to raise capital. First, over time, profits will increase the level of capital that an organization will have. This takes time and is the solution to the crisis only if institutions have sufficient remaining capital to replenish capital by means of longer run profitability. Second, the institution must go out and obtain capital from other sources. The availability of capital is dependent upon two things…that there are pools of capital available for investing…and that the institution has sufficient viability to justify investors risking their funds by investing in that institution. The Sovereign Wealth Funds have provided the pools of capital required to meet at least some of the needs of the current solvency crisis. One presumes that these Funds have done their due diligence and hence believe that their investments have long term viability.

The Federal Reserve cannot resolve a Solvency Crisis. That is, a central bank is not in a position to inject capital into banks or other organizations in order to resolve this kind of crisis. If there are not pools of funds available to put capital into troubled institutions then the solvency crisis can cumulate and spin out-of-control like it did in the Great Depression of the 1930s. The only thing the central bank can do is to help create a favorable environment so that the economy can grow and sufficient profits can be generated to replenish capital in this way. But, this takes time and patience…it cannot be done quickly.

It has been argued that Ben Bernanke and the Fed failed to realize the severity of the economic problem soon enough and did not act quick enough to lessen its impact. In my next post I am going to look at the operational behavior of the Fed in 2007 in an attempt to discern whether market conditions existed during 2007 indicating the existence of a liquidity crisis. If a liquidity crisis did not take place in 2007, then this may explain why the Fed did not want to take any precipitous action during that time when the extent of the problem was not obvious…particularly when there were other issues on the table like the decline in the value of the US dollar and the inflation being slightly above the range acceptable to the policymakers.