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. 

Economic Policy in the Decade of the Twenty-Tens: More of the Same

Happy New Year!

I have spent a good portion of the last week and a half reviewing my perception of the foundational philosophy undergirding the economic and financial policies of governments in the United States and Europe and I come to the same conclusion over and over again.

Governments in the United States and Europe and the people working in and for them have learned little or nothing over the past fifty years.

These governments are still united in their belief that continuing credit inflation is what their economies need. It is the policy that they plan on delivering. And, if troubles develop, then they just bail troubled institutions out and continue on their merry way. Europe, in the first quarter of 2011, seems to be headed for another round of this bail and run behavior.

The underlying rationale for this is that the leaders of these governments believe that every effort must be made to keep unemployment as low as possible for as long as possible by aggregate governmental actions.

These leaders are unwilling to accept the fact that their policies only make it harder for them to achieve their goal over time and just applying more and more stimulus to the economy will just make things worse.

It is not enough to see that, in the United States alone, underemployment has gone from around ten percent in the 1960s to about twenty-five percent now and that over these past fifty years the income distribution has become more and more skewed toward the higher income end of the spectrum.

The reasons for these results? First, you cannot keep putting people back in their legacy jobs by means of fiscal and monetary stimulus and expect them to maintain their productivity and job competitiveness in a fast changing world. Second, credit inflation can only be taken advantage of by the wealthier people in the country; the less wealthy in such an environment, even though they might be benefitted by it in the short run, lose out to the wealthier over the longer run.

Stock markets, of course, like this environment of credit inflation. Note the following measures of stock market performance. Here we have charted Bob Shiller’s CAPE measure (Cyclically Adjusted P/E Ratio) and Jim Tobin’s q ratio. These statistics, obviously, roughly measure

the exact same thing, whether or not the capital stock in the United States is over- or under-valued. In the 1960s and early 1970s equities seem to be overvalued as the period of credit inflation gets underway. In the late 1970s, of course, we get the period of extremely tight monetary policy aimed at thwarting the rapid acceleration taking place at the time. However, the 1980s revived the bias toward credit inflation, and, as can be seen, the stock markets seemed to take advantage of this policy stance as both measures never dropped below their long-term averages even through the “Great Recession” up to the present time.

This fifty year period was, of course, the time in which the financial sectors of the economy grew to become such a large proportion of the economy and it was the heyday of financial innovation.

It was not the less-wealthy part of the country that benefitted from this policy stance over this period of time.

If the current foundational policy stance of the government remains one of credit inflation similar to the one in place for the last fifty years then all we can expect is more of the same.

And, in my mind, there is no separating out Republicans or Democrats on this issue. Both have proven equally committed to the same policy stance (just using different words to justify it) and both seem to remain oblivious to the facts.

Also, in my mind, the amount of debt people carry matters, but many of our policymakers seem to believe that the existence of debt carries with it no consequences. In fact, the belief seems to be that the solution to the problem of too much debt outstanding is the creation of even more debt. And, if the amount of debt outstanding seems to be troublesome, well, then just let a central bank buy it.

I see nothing on the horizon to change my mind concerning the economic philosophy that serves as the foundation for policy making in the United States and Europe. Credit inflation remains the underlying stance of the economic policies of these governments for future.

Thus, we can expect, over the next decade, a continuation of the economic and financial environment of the last fifty years.

Monetary Warfare: Is An Independent Economic Policy Possible for a Nation?

John Maynard Keynes, after 1917, wanted to achieve full employment for England, but also for other major countries in Europe and the western world. The reason for this goal was that he was afraid of the Bolshevik menace threatening his civilized world.

Thus, beginning with the time that he returned to England from the Paris Peace Conference following World War I, Keynes sought ways that would allow a country to follow an independent economic policy that would primarily focus on full employment for the nation. Before the First World War, Keynes was, like most of his liberal counterparts, a free-trader who believed in capital mobility and flexible exchange rates

Keynes, in essence, developed a policy prescription that is consistent with what is now called the “Trilemma” problem as it is applied to economics. The “Trilemma” problem is that a nation can only achieve two out of the following three policies: fixed exchange rate, independent economic policy, and capital mobility.

