Government Incentives Do Matter--Part II: US Home Ownership

Just saw another example of the role that government incentives play within an economy. 

On Friday, I took off on the interesting essay by Financial Times columnist Gillian Tett about the impacts that the regulatory declaration that European sovereign debt was “risk free” had on the European sovereign debt crisis. (http://seekingalpha.com/article/305431-government-incentives-do-matter-the-european-case)

The conclusion presented by Ms. Tett was that declaring the debt of a government as “risk free” results in too much government debt being issued because it is so cheap to issue it.  Continuing to maintain the “risk free” tag after it becomes obvious that the debt is no longer “risk free” just exacerbates the situation.  Too much sovereign debt gets issued and a financial crisis can result.

Within that post I pointed to another situation in which government incentives produce a result that inconsistent with the original goal of the economy.  I argued that the credit inflation policies followed by many western governments over the past fifty years to keep people employed and provide a buoyant economy so that the income/wealth distribution of the country can stay more balanced or at least not deteriorate has had the exact opposite effect of making the income/wealth distribution more skewed toward the wealthy end of the spectrum.

Today in the Financial Times there is a major article on the United States housing market. (http://www.ft.com/intl/cms/s/0/a05d2a58-0565-11e1-a429-00144feabdc0.html#axzz1d1bsytCm)

Included within this article is more evidence of how government incentives, created with the best intentions, have produced results that are inconsistent with the original goals and objectives of the government’s policy. 

The specific programs at issue in this article are those US government programs intended to bring home ownership to more and more Americans.  These governmental efforts were an integral part of the credit inflation program of the United States government over the past fifty years, in both Republican and Democratic administrations.

The housing programs of the American government appeared to be very successful for a long period of time and with the underlying credit inflation policies in place, it seemed as if this success would continue on unabated.  Not only could people own their own home, home ownership seemed to be the “piggy bank” that accounted most of the wealth increases being experienced by the middle class. 

This was income/wealth re-distribution at its best because it was achieved without any overt or explicit governmental policies aimed a achieving such a re-distribution!

The numbers: in 1960, approximately 62.0 percent of Americans owned their own home; in 2004 69.4 of all Americans owed their own homes.  And, it looked like this number would continue to rise for the foreseeable future. 

The government programs worked!

Unfortunately, the current number is slightly more than 66.0 percent. 

And, analysts at Morgan Stanley argue that the true number is around 60.0 percent because many delinquent borrowers who say they are “merely renting” homes will soon be forced to give these homes up.  Hence, the number of actual homeowners in the country is substantially over-estimated. 

Behind this argument is the fact that about 20.0 percent of homeowners are either unable or unwilling to make their mortgage payments. This is consistent with those analysts who predict that one in five borrowers will default in the near future.  This problem only places more pressure on the prices of homes to continue to fall. 

The actual rate of home ownership in the United States could drop below 61.0 percent in the next three- to five-years.  This estimate is attributed to Karen Weaver at Seer Capital Management.  The shrinking of the American middle class will only add to this decline.

Thus, the picture of the United States as “a nation of renters.”

Who would have thought?

The structure of the United States housing industry, as we know it at the start of the twenty-first century, was built on the foundation of the continuation of credit inflation as the basis of the government’s fiscal policy.  This credit inflation and the ease with which someone could become a home builder helped to account, not only for the number of builders that existed within the industry, but also the size of many construction companies that were able to achieve substantial scale in home-building.

This structure is changing and will continue to change in the near future. 

But, all the firms and businesses that supported this structure will also have to change.  Business, especially if America becomes that “nation of renters”, will have to change and this will include real estate agents, mortgage brokers, security bundlers, and so forth. 

This is not a philosophical question, it is a reality for hundreds, even thousands, of people who have worked in the real estate area.  What is going to happen in this area and how will this impact investment opportunity in the “housing” space?

But, perhaps even more important is the question about how will this situation impact the federal government and the federal programs and the incentives that they create?  Fannie Mae and Freddie Mac are insolvent and costing the American taxpayer billions of dollars.  Who is going to finance mortgages in the future?  Security bundling and packaging is under scrutiny and is going to change.  And, who is going to buy these mortgage securities in the future?  The Federal Reserve? The rating agencies have been under attack and there is a movement for government to oversee or control them.  And, how about the subsidy of construction... and the construction of low-income units…that the government has played such a large role it?

