Developments in the Banking Sector: Large Amounts of Funds Still Going to Foreign Institutions

There seem to be three major stories in commercial banking these days: first, the cash going to foreign-related institutions; second, the pickup in non-real estate business lending; and three, the continued weakness in consumer borrowing.

Excess reserves at depository institutions in the United States averaged $1,509 billion in the two weeks ending January 25, 2012.  Cash assets at commercial banks in the United States were $1,597 billion in the week ending January 25, 2012.

In December 2010, excess reserves were $1,007 billion and cash assets $1,082 billion. 

Both excess reserves and cash assets rose by about 50 percent during this time period.

In recent years excess reserves at depository institutions and cash assets held by commercial banks have moved closely together.  The reserves the Fed has injected into the financial system have gone primarily into cash assets. 

It is interesting to note that of the $590 billion increase in cash assets at commercial banks, $403 billion went onto the balance sheets of foreign-related institutions in the United States.

For the week ending January 25, 2012, roughly 47 percent of all the cash assets held in commercial banks in the United States were held on the books of foreign-related institutions.  This is up from about 32 percent in December 2010. 

Note: These foreign-related institutions hold only 14.5 percent of the total assets in the United States banking system (up from about 11 percent a year earlier) so they are now holding a disproportionate share of the cash assets in the banking system.   

 

On the liability side of these foreign-related institutions there was a net increase in “net (deposits) due to foreign offices of $625 billion and a decrease in US held deposits (large time and other deposits) of $185 billion.  Thus, the right side of the balance sheets of these foreign related institutions rose by a net amount of $440 billion related to movements of funds “offshore”, i.e., primarily to Europe.

The Federal Reserve has not only supplied liquidity to the European continent through dollar swaps with foreign central bank, it has supplied funds to international financial markets through its open market operation.

It is not expected that many of the funds going to these foreign-related financial institutions will go into loans in the United States market as these institutions only hold about 8 to 9 percent of all commercial loans in the United States.

Therefore, when we look at what the Federal Reserve has done, we have to realize that only about fifty percent of the funds the Fed has injected into the banking system has gone to domestically chartered banks.  It is only this domestic portion of the Fed’s injection of funds that can have the greatest possibility of impact on business lending and hence economic growth.

Cash assets did increase at domestically chartered commercial banks during this time period: the increase was about $112 billion as total assets grew by $243 billion.  At the largest twenty-five banks in the country, the increase was $75 billion in cash assets and $130 billion in total assets.

The important thing is that business loans (Commercial and Industrial loans) at commercial banks have been increasing, primarily at the largest twenty-five domestically chartered banks in the United States.  From December 2010 to December 2011, C&I loans rose by $123 billion in the commercial banking system, with $94 billion of this increase coming at the largest twenty five banks, a 15 percent year-over-year rate of increase. 

Business loans did increase at the rest of the domestically chartered US banks, but they rose by only about $18 billion or about 5 percent year-over-year.

Over the past thirteen-week period, however, C&I loans at these smaller banks hardly increased at all and actually fell over the last four-week period.

At the largest banks, business loans continued to rise over the past four weeks ($15 billion) and over the past thirteen weeks ($35 billion).  My question about these increases has to do with the uses that the funds are being put to.  The national invome statistics showed that inventories increased in the latter part of last year and these loans could have gone to increase the inventory buildup.  Many economists seem to believe that given the weak consumer behavior (see below) that the inventories will decline in the first quarter of 2012 and this will result in some weakness in business loans.  Alternatively, some of the borrowing could be so that corporations could buildup cash positions for either acquisitions or for stock repurchases.  There does not seem to be any inclination to increase spending on business plant or equipment.

Commercial real estate loans continue to decline at the smaller banks in the country although there has been a pickup in these loans at the largest banks.  All-in-all, lending on commercial real estate continues to go down: and given all the loans that will mature over the next 12 to 18 months, with many of them being unable to re-finance, there is a continued likelihood that these loans will continue to decline in the near future.    

On the other hand, residential mortgage lending rose across the board at commercial banks.  Although residential mortgages fell on the books of the banks from December 2010 to December 2011 by $12 billion, over the past thirteen-week period, these mortgages grew by almost $19 billion, with $11 billion of this increase coming in the last four weeks.  And, the increases came in all sizes of banks.

This line item will be interesting to watch over the upcoming months since housing prices continue to decline and foreclosures and bankruptcies seem continue to occur at a rapid pace.

Just a further note on real estate lending: home equity loans have declined over the last thirteen weeks and held roughly constant over the past four.  

Counter to this increase in residential spending is the decline in the dollar amount of consumer loans on the books of the banks.  Over the past six months consumer lending has dropped by a little more than $6 billion with a major decline of roughly $15 billion coming over the last four weeks.   Most of this decline has come in credit card debt outstanding at the banks. 

This information on consumer lending seems to point to a continued weakness in consumer expenditures. 

In terms of the domestic economy it seems as if there is not much encouragement for a stronger economic recovery in the banking numbers.  There seems to be little demand for any kind of loans in the current environment, but, one also gets the feeling that the banks, especially the smaller ones, are not willing to lend even if there were an increasing demand for loans. 

Where is the US Consumer?--Part 2

Two pieces of news today that go along with my earlier post about the pressures families are facing in the United States. (http://seekingalpha.com/article/328252-where-is-the-u-s-consumer).   

