The Basics of Turnarounds: the United States Situation

A part of my life has been connected with company turnarounds, bank turnarounds to be more precise. I would suggest that the United States is in a turnaround situation right now but its leaders claim that the economic model it is using is still relevant and that all that is needed is a little more time and a little more co-operation from others and everything will turn out alright.

My experience has led me to some conclusions about what is needed in a turnaround situation. (By-the-way, all my turnarounds were successful and I can say that now because I am not doing turnarounds any more.) We don’t have much space to discuss these things so let me just summarize what I believe to be the four most important factors in achieving a turnaround: the business model; information coming from the market place; the need for transparency and openness; and the existing business culture.

Although these factors relate to a business situation, I believe that they can be applied to any “turnaround” situation, including the “turnaround” of a government.

First, and foremost, an organization gets into trouble because its business model, or economic model, is not working. But, because a leader or a management team believes that the organization has gotten where it is because of that business model, they tend to stick with the model and apply the model even more forcefully.

In some cases, the success of the model has come because of the timing of the model’s use and not because of any inherent characteristics of the model are correct. To justify this statement I refer the reader to the book “Fooled By Randomness,” by Nassim Nicholas Taleb.

In terms of the economic model that the United States government is applying, and has been applying for a very long time, there is no real evidence that it works. I am, of course, speaking of the Keynesian macro-economic model.

Ever since the 1930s when the model was first presented, all I have ever heard in times of difficulty is that the reason the Keynesian model falls short is that not enough stimulus has been forthcoming. Keynesian economists contend that the Great Depression continued on for as long as it did because governments did not create sufficient budget deficits. Only the war effort, World War II, got the US out.

This criticism has been applied over and over again during the last fifty years. All we have been hearing from the fundamentalist preacher Paul Krugman is that the Obama stimulus package must be greater. He has been consistent in applying this remedy since early on in the Great Recession. More spending, more, more!

Maybe the economic model the government is using is wrong!
The application of this model over the past fifty years has produced falling capacity utilization, rising under-employment, and greater income inequality.

Maybe the economic model has not been applied correctly!

Defensive comments like these are heard over and over again within a company that is in decline.

Second, it seems that others recognize the decline in the company even though the leaders and management of the organization do not. That is, the market recognizes that the model of the organization is not working and that the organization is in decline.

And, what is the response of the leaders or managements of the targeted organization. The response is “The market doesn’t understand us!” I don’t know how many CEOs I have heard express this sentiment in the face of a falling stock price.

The thing is, the market does understand the company and the fact that the company is applying an inappropriate business model.

The market response to the economic policy of the United States? Well, the behavior of the United States government in the 1960s resulted in the need for the United States to go off the gold standard. Since the United States has been off the gold standard, the value of the United States dollar has declined almost constantly (with the two exceptions, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve system and during the 1990s when Robert Rubin was the Secretary of the Treasury).

Obviously, for the value of the United States dollar to substantially fall, almost continuously, over a fifty year period, indicates that something must be wrong with the economic model the government is using. During the past fifty years, the government has relied on a credit inflation whose foundation is a federal deficit that has resulted in the federal debt increasing at an annual compound rate of growth of more than 9% over this time period. The government has created other avenues of credit inflation through programs like those built for housing and home ownership. The whole economic model was based upon inflating the economy causing people to constantly “leverage up” and take on more and more risk.

Third, transparency and openness goes by the wayside as organizations experience decline. Cover ups abound! President Obama came into office declaring that he was going to change the way things are done in Washington. Yet, his administration is now charged with opaqueness and obfuscation like every other presidential administration. Even little bits of information, like the recent report by the special inspector of the TARP program, only adds to the accusation that this administration is hiding things. This was in all the papers this morning. (See “Treasury Hid A. I. G. Loss, Report Says,” http://www.nytimes.com/2010/10/26/business/26tarp.html?ref=business.) This does not help!

Fourth, the culture of an organization begins at the top. In a turnaround situation, a new culture
must be implemented and that culture must begin with Number One. The new leader that takes on a turnaround situation must change the way things are done and introduce a new business or economic model into the organization.

However, this new business model cannot be introduced or implemented if the (new) leader assumes that little or nothing needs to be changed. And, this implementation cannot be carried off unless the members of his or her team are all on board.

In my view, things need to be changed in Washington, D. C. The evidence in the market place is hard to ignore, although Washington has done its best to shift attention to others. But, the weakness of the United States position has been observed and others (China, Brazil, and India, and others) have moved into the void to take advantage of it. (See my post http://seekingalpha.com/article/229112-the-imf-bowl-u-s-vs-china.)

