The Problems in Housing and the Labor Markets Will Not Go Away Soon

President Obama announced a mortgage plan aimed at giving relief to homeowners that are facing problems with their mortgages.  Yet, this is just putting a finger in a hole in the dike.

The problem is that after fifty years of governmental credit inflation many homeowners are facing the reality that their homes were grossly over-valued and that they assumed too much debt to finance their “American Dream.”

One out of every four or five houses has a mortgage on the property that is greater than the market value of the house.  Many of these homes are now valued at only 75 percent or less of their mortgage value. 

Regardless of a government “solution” to this situation, either through debt relief or a renewed bout of government-induced inflation, the attitudes and expectations of homeowners have changed.  These homeowners have been “burned” and are unlikely to expose themselves to this possibility again in their lifetimes. 

Even if the market stabilizes in the near term and housing prices bottom out, many potential home buyers will be much more financially conservative in the future given the experience that they have just been gone through. 

The reluctance to buy a home will also be affected by the situation in the labor market.   And, here again there is a longer-term problem that will not be resolved in a matter of months. 

One out of every four or five people of employment age are either unemployed, employed in a part time job but would like to be employed full time, or are not seeking employment.  The percentage of working age people in the labor market has recently dropped to a level not seen for several decades. 

With conditions in the labor market so tenuous, people will not have the same resources to purchase housing as they have had in the recent past. 

But, how is this under-employment situation in the labor market going to be resolved in the short-run?

The fundamentalist preacher Paul Krugman cries out for short-run government “solutions” to put people back into the jobs that were in existence at another time.  Krugman writes, “We have become a society in which less-educated men have great difficulty finding jobs with decent wages and good benefits.”  For example, “Adjusted for inflation, entry-level wages of male high school graduates have fallen 23 percent since 1973.” (http://www.nytimes.com/2012/02/10/opinion/krugman-money-and-morals.html?ref=opinion)

Maybe, part of this problem is that the government has emphasized putting high school graduates into what have historically been entry-level jobs, jobs that are shrinking as a proportion of the jobs available due to changes in technology and needed training.  And, what about those that do not graduate from high school…they are in an even less-favorable position. 

Elsewhere in the New York Times, we read that “Rich and Poor Further Apart in Education.” (http://www.nytimes.com/2012/02/10/education/education-gap-grows-between-rich-and-poor-studies-show.html?hp) “Education was historically considered a great equalizer in American society, capable of lifting less advantaged children and improving their chances for success as adults.  But a body of recently published scholarship suggests that the achievement gap between rich and poor children is widening, a development that threatens to dilute education’s leveling effects.”

This is a gap that cannot be overcome quickly.  And, it is a gap that cannot be overcome by national tests and government spending.

  

Since the end of World War II, politicians have generally believed that they could get elected and re-elected by keeping people employed and by helping more and more people become homeowners.  This underlying emphasis has resulted in the fifty years of credit inflation the United States has experienced since the early 1960s. 

People were kept employed by short-term government economic programs that put the unemployed back into the jobs that held previously before becoming unemployed.  And, why should someone going through high school be concerned about employment when they knew that the government would continue to stimulate jobs in heavy manufacturing and industry and keep them employed. 

The government continued to promote these kinds of stimulus programs even though under-employment increased steadily over the past fifty years and the capacity utilization in manufacturing was declining over the same time period. 

The federal homeowner programs and credit inflation created in the housing sector over the same time period created a “piggy bank” for many people not only helping them to own their own home, but also to allow them the ability to borrow more and more money to binge on consumer goods.     

So, we ended up with the “less wealthy” being under-educated and hence not readily employable in the labor markets of the 21^st century and with many of these same people owning homes and over-their-heads in debt. 

  

This is a situation that does not have an easy or ready solution. 

Under-employment can only be resolved over an extended period of time.  The same holds for people with too much debt.  Short-run stimulus is not the answer.  In fact, the emphasis on short-run stimulation has created and further exacerbated the situation. 

A safety net may be necessary for many of the under-employed and overly leveraged.  In fact, the efforts to keep people in “legacy” jobs and to put families in homes to make their life better may have resulted in a whole generation of individuals being excluded from the mainstream.  They are going to need some economic support.

But, the only real solution to the labor market situation is a long run one and it begins with education and the environment that surrounds the culture of education. 