First, “Home Prices Tumble.” (http://professional.wsj.com/article/SB10001424052970204652904577194752102528744.html?mod=WSJ_hp_LEFTWhatsNewsCollection) “For November, the Case-Shiller index of 10 major metropolitan areas and the 20-city index both fell 1.3% from the previous month. David M. Blitzer, chairman of the index committee at S&P Indices, also noted that 19 of the 20 major U.S. metropolitan markets covered by the indices in November saw prices decline from October…

The 10-city and 20-city composites posted annual returns of negative 3.6% and negative 3.7%, respectively, compared with November 2010.”

Second, “Consumer Confidence Unexpectedly Declines.” (http://blogs.wsj.com/economics/2012/01/31/consumer-confidence-unexpectedly-declines/)  “U.S. consumer confidence in January gave back some of the huge gains posted in the previous two months, according to a report released Tuesday. Views on labor markets darkened.

The Conference Board, a private research group, said its index of consumer confidence retreated to 61.1 this month from a revised 64.8 in December, first reported as 64.5. The January index was far less than the 68.0 expected by economists surveyed by Dow Jones Newswires.

Perceptions about the job markets worsened this month. The survey showed 43.5% think jobs are “hard to get” up from 41.6% saying that in December, while only 6.1% think jobs are “plentiful” down from 6.6% in December.”

These data are consistent with the material presented in the earlier post.  The United State consumer has lots to worry about and, for a large portion of this consumer base, spending is not expected to be very robust in future months.  And, their situation cannot be turned around soon by either monetary or fiscal policies. 

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.   

The United States Economy Will Continue to Grow

I believe, as I have written before, that the United States economy is recovering and will continue to recover. 

However, I also believe that “financial crises are protracted affairs.” (Reinhart and Rogoff, “This Time is Different”, page 224.)

Why don’t I believe that there will be a “double dip” recession, a 1937-38 depression like the one following the 1929-33 Great Depression?

In the case of the 1930s, there were policy errors committed that resulted in the 1937-38 depression: the most prominent one being the effort of the Federal Reserve to eliminate all the excess reserves being held by the commercial banks at that time so that the Fed would have more “control” over the money markets.

Unfortunately, the banks wanted those excess reserves around even though they were not in the mood to expand their lending activities.  As a consequence, when the Fed attempted to remove those excess reserves by raising reserve requirements, the banks cut back even more on their lending activities in an effort to achieve the financial protection they believed those excess reserves brought them.    

This has not happened in the current situation because Fed Chairman Ben Bernanke (a student of the Great Depression era) and the Fed have done just about everything possible to make sure that the banking system is flooded with excess reserves so that a similar contraction of the banking system does not occur.  There are questions about what this means for the future, but we are not at that future yet.

So, I believe that the economic recovery will continue.

The economic recovery, however, will not be robust.  One reason for this is the debt overhang that exists in the private sector.  David Brooks speaks to this point in his Tuesday morning column in the New York Times. (http://www.nytimes.com/2011/10/18/opinion/the-great-restoration.html?_r=1&hp) 

“Quietly but decisively, Americans are trying to restore the moral norms that undergird our economic system.

The first norm is that you shouldn’t spend more than you take in. After an explosion of debt over the past few decades, Americans are now reacting strongly against the debt culture. According to the latest Allstate/National Journal Heartland Monitor poll, three-quarters of Americans said they’d be better off if they carried no debt whatsoever. Not long ago, most people saw debt as a useful tool for consumption and enjoyment. Now they see it as a seduction and an obstacle.
 
By choice or necessity, eight million Americans have stopped using bank-issued credit cards, according to The National Journal. The average credit card balance has fallen 10 percent this year from 2010. Banks, households and businesses are all reducing their debt levels.”

This same phenomenon is occurring in the world of state and local governments, and the non-profit world.

How is spending going to expand within the context of this kind of behavior?

The general fundamentalist Keynesian response to this is that the federal government needs to do more to stimulate the economy.  The argument is that government spending actually needs to be much greater than is being proposed at the present time.  The people that are making this argument also state that the economic recovery in the 1930s was as slow as it was because the government did not spend as much as it should have back then.  Government expenditures will never be large enough for these people. 

But, how is more government debt going to change the picture?  As Reinhart and Rogoff state in their book, “the value of government debt tends to explode” (page 224) in the aftermath of any severe financial crisis anyway.   

The reason is that as incomes drop, tax revenues decline and the government deficit increases. 
But, greater deficits mean greater interest and principal payments in the future, and someone like Robert Barro argues that this will mean more taxes for the private sector in the future so that current savings will increase even further to offset this future obligation.     

Even if the private sector does not fully discount future taxes into their current spending plans, people may just accelerate their efforts to save to provide themselves with more flexibility to manage their financial affairs in an uncertain future world dominated by huge government debts. 

The problem that results from this scenario, in my mind, is that given the behavior of the Federal Reserve System there is lots and lots of cash floating around in the economy, but this cash is not in the hands of those people and businesses that are trying to restructure their balance sheets.  Because, this cash is not in the hands of those people and those businesses that are trying to restructure their balance sheets, the fundamental economic recovery will continue to be modest. 