Keynes opted for an independent economic policy for a government in order to achieve high levels of employment. He also believed, in his later years, that exchange rates should be fixed. This was ultimately achieved in the Bretton Woods agreement in 1944. This agreement set up the current system of international financial organizations and created a foreign exchange system that stayed in place until August 15, 1971.

The third component of this, international capital mobility, was severely restricted at the time.

What occurred in the 1960s was that inflation increased in the United States due to the fiscal and monetary policies of the government and capital began flowing throughout the world. Thus, the value of the dollar had to float in world markets. Thus, President Richard Nixon set free the dollar on August 15, 1971 and we entered a new age.

Full employment remained a policy goal of the United States government written into law by the Congress. So, the monetary and fiscal policy of the government had to remain independent of what other nations did.

Capital mobility increased as the world became more and more globalized in the latter part of
the 20th century.

And, the consequence of this combination of events left the value of the dollar on its own. And, since the early 1970s, the value of the dollar has declined by about 40% against other major currencies.

The fundamental reason for the decline in the value of the dollar was the credit inflation created by the United States government. The gross federal debt of the United States has risen at an annual compound rate of about 9.5% in the fifty years from 1961. Financial innovation on the part of the United States government has been huge.

The private sector has emulated this governmental behavior as incentives all pointed to increasing amounts of leverage on family and company balance sheets. Again, following the government, financial innovation was everywhere, especially in the area of housing finance.

World financial markets reacted by sinking the value of the dollar…except in a crisis when there was a so-called “flight to quality”. The dollar continues to remain weak and will continue to be weak as long as the United States government follows its policy of underwriting the credit inflation which is undermining the strength of the economy.

But, given conditions of the Trilemma, the dollar must continue to sink as long as international capital mobility continues and the deficit of the United States government is expected to add $15 trillion or more to federal debt over the next ten years. The United States can inflate credit all it wants, but it will have to pay in terms of a falling dollar. The two parts of the Trilemma, flexible exchange rates and the independent economic policy of the government are not really compatible at this time.

For one, this seems to play right into the hands of the Chinese. They are building up enormous international reserves. These reserves are being used to buy productive resources around the world, acquire commodities which they badly need, and increase their political power and influence throughout the nations. (See my post “Monetary Warfare: U. S. vs. China?”: http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.) Yes, we have a major case of mercantilism, here.

And, how does the United States respond? In terms of the policy of the government, it continues to pump things up, just what the Chinese want. And, then the United States government points its finger at China as if it is the bad guy. Well, China is the “bad guy” because it is growing stronger as the United States weakens itself.

The other piece of the picture has to do with what the economic policy of the United States government is doing to its own economy. Well, the results are not good: one in four workers of employment age are under-employed; in industry, capital utilization is between 75% and 80%; and income inequality has increased dramatically over the past 50 years as the wealthy have taken advantage of the credit inflation and the less-wealthy have suffered dramatically from the massive increase in debt leverage. (See my post “Does Fiscal Policy Really Work?”: http://seekingalpha.com/article/227210-does-fiscal-policy-really-work.)

The United States must either get its monetary and fiscal policy in order or it must seek to reduce or prohibit capital mobility. The United States cannot continue to pursue a policy of credit inflation in this era of almost totally free capital mobility without serious ramifications to the strength of its economy. The evidence of this is the current status of the American economy.

The weakness in the economy is what is driving the decline in the value of the dollar. The first conclusion one draws from a declining currency is that the decline is related just to monetary factors, to inflation. However, what we are seeing in the case of the United States is that the U. S. has exported inflation to the emerging nations through the freely flowing capital in the world. The inflation has not shown up explicitly in U. S. prices. But, the inflation has shown up implicitly in terms of the dislocation of economic resources within the United States economy.

That is why I argue that either the United States must change its philosophy about what governmental policy can do or it must seek to reduce or prohibit capital mobility. It cannot continue to support both.