The situation in the housing market will only get better as people lower their expectations and get their balance sheets back in order.  This, too, will take a substantial amount of time because it is related to a major change in expectations.  People, in the future, just cannot expect a “free ride.”      

Credit Downgrades and Europe

The problem is the free flow of capital throughout most of the world. 

When capital flows freely you cannot escape the consequences of your actions.

What is called the “trilemma” problem of international economics makes this very clear.  The “trilemma” problem states that a country can only choose two of the following three options.  The three options are to be a part of world capital markets where capital flows freely; have a fixed exchange rate; or, be free to run an independent economic policy.

If there is a free flow of capital internationally, then the choice is reduced to just one of the two remaining options.  But, there are consequences to either choice.

First, if a country choses to run its economic policy independently of all other nations, then it must let it currency float in the foreign exchange markets.  Generally, a nation that wants to run an independent economic policy has particular domestic economic goals it wants to achieve and so wants to be able to choose an independent economic policy that supports these goals.

The goals most often chosen in the latter part of the twentieth century have been full employment and social welfare programs like government jobs, early retirement, substantial amounts of vacation, and high pension levels.  The means of achieving these goals has often been a policy of public sector credit inflation. 

If a country chooses the path of credit inflation then the price of its currency in foreign exchange markets must be allowed to float.  And, if credit inflation becomes extreme, the value of the currency in the foreign exchange markets will decline.  And, this will bring on other problems. 

This is one reason John Maynard Keynes wanted restrictions on the international flow of capital in the 1920s and 1930s. (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell)   A limited flow of capital internationally was a reality when Keynes helped to craft the Bretton Woods agreement that created the rules for the post-World War II international monetary system.  This agreement also included fixed exchange rates between the currencies of the participant nations. 

The purpose of this system was to allow member countries to follow their own economic policies aimed at achieving high levels of employment in their own country.  Therefore, a policy of credit inflation could be followed in each country without disrupting changes in foreign currency rates.

The Bretton Woods system fell apart as international capital markets opened up in the 1950s and 1960s and the credit inflation created in the United States in the 1960s resulted in a situation where the United States could not maintain its fixed exchange rate.  On August 15, 1971, President Nixon choose to float the value of the U. S. dollar.

A second choice, given the unrestricted flow of capital internationally, is to choose a fixed exchange rate.  But, if a nation chooses a fixed exchange rate then it must give up its sovereignty with respect to running an economic policy that is independent of other nations. 

This is what the European nations did when they choose to form a monetary union based on a single currency, the euro: in essence, they choose to have a fixed exchange rate between member nations.  But, the nations forming the union did not want to give up their sovereignty with regards to the formation of their government budgets. 

Oh, they allowed for budget deficits to be run, but they were to be limited in scope.  This, they felt, gave the included nations some flexibility in creating their budgets, but, they were not supposed to exceed the set limits.  The problem was that these limits were unenforceable. 

Which brings us to the current time.  Budget limits have been grossly exceeded and the nations forming the European currency union and these eurozone nations are unable…or unwilling…to give up the sovereignty of running their own economic policy or abiding by the rules of the union.

The “trilemma” analysis states very clearly that in circumstances like this the monetary union must be broken up and the countries must form a central budgetary unit or must once again establish their own currency units whose price will be floated against the other currencies of the former eurozone countries. 

The ultimate cost of running independent economic policies and trying to run a single currency monetary union will be the destruction of the sovereign political bodies as we know them in Europe or the euro, as we know it now, will have to become history.

Current events now relate to the break down of solvency talks, which had been taking place between the Greek government and private investors in Greek debt.  An “unrealistic” proposal has been rejected by the debt holders.     

Furthermore, the credit downgrades of France and other nations, which took place over the past week, were expected, yet no one really exhibited any sense of urgency.   Now that the downgrades have taken place a downward spiral seems to be starting.

“Both events are important because they show us the mechanism behind this year’s likely unfolding of events.  The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades.  A recession has started.  Greece is now likely to default on most of its debts and may even have to leave the eurozone.  When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.” (http://www.ft.com/intl/cms/s/0/987fd2fe-3ddc-11e1-91ba-00144feabdc0.html#axzz1jd5VycTs)

The European Financial Stability Facility has also been downgraded and this means that its effective lending capacity has been reduced.  The ability to “bailout” distressed countries has declined.  And, the European Central Bank cannot resolve the longer-term issues.  There is very little still available to the European officials to “kick the can down the road” any more.