Thus, you have lots and lost of cash looking for places to invest where there are very few “productive” places for the money to go.  So, money seems to be chasing assets.  However, the uncertainty seems to be causing other problems and this is resulting in increased market volatility. (http://professional.wsj.com/article/SB10001424052970203658804576637544100530196.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

“The problem is a lack of liquidity—a term that refers to the ease of getting a trade done at an acceptable price.

Markets depend on there being many offers to buy and sell a particular stock, across a range of prices. But as investors have gotten nervous, many of those offers have dried up. That is causing wider-than-normal gaps between prices showing where stocks can be bought and where they can be sold—the difference between the "bid" price and the "ask" price.

Many big investors, such as hedge funds and mutual funds, which at times can act as shock absorbers for trading because they tend to trade large chunks of stocks, have been on the sidelines. Some hedge funds, for example, say they're not trading as much until they know how much money their clients will withdraw at the end of October, a deadline some clients have to inform funds of intentions to redeem money at year-end. “

In my mind, the economic recovery is going to continue on its slow path.  But, given all the money around and given the general impatience that is attached to this money, wide swings in asset prices are going to continue well into the future, especially if the Federal Reserve really keeps interest rates as low as they are into the middle of 2013.

Patience is not an attribute of traders…and of politicians…but that is another story.

The Solution to the European Problem?

“The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bonds markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately.”

‘

This is the prognosis of Mr. Martin Wolf, the economics editor of the Financial Times, in today’s edition of the paper. (http://www.ft.com/intl/cms/s/0/3ba2f7c4-ee76-11e0-a2ed-00144feab49a.html#axzz1ZuI4wzxo)

“Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health.”

The word is getting out…the European banks are going to have to take bigger write downs of their holdings of sovereign debt than ever imagined. 

Can the eurozone governments cover the hole in the balance sheets of these banks?

The United States stock market seems to think that they can.  This is the reason given for the rapid recovery of stock prices in the market yesterday. 

But, let’s look more closely at what Mr. Wolf is saying.  In the first condition, he writes about how the amount of the write down will be determined along with how the write down will be administered.  This is a daunting task in, and of, itself. 

Note further, however, that he is including ‘private’ debt along with the debt of sovereign borrowers.  The need to write down the ‘private’ debt is something new, something that has not gotten a lot of attention in the press in all the noise relating to the sovereign debt issue.  

The second point Mr. Wolf makes is about contagion.  How is any write down of the debt of the peripheral nations going to be kept to just the peripheral nations bonds, themselves?  The concern is that once write downs take place in bonds of the fiscally weaker nations that some spread is bound to occur to the nations that are in a stronger position, fiscally.

Then, Mr. Wolf addresses the issue of credibility.  Given all the “messing around” for the better part of almost three years, how can financial markets come to believe that solvency has been restored to the impacted nations?  If anything has increased over the past three years or so, it is the lack of trust in the eurozone governments when it comes to how the politicians carry out their responsibilities.  There is little or no trust in the people heading up most of the governments in Europe.  Can this “trust” be regained…and in time?

The add-on to this analysis is that the eurozone countries also need an immediate return to a robust economic recovery.

The happy conclusion to the analysis: “If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.”

Two comments on this analysis: first, I am glad to see that some people are finally seeing the problem as one of solvency and not one of liquidity.  It has taken a long time for the analysis to get to this point.  Now, it is time for the policy makers to accept this fact.

Second, Mr. Wolf pretty well lays out the dislocation that is going to have to take place in order to restructure and restore the eurozone to some sense of order and balance. 

“How, then, did the eurozone fall into its plight? The easy credit conditions and low interest rates of the first decade (of the European Union) delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain.”

The European condition is the result of credit inflation!  Quite an admission for a dyed-in-the-wool Keynesian!

The point is, however, that a long period of excesses must be matched by a painful and uncomfortable period of restructuring. 

In conclusion, however, one cannot ignore the social situation in Europe.  The “social contract” of the post-World War II era appears, to many, to be broken, and there is protesting and rioting in the streets.  Strong economic growth and low levels of unemployment, something that seems more and more unlikely to happen in the near future, of course, can resolve this situation.  Writing a new “social contract”, as history shows us, is not an easy thing to do.

Are there any lessons here for others?

An Economic View from the Supply Side

As I have written before, the United States economy is recovering.  It may not be recovering as fast as some would like, but economic growth is positive.  Economic growth is not as rapid as some would like because there is still a massive debt overhang that must be eliminated, one way or another.

Furthermore, unemployment and under-employment are not dropping as fast as some would like.  The labor market is not improving with any speed because the economic policies of the last fifty years has resulted in a large amount of the United States manufacturing capacity being unused.  As physical capital is unused so is human capital.

Both of these situations took a long time to get to their present state and will take a long time to regain higher levels of economic growth, capacity utilization, and employment. 

The background for this situation can be examined from the following chart.

  This chart contains a graph of real Gross Domestic Product beginning in 1960 and ending in 2010.  I start with the year 1960 because that is the year before the United States government, both Democratic and Republican, introduced a “new” economic philosophy into its policy considerations, one that emphasized the inflation of credit throughout the economy. 

To me, the important thing about this chart is that real GDP is almost continuously rising.  Yes, there is a sizeable bump at the far right-hand side of the chart, and this is associated with the Great Recession, an apt title.  Otherwise, there are other little deviations from the upward trend, but these are relatively minor movements along the way.