In this mobile global world we live in, we cannot achieve the Keynesian requirement that the monetary and fiscal policies of a country can conducted independently of the rest of the world. Economists have to move on from the Keynesian prescription. The funny thing is, I believe that Keynes would have changed his mind many years ago.

Oh, No, the Fed is Expected to Discuss More Ways to Revive the Economy!

The New York Times contains the headlines, “Fed is Expected to Discuss More Ways to Revive Economy.” (See http://www.nytimes.com/2010/09/20/business/economy/20fed.html?ref=todayspaper.) The Fed is mulling over ideas about how it can provide more stimulus to the economy to get more “oomph” into the economic recovery.

Chairman Ben, at the Fed’s conference held in Jackson Hole, Wyoming in August, said that the Fed was prepared to “take additional action” to protect the economy from falling into a period of deflation.

My question is “why do we need more Fed stimulus”?

Let me talk about the long term. I know, Americans don’t like to talk about the long term. And, we have an election in six weeks and Americans are in the middle of a debate about tax cuts and spending plans and arguments about how we can get the economy going again. After all, Americans want something done within two years or less! (See my post “What Should the Fed do next,” http://seekingalpha.com/article/224423-what-should-the-fed-and-the-federal-government-do-next.)

Let’s talk about the longer term anyway.

Since, 1960 Real Gross Domestic Product has grown in the United States at a compound rate of growth of 3.14% through 2009. (It grew at a 3.34% compound rate through 2007, the peak of the most recent cycle.)

This compound rate of growth is consistent with what economists have felt that the economy could grow at over the longer term. In the 1960s, the expected long term rate of growth of the economy was put at 3.20%.

My question is, could the economy have grown any faster over this time period? If you would have told an economist in the 1960s that the economy would grow at a compound rate of growth of about 3.2% over the next fifty years, would he or she have taken that growth rate and “put it in the bank”?

Could it be, unless a government creates hyperinflation or serious deflation, that governmental economic policies have very little effect over long term economic growth although it can have significant impacts on underemployment, the utilization of physical capital, and income distribution?

Yet during this time period the politicians (and many economists) have continually put pressure on the government to push for greater economic growth, first cyclically, but then also in a secular way. And yet, decade after decade the compound growth rate of the economy has remained, roughly, in the 3.2% range.

The continued pressure to “goose up economic growth” through fiscal stimulus has resulted in a continued rise in the gross federal debt of the government. The compound rate of growth of the federal debt is just under 8.0% for the 1960-2009 period of time.

This pressure on the economy has resulted in a secular climb in prices over this same period of time of slightly more than 4.0%. As I have argued before, this was a perfect environment for financial innovation and massive debt-leveraging, exactly what we saw.

This economic environment resulted in businesses, state and local governments, and families accumulating excessive amounts of debt.

This fiscal pressure to keep unemployment low kept many businesses in the same “legacy” physical plant and equipment being utilized so that the businesses could put workers back-to-work in their old jobs. As a consequence, the capacity utilization of industry continued to fall from peak-to-peak throughout the last fifty years. Maybe, just maybe, some of this physical capital should have been allowed to leave the scene.

And, in terms of labor, since the government tried to keep unemployment low by forcing the economy to hire people back into their old jobs, maybe, just maybe, a class of people became less employable in the general economy. Under-employment grew constantly over the past fifty years and now about one out of every four people of working age are either unemployed or underemployed.

Furthermore, recent research indicates there has been a serious skewing of the income distribution in the United States. Maybe, just maybe, continuous efforts to stimulate the economy through the government's fiscal policies to keep unemployment low among those that are less educated or are blue-collar workers and keep them in their "legacy" jobs puts these people at a significant disadvantage in the modern economy. If this happens then the income distribution in the economy can become more and more unbalances over time.

Maybe, just maybe, the American economy needs to re-adjust, to get itself up-to-speed in the modern world. It seems as if every week, someone else is measuring that the United States as less-and-less competitive relative to other up-and-coming nations. Could it be that the economic policies of the government created this environment?