Even if the philosophy of economic policy used by the United States government was appropriate forty or fifty years ago, things have changed since then. (See my post http://seekingalpha.com/article/232044-maybe-things-have-changed.) The United States needs to be “turned around”. But, to do a turnaround, those that are in leadership positions must accept the fact that a turnaround is necessary. I don’t see this happening any time soon.

High Taxes and Tax Avoidance

The most profound comment in the news yesterday was, in my mind, this quote:

“The highest tax bracket income earners, when compared with those people in lower tax brackets, are far more capable of changing their taxable income by hiring lawyers, accountants, deferred income specialists and the like. They can change the location, timing, composition and volume of income to avoid taxation.”

This comes from the keyboard of Arthur Laffer of Supply-side economics fame. (See, http://professional.wsj.com/article/SB10001424052748703977004575393882112674598.html.) Laffer then gives several examples of such avoidance behavior: Senator John Kerry of Massachusetts, former Senator Howard Metzenbaum, and former Chairman of the House Ways and Means Chairman Charles Rangel.

I totally agree with Laffer on his major point.

This avoidance behavior also exists in the presence of an “inflation” tax. Whereas inflation has been touted as benefitting the “less well-to-do”, this is just a short-run help. Over the longer run, the “less well-to-do” cannot protect themselves very well against rising prices and so end up with lower real wages, real wealth, and fewer job opportunities.

As in the case of government assessed taxes, those individuals in the highest tax brackets or who have accumulated the greatest amounts of wealth are more capable of protecting their real income and real assets from an inflationary depreciation “by hiring lawyers, accountants, deferred income specialists and the like.” They can find many ways to avoid inflation that are not available to the “less well-to-do.”

There are three points that I would like to make relative to the above comments. First, many policies that attempt to help one class of people in a democratic society at the expense of another class of people may succeed in the short run. However, in the longer run, these policies tend to rebound on the former class of people, making them worse off, while achieving little or nothing in terms of the latter class.

In some cases these efforts produce a “negative-sum game” result in which everyone loses something. And, this leads me to the second point. By facing off “one class” of society versus “another class” of society, antagonisms are created, suspicions are raised, and society tends to be worse off. This is not what is supposed to happen in a liberal, democratic nation.

A liberal society works where people cooperate with one another and build community. To quote Ludwig von Mises on a liberal society: “It is important to remember that everything that is done, everything that man has done, everything that society does, is the result of such voluntary cooperation and agreements.”

I am not arguing in this post for or against renewing the “Bush tax cuts”. What I am arguing for
is a change in the rhetoric surrounding discussions about the federal budget, the rhetoric surrounding discussion about the financial reform bill, and the rhetoric surrounding many other issues in front of the American public these days.

Yes, arguing for one class against another may seem like good politics, but in America this really doesn’t win elections. Arguing for one class against another is a form of populism and the very politically astute Bill and Hilary Clinton have stated that elections cannot be won on a populist platform. (One reference on this point to Hilary Clinton can be found in Robert Rubin’s book “In An Uncertain World”.) I still remember watching Al Gore, in the 2000 election campaign, speaking in Mark Twain’s home town on the Mississippi River, Hannibal, Missouri, re-framing his campaign in populist terms. My immediate reaction was…Gore has just lost the election! And, he was well ahead of dubya in the polls at the time.

My third point is that very often people (and especially politicians) get caught up in the consequences of actions, which are current, and fail to see the causes of the these outcomes. This is a big problem in economics: many economic causes occur long before the consequences of the cause are recorded. For example, rent controls on apartments may lower housing costs for renters in the short run. However, if the owners of the apartments fail to maintain the units over time because of the reduced cash flows from the lower rental revenues, many will blame the “owner” and not the rent controls, for the now shoddy apartments .

An important example of this is the government caused inflation over the past fifty years or so. The gross federal debt increased by a compound rate of more than 7% per year from 1961 through 2008. A lot of this debt was monetized so that inflation increased at a compound rate of more than 4% per year during this time period accompanied by numerous asset bubbles which resulted from the excessive creation of credit. Financial innovation prospered in such an environment leading to greater and greater use of financial leverage, the taking on of greater amounts of risk, and the growth of “creative” accounting practices. Ponzi schemes also thrived in such an environment.