This is where I take my stand with the economic growth proponents.  In the United States economy, growth is almost always positive.  The annual compound rate of growth for the period covered in the chart is 3.1 percent.  The annual compound growth rate of the United States economy, ending the calculation in 2007 (the Great Recession began in December 2007) the rate of growth rises to something around 3.25 percent.  But, growth is dependent upon the private sector, not directly on the government.    

I define credit inflation as a period in which the rate of growth of debt in the economy exceeds the rate of growth of the economy.  Over the past fifty years, the debt of the United States government has increased by more that a 7.0 percent annual compound rate of growth.  The debt of the private economy has risen in the range of 11.0 to 12.0 percent every year.  This meets my definition of credit inflation because these growth rates are far in excess of the rate of growth of the economy. During this period, the purchasing power of the dollar declined by about 85 percent.  In other words, a 1960s dollar could only buy 15 cents worth of goods and services today versus a dollar’s worth in 1960.

Side note on credit bubbles: when the annual compound rate of growth of the debt being created in a subsector of the economy exceeds the annual compound rate of growth of the economic growth of the subsector, a credit bubble can be said to exist.  The housing market bubble of the early 2000s fits this definition.

Credit inflation can have a detrimental impact on economic growth.  Credit inflation creates incentives that cause manufacturers to move away from the producing of goods and to move into the creation of finance.  Two examples of this are GE and GM: for example a couple of years ago GE was earning more than two-thirds of its profits from its finance wing.  In terms of the whole economy, there has been a huge swing over the past fifty years from the manufacturing sectors of the economy to the financial services sector of the economy.

Some of the consequences of this re-allocation of capital is that the employment of capital declined: capacity utilization is around 77 percent now relative to more than 90 percent in the 1960s.  Under-employment is over 20 percent now and was under 10 percent in the 1960s.  And, the income/wealth distribution is more skewed toward the wealthy than it was 50 years ago.

This has impacted economic growth.  For example, the annual compound rate of growth of real GDP has only been 2.5 percent over the past twenty years, down substantially from the rate of growth for the whole period.  Credit inflation, as an economic policy of the government, seems to have exactly the opposite impact on the economy that is desired by policy makers.

But the other important thing to notice in the chart is the “bumps in the road”.  In my opinion, all of these “bumps” resulted in some way from dislocations in the growth of credit instruments as a result of the monetary or fiscal policies of the United States government.  In most cases, the dislocations were relatively minor. However, as the debt load expanded and the private sector devoted more and more resources to financial services, the ability to carry the load grew greater and greater.

The debt burden cannot keep growing: it has to collapse sometime and along with it the economy.  In most cases the “bumps” were relatively minor.  I know it is never fun for anybody to be un-employed or under-employed, but in the aggregate sense, the “bumps” were not large. 

During the Great Recession and following, the “bumps” were much larger because the build-up of the debt dislocations were greater than ever.  However, since the debt burden must be worked off, it will take more time for the economy to achieve the longer run rates of growth that were achieved earlier in this fifty years of economy prosperity.  But, it will come. 

We must be aware of these dislocations and the things that must be done to re-structure the economy and get back to the economic growth performance we are looking for.  For example, we cannot ignore the state of the banking industry in this recovery. (See my post from last Friday: http://seekingalpha.com/article/295630-why-banks-aren-t-lending.)  Resolving the “bumps” just means that the previously created dislocations in finance and economics must be resolved.    

The "New Way" of Business

 I have been talking with a lot of people recently about the changes that are taking place in the United States and elsewhere.  More and more people are discussing the possibility that the world is changing in a way that only happens every once every eighty years or so.  These people are saying that whatever comes out in the 2010s and 2020s will be incredibly different than what was there before 2000.  In essence, the sixties are dead!

They seem to be saying that what came out of the 1940s and 1950s was “different” from what existed in the 1920s.

An interesting case-in-point is the recent demise of Osama bin Laden.  Although the general response to this action has been that this was an important occurrence, there is also the undertone that the “times have changed”; maybe the world has moved on and the significance of this event lies more in the past than the future.

In this the “protestors” and the “street” in the Middle East have become more important than the purveyors of a closed fundamentalist group that promotes jihad and the return to a model of society that is more from the Middle Ages than from the 21^st century. 

To these people seeking broader rights, the passing of bin Laden is just a footnote to the real battle.  To these people the cell phones and the social networks represent the path to freedom and self-respect.  Osama bin Laden was legacy, coming from the age of the television where he saw and rejected the creeping intrusion of Western culture into his image of what the Middle East should be. 

Where Osama bin Laden saw the end of the “old way”, the young people now protesting in the streets see the “new way” of opportunity and greater self-determination.

The “old way” was movies, newspapers, and television.  The “new way” is instantaneous photographs, videos, tweets and texts. 

Maybe this is the way we need to look at business and finance.  That is, the “new way” which is the time after 2000, and the “old way” which live in a time before 2000. 

The “old way” is the time of General Motors, United States Steel, and General Electric.  The “new way” is the time of Microsoft, Google, and Facebook.

The “old way” is the production line; the “new way” is the instantaneous trading of stocks and the presence of an immense amount of information at our fingertips.