The governmental incentives related to home ownership are changing as it the behavior of the American public with respect to whether or not people want own their own home.  As individuals continue to de-leverage, home ownership does not seems to be such a desirable allocation of their income/wealth. 

Government incentives obviously are important.  But, as with most incentives, one has to separate the impacts of the incentives in the short-run from the consequences of the incentives in the longer-run.    

Read My Lips! Too Much Debt!

People and businesses leverage when an economy expands over an extended period of time.  The last major period of leveraging in the United States occurred over the past fifty years beginning in the early 1960s.  This was a period of sustained credit inflation that resulted in an 85% decline in the purchasing power of the dollar. 

People and businesses de-leverage when the economy reaches an unsustainable level of debt and that de-leveraging can take a substantial period of time. 

Research by Carmen Reinhart of the Peterson Institute and her husband Vincent Reinhart of the American Enterprise Institute has suggested that “excessive debt could be corrected only by a long period of deleveraging.” (See the article “Running Out of Road” in the June 18, 2011 copy of The Economist, pages 77-78.)

De-leveraging also means, in aggregate, that increases in lending (debt creation) will not become too buoyant during the restructuring of balance sheets. 

Consequently, de-leveraging will tend to reduce the multiplier effect of any fiscal stimulus program and the creation of more debt through fiscal stimulus will only add an additional burden on the economy that is trying to get its balance sheet back under control.

The desperate hope to counter this de-leveraging is to flood the financial markets with liquidity and pray that the printing of money will somehow stop the de-leveraging and make debt acceptable once again. Hence, QE2!

A caveat here: there are a number of large companies that came out of the Great Recession with their balance sheets well in hand.  For example, Microsoft was one of these companies.  Many of these companies have issued debt over the past year or so to build up cash reserves to acquire other companies that have been overleveraged and are not in such good financial shape. This generally represents a separation in the market between large organizations and all others.

Thus, the only way this de-leveraging will be overcome is by reducing the real value of the debt through a period of credit inflation like the one experienced over the past fifty years.  Otherwise, the debt levels are not sustainable.  Efforts to bail out the people, businesses, and governments that have issued too much debt will only postpone the problem.  The debt levels will have to be reduced sometime…now or in the future. 

The debt loads that people, businesses, and governments are carrying seem to be un-sustainable, even with the very, very loose monetary policy.  For example, household liabilities have declined by a little more than $600 billion since the recession began in December 2007, but the total amount of household debt still totals a little more than appeared on the household balance sheets in the second quarter of 2007. 

Household debt at the start of 2011 is almost double the amount of household debt that existed at the start of the year 2000.  This represents a compound rate of increase of more than 8 percent per year.  One could argue that this rate of increase is not sustainable given that over the long haul the real economy grows only slightly more than 3 percent per year.

Total business debt shows roughly the same pattern.  This debt has declined by a little more than $160 billion from the start of the recession to the first quarter of 2011.  However, the current total is around the same level it was in the third quarter of 2008 indicating that in total, businesses have not accomplished a great deal of de-leveraging to this point. 

And, the debt problem is also entangled with the ability of people and businesses to unravel their situations through foreclosure and bankruptcy proceedings.  Foreclosures take time.  If people or businesses are in foreclosure but these foreclosure proceedings take longer and longer to work out, the economic units involved in the proceedings will be more or less relegated to the sidelines in terms of any additional borrowing or spending. 