I just do not see the European countries at this time getting over their resistance to form “a strong central fiscal authority with power to tax and allocate resources across the eurozone.”  Hence, I don’t have much confidence for the continued existence of a common currency for Europe, except maybe, on a much more limited scale.  Right now, I don’t see alternatives to the downward spiral mentioned above.

The bottom line is that the conditions of the “trilemma” problem seem to hold.  Given that capital is flowing freely throughout the world nations cannot just totally ignore the consequences of their choice of economic policy.  And, if the consequences of that economic policy are not realized immediately, the evidence shows that they will be realized sooner or later.  This is a lesson in macroeconomic decision-making that all countries need to take into account when determining what economic policy they should be following.  Are you listening America?     

The Banks, They Are A Changin'

The banking system is going through massive changes.  The morning papers are filled with stories about what is happening in the banking area, although they cover only a minor portion of what is going on in the industry.

The Wall Street Journal trumpets, “Bank of America Ponders Retreat.” (http://professional.wsj.com/article/SB10001424052970204409004577156881098606546.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj) The current Bank of America represents, perhaps as well as any organization the excesses of the financial institutions over the past twenty years or so.  Currently selling at 33 percent of book value, the Bank of America can be potentially classified as one of the “Zombie” banks that now meander through the environment. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The Journal article does not give us much faith that management has a firm grasp on the situation…or, at least, is not revealing to us the reality that they face.  “Bank of America Corp. has told U. S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen…”

The crucial hedge word is “if”.

Commercial banks have to recover from the binge that has taken place in the banking industry over the past fifty years.  This binge has seen commercial banks grow to enormous size and many have become “too big to fail.”  It has resulted in a massive shift in employment in the United States as the proportion of people working in the manufacturing trades has declined substantially relative to those working in the financial industry.  It has resulted in a huge shift in risk-taking in the industry, a move to more and more financial innovation, and a substantial increase in the amount of financial leverage used in the industry. 

Several of the articles in the morning paper discuss the reductions that are taking place employment.  For example, yesterday the Royal Bank of Scotland Group PLC announced that it will be laying off 3,500 people.  Cutbacks have also been announced by UBS AG and UniCredit SpA and well as Credit Suisse Group AG and many other major players.  The reductions in staff of the smaller institutions do not get as much publicity and play in the press. 

Some have argued that the industry is going through a cyclical shift that generally happens after a downturn in the economy but more and more industry analysts are claiming that they see a more permanent shift taking place.  And this is true of other parts of the financial industry than just the commercial banks.  “It isn’t just the lackluster business environment that is prompting banks to rein in their lofty investment-banking ambitions.  A realization is sinking in among securities-industry executives that because of the huge potential losses they are exposed to in bear markets, the business just isn’t as attractive as it once seemed.” (http://professional.wsj.com/article/SB10001424052970204409004577156833880721736.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The fifty year period of credit inflation bought out over time many of the bad decisions and allowed the banks to go merrily on their way.  As “Chuck” Prince, former CEO of Citigroup expressed it…”As long as the music continued to play, people had to keep dancing.”

But, this continual pressure to grow and expand and take on more risk resulted in a massive change in the banking industry itself.  Going from around 14,000 commercial banks in the 1960s the commercial banking industry now contains less than 7,000 banks.  My forecast is for this number to drop below 4,000 in the next several years. 

And, the banking industry is bifurcating: almost two-thirds of the assets in the banking system are owned by the largest 25 banks in the country.  That leaves just one-third of the assets in the hands of about 6,300 banks.  More and more wealthier personal banking relationships are being handled by firms that cannot be considered to be community banks.  The products and services in these banks are many and the electronic interchange and access between financial assets and transactions are seamless and almost instantaneous.  

One could imagine a banking system in which the wealthier people worked with institutions like these and the less wealthy “banked” at non-profit credit unions, the non-profit institutions being the only ones that could provide the products and services needed without having to achieve a competitive return on shareholder’s equity.

The last factor producing major changes in the banking industry is the advances taking place in information technology.  Finance is nothing more than information.  That is, finance can ultimately be just a recording of 0s and 1s.  Thus, as information technology advances, so does the innovation in the financial industry. 