Why did businesses succumb to the taking on of excessive risk? The answer: in an inflationary environment, that is where the incentives are. If a company is out-performing its competitor by ten basis points then the competitor may assume more risk or take on greater financial leverage to pump up returns to match the competitor. The environment is cumulative in that more risk begets even more: or, as Chuck Prince, the CEO of Citigroup stated, “If the music keeps on playing, you have to keep on dancing.”

And who gets blamed? The greedy bankers…and not the government that created the inflationary environment. This point was made by the economist Irving Fisher in 1933: “If it is inflation and the one who profits is the business man, the workman calls the profiter a ‘profiteer.’ The underdog reasons as follows: ‘How did I get poor while you got rich? You did it, you dirty thief. I don’t know just how you did it; your ways are too subtle, sinister, dark and underground for simple me; but you did it all the same’

But, none of us—neither the farmer, nor the workman, nor the bondholder, nor the stockholder—thinks of blaming the dollar. So the real culprit stands on the curbstone watching us poor mortals as we beat out each other’s brains, and has the last laugh.”

Working together can result in a “positive-sum game”. The wealthy and those earning high incomes, at least most of them, believe that they should pay taxes. Maybe a new approach needs to be tried rather than attacking them and then trying to penalize them by enacting highly restrictive rules or excessive tax structures which they will spend great amounts of money to avoid.

The old methods don’t seem to work. Maybe we need to work to balance the tax laws so as to maximize tax revenues rather than punish one group of people over another. Maybe we need to think about creating a more open and transparent financial system that allows the economic process to work rather than saddle the economy with rules that dictate “outcomes”.

However, the old methods are built into the political system and will not change before this November. Guess we will just keep on shooting ourselves in the foot!

Is the United States on the Right Track?

The debate rages on: is the economic policy of the United States on the right track? On one side of the argument we hear that not enough has been done by the government to get the economy going again and to reduce unemployment. On the other side we hear that the government is creating too much debt and that most attention needs to be given to the reduction of the looming federal deficits.

Which argument is correct?

Well, if we look at the value of the dollar for an answer to this question, it seems as if investors are leaning a little more on the side of the latter.

This chart shows the value of the United States dollar against other major currencies in the world. The grade that is being given the economic policies of the United States government is not a good one. It should be noted that this index includes the Euro and the British Pound, two currencies that have been quite weak against the United States dollar recently.

Since January 2001, the value of the United States dollar has declined by about 26% against these major currencies. At one time, in 2008, the value was about 32% lower than in January 2001, but the ‘flight to quality’ during the Great Recession allowed the dollar to recover somewhat, but it then declined again to its current level as confidence rebounded.

Even with the situation in Greece (and Portugal and Spain and Ireland and…) investors in international markets still seem to believe that the United States government is on the wrong path with respect to its fiscal and monetary policies. Federal deficits totaling at least $15 trillion over the next ten years connected with a monetary policy that is keeping its target interest rate close to zero for an unknown length of time is not a combination that builds much confidence.

It could be argued that these international investors are giving the Obama Administration about the same grade it gave the Bush (43) Administration. If it were not for events going on in other countries, the value of the dollar could be even lower.

In fact, the recent performance of the dollar indicates that the international financial community sees little difference between the performance of the current administration and that of the administrations that preceded it over the past forty-five years of so, going back to 1961. Yes, different administrations pursued different specific policies that represented what they thought was best for the country, but in terms of aggregate policies, there has been little difference overall. The general thrust has been more federal debt and more private credit. The result: an almost constant increase in credit inflation.

Now, there is the threat of a debt deflation as a consequence of the Great Recession, but world currency markets don’t seem to think that a debt deflation is the most likely prospect.

With a government whose gross debt doubled since January 2001 and is projected to double again within the next decade and with a Federal Reserve that has injected $1.1 trillion of excess reserves into the banking system, little confidence exists among international investors that the United States government can “exit” this situation without losing control.

You can say all you want to about the policy differences of the different administrations over the last fifty years, but if you look at the aggregate economic data, very little separates the performance of the Republican and Democratic Presidents. President Nixon, perhaps, spoke for all Presidents of the past fifty years: “We are all Keynesians”.

One could argue that the Clinton Administration was the exception in terms of fiscal policy. And, Paul Volcker had to overcome the fiscal prodigals, Carter and Reagan, to achieve some credibility for the United States in international financial markets.

This relatively steady performance has weakened the United States internationally and the continued weakness in the dollar indicates that investors think that the current direction of policy will weaken the United States further going forward. This decline, connected with the ascension of the BRICS and other emerging areas in the world, is shifting power relationships all over the globe. The move from the G8 to the G20 captures this change.