An instructive article appeared on the front page of the New York Times yesterday. (“Backlog of Cases Gives a Reprieve on Foreclosures,” http://www.nytimes.com/2011/06/19/business/19foreclosure.html?_r=1&scp=2&sq=foreclosure&st=cse.) “In New York State, it would take lenders 62 years at their current pace, the longest time frame in the nation, to repossess the 213,000 houses now in severe default or foreclosure, according to calculations by LPS Applied Analytics, a prominent real estate data firm.
Clearing the pipeline in New Jersey, which like New York handles foreclosures through the courts, would take 49 years. In Florida, Massachusetts and Illinois, it would take a decade.“
And, this problem is not easing.  In May 2011, total foreclosures in the United States totaled 1,736,724.  Six months earlier the total was 1,682,499.  And the number of sales has declined reflecting the back up in the whole foreclosure process. 
Personal bankruptcies are down but are still running near record rates of 1,450,000 to 1,500,000 per year.  In 2010 there were only 56,425 business bankruptcies, down from 60,851 in 2009.  For the first three months of 2011, business bankruptcies are running around a 50,000 annual rate, far above the figures for the rest of the 2000s.
And, this doesn’t even get into the problems connected with the debt of state and local governments. 
Debt loads must be reduced sometime…in one way or another.  People, businesses, and governments are still carrying too much debt.  And, more and more federal government debt does not really help the situation.  A good portion of the debt must be repaid.
This is the drag on the economy.  And, until a lot of this load is worked off…in one way or another…economic growth will remain weak. 
Why hasn’t this gotten the notice it should in all the discussions going on? 
Because almost all of the economic models used to predict economic activity do not contain information on debt levels and leverage.  The reason is that debt levels and leverage levels are quite subjective over time and depend upon what governments are doing and what people believe to be acceptable.  These decisions vary from cycle to cycle and are extremely hard to model.  Furthermore, as the Reinhart’s have argued, there has not been a sufficient amount of data available to adequately study the influence of debt on economic activity.
My conclusion from this information is that the major problem facing the western countries now is that there is too much debt outstanding.
And, when I look at how the system is working off this debt I can only conclude that there is still a long way to go before people, businesses, and government get to levels of debt that are sustainable.  Even QE2 does not seem to be shaking these economic units from their desire to rebalance their balance sheets.  There is just too much debt still in the system and it doesn’t need more.

The Consequences of Debt Are All Around Us

Why isn’t the economy expanding at a faster pace?  Why aren’t consumers spending as robustly as they have in the past?  Why aren’t banks lending?

The answer has to do with either the debt still on the balance sheets of businesses, banks, and households, or the remains left by the debt that was created over the past fifty years.

We see the consequences of the half-century debt binge posted all over…on the Internet, in newspapers, and on radio and television.  Lots and lots of debt or the results of debt everywhere. 

Of course, the Greek debt situation is all over the papers this morning  In addition, the Socialists lost control of many local governmental bodies in Spain on Sunday, giving rise to fears that large amounts of unrecorded debt in many of these units will be discovered as a result of the change in government. (http://seekingalpha.com/article/271083-the-global-economy-debt-and-accounting-gimmicks)   

State and local governments in the United States are offering thanks that the media attention has shifted from them to the European entities.  But, the debt problems of state and local governments will not go away…so just wait!

The most important news this morning, to me, is the attention given to the banking systems of both Europe and the United States.

The headline in the Wall Street Journal proclaims, “Buyers Battle for Europe’s Bad Loans,” (http://professional.wsj.com/article/SB10001424052748704083904576335510788215984.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) “The push by banks across Europe to clean up their balance sheets is causing a feeding frenzy among hedge funds and private-equity firms hungry for their troubled assets.”

“Banks from the U.K., Ireland, Germany, Austria, Greece, Italy, Portugal and Spain have been unloading tens of billions of dollars worth of assets…”

Marathon Asset Management LP, for example, is reported to have purchased bank assets “usually in batches of $25 million to $100 million, at discounts of as much as 50% of their face value.” 

“European banks are sitting on more than €1.3 trillion ($1.9 trillion) of loans that are considered ‘non-core’ to their businesses and are likely to be put up for sale over the next decade.”

“In the U.S., a similar process has been going on for years…Until recently, European regulators generally were content to let their banks work through their problems over time.” 

Europe’s sovereign-debt crisis put an end to that!

The point is that there is still a “ton” of debt “out there” that is being written down or is going to be written down and still has to be “worked out.” 

In other words, the economies of Europe and the United States are not fully out-of-the-woods.

The “working out” part of this statement is captured in the New York Times headline, “Banks Amass Glut of Homes, Chilling Sales” (http://www.nytimes.com/2011/05/23/business/economy/23glut.html?_r=1&hp). “The nation’s biggest banks and mortgage lenders have steadily amassed real estate empires, acquiring a glut of foreclosed homes that threatens to deepen the housing slump and create a further drag on the economic recovery.”

“All told, they own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007.” 

“The pileup could lead to $40 billion in additional losses for banks and other lenders as they sell houses at steep discounts over the next two years…”

And, this problem is extended to other areas of the real estate market like the commercial real estate sector. 

The good news…”the number of new foreclosures and recent borrowers falling behind on their payments by three months or longer is shrinking.”

Where is the focus of the banks?

The focus is more on attempting to minimize the amount of write down the banks must take and is not on generating new loans to build up revenue streams.  Right now, the balance of effort in banks seems to be on the side of keeping down charge-offs because of the larger impact on solvency, rather than just on earnings.  In fact, the recent increase in bank earnings has been largely due to a reduction in loan charges rather than an increase in revenues. 