Maybe, just maybe, American businesses and families and state and local governments need to
reduce their debt load.

Maybe, just maybe, American businesses need to modernize and up-grade their physical capital.

Maybe, just maybe, some in the American workforce need time to become employable again. (However, because of the above, some workers may never be employable again: http://www.nytimes.com/2010/09/20/business/economy/20older.html?hp.)

Forcing stimulus on the United States economy can stale the economy from restructuring and may keep people and businesses and governments from making the incremental changes they need to make in order to stay current. And, incremental adjustments are not so hurtful, so costly, and so time-consuming, as the discrete jumps in the economy that come about after things have been “forced” to stay as they were for such a long time.

Maybe, just maybe, the Fed needs to allow events to progress in a natural way. The Fed has provided the banking system with $1.0 trillion in excess reserves. The FDIC is working out “problem banks” in an orderly fashion. (Another six banks were closed last Friday helping to maintain an average of 3.4 bank closing per week this year.) It is expected that bank closings will continue at a very rapid pace well into 2011. Maybe, just maybe, this is all the economy needs at this time.

More action on the part of the Fed may only create even more problems in the future. Maybe, just maybe, the Fed needs to avoid any sign of panic at this time.

What Should the Fed (and the Federal Government) Do Next?

This morning there is a series of articles in the opinion section of the Wall Street Journal titled “What Should the Federal Reserve Do Next?”. It consists of several short pieces written by well known economists. I recommend that you read them.

I would especially recommend the opinion piece written by Allan Meltzer, a professor of economics at Carnegie Mellon University and the author of “A History of the Federal Reserve”. The following quote is, I believe, especially important for the monetary policy of the Federal Reserve…and for the fiscal policy of the federal government.

“In ‘A History of the Federal Reserve,’ I concluded that the principal mistakes the Fed has made have resulted from giving excessive attention to current events and forecasts of highly uncertain near-term developments. By focusing on the short-term, the Fed neglects the longer-term consequences of its actions. The transcripts of FOMC show that the members are paying little attention to medium- and longer-term consequences.” (http://professional.wsj.com/article/SB10001424052748704358904575477580959771188.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj.)

Unfortunately, we are in a short-term world. Everyone focuses on “current events and forecasts of highly uncertain near-term developments.” As a consequence, there is a tendency to over-react to situations and, in doing so, set the stage for further difficulties down-the-road.

The policy-cycle has gotten shorter and shorter. Richard Nixon believed that he lost the 1960 election to John Kennedy because the economy was not performing well. Thus, when Nixon became president he focused on making sure the economy would be expanding during the 1972 election. He froze wages and prices and took the United States off of gold in August 1971 because he believed it was necessary to contain the inflation begun in the Kennedy-Johnson years so that he, Nixon, could re-stimulate the economy so that he would be re-elected.

This four year cycle became the “thing” for Presidents. Slow down the economy immediately after getting elected so that the economy could be re-started in time to get re-elected.

In the 1992 election, “It’s the economy, stupid!” became the mantra of the Clinton campaign. And this approach appeared to be was in Clinton’s election.

But, then a funny thing happened: the cycle shortened. The mid-term elections became the thing. Whereas the Democrats controlled both houses of Congress when Clinton took office, the 1994 congressional elections turned the tide and resulted in the President facing a hostile legislature for the rest of his tenure. Focus was placed on mid-term elections as well as presidential elections.

Bush (43) experienced a similar turn-around in the 2006 election where the Democrats once-again established their control in Congress.

Now presidents must get re-elected, but also get “their” Congress re-elected.

Current economic policy making in the United States is on a very short string…not that it hasn’t been for a long time.

The problem this creates is that the economy is never allowed to fully adjust to the economic dislocations that appear over time. The efforts to re-stimulate the economy are over-whelmingly aimed at putting people back to work in the jobs and industries that existed before the previous recession. As a consequence, the economy never fully adjusts as it needs to.