Exciting to me is the headline “Rejecting Wall Street, Graduates Turn to Entrepreneurship,” found in the morning New York Times (http://dealbook.nytimes.com/2011/05/02/rejecting-wall-street-graduates-turn-to-entrepreneurship/?ref=business)

This article discusses the rapid increase in new companies started by students at Harvard and at the Wharton School, UPENN.  The article states “Graduates (of Harvard) from the class of 2010 started 30 to 40 businesses last year, a 50 percent increase from the previous year.”     

And, I have directly experienced some of the effort and energy of these students the article talks about through the angel networks and venture networks in which I participate.

The ideas for the new companies generally come from the students themselves.  They see something missing in the markets they work within.  For example, in the New York Times article, one of the young entrepreneurs discussed got his idea “after trying to find diapers for his son during a family trip to Rio de Janeiro…  Struck by the lack of high-quality baby care goods (the young entrepreneur) saw an opportunity in Brazil’s fast-growing markets, where more than three million babies are born every year…” His grades suffered this year as he often traveled from Cambridge, MA to Brazil to develop his new business. 

The company was one of the top three winners of Harvard’s annual Business Plan Contest, which added to other capital the founders, raised for the new business.  The “fund-raising effort, which valued the company at $5.6 million, included several well-known venture capitalists…”

And, these schools are contributing to this movement by starting other initiatives on campus to encourage interested students in new ventures and to encourage them to talk with one another and bounce ideas around.  They also have money and space where “entrepreneurs-in-residence” can get started.

I see this kind of entrepreneurial activity going on all over the place.  It is exciting, energizing, and cause for hope.  It is the new world based on information technology, not the old world based on physical capital.  And, in my mind, its future dominance is unstoppable.

We are transitioning to this new period in our history.  And, transitions cause pain.  Let’s look at three areas, the current business structure, financial structure, and work force.

In terms of the current business structure, shifts have been taking place for several decades now.  The emphasis on manufacturing and the capacity utilization of industry is receding.  Capacity utilization of US manufacturing, which was over 90 percent in the 1960s has been declining constantly through the late twentieth century and now hovers below 80 percent as the economy now recovers. 

Physical output is going to continue to decline as a proportion of what the US economy does.  Ideas are going to come from all over the place.  As observed above, more and more people are going to find “missing markets” and attempt to fill them in.  Much of this activity will be information based.  The evolution into this new structure will take time and this is one of the reasons why the economy is not picking up that quickly: a restructuring is taking place and people are not being hired back into the jobs they lost in the Great Recession. 

This gets us to the work force.  There is a very powerful article in the Economist this week, (the April 30 issue) titled “Decline of the Working Man.”  The sub-title is “Why ever fewer low-skilled American men have jobs.”  The big culprit?  Education.  The less education you have the less likely you are to be fully employed and this is consistent with the restructuring going on in American industry. And note, the article is about American men…American women have learned this lesson and are way ahead of men in this area.

But, this means that the old Keynesian idea that when there is unemployment, fiscal stimulus can just put people back to work in their old jobs, is not really valid: especially if you want to help the “low-skilled” find meaningful, long-term employment.

And finance?  More and more financial capital is coming from angel finance networks, private equity, and hedge funds…the shadow banking industry.  This is the kind of finance that the young entrepreneurs need.  And they are getting it.  It is not coming, nor will it come, from the commercial banks, especially the smaller ones, who have come to rely more and more on residential real estate loans and commercial real estate loans…not on business loans. 

Yesterday, the Chrysler Group posted its first quarterly profit since 2006.  To me, as with the other news reported above, this should be just a footnote.  This is news about the “old way.”  We need to focus on the “new way” and like some of the other revolutions taking place, the “new way” in business is found in non-traditional places.  But, that is what information technology allows us. 

Long-term Treasury Yields in 2011

Yesterday, I attempted to lay out how I thought 2011 would play out in terms of the value of the United States dollar. In “The U. S. Dollar in 2001” (http://seekingalpha.com/article/242766-the-u-s-dollar-in-2011) I argued that the general outlook for United States monetary and fiscal policy was more of the same policy stance that the United States government had taken for the last 50 years: credit inflation. (For more on this see the Financial Times/ Goldman Sachs business book of the year, “Fault Lines” by Raghu Rajan: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.)

The year 2011 will follow the pattern of large fiscal deficits and monetary ease and this will carry into the foreseeable future. As a consequence, the long term direction of the value of the United States dollar will be downward. I focus on this initially because this sets the stage for how financial market participants view the actions of the United States.

This downward movement, however, will be interrupted in the short run by the continued problems relating to the sovereign debt of various countries within the European Union. The United States, in 2011, will still be seen as a refuge from risk which will result in the dollar being supported by a “risk averse” investment community through much of 2011.

The turmoil in Europe is taking the pressure off of the policy makers in Washington, since they will be free of any criticism that might come their way because of a declining value of the dollar. As a consequence, the Obama administration will not need strong leadership to execute an “unpopular” monetary or fiscal policy: this was the case in the late 1970s and early 1980s as Paul Volcker, leading the Federal Reserve, put the brakes on the economy and the value of the dollar rose significantly; and Robert Rubin, leading the Treasury Department in the 1990s, helped to bring the federal budget from a deficit to a surplus, which produced another significant rise in the value of the dollar.

So, my basic expectation for the economy for the next year (and for the near future) is similar to that being called “the new normal”. The new normal incorporates sluggish economic growth, high unemployment, and weak inflation. (See “Champions of the ‘new normal’ stick to their guns,” http://www.ft.com/cms/s/0/b9c8a49e-0c5b-11e0-8408-00144feabdc0.html#axzz18l9xj6XV.)