If we are to get the focus of banks back on lending and on supporting economic growth we must get through this period of restructuring the balance sheets of commercial banks to remove the bad assets.

But, this presents a problem to the policy makers in Washington, D. C.  If commercial banks, and other economic bodies, must work through their debt problems before they can focus on increasing loans and increasing spending, efforts to stimulate the economy through further governmental credit inflation will have little impact on picking up economic growth.

This factor is not considered in most macro-economic models because the importance of debt on business decision-making will vary from time-to-time.  At lower levels of indebtedness, economic units may not feel that they have to restructure their balance sheets to reduce debt loads and further fiscal stimulus, more credit inflation, will bring about more rapid economic growth.

However, in periods when the burden of the debt loads become too heavy, people will need to re-adjust their behavior and reduce levels of financial leverage to more reasonable amounts.  At these times, further fiscal stimulus, more credit inflation, may have only a modest impact on economic growth.  In situations like these, fundamentalist preachers like Paul Krugman may cry all they like about the need for more and more governmental spending, but even that will not bring on “the Rapture.”

We are in a period when the excesses of the credit inflation of the past must be worked off before people can begin to fully focus again on the future.  The economy is highly bi-furcated, both in Europe and in the United States.  Those people and institutions that are not highly leveraged and have cash-on-hand, will prosper relative to those that are highly leveraged and are short on cash.  The last fifty years has seen a tremendous skewing of the income and wealth distribution in the United States toward the richer end of the spectrum.  My guess is that, given the current situation and the current economic policies, this trend will continue.  Maybe debt is not such a “good thing” after all.      

Debt and Accounting Gimmicks

Isn’t it interesting that highly leveraged institutions and organizations seem to bring out very innovative accounting strategies?

It is in times like these that were learn just how creative accountants can be. 

“Weekend elections that threaten to drive Spain’s ruling Socialist party from power in several regions and cities also promise a potentially nasty surprise: the revelation of piles of undisclosed debt in local governments that could undercut the country’s drive to avoid an international bailout.” (See “Spain Vote Threatens to Uncover Debt,” http://professional.wsj.com/article/SB10001424052748704281504576331280001740702.html?mod=ITP_pageone_2&mg=reno-wsj.)

“Five months ago, a government change in Spain’s Catalonia region revealed a budget deficit more than twice as big as previously reported.  Now a growing chorus of economists, local politicians and business leaders say that new governments are likely to discover, as Catalonia did, piles of ‘hidden debt’ owed to health clinics and other suppliers.”  It is suggested that “there is widespread, unrecorded debt among once-free-spending local governments.  Some companies are complaining that fiscally frail administrations are pressuring them to do business off the books and not immediately bill for goods and services…”   

“Such bills could add tens of billions of euros to the official debt figures reported by local and regional governments.  If such skeletons come out of the closet in coming weeks, Spain’s cost of funding could continue to rise—throwing the country back into the limelight after it has struggled to demonstrate it doesn’t need to be bailed out like Greece, Ireland, and Portugal.”

Wait a minute…didn’t the renewal of concern over the debt situation in Greece come about because it was discovered that the amount of debt owed by the Greek government was worse than had been previously accounted for. 

We don’t need to just keep picking on European states.  What about state and local governments in the United States?  Pension funds grossly underfunded?  Off-balance sheet financing?  And more?

But, why stick with governments?  What about Lehman Brothers?  What about AIG?  What about Citigroup?  The amounts of off-balance sheet tricks used by these organizations fill the current library of books about the recent financial crisis.  The story is about CDOs and SUVs and so forth.  Trying to disguise liabilities is not just a gimmick of the public sector. 

To me, however, this mis-accounting goes even further.  The question really is one about where do you draw the line.  That is, what types of accounting efforts are meant to evade discovery and hence are not exactly kosher…and which ones are of little or no harm? 

For example, how do you value an asset on the balance sheets of financial institutions?  If you hold a marketable security you must be concerned with the liquidity of that security when valuing the asset.  If interest rates rise and the market price of the security goes down, do you mark-to-market the value of the security on your balance sheet?  If the security is a part of the trading portfolio of the institution then the general answer is that the value of the security on the balance sheet should be marked down.

But, if the institution bought the security to hold then the question becomes more difficult for some people to answer because the intention is to hold the security to maturity at which time the full amount of the principal would be repaid to the institution.