Several things can happen. Human capital does not evolve as it should to meet the changes in technology taking place. The result is that unemployment rises, but even more important under employment rises. America now faces the problem that about one out of every four individuals of working age is either unemployed or underemployed. Income inequality is highest in sixty years.

The capacity utilization in the United States has dropped continuously since the 1960s and still rests substantially below the previous levels attained. It is expected that the near-term peak in this measure will be well below the previous peak. This, I contend, is a result of the government’s efforts to force resources back into “legacy” physical capital. (See my post http://seekingalpha.com/article/213163-jobs-and-skills-the-current-mismatch.)

Another area of major concern is the debt burden taken on by individuals, businesses, and governments. In the past fifty years, the federal government has created deficits and excessive monetary growth to combat unemployment and income inequality and sustain as much economic growth as it could. This has been the perfect environment for people to take on more and more debt…and that is exactly what they have done.

However, history shows over and over again that debt levels can eventually reach heights that are unsustainable. And, when this happens, the debt loads have to be worked off. The relevant question is, have we reached that stage where people must de-leverage and work with lower debt levels? If this is the case, working off current debt loads will not be easy.

It takes time for economies to re-adjust and re-structure. Debt loads have to be worked down. Labor must be re-trained. Legacy capital must be replaced with physical capital more attuned to the age. And, continued monetary and fiscal pressure only delays such adjustment and makes American commerce less competitive. (See “U. S. Falls in Ranks of World Economy,” http://professional.wsj.com/article/SB10001424052748704362404575480023901940654.html?mod=ITP_pageone_4&mg=reno-wsj.)

Furthermore, the existing panic in United States policy making, both monetary and fiscal, is creating a world exactly the opposite of what policy makers seem to be attempting to achieve. For example, the Fed’s low interest rate policy is subsidizing the largest financial institutions and creating a world where more and more of the banking assets in America will be controlled by the largest banks. Currently, the largest 25 domestic commercial banks control 67% of the assets of the banking system. Analysts believe that this will go to 75% or 80% in the next five years.

In addition, the ranks of the middle class are dwindling. The low interest rate policy of the Fed has encouraged big companies, big banks, and the wealthy to borrow but these borrowers are just sitting on the cash waiting to engage in an acquisition binge once the economy starts to pick up steam. The middle class? Well, the middle class, those that have paid their bills, who have stay married and worked hard throughout their lives and have saved: this middle class is facing the fact that they will earn next to nothing on their savings. (See “Falling Rates Aid Debtors, but Hurt Savers,” http://www.nytimes.com/2010/09/09/business/economy/09rates.html?_r=1&hp.)

United States policy makers, in an attempt to stay in office, have advocated monetary and fiscal policies aimed at putting people back to work and making it easy for these people to buy “things”, especially houses. They continue to follow such “populist” policies in order to get re-elected and maintain their power. Both parties are guilty. (See my “Wall Street Greed vs. Washington Greed,” http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed.)
The speech given recently by President Obama offering $350 billion in new economic stimulus, even though some of this is aimed at “longer term” projects, appears to be an example of just another politician experiencing the panic that comes with an upcoming election.

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!

Why Krugman Is Wrong!

Talk about a fundamentalist preacher! Paul Krugman continues to rely upon his inerrant interpretation of the dogmatic Keynesian worldview as he condemns those “sinners” that have followed another path from the one he draws strength from.

Krugman’s New York Times column on Monday chastises those that take an alternative view: “More and more, conventional wisdom says that the responsible thing is to make the unemployed suffer.” (See “The Pain Caucus”, http://www.nytimes.com/2010/05/31/opinion/31krugman.html.)

He goes on: “What’s the greatest threat to our still-fragile economic recovery? Dangers abound, of course. But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.”

Amen, brother! Alleluia!