The sluggish economic growth of the United States will remain around 3.0 percent to 3.5 percent, year-over-year, something way below what ordinarily has occurred in economic recoveries in the past. This modest growth rate under-scores the structural problems exhibited in the economy, the unusually low level of capacity utilization on the part of industry, the fact that the under-employment rate will remain in the 20 percent to 25 percent range as employers remain reluctant to bring back workers on a full time basis, and the fact that the year-over-year rate of growth of industrial production has been dropping off every month since June 2010.

I do see three ominous clouds on the horizon present in the financial sector. First, the solvency problems in the smaller commercial banks will continue to linger. As readers of this column know, I believe that the Quantitative Easing on the part of the Federal Reserve is more to keep the banking system afloat as the FDIC closes a sizeable number of banks over the next year or so. This will keep a lid on bank lending.

Second, there are the financial problems being experienced by state and local governments and these problems spill over into the financial markets for the bonds of these entities. The implications of this situation for the reduction in budges are huge.

Finally, large corporations have accumulated a huge chest of cash (both in the United States and Europe). It is my belief that this accumulation of cash is for “buying” purposes and we will see a sizeable pickup in mergers and acquisitions as the economic recovery continues. But, this restructuring of the economy will not create more jobs and increase production. In fact, it will do just the opposite. Large banks will also participate in this expansion of mergers and acquisitions. And, the big will get bigger.

Overall inflation will remain moderate. The year-over-year rate of increase in the implicit price deflator of gross domestic product remains around 1.0 percent and this probably will not go much above 1.5 percent this year, if it goes that high. Thus, general inflation does not seem to be a near-term problem.

However, given the current stance of monetary policy we see the possibilities of bubbles forming all over the place. (See “The Fed: Bubble, Bubble, Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.) As we saw over the past 25 years or so, general inflation was low and policy makers felt under control of things. Yet we saw bubbles here and bubbles there. Now, the actions of the Federal Reserve are being picked up in a rise in commodity prices, rising stock markets of emerging nations, and the buildup of inflationary pressures in export driven countries like China and Germany.

Putting this all together, my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5% to 5% in the upcoming year, a rise from around 3.3% to 3.5% now. The 30-year Treasury security will rise to the 5.5% to 6.0% range, up from around 4.4% to 4.5% now. The spread between the yields of these two maturities will be about 100 basis points, slightly lower than it is at the present time.

Bernanke will not be able to keep long-term interest rates down!

This just puts long term Treasury yields back at the levels they were for much of the 2000s.

From this, I argue that the long run expectation for inflation built into these securities would be in the 2.0 percent to 3.0 percent range. For myself, I find that this level of inflationary expectations over the next ten to thirty years is low. But, that is another story.

The major uncertainties in this picture? The first uncertainty pertains to the stability of the banking system. I believe, however, that the Federal Reserve will continue to flood the financial market with liquidity in order to allow the failing banks to be worked off in an orderly fashion. If this occurs, the recovery will continue but at a slow pace.

The second uncertainty pertains to state and local finance. My feeling is that the federal government will not allow this situation to get out of hand. Welcome to the bailouts of 2011.

The third uncertainty pertains to the bubbles that have been created or are being created. As we have learned, bubbles can last only so long. The question will remain about how long the bubbles created will last. Given that the Fed will continue to flood the market with liquidity, it is unlikely that the world will be bubble-free.

One thing mentioned above I believe will be an uncertainty only in timing. That is the increase in the amount of mergers and acquisitions taking place. I believe that 2011 will see a continuation in the acquisition splurge that has already started and will continue beyond this coming year. The only uncertainty related to this is the reaction of the federal government to the bigger companies. My guess is that the new Congress won’t challenge this and the Obama administration will not have the will to challenge it.

Long-term Bond Yields and QE2

One of the fundamental things I learned when working in the Federal Reserve System and in running financial institutions was that the Federal Reserve could only temporarily lower long term interest rates.

In attempting to achieve a goal of lowering these rates, the yield on long-term Treasury securities would initially dip below its previous level and then rise to a point where it was above the previous level. The moral of this market behavior was that attempts to keep long term interest rates lower than the market desired only ended up causing the rates to go up as the market adjusted to the efforts of the central bank.

In my professional career I have not observed anything that would lead me to change this viewpoint.

Yet, supposedly, the QE2 efforts of the Federal Reserve are aimed at reducing the yield on long-term Treasury securities so as to encourage a more robust recovery of the economy. The argument given is that there is little or no indication that inflation will pick up because, if anything, the probability that we might enter into a period of deflation is high enough to be of concern.

As recorded in my post yesterday, I believe that on the subject of inflation/deflation, Ben Bernanke is a lagging indicator. He always seems to be behind what is happening. (See “The Fed: Bubble, Bubble Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.)

Let me start from where I am. First, the United States economy IS recovering. However, this recovery is going to be a very slow one because of all the re-structuring that needs to be done within the economy of the United States. We have considerable under-employment with one out of every four individuals of working age being under-employed. We have a capital structure in which a lot of capital is not being used: current capacity utilization is around 75% and the previous peak “high” was only about 81%. We have built too many houses and there seems to have been too much development of commercial properties. There is still too much debt outstanding: more deleveraging needs to take place. And, this doesn’t even come close to touching the needs of our educational system. (See “Top Test Scores from Shangshai Stun Educators,” http://www.nytimes.com/2010/12/07/education/07education.html?ref=education.) And, so on.