Now, what if the credit quality of the security comes into question?  There are really two questions here: the first has to do with the credit quality of the security; the second has to do with the liquidity of the security?  If the credit quality of the security declines, then, given the value of the asset should decline…its price should fall.  Thus, the market price of the security should decline.  However, if the market is uncertain about how to price the asset, given the decline in its quality, the market for the security may “dry up” and the security may not be able to be sold immediately.

Thus, the value of the asset on the balance sheet should be adjusted downward, but without any market judgment about what the price of the security should be…how do you determine the amount the asset should be written down?

Here we have a problem that was addressed by the US government’s Troubled Asset Recovery Program (TARP) during the financial crisis.

Many in the financial industry have argued that the assets should not be marked-to-market in such cases because there is really no market for the asset.  Hence, these securities should be retained on the balance sheet at book value.

Now, what about the direct loans a financial institution makes?  Almost all of these do not have markets in which they can be sold.  So, the loans are totally “illiquid”.  Furthermore, bankers consider that most of the problems the borrowers face are “cyclical” and all that is needed when economic times are not good is for the economy to improve and the loans will work themselves out.  That is, the financial institutions must hold the loans “to maturity” and, thus, they can be held on the balance sheet at book value. 

The question is…what should be the accounting treatment of these assets of financial institutions?

Of course, this problem only occurs during bad times after most of the economy has become excessively leveraged and loan value are under attack.  For example, currently, in terms of residential real estate loans, mortgages, we see that seriously delinquent loans (90 days or more delinquent) are declining but still near historic highs, the number of borrowers in foreclosure remain near record highs, and the sale of houses and housing prices continue to decline. (http://professional.wsj.com/article/SB10001424052748704816604576333222700445278.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj) The commercial real estate area remains depressed.  The loans of these two kinds of loans continue to plummet. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)  But, has the status of these loans been changed on the books of the banks?

The concern, in these cases, is not with the liquidity of the asset.  The concern is with the solvency of the financial institutions.  Have accounting practices not given investors…and others…a true picture of the financial condition of the institutions under review? 

My concern in all these cases is that we really don’t find out the truth until too late…until it is “after-the-fact.”   Then we blame speculators or others, who take advantage of the situation, of preying on the innocent, of creating the crisis, and, of course, we don’t want to reward speculators. (http://professional.wsj.com/article/SB10001424052748704904604576333393150700686.html?mod=ITP_pageone_2&mg=reno-wsj)  

The bottom line: the pressure to use accounting gimmicks to cover up the “real picture” grows as high degrees of leverage come to dominate an economy.  This is because debt requires contractual payments.  Debt requires an obligation and a responsibility. 

And, so we see a pattern.  Just as credit inflation is the foundation for greater risk-taking, higher degrees of leverage, and more financial innovation, we see that greater risk-taking, higher degrees of leverage, and more financial innovation is the foundation for more creative accounting practices. 

In both cases, we all ultimately lose in the end!

"We Don't Expect Americans to Fight Temptation"

Suggested reading for today: Gillian Tett’s piece in the Financial Times, “ECB rate rise will spark new debate about US tightening.” (http://www.ft.com/cms/s/0/e40ec032-613b-11e0-ab25-00144feab49a.html#axzz1ImD5RZZn)

She quotes a senior Latin American official in attendance at the recent annual meeting of the Inter-American Development Bank: “We don’t expect Americans to fight temptation” when the United States government has to make tough monetary and fiscal decisions. The speaker, Tett states, ended this statement “with a hint of the disdain developed nations used to deploy when discussing the third world.”

A specific concern is that United States monetary policy is flooding the world with liquidity and, in doing so, causing dramatic increases in commodity prices and asset prices.

Many countries in Asia and Latin America have responded with controls and other attempts at protection to stem foreign money coming into their countries via the carry trade. Brazil just imposed another round of controls this week.

Of course, Federal Reserve officials, including Mr. Bernanke, claim that the problem is “out there.”

American “officials insist it is poor local policy and excess savings in the emerging markets and not cheap dollars that are creating bubbles.”

And, anyway, a decline in the value of the dollar is good for America because the falling value of the dollar will make American goods cheaper in world markets and will help to improve the trade balance. Christina Romer, former Chairperson of the President Obama’s Council of Economic Advisors, just reiterated this claim when interviewed on national television this week.

Funny, but the statistics don’t seem to support this claim. Since the dollar was floated on August 15, 1971, the value of the dollar has declined by about 35 percent and the United States balance of trade turned negative in the late 1970s and, on an annual basis, has not been close to achieving positive territory since.