Right out of the creed! When you need to protect your economic doctrine, bring out unemployment and the unemployed. This goes back in history at least to Keynes and the Paris Peace Conference in 1919 when there was a fear about the spread of the Bolshevik revolution throughout Western Europe. (See my book review from October 25, 2009 of “John Maynard Keynes and International Relations”, http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

To support his argument, Krugman claims that America would be creating a situation not unlike that of Japan in the 1990s if the United States followed the “conventional wisdom” he disdains. “We are, however, looking more and more like Japan….[Recent data] suggests that we may be heading for a Japan-style lost decade, trapped in a prolonged period of high unemployment and slow growth.” (See the article by William Galston, “the Case Against Keynes (With Some Questions for Krugman, Too)” at http://www.tnr.com/blog/william-galston/75228/the-case-against-keynes-some-questions-krugman-too.)

The problem is that Krugman (and other fundamentalist Keynesians) interprets the Japanese situation—and the current situation in the United States—and the current situation in Europe) as “a rare real-world example of Keynes’s famous ‘liquidity trap’ in which monetary policy loses its effectiveness.” (See the Galston article.) The Keynesian solution to such a dilemma is to engage in “pump-priming” government expenditures that, through a cumulative multiplier effect that substantially increasing private demand, initiates a self-sustaining process of economic recovery.

The difficulty with this is that it does not take into account the huge amounts of debt that may have been accumulated through the earlier credit inflation that caused people and businesses to increase their financial leverage and risk taking. It was this credit inflation that ultimately led to the financial collapse that put the economy into the current situation. The other side of a credit inflation is a debt deflation.

The problem? People and businesses (including commercial banks) may find themselves so in debt with loan and interest payments far in excess of their own cash flows that they stop spending because they must repay or write-off large chunks of debt. They choose to become as liquid as possible because they must continue to live and finance their daily needs as much as they can through any wealth they may have accumulated. They do not become liquid because of they are afraid or unwilling to commit to the purchase of investment goods. They become liquid to survive.

Within such an environment, the Keynesian solution of pump-priming which leads to credit inflation becomes the only real response because it leads to inflation. To Krugman, Galston argues, “The root of the Japanese crisis is deflation, and the only remedy is a credible shift to a long-term inflationary policy.”

Although not stated in the “liquidity preference” arguments for such a policy, inflation reduces the debt burden because it reduces the real value of the debt. Inflation is always a way to get out-of-debt. The problem is, inflation encourages more financial leverage and more financial risk taking. This is what we in the United States have been doing for the last fifty years. And, ultimately it does not prevent the problem of a financial correction, it just postpones it.

Getting ones financial books in order is not necessarily a bad thing. It appears that Ireland is pulling out of its crisis situation after enduring “one of the worst recessions of any developed economy since the Great Depression.” (See the Bloomberg article: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_gxU5nfACkg.)

Also, the United States in the 1990s presents an example fiscal prudence which contributed to a period of sustained economic growth. The Clinton administration pulled off a very successful policy of deficit reduction which was accompanied by the longest post-World War II period of economic expansion on record. So it can be done.

Other countries around the world are showing the fruits of fiscal discipline in the face of the economic slowdown of the past three years. Even with the turmoil in Europe, manufacturing seems to be recovering around the world, in the U. S., in the U. K., in Canada (where the Bank of Canada just raised interest rates yesterday over concerns about its robust economy), and in Australia, Brazil, China, India, and Japan.

The lingering problem connected with the buildup of debt is the “debt overhang” that remains once the peak of the credit cycle has passed. Yes, there may be liquidity problems connected with reversing out of the expanding economy into an economy that is contracting. Any reversal of direction will experience a dislocation of markets. But, the liquidity problem is a short-run phenomenon. Once the short-term problem is eradicated, the issue becomes one of getting the balance sheets of individuals, businesses (including commercial banks) back into a more conservative structure. And this can take time and can hinder the strength of the recovery.

But, unless one is inflating the country out of its debt load, this re-structuring of the balance sheets must take place for the recovery to become a healthy recovery. There will be pain during this time. But, living beyond ones means for fifty years creates a situation that is uncomfortable for some. Unfortunately, the people that are hurt are not generally the people that really profited from the credit inflation that caused the excesses.