And, don’t think of how you use banking services right now…think about the electronic gadgets that your children or your grandchildren are using.  This is where you will see what financial institutions are going to need to provide for in the coming years.  What goes on in “electronic stuff” is real to these children and will become a part of the financial system as electronic finance becomes ubiquitous in the future. 

Furthermore, as advances in information technology has allowed “finance” to become more innovative, my guess is that for the future…we haven’t really seen what financial innovation can do.

This has tremendous implications for the regulatory efforts going on in the United States and the world.  I have argued for three years now that the efforts of the United States Congress and others throughout the world have been to create a regulatory system that will prevent a 2007-2008 financial collapse.  To me, the commercial banks in the United States are way beyond this system already.  Oh, the banks fight Congress and the regulators all along the way.  But, how much of this is real and how much of this is a smokescreen. 

Throughout my professional career…and I have run three banks…the banks have always been ahead of the legislators and the regulators in terms of what is going on in the banking system.  I am no less confident now that the banks are still far ahead of legislation and regulation and will continue to be so into the future. 

I can’t imagine what banking will be like in five years…but, it will be something substantially different than it is now.  It will be more electronic, it will be more innovative, and it will be harder to control.  The only way we can hope to keep up with what is going on is to increase the openness and transparency with which the banking system operates.   

"In the Real World Creditors will Always Have the Whip Hand with Debtors"

The lesson that never seems to be learned in the real world: “In the real world creditors will always have the whip hand with debtors.” (http://www.ft.com/intl/cms/s/0/f05edd3e-27ee-11e1-a4c4-00144feabdc0.html#axzz1i1eGuNp3)

John Plender writes in the Financial Times, “From the wreck of the sovereign debt crisis Germany has unquestionably emerged as Europe’s pre-eminent power.  And a central tenet of the German solution to the crisis—for it is primarily a German solution—is that other eurozone members must be recast in their mold of fiscal orthodoxy and financial conservatism.”

He concludes his essay, “So Germany rules and southern Europe should prepare for austerity, followed by deflation, unemployment and, eventually, civil strife, if the eurozone holds.”

Europe…and the United States…have experienced roughly fifty years of Keynesian-type credit inflation.  The public debt in these areas expanded at a pace at least double the rate at which the real economy has grown.  Private debt in all of these areas grew at even faster rates than did the public sector debt. 

During this period of credit inflation, risk-taking increased, financial leverage exploded, and financial innovation and financial engineering accelerated at a pace never before seen. 

And, in the end, the weight of all these developments proved to be unsustainable.

While it was going on, the credit inflation was delightful…especially in the country owning the reserve currency of the world.  Oh, there were cyclical swings during this time period, yet, all-in-all, everyone grew together.

Where was the pain connected with being a debtor?

Well, until the music stops, everyone, especially the debtors, keeps dancing and everyone has a pretty good time. 

There were some undercurrents of pain.  Underemployment in these Europe and the United States more than doubled from the 1960s to the 2000s.  Income inequality increased dramatically as the more astute or wealthy took advantage of the credit inflation whereas the less wealthy could not. 

But, as “Chuck” Prince, the Chairman and CEO of Citigroup, put it: “As long as the music is playing you have to get up and dance.”

And, what about the financially prudent?

Well, they had to bend to the times…for they had to dance as well.  If the way to increase or maintain ones return on equity comes from assuming riskier assets, increasing financial leverage, or financing long-term assets with short-term liabilities, the prudent had to play the game to some degree or face the real fact that money was going to move to those producing the greater return.

Even Germany played the game! 

As Plender points out, “Germany was the first in the European monetary union to break the stability and growth pact rules on deficits and debt.”

But, the Germans pulled it together…and now they are in the driver’s seat.

And, we see this to be true in the banking sector…and in the manufacturing sector…and with individuals and families.  When the bubble bursts, those with their balance sheets in the best shape control the future. 

“In the real world…”

Those that did not get their act together face the pain…and, they even come to resent…and dislike…those that did get their act together.  This is where civil strife can come into the picture, where the discontented can attempt to “occupy” the other.

The lesson for the new year…and for every new year…is that one needs to be careful about the debt one accumulates.  Too much debt can always come back to haunt you.  I know that the phrase “too much debt” is only relative, but, it seems that over time, having less debt than others can be to the benefit of the prudential. 