History does not support the conclusion that the falling value of a currency will improve a country’s balance of trade when that country is experiencing a period of sustained credit inflation.

Something happens to the production of a country’s goods and services when it is going through a period of sustained credit inflation. The productivity of that country declines relative to those countries that are not experiencing as severe a period of credit inflation.

For one, a country experiencing a sustained period of credit inflation will shift resources, building up finance and financial services at the expense of manufacturing. For example, about 35 percent of the output of the United States in 1965 came from the manufacturing sector. Early in 2011 this figure dropped to less than 14 percent. Also, exposure to risk increases during periods of sustained credit inflation along with increasing financial leverage and financial innovation.

Furthermore, in the United States the industrial use of capital declined from over 90 percent of capacity around the middle of the 1960s to around 80 percent at the last peak of capacity utilization. Capacity utilization now stands around 75 percent. The under-employment of labor also increases during such times. My estimates place under-employment of the American worker at around one in five people of employment age. I believe that over the next year or two this figure will not decline, even in the face of declining un-employment because of the wave of mergers and acquisitions that are going to take place.

The assumption of the economist that “everything else will not change” in the face of a declining value of the dollar does not hold. Yes, the declining value of the dollar does make American goods cheaper in world markets, but this does not account for the changes in the structure of the American economy when credit inflation pervades the nation for a fifty-year period. In the American case, the changing structure of the American economy has not helped solve the balance of trade problem.

The view from the “rest-of-the-world” is that the United States is not going to change its viewpoint. The United States has been able to act the way it has because it has had the “reserve currency” of the world and has been big enough to absorb the international capital flows that have existed over the past fifty years.

But, the United States fiscal and monetary authorities are in a battle now which, given their views, will not allow them act any differently than they have over the past fifty years.

They argue that government spending must be maintained or increased in order to put people back to work.

They argue that credit inflation must be forced on the American people so that the efforts of individuals and businesses to deleverage, to reduce the excessive leverage they had built in the past, can be offset and these individuals and businesses can get back to the process of re-leveraging so as to stimulate economic growth and reduce unemployment.

Ms. Tett speaks of the existence of the culture war between the European Central Bank and the Federal Reserve. Certainly, different worldviews seem to exist between the leaders of these two organizations.

But, it is the assumptions behind the worldviews that seem to be dramatically different and it is the assumptions that ultimately prove to be so important. The worldviews are derived from the assumptions, but it is the assumptions that people find so hard to give up because they become so personal.

As long as the United States continues to believe that the declining value of the dollar is good for the country, based on arguments similar to the ones attributed above to Christina Romer, and looks for excuses like “poor local policy” and “excess savings in emerging countries”, the leaders of the United States will continue to believe that it can proceed as it has for the last fifty years.

As long as the leaders of the United States continue to act as they have for the last fifty years then the value of the dollar will continue to decline.

And, the attitude toward American policymaking will continue to be: “We don’t expect Americans to fight temptation.”

Liqudity Traps are For Real

When I was studying economics, the idea that an economy might face a “liquidity trap” seemed absurd. Basically, the concept of the liquidity trap was that the monetary authorities could not “push on a string”. In other words, the liquidity trap represented a time when the central bank could inject a large amount of reserves into the banking system and people (and businesses) would prefer to hold more money than to hold debt. Thus, funds could not get into the bond market which would mean that businesses would not invest in inventories, plant, or, equipment, and the economy would stay mired at a low rate of activity.

This was why deficit spending on the part of the government was necessary, at least for those following the Keynesian dogma, because it was the only way to increase aggregate demand and re-charge economic activity.

Well, we are in a liquidity trap. The Federal Reserve has injected more than $1.0 trillion of excess reserves into the banking system and has kept short-term interest rates close to zero. And, commercial banks have not lent these excess reserves so they continue to rest on the balance sheets of the banking system. The question is, what needs to be done next?

Furthermore, the government has tried deficit spending to spur on the economy, but this effort seems to have had a less-than-dramatic impact on the economic recovery now seemingly underway. Keynesian dogmatists argue vociferously that the problem is that the government has not spent enough…that the Obama administration has been too timid.