I just do not believe that monetary stimulus, or, for that matter, further fiscal stimulus is going to achieve much faster economic growth.

The financial system is still fragile and this, I have argued is the real reason for the Fed’s attempt to flood the world with liquidity. Banks, other than the largest 25 banks, are still extremely distressed. State and local governments face huge fiscal problems. And, the federal government is going to post $15-$18 trillion in new debt over the next ten years given the current budgetary posture. Financial markets must be kept calm so that the FDIC and others can work off insolvent banks; where pension accounting in government can be brought into line; and assets values can be written down throughout the economy.

Let me reiterate: the economic recovery is progressing.

And, what about inflation?

According to the implicit price deflator of Gross Domestic Product, inflation was running at about a one percent year-over-year annual rate in the third quarter of this year. I prefer this measure of inflation as opposed to the Consumer Price Index (CPI) because of all the expert “fussing” with this latter measure over the past 15 years. Also, I do not really trust an indicator that has a large component relating to the rental price of owner-occupied housing that is estimated and has been shown to have substantial biases.

As can be seen from this chart, the year-over-year rate of change in prices did not turn negative during the Great Recession and seems to be on a relatively steady upward movement. It is my belief that the inflation shown in the GDP Implicit Price Deflator will continue to rise, but not explosively.

That is, the economy will continue to grow, but only modestly over the near term. And, I believe that the longer-term trend in prices in the United States economy is up. Furthermore, I believe that the longer-term trend in the value of the dollar is down.

In terms of the last forecast I believe that the value of the dollar will continue to decline in world markets over time in spite of the best efforts of Europe to “prop up” the dollar through the absence of leadership and guts that seems to prevail in the halls of the European Union.

Now, back to bond yields. Within the scenario I have described above, I really cannot see how the Federal Reserve, through its QE2 efforts, can keep long-term Treasury yields down. I guess my major question becomes, is this really the goal of the Federal Reserve? Or, are the statements coming out of the Federal Reserve a diversion to keep people from looking too deeply into the continuing problems of the banking system, and of the state and local governments, and asset values? Are the efforts of the Federal Reserve just a holding action while the value of assets, those of banks, those of state and local governments, those of home owners, and those of businesses, are written down?

To me, long-term bond yields should rise over time. I just can’t see how the Fed can keep them down.

What is most disturbing in all of this to me is the fact that the Chairman of the Board of Governors of the Federal Reserve System has become the primary spokesperson of the Obama administration. Tim Gaithner has failed in that role; Christina Romer has failed in that role: and Larry Summers has failed in that role. Now, Ben Bernanke has become the voice of Obama on economic affairs. How sad!!!

Bernanke in the Hole

"Regardless of the risks of deflation, the FOMC
will do all that it can to ensure continuation of the economic recovery."

Ben Bernanke, Chairman of the Board of Governor of the Federal Reserve System at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 27, 2010.

Translation: Over the past three years or so, I have led the Federal Reserve in throwing everything it can against the wall to see what would stick. I will continue to do so in the future!

May I quote my post of August 12 (http://seekingalpha.com/article/220224-does-the-fed-even-know-what-it-s-doing-anymore).

"The Federal Reserve has two basic problems right now. First, those running the Fed don’t seem to know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period. (Details here.)"

I see nothing from the current speech to clarify the situation!

Some Sustained Lending Activity at Smaller Banks

In reviewing the banking data put out by the Federal Reserve System last month, I titled my post “Grasping at Straws” because there was some indication of an increase in lending at the smaller banks. (See http://seekingalpha.com/article/215058-grasping-at-straws-in-the-banking-data.) In that post I made the following statement: “An interesting pattern is showing up in the data, however, and gives us something to look for going forward. The smaller, domestically chartered banks in the United States increased their loan balances a little bit over the four-week period ending in the week of July 7, 2010.”

In these releases the “smaller banks” are defined as all domestically chartered commercial banks in the United States with assets less than the largest 25 domestically chartered commercial banks in the United States. The largest 25 domestically chartered commercial banks in the United States hold roughly 67% of the banking assets in the United State while the other roughly 8,000 banks in the United States make up approximately 33% of the banking assets.

Focus is placed upon the smaller banks because this is where the vast majority of “troubled” banks in the United States reside and the concern about these troubled banks is significant enough that Elizabeth Warren has stated in Congressional testimony that there are serious problems which still persist in the smaller banks in the country and the Federal Reserve continues to keep its target interest rate low in order to help the process of bank consolidation flow smoothly. (See http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.)

The increase in bank lending at the smaller banks seems to have continued through July according to the latest data released by the Federal Reserve. Loans at small domestically chartered commercial banks in the United States rose in the four weeks ending August 4, 2010, by about $16 billion or roughly 0.7%. Loans at these banks are still down, year-over-year, by about 3%, but we are looking for “green shoots” and this represents the second consecutive four-week period in which we have seen an increase in small bank lending.

The gains are concentrated in the consumer area as residential loans rose by over $13 billion in the last four-week period, consumer loans added about $10 billion over the same period, and home equity loans increased by a little more than $1 billion during the time.