Remember, the general rule for winning the Super Bowl is to have the superior defense!

Happy New Year!

Capitalism is Capitalism Because It Changes and is Never the Same

There is an interesting lead editorial in the Financial Times this morning: “Capitalism is dead; long live capitalism.” (http://www.ft.com/intl/cms/s/0/2dd6f264-2d6c-11e1-b985-00144feabdc0.html#axzz1hq4siSP2)

The basic conclusion of this piece is that “Capitalism will endure, by changing.”  It has in the past.  Capitalism will change in the present circumstances.  And, it will change in the future.

The argument: “the market economy is not…unchangeable…It is successful not because it stays the same, but because it does not.

Two centuries ago there was no limited liability, no personal bankruptcy, little central banking, no environmental regulation and no unemployment insurance. 

All these changes occurred in response to economic or political pressures.  All brought with them new solutions and new challenges.

At a time of ongoing financial shocks, this need for adaptation has not ended.  On the contrary, it is as important as ever.”

The argument presented in this editorial is aimed at a “straw man”.  That “straw man” apparently believes that capitalism is an ideal system that can function in total independence of changing technology, changing institutional arrangements, and changing flows of information. 

The “straw man” believes in the “general equilibrium” model of the theoretical economist, a model that only includes profit maximizing and utility maximizing economic units…such units, by the way, are all exactly the same.

This pure economic view of the world has very little basis in reality.  In fact, this economic view of the world is at odds with current work in economics that views the study of economics as the study of incentives…incentives that exist everywhere.  This current view of economics is represented by work of Steven D. Levitt and Stephen J. Dubner in the books “Freakonomics” and “SuperFreakonomics”.

Economics, the study of incentives, is a field that indicates that “things” are always changing because the flow of information is always changing and, as a consequence of this, incentives are always changing.  If incentives are always changing then the behavior of individuals and institutions will always be changing.  And, that is exactly what we see in the world. 

The Financial Times editorial goes on: “At the heart of the renewed debate (about capitalism) are three issues: finance, corporate governance, and taxation.  These are the questions raised by the ‘occupy’ movements which, for all their intellectual incoherence, have altered the terms of the political debate.

The financial sector grew too big, partly because risks were misunderstood and partly because it was encouraged by policymakers to expand. …

Again, corporate management has too often rigged executive compensation in its own interests, rather than that of shareholders.

Finally, a plethora of incentives have allowed many of the most successful people to escape taxation.”

In response to the issue that the financial sector grew too big, I can only agree with the conclusion that “it was encouraged by policymakers to expand.”  Fifty years of “Keynesian-type” government policy aimed at stimulating high levels of employment and home ownership for more and more people in society created an environment of almost continuous credit inflation that encouraged increasing levels of risk taking, greater degrees of financial leverage, and more and more financial innovation.  And, given these incentives, General Electric and General Motors, to take two major manufacturing companies, became major financial institutions by the end of the twentieth century.

Why did the financial sector grow to become such a large proportion of the economy?  The incentives were created in such a way that the financial sector had to become a larger proportion of the economy.

Within an economy that produced almost fifty years of steady credit inflation, things were good: the real economy grew (but not at an exceptional rate), people owned their own homes, they owned TV sets…and cars…and second homes…and so forth.  Debt was readily available for all!  Who really cared if executive compensation was excessive if the prices of homes were rising at close to double-digit rates?  The “piggy bank” of the middle class (the homes that were owned by the middle class) kept growing and growing…so who should be concerned about top management salaries?

And, the Financial Times article explicitly states that “a plethora of incentives” existed to allow “many of the most successful people to escape taxation.”  But, the rising incomes created by credit inflation can itself create higher taxation where a progressive tax system exists, and this, alone, may be an incentive to find ways to evade taxation. 

People respond to incentives.  They always have.  They always will.

What we have found is that “The market economy is the most successful mechanism for creating prosperity humanity knows.  Allied to modern science, it has done more than transform the world economy; it has transformed the world.” 

In other words, if the “right” incentives are in place, a market economy can produce incredible prosperity and “good.”

However, if the “wrong” incentives exist, prosperity will not be as great and many, many people can face stagnation and suffer, as a consequence.