But, this approach to the concept of liquidity traps hinges upon the assumption that the crucial economic relationship is found on the asset side of the balance sheet, on the division of assets between holding money or holding bonds. The analysis completely ignores the liability side of the balance sheet. Nothing is said about the amount of leverage the economic unit has built into its balance sheet. Hence, the issue of whether or not an economic unit has “too much” debt doesn’t even enter the picture. And, this is the problem.

There is an article in the Financial Times this morning that I believe does a good job in addressing this issue. The article is “Leverage Crises are Nature’s Way of Telling Us to Slow Down” by Jamil Baz, Chief Investment Strategist for GLG Partners (http://www.ft.com/cms/s/0/580fa460-8e8d-11df-964e-00144feab49a.html).

Baz argues that the near-collapse of the world financial system followed by a deep recession was “a crisis of leverage.” The ratio of total debt to gross domestic product in the United States reached 350 percent in 2007. Whereas nations could perhaps maintain a level of 200 percent and still achieve healthy economic growth, the 350 percent figure that remains in the United States (and that also exists at higher levels in many of the leading developed countries) cannot be sustained.

The consequence is that at some time in the future the United States and other developed countries are going to have to deleverage. But, deleveraging is going to be costly in terms of future economic growth. We, in essence, have to pay for the past sins we have committed in building up such an enormous debt structure.

Baz presents “three hard realities we need to bear in mind” that result from having too much leverage. These hard realities are:

• When you are bankrupt, you either have to default on your debts or you save so you can repay your debts;
• Policy choices under such circumstances are not appetizing with one school of thought advising taking morphine now followed by cold turkey later and the other school proposing cold turkey now;
• If you are a politician, you may be under the illusion that you are in charge whereas the real decision-maker is the bond market.

He concludes: “maybe leverage crises are nature’s way of telling us to slow down. Policymakers can ignore this message at their own peril. In their anxiousness to avoid past mistakes, they run the risk of an even bigger mistake: fighting leverage with still more leverage, a strategy that might suitably be dubbed “gambling for resurrection”.

The liquidity trap now being faced by policy makers comes from the liability side of the balance sheet. People and businesses are faced with the choice of either going bankrupt or increasing their savings so as to repay their debts. As Baz says, “This is neither ideology nor economics, simply arithmetics.”

But, it does mean that commercial banks may not want to lend and people and businesses, in aggregate, may not want to borrow. Pushing on a string in this case has little or nothing to do with the asset side of balance sheets and everything to do with the liability side of balance sheets. The Federal Reserve cannot force the commercial banks to lend or people to borrow.

The liquidity trap looked at in this way is real and has been operating for more than a year.

The problem is that if you consider the liquidity trap in this way you can clearly see the dilemma presented by Baz in terms of the policy choices that are currently available. This is why one could argue that it took so long for the Great Depression to end. People and businesses had to work off their debts…they had to go “cold turkey” for a while. In this sense, the economists Irving Fisher and Joseph Schumpeter were closer to understanding the economic situation that existed in the 1930s than was Keynes!

If Baz is correct then the choices are pain now versus more pain in the future. The problems associated with the increased leveraging of the economy cannot be put off forever. Debt must eventually be paid down!

Discipline is Needed for Real Economic Performance

There is an interesting article inside the Wall Street Journal this morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises,” http://online.wsj.com/article/SB125798960525944513.html#mod=todays_us_page_one.) In the article a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”

During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.

Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)

The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.

Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.

Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.

Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)

Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.

The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.

Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.

Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!

Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.

In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.

But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.

In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.

Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lessons on How to Beat Deflation Trap

As the United States is gearing up for additional massive efforts in both the areas of monetary and fiscal policy we need to listen to the experience of other nations who have gone through recent periods of economic distress. We need to understand, as well as possible, just how this modern recession/deflation thing works.

There is a very interesting interview with Masaaki Shirakawa, a governor of the Bank of Japan, in the Financial Times today (http://www.ft.com/cms/s/0/18086fba-ca0c-11dd-93e5-000077b07658.html). One of the important things about this interview is the emphasis it puts on understanding what is happening in different sectors of the economy instead of just focusing on aggregate information. This has importance in understanding how recessions begin as well as for understanding the depth and length of recessions.

One of the problems with modern macroeconomics, as discussed in my review of Paul Krugman’s “The Return of Depression Economics and the Crisis of 2008” appearing on Seeking Alpha on December 9, 2008, is that macroeconomists want to focus on aggregates and not what makes up the aggregates. For example, capital is defined by one of the most popular text books on macroeconomics as “the sum of all the machines, plants, and office buildings in the economy.” And, all these component parts are perfectly and costlessly interchangeable.