The thing is, power cannot stand a vacuum. If the United States is wobbling a little, China, Brazil and others are there to fill in the spaces. Other nations will not stand still so as to allow the United States to dig itself out of the hole that Bush (43) put it in. In fact, by pursuing the same kind of aggregate economic policies that were followed by the Bush (43) Administration, large deficits and extremely loose monetary policy, the Obama Administration, in many ways, just seems to be digging the hole deeper.

Ben Bernanke is even calling for the Obama Administration to produce an “exit” strategy to reduce future federal deficits. But this just highlights the problems that this administration faces. The government must “exit” both an excessively loose monetary policy as well as an excessively prodigal fiscal policy stance. It will be a truly exceptional performance if this administration can pull it off.

Right now, I believe that world markets think that they cannot pull it off. The place to watch is the foreign currency markets: keep your eye on the value of the dollar!

The New Way for the Fed to "Exit"?

Has the Federal Reserve begun its exit strategy? Has the Fed already started the “Great Undoing”? It has, but the new exit movement is not taking place in open market operations…or in repurchase agreements. It is occurring with the help of the Treasury Department. Let’s look at the line item on the Fed’s balance sheet titled “U. S. Treasury, supplementary financing account”.

The Federal Reserve defines the U. S. Treasury, supplementary financing account in this way:

“U.S. Treasury, supplementary financing account: With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.”

Thus, this account is a deposit facility of the Federal Reserve similar to the U. S. Treasury, general account, the account that the Treasury conducts its general business from. Thus, it is a factor “absorbing reserve funds”, or, in other words, placing funds in this account removes reserves from the banking system. Hence, it contributes to the “exit” of the Fed from its inflated balance sheet.

I posted a note on this account on February 24, 2010 titled “The Treasury’s Latest Maneuver With the Fed”: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed. In that note I described what was going on in the following way: “On September 17, 2008, the Treasury Department announced something called the ‘Supplementary Financing Program.’ Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.”

In recent weeks a lot of activity has taken place in this account. As stated in the post on February 24, 2010, there were $5 billion on deposit in this account.

On March 3, this balance was just under $25 billion. The balance rose to about $50 billion on March 10, around $75 billion on March 17, and near $100 billion on March 24. Again it rose to about $125 billion on April 1, $150 billion on April 8, and $175 billion on April 15.

Obviously, the plan is for this account to increase by $25 billion every week until the Treasury reaches its stated goal of $200 billion in this supplemental financing account.

What impact has this had on bank reserves?

Well, on February 24, factors, other than reserve balances, absorbing reserve funds totaled $1.082 trillion. On April 14, this total was $1.320 trillion, an increase of $238 billion. Reserve balances at Federal Reserve banks declined from $1.246 trillion on February 24 to $1.061 trillion on April 14, a fall of $185 billion.

The latest information we have on excess reserves in the banking system indicates that for the two banking weeks ending April 7, excess reserves averaged about $1.094 trillion, a decline of about $100 billion from the average that existed for the two banking weeks ending February 24 of $1.092 trillion.

Thus, this “maneuver” accomplishes two things. First, it is connected with the issuance of Treasury debt to finance the huge budget deficits of the government. Second, the proceeds of the debt issuance do not stay in the banking system, but are withdrawn and put on deposit at the Federal Reserve so that excess reserves are drained from the banking system.

Therefore, the Federal Reserve, with the help of the Treasury Department, has begun to exit!

One could argue that these reserves are coming out of the banking system willingly. That is, the big concern associated with the “Great Undoing” is that the Fed would take reserves out of the banking system that the commercial banks really wanted to “hang onto.” If this were to take place we might get a replay of the 1937 actions of the Federal Reserve when it took excess reserves out of the banking system that the banks wanted to hold onto which resulted in the contraction of bank lending contributing to the 1937-38 depression.

Removing reserves in this way, with the help of the Treasury, might be a benign way to begin the “undoing” which can then be followed up by more traditional central bank operations using repurchase agreements and outright sales of securities. Also, it takes pressure off the Fed in that open market operations could just focus on the Fed’s holdings of U. S. Treasury securities leaving the Fed’s portfolio of mortgage-backed securities and Federal Agency securities free to just decline by attrition. The Fed has only about $777 billion in Treasury securities in its portfolio and, depending upon how much it needs to reduce the excess reserves in the banking system, would probably not want to be forced to use other other parts of its portfolio in removing these reserves.