We can look back over the past two centuries and argue that people responded to “right” incentives and, as a result, we put in place limited liability, developed the concept of personal bankruptcy, created central banking and environmental regulation and produced unemployment insurance.  The response to these incentives worked to complement the market economy to bring about even greater prosperity.

Over the past fifty years the credit inflation created by many governments in the developed world produced incentives that have turned out to be harmful, even to the people that the credit inflation was supposed to help.  The consequence has been economic stagnation and human suffering.   

Therefore, one can accuse “Capitalism” of many things and make “Capitalism” the villain in the picture.  But, capitalism is going to continue to exist and the market economy will continue to create prosperity.  What we need to be careful of is the incentives that we create within this “capitalistic” economy and the “unintended consequences” that might result from these incentives.  Ideally, what we really want is a system of incentives that creates opportunities for everyone and the openness and mobility for anyone to take advantage of these opportunities and prosper in them.  These incentives will come from the public sector as well as from the private sector.  But, we must be careful of the incentives that are created and how they are implemented.    

The Problem is Germany

Last Friday, December 9, I ended my post with this concern: “So much was made of the role that Angela Merkel was playing in the effort to get a more comprehensive solution to the European problems that concerns were raised about the possibility of German dominance of the European Union. I even saw articles that made the following assertion: ‘What Germany could not achieve by military might may be obtained through financial strength.’

If this is true then it appears that Europe is still fighting the old battles. As long as Europe continues to operate on the basis of prejudices established years ago it will not move itself into the 21^st century. If this is true, the European financial crisis still has a long way to go.” (http://seekingalpha.com/article/312920-initial-verdict-on-european-summit-the-can-got-kicked-further-down-the-road)

Tuesday, in the Wall Street Journal, Alan Blinder lays it on the line: “the eurozone has a big, visible Greek problem, which is a result of failure.  But, it also has a far bigger, though less visible, German problem, which is a result of success.” (“The Euro Zone's German Crisis: Blame Teutonic efficiency for what ails Europe. The other countries just can't compete”: (http://professional.wsj.com/article/SB10001424052970203430404577094313707190708.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“When it comes to productivity, Germany has simply pulled away from the pack…Since 2000, German unit labor costs have risen about 20 to 30 percent less than unit labor costs in the other euro countries.  That gap has left Germany with a large intra-Europe trade surplus while most other countries run deficits.”

The referee could blow the whistle and call a foul…Germany is guilty of mercantilism!

On Wikipedia, mercantilism “is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy…from the 16th to late-18th centuries.”

But, mercantilism has not been an overt policy of the German government.  In fact, over the past decade or so, Germany has been trying to get its act together, dealing with putting two separate nations together as well as dealing with the newly constructed common currency area. 

But, Germany is Germany with a strong work ethic and a desire to pull things together with “thorough-going-labor reforms in the last decade.” 

It has not conducted a mercantilist economic policy, but the results have been roughly the same. 
Besides being ahead of most of the rest of its eurozone partners in terms of labor productivity, Germany also had the lowest rate of inflation.  The highest?  Well, of course Greece…and Spain…falling off to France, who had the second lowest rate of inflation.

The way out of this for the non-German eurozone countries?  Debt deflation!

The eurozone countries have one currency, so there can be no adjustment of individual currencies to revive some competitiveness among the nations. 

The eurozone countries have one central bank, so the individual countries cannot use monetary policy to correct their individual situations.

And, the eurozone countries in trouble have foolishly created so much debt in order to build up their economies through credit inflation that this avenue of spurring on economic growth has been closed.

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

Blinder closes, “Sadly, this may be the most likely way out.”

We knew it…the whole situation has been caused by those damn Germans!  They couldn’t get what they wanted by military means so they resorted to trickery…they worked hard, they innovated, they reformed their labor laws, and they didn’t issue too much debt.  Damn them!

If we blame the Germans, however, as I reported above, we…the Europeans…are just living off the same prejudices and wars that were fought in the past. 

Again, to quote Stephen Covey once more…”if we believe the problem is out there, that is the problem.”

This situation may be an uncomfortable one and the resolution of it may be “incredibly difficult and painful…and protracted.” 

Maybe that is what we need to work with.  Maybe the non-German countries need to get their budgets under control, get their labor laws reformed, get their educational systems up-to-speed, and move into the twenty-first century

Maybe the eurozone countries need to actually resolve the sovereign debt crisis, create a fiscal compact, and get on with these other problems that really need to be addressed.  