The difficulty with this is, according to Governor Shirakawa, is that it does not allow for an understanding of the “imbalances” and “dislocations” that evolve during an economic expansion or during asset bubbles. Thus, when the economy is expanding the monetary authority needs to “watch carefully whether the broadly defined imbalances are accumulating or not.”

Furthermore, during these times, risk-taking and financial leverage tend to expand dramatically. It is not just aggregate demand or supply that is important in understanding the evolution of the economy but also what is happening in various sectors of the economy and how the financial structure needs to unwind.

And, experience has shown that these imbalances occur even when things like the consumer price index is behaving well. “Very often in recent decades we experienced a situation in which imbalances are accumulating, despite the fact that the inflation rate is quite subdued.” He continues that “Inflation targeting is one part of a good framework to explain monetary policy. But if inflation targeting creates the social presumption that the central bank can look at consumer price inflation alone, then it might have some unintended effect of helping the creation of a bubble.” That is, asset prices in different markets, housing, stocks, and so forth, must be observed also.

Why is it important to understand this?

We need to understand this because it points to the fact that recessions or periods of deflation cannot be handled by just appeals to pumping up aggregate demand. We need to understand that the previous upswing created imbalances, bubbles, dislocations, over-investment and these previous decisions cannot just be dissolved by assuming that all capital investment is alike and that stimulating aggregate demand is not the only thing that needs to be done.

But, Governor Shirakawa argues, this does not mean that monetary or fiscal policies are not needed in combating deflation and turning the economy around. Both are a part of a sound strategy to get the economy going in the right direction.

What is also important is a focus on the imbalances and dislocations that were created in the previous run-up. The policy makers need to understand how the various sectors are working themselves out and what, if any, bumps in the road lie ahead.

For example, the prime example of the ‘asset bubble’ just experienced is the housing industry. Until the summer of 2006, the housing market was ‘riding high’ with housing prices and housing starts seeming like they would never stop. Yet they did and housing prices have dropped steadily ever since. How far will they drop? Some analysts say that housing prices must drop to at least 50% of their peak value. Also, the picture gets even darker when one observes that there are still two major clouds hanging over the future. Both are related to the ‘financial innovations’ of the 1990s…major amounts of Alt-A mortgages and the Payment-Option ARMS are going to re-price over the next two to three years. The peak in housing foreclosures and personal bankruptcies is not expected to arrive for at least a year from now.

Another example is the financial industry. Tremendous losses have already been taken by banks and others, yet more are expected. The reason for this is that the banks still don’t fully comprehend the extent of the write-downs they are going to have to take on existing assets. Then, there is the fact that the banks have not yet seen the extent of the write downs connected with credit cards, auto loans, high-yield securities, and commercial and industrial loans. And, this doesn’t even consider the possible adjustments that will need to be made in the mortgage area mentioned in the previous paragraph. Mutual funds and hedge funds now are restricting investors who want to get their money back. And, then we are starting to see some of the fraud schemes surface that were a part of the recent credit inflation.

A further example is the auto industry (which also applies to other areas of manufacturing in the United States). I think everyone can agree that there are massive areas of imbalance and dislocation in this industry. Who is at fault? The auto executives? The labor unions? The politicians? The consumer? Everybody else? I don’t believe that any one person or group can be singled out as the cause of the problems in this industry.

But, I think that we can all agree that the problems are massive. These problems have to do with technology, innovation, out-of-date facilities, inappropriate pricing of resources, and other excesses that have been built into the structure over many years. Regardless of whether or not there is a bailout of this industry, it is going to take many years for the auto industry (and, I would argue many other areas of manufacturing in the United States) to really join the 21st century. Obviously, aggregate demand policies are not going to take care of the restructuring that is needed here.

Shirakawa summarizes: “Based on our experience, the world economy or the US economy needs the elimination of excesses. Of course the exact excesses vary from country to country…In today’s US for instance, housing is excessive; household debt is also excessive—I don’t know by how much, but anyways ‘excessive’ is there.”

“Negative feedback is now at work and I cannot give you a precise answer (to how long the global crisis is to run). What is crucial is to avoid a situation in which the adjustment leads to a serious downturn in the economy.”

In conclusion, there is no quick fix. The ‘excesses’, ‘imbalances’ and ‘dislocations’ in each sector must work themselves out. Monetary and fiscal policy may be able to soothe the pain…but they will not eliminate it. I tend to agree with Governor Shirakawa