So, we observe another financial innovation on the part of the government. Niall Ferguson has argued that, historically, governments have been the biggest innovator when it comes to finance. The reason? Governments have been the largest issuers of debt and have had to be very creative in finding new ways to place debt and to manage debt. Certainly in the last fifty years, governments have shown themselves very adept at coming up with new ways to spend money…and to finance this spending.

The Beat Goes On Concerning the Dollar

More headlines this morning on the dollar strategy of the Obama administration. First, the main headline in the Wall Street Journal contains the blast: “U. S. Stands By as Dollar Falls.” (See http://online.wsj.com/article/SB125498941145272887.html#mod=todays_us_page_one.) Then the lead editorial follows up with “The Dollar Adrift.” (See http://online.wsj.com/article/SB10001424052748703746604574461473511618150.html.)

We also learn that the administration was worried enough about this type of thinking to send out Chairman Bernanke and presidential advisor Larry Summers to indicate how serious the Obama Administration is in maintaining a strong dollar.

Again the phrase “Watch the hips and not the lips” comes to mind. There is very little the administration can do right now to introduce fiscal responsibility into what they are proposing. The die has already been cast and no one sees a quick reversal of the administration’s mindset.

And, this is the problem. Time-after-time in the last half of the 20th century countries got themselves into predicaments like the one being faced by the United States. Uncontrolled government budgets with the promise of growing amounts of debt outstanding. Connected with this fiscal irresponsibility was the concern that central banks were really not independent of the national government. This is a situation not unlike that currently in place in the United States.

There were a number of books that came out in the late 1980s and early 1990s that basically asked the question: “Is national economic policy in the hands of unknown bankers and financial interests around the world?” The general scenario depicted was that of a national government that proposed large and growing budget deficits that seemed unsustainable without the support of a captive central bank that would monetize the debt as pressure on local interest rates grew. The reaction of these “unknown bankers and financial interests” was to sell the currency of that nation and force the national government to reverse direction and introduce fiscally responsible budgets.

The primary example of such a historical event was that which occurred during the presidency of François Mitterrand in France. The French Franc came under such pressure that Mitterrand backed off his budget proposals and became fiscally quite conservative and supported the independence of the French central bank.

The issue here is not so much the size of the deficits, although that can be important, or the ratio of the deficits to GDP, or the ratio of government debt to GDP. The question relates to whether or not the government is acting in a fiscally responsible way and will it continue to do so in the future. The side question to this is the independence of the central bank.

Absolute numbers are fine, but it is the direction those numbers are going that are the crucial concern.

The facts to me are as follows: since the 1960s, the United States government has erred on the side of fiscal ease in terms of the budgeting process. This has not been a Republican or a Democratic fault. The leadership in both parties has contributed to the stance of fiscal leniency that has existed within the federal government over this time period.

During this time the value of the dollar has trended downward, with one or two side-trips.

During the Bush (43) administration fiscal irresponsibility got way out-of-hand. The fiscal irresponsibility was supported by monetary irresponsibility. Thus, we get to the current situation.

Nothing has changed!

Financial markets are seeing the same behavior in the current administration that they observed in the previous administration. O’Neill, Snow, Paulson, and Geithner are all of one package. Greenspan and Bernanke are linked at the hip. And, the words coming out of the mouths of our leaders seem to be “pre-recorded.”

I have been trying to call attention to this issue for four or five years now. Very little attention has been paid to the issue even though at one time in the Bush (43) administration the value of the dollar had declined by about 40%.

The problem is that there are no good solutions to the situation when you let it go for that long. The obvious picture is that of a binge drinker that has been an alcoholic for a lengthy period of time. More and more people are going to get hurt and this will just add to the many that are feeling pain at the present time. But, that is what happens when people lose their discipline and become addicted.

The event we see over and over again in economics is that ultimately the system has to correct, either on its own or with the help of those that are a part of the system. And, the correction takes place sooner, or, later, but it eventually takes place. Unfortunately along the way, as with alcoholics, some of the best attempts of “friends” to cure the patient only end up exacerbating the situation.

This Issue Is Debt! Too Much of It!

Going forward…the primary issue the world is going to have to face is debt…lots and lots of debt. Debt is clogging the blood vessels of the world financial system!

And the proposal to get us out of this dilemma?

Create even more debt!

If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.

This is what the people and the government want to avoid…if possible.

The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.

Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.

Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.

This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.

However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”

Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.

These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.

In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.

I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.

People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.

I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.