One final note…the United States is still benefitting from the role it plays as the country with the reserve currency of the world.  United States Treasury securities are still the place to go when there is a “flight to quality” and international investors become overly concerned with risk. 

But, let me just say that the world is becoming more competitive.  There are other countries in the world that may be less generous, more mercantilist.  There are other countries in the world that may be honing their productivity, their economic strength, their currency strategy to establish trade balances in their favor in order to change the relative power structure of the world. 

The United States is going to feel this is the future and needs to take a lesson from what is happening in the eurozone.  The unfortunate thing is that unless something is done the United States is not going to be in the position in the world that Germany now finds itself within the EU.    

The Focus Should Be On Under-Employment Not Un-Employment

The president, the press, and the political pundits focus on the unemployment rate in November as it dropped to 8.6 percent of the workforce, a drop from 9.1 percent in October.

However, under-employment still remains in the 20.0 to 25.0 percent range as it has for the past several years.

Under-employment includes those people that are working part time but would like to work full-time.  This component did decline by more than 4.0 percent in November from a month earlier but was down by only about 5.0 percent year-over-year.

Under-employment also considers people that are not working but say that they would like to be.  This includes discouraged workers and those who cannot work for reasons like ill health.  The number included in this classification increased by about 6.0 percent over the last year.  Does this capture the movement from part-time employment to discouraged workers? 

These figures indicate that there are long-run factors at work in the labor market that cannot just be solved by short-run fixes or election-year accusations and verbal confrontations.

My argument is, and has been, that fifty years of credit inflation has left the United States with a substantial dislocation of economic resources, like labor, and a vast redistribution of income toward the wealthy.  These dislocations are not subject to the “quick fix”. 

The economy is recovering, but the economic recovery is not doing much…and cannot do much…to create the restructuring that is needed.  You cannot try and put an employee of the auto industry back to work in the same job he/she held for the last ten years when the industry has moved on technologically and that job no longer exists. 

Another significant indicator of this is that the share of the population in the labor force has dropped to 64.0 percent, the lowest level in decades. 

This drop in labor force share is being driven by people retiring early from the labor force.  We see this in a lead article in the New York Times this morning, “Many Workers in Public Sector Retiring Sooner.” (http://www.nytimes.com/2011/12/06/us/more-public-sector-workers-are-retiring-sooner.html?_r=1&hp)  This is a result of the budget problems being faced by state and local governments, but it is also a result of events taking place in the private sector as well.

Further supporting information comes from the data of the manufacturing sector.  Capacity utilization continues to be below the levels attained over the past fifty years. 

The latest figure for capacity utilization was 77.8 percent.  This is above the level capacity utilization reached in the depths of the Great Recession, 67.3 percent in June 2009, but it is only slightly higher than the level at the trough of the 2001 recession.  And, the trend throughout the last fifty years has been down with capacity utilization being near 90 percent in the 1960s.

Over the past fifty years in the United States, under-employment has increased dramatically and capacity utilization has declined dramatically.  Note, that this is the time period that the income distribution skewed so dramatically toward the wealthy in the United States.

The economic policies of the United States government, both Republican and Democratic, have produced this outcome over this time period.  More of the same will not be helpful. 

Economic growth and economic recovery will not be robust unless and until people come to understand that the economic policies of the government must change.  And, these economic policies must deal with the structural dislocations that have evolved over the past fifty years as well as put the economy back on a more stable foundation with less reliance on debt and credit inflation. 

Credit inflation paints a very pretty picture while it is accelerating.  But, the consequences of this inflation is anything but pretty.  Just ask the less wealthy, the under-employed, and the manufacturers that cannot use their full capacity.   

Debt Deflation: Is It a Possibility?

There is still too much debt around.  The fact that there is too much debt around is a result of fifty years of credit inflation and financial innovation that resulted from it. 

The concern now as financial deleveraging takes place is whether or not we will go into a spiral of debt deflation.

The headlines currently are coming out of Europe.  Austerity plans are forthcoming everywhere.  Sovereign debt is the crowning issue…but there is growing concerns over corporate debt. 

And, with the cutback in government spending, the cutback in business spending, and the cutback in personal spending people are getting gloomier and gloomier about a new, European recession.  The clouds seem to be on the horizon.