Perhaps focusing on longer term financial discipline might be better for workers over time rather than concentrating on every little short-term wiggle in unemployment. Certainly, the countries that are paying more attention to longer-run issues (like China) are going to put a lot more economic pressure on those countries that only focus on the short run (like the United States and Europe). For more on this see “How China is Changing the World” http://seekingalpha.com/article/206830-how-china-is-changing-the-world.

The Chinese Dilemma

China seems to be determined to continue to peg the value of its currency against the dollar. Then it points its finger at the United States anytime someone representing the United States raises a question about its practice.

As long as China continues to follow this policy, the United States is locked into a corner with no really good options.

The problem of the United States is the problem of a country that has lost its discipline: a person, an organization, a nation, that loses its discipline is only left with painful decisions. And, given an adversary like China that knows when it has a favorable advantage over another, the bad situation only becomes worse.

The assumption of United States supremacy which most presidential administrations worked with since the 1960s created an aura of invincibility, a feeling that the government could conduct its monetary and fiscal policies without regard for the rest of the world. The Bush administration “strutted” into power in its cowboy boots and its Colt 45s ready to enforce this attitude on other nations.

Unfortunately, for the United States this assumption no longer holds. Although the United States is still the most powerful nation on this planet, both in terms of its economic machine and its military presence, it is not in the same place it once was relative to other nations. As a consequence, the country pays a price if it tries to disregard the rest of the world in the conduct of its monetary and fiscal policies.

The prodigal nature of Bush 43 resulted in the value of the dollar, using almost any measure, declining by about 40% between early 2002 and the summer of 2008. Obviously, the monetary and fiscal policies of Bush 43 were not well received by the international financial community.

After the flight to quality into the dollar during the financial crisis of 2008, the value of the dollar has dropped about 14% from its near-term peak in March 2009 to the present time. World financial markets are not approving the economic policies of the United States government!

Meanwhile the Chinese sell goods to the rest of the world and live off of an export driven economy.

And, what happens if the United States does nothing about this?

The value of the dollar will continue to decline and the prestige of the United States in the world will continue to fall. And, the carry trade will continue to prosper and big financial institutions and financial players will continue to rake in billions of dollars in profits by borrowing dollars at ridiculously low United States interest rates, selling the dollar, and investing in higher interest rates throughout the world.

The big banks will continue to get stronger…and bigger. The rest: well that is their problem!

The two major alternatives being suggested are either to raise interest rates and try to moderate the rise in government debt or to raise protective barriers against international trade.

The first of these alternatives does not seem realistic to expect at this time. With unemployment at current levels and with foreclosures and bankruptcies remaining high, the political interests in the United States are not going to condone higher interest rates and a less expansionary fiscal policy. Using monetary and fiscal policy to stem the decline in the dollar is, it seems to me, just not going to happen.

The other major alternative now being floated: greater protection for United States manufacturing and industry. Paul Krugman, the Nobel prize-winning economist, writes about “Chinese New Year” in last Thursday’s New York Times (see http://www.nytimes.com/2010/01/01/opinion/01krugman.html). He concludes as follows:

“there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.”

If unemployment remains high and economic growth continues to stagnate, and the value of the United States dollar continues to decline, the argument that Krugman presents will become more and more convincing, especially as we move to an election. Krugman is now saying that a double-dip economy is more probable than it was a month or two ago and the current stimulus will disappear after the middle of the year. Thus, tighter monetary and fiscal policies, toeing this line, are not appropriate.

This alternative can, therefore, become a real threat and we could experience a rising tide of interest in greater amounts of protectionism as 2010 proceeds. Once the ball gets rolling in this direction it becomes hard to stop and other nations must respond in kind to protect themselves. This would just be a replay of the 1930s, when an earlier death spiral of globalization took place. Even a person who was generally in favor of free trade like John Maynard Keynes became, for a while, a supporter of protectionism because the British government was doing nothing else.

The United States is in a corner and there are no real good choices available to it. As said earlier, when one loses their discipline nothing becomes easier. Bush 43 was totally undisciplined and we are currently paying the price for it. No one seems to have a good idea how to get out of the current malaise and so alternatives like protectionism are bound to gain ascendency.

A Word on the