Business lending continued to fall as commercial and industrial loans dropped by about $8 billion and commercial real estate loans fell by $3 billion. Furthermore, these latter loans are down by more than $16 billion over the last 13-week period. It is in the area of commercial real estate that Elizabeth Warren and others believe continued problems will plague the smaller banks in the United States.

One can draw the tentative conclusion from these data that some of the smaller banks are beginning to lend, but primarily to consumers and mainly in areas where real estate can serve as collateral. But, this is good news.

Still, in the aggregate, the smaller commercial banks are managing their balance sheets in a very conservative manner. Cash assets at these institutions rose by more than $23 billion or by about 8.5% over the past four weeks, and by almost $30 billion over the past 13 weeks. Total assets at these institutions increased by $46 billion and $70 billion, respectively, over the same time periods.

Overall, however, commercial banking shows very little life in the lending area. Year-over-year, the total assets of all commercial banks in the United States rose by less than one percent and total loans at these institutions fell by a little more than one percent. Commercial and industrial loans were the hardest hit category, falling by almost 15%, followed by commercial real estate loans, which dropped by more than 8%. Shorter periods of time do not present a much different picture.

In my post “No Banks, No Recovery” (http://seekingalpha.com/article/218027-no-banks-no-recovery) I presented the following argument: “It is very difficult to see the United States economic recovery accelerating if the banking system is sitting on the sidelines. The part of the banking system to worry about is the 8,000 banks that do not make the list of the 25 largest domestically chartered banks in the country.”

This is why I am giving so much attention at this time to the smaller banks. We have looked for “Green Shoots” before in this economic recovery and have been disappointed. We continue to look for positive signs that are not just of a passing nature. Hopefully, the data on the commercial banking system contain some positive signs that will continue to show indications that the economic recovery is, in fact, progressing.

Federal Reserve Exit Watch: Part 13

In the summer of 2009, a great deal of concern was expressed about the Federal Reserve and the excessive amounts of Reserve Bank credit that had been pumped into the banking system. The Federal Reserve stated that it had an “exit” plan to withdraw these reserves from the banking system so as not to create an inflationary or hyper-inflationary environment once the economic recovery began to pick up speed.

Here we are 13 months into the “exit watch” and there has been “no exit” of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.
The stated reason for this “no exit” performance: the economy has remained stagnant and as long as the economy stays very weak the Federal Reserve will keep its low target interest rates which means that the target Federal Funds rate will remain close to zero for an “extended period”.

As I have reported in my blog posts, my belief is that the Federal Reserve is excessively concerned about the solvency difficulties being experienced by the small banks in this county, a concern that I have recently summarized in my post of August 2, titled “No Banks, No Recovery,” http://seekingalpha.com/article/218027-no-banks-no-recovery. There are many small banks experiencing extreme problems and the Federal Reserve is not going to begin withdrawing reserves from the banking system until there is some indication that this solvency problem is over.

Commercial bank Reserve Balances with Federal Reserve Banks has risen by $334 billion over the past year, an increase of 46.6% since August 5, 2009. Note that Excess Reserves at depository institutions rose from a monthly average of $750 billion in June 2009 to $1,035 billion in June 2010, an increase of 38%.

This is a strange “exit.”

And, as the Federal Reserve has pumped these additional reserves into the banking system, the total assets of the commercial banks in the United States fell by 1.7% from almost $12.0 trillion to about $11.8 trillion from June 2009 through June 2010. Loans and leases at these commercial banks declined by 2.6%. Banks got out of a substantial amount of business loans during this time period, as commercial and industrial loans fell by 16.7%, June-over-June, and commercial real estate loans declined by 7.8%, year-over-year.

The reserves the Fed is pumping into the banking system are not going into “pumping up” the economy. The reserves the Fed is pumping into the banking system are just going into excess reserves!

Looking at a shorter period of time, over the past 13 weeks, the last quarter, Reserve balances with Federal Reserve banks rose by $8.0 billion. The primary swings in the Fed’s balance sheet over this time period were operational in nature. There was a $26 billion decrease in the General Account of the U. S. Treasury, a seasonal increase in currency in circulation of about $9 billion and a $7 billion rise in Foreign Reverse Repos. The offsetting transactions of the Fed to neutralize these changes was an increase in Securities Held Outright by the Fed of about $12 billion, the primary increase coming in the Fed’s purchase of Mortgage-backed securities.

In the past 4 weeks, the U. S. Treasury balance reversed itself, increasing by almost $28 billion and there were modest declines in currency in circulation and Foreign Reverse Repos. The Fed offset a portion of these by letting it holdings of Federal Agencies decline by a little more than $5 billion. The net effect of these operating transactions was a $19 billion decline in Reserve balances held at Federal Reserve banks.

Thus, over the past 4 weeks and over the past 13 weeks, Reserve Bank Credit barely changed. Both periods were dominated by operating transactions within the banking system offset by Federal Reserve balancing transactions.

As a consequence, excess reserves in the banking system stayed relatively constant over the last quarter of the year.

Loans and leases at commercial banks continued to decline over the last 4-week and 13 week periods as did commercial and industrial loans and commercial real estate loans.

In summary, the Exit Watch in the thirteenth month of its existence can report little or no action on the exit front over the past month or the past three months. “Exit” is still on hold until either the general condition of the small banks improves or the economic recovery really becomes an economic recovery…or both.