But, a spillover of a European recession would be another American recession.  The United States depends upon the exports that it sells to Europe.  If Europe goes into a recession then the probability of the United States going into another recession increases. 

The problem is that America still has lots of problems on its own.  Just note some of the issues that have recently been floating around.

For one, corporate bankruptcies still are taking place on a regular basis.  Just recently we have Solyndra going bankrupt which brought attention to the solar industry area as a source of more financial difficulties.  Then we had Syms and its Filene’s Basement go into bankruptcy.  And, then who could forget MF Global.  And, there are many more still on the edge of considering such action…one of them possibly being Kodak.

And, what about the financially tenuous position of state and local governments?  Just Wednesday, Jefferson County, Alabama filed for the largest municipal bankruptcy in United States history.  And, Harrisburg, Pennsylvania was just taken over by the state of Pennsylvania because of its financial problems.  Now we learn that Flint, Michigan is on the verge of insolvency where the state government will takeover there.  And, what about Detroit, Michigan?  Again, the state is about to take over this financially distressed city.  And, there are many more still cities and states still on the edge of financial ruin with underfunded pension funds and so on.

Then we hear that mortgage problem is still not over and that banks are facing further write-downs of the mortgages on their books.   The latest case is that of HSBC which has garnered all sorts of attention over the past few days.   HSBC is still paying for its move into subprime loans earlier.  But, it is also facing a relatively new thing…a customer taking a mortgage payment “holiday.”  Given the political climate financial institutions are finding that people feel that they have very little to lose if they just stop payments on their mortgages.  Banks are finding it very difficult to foreclose on delinquent properties these days and that people fear little retribution if they just quit on any kind of payment to the bank. 

“Customers realized that if they stop paying, there’s very little we (HSBC) oar other banks can do.  This is an emerging trend.” (http://dealbook.nytimes.com/2011/11/09/hsbc-warns-of-economic-challanges-even-as-profit-rises-66/?scp=3&sq=julia%20werdigier&st=Search)

The commercial real estate market is not in very good shape either.  Although commercial real estate is picking up in some areas of the country, a look at the commercial banking data indicates that loans on commercial real estate is the item that is declining the fastest on the balance sheets of commercial banks…especially those that are smaller than the largest 25 in the country. 

Of course, these problems come through when we consider the condition of the banking system.  The commercial banking industry is still not very healthy yet and the prospect of it getting much better through 2012 is not that great.  Many small- and medium-sized banks are still really suffering. (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

The Federal Reserve can’t really afford to tighten up at all because of the weakness that still exists within much of the banking system.  (See my post, “Post QE2 Federal Reserve Watch: Part 3” of November 7: http://maseportfolio.blogspot.com/. ) And, the FDIC still continues to close two banks per week and this does not include any banks that have been acquired and absorbed into other banks within the system.

The general desire within the economies of both Europe and the United States is to continue to shed debt…to de-leverage.  But, if this de-leveraging takes place at the same time that the economies of Europe and the United States go into another recession, the situation can become a cumulative one.  That is, de-leveraging can contribute to slower economic growth or even declining growth, which leads to more de-leveraging, which leads to even slower economic growth and so on.

This is a debt deflation.

We are not there yet, but, it seems as if we are edging closer to the precipice. 

The problem seems to be that this situation cannot be undone by fiscal stimulus.  If people want to de-leverage they will de-leverage.  Adding more debt to the situation, even government debt created through more government spending, does not help the situation as the “fundamentalist” Keynesian would like to think.  More debt implies more taxes in the future, which just adds that much more of a burden to the person trying to de-leverage.  And, maybe, this just adds incentives to the equation leading the individual to take a debt payment “holiday”.

But, more debt write-downs can cause more debt write-downs.  And, this is the problem of a debt deflation.  It can become cumulative.  And, this is something the Keynesian models cannot pick up.

And, writing down debt for some people just means that someone else has to “eat” the loss elsewhere…and then someone else has to take a loss…and so on and so forth.  The consequences of debt do not just go away. 

The dilemma: if fiscal spending is not an option and monetary policy is basically “spent”, what is there left to do?  Not much?  Is the problem of creating a situation where there is too much debt outstanding that you just have to wait until people work off the excess debt?

This is a conclusion that most people don’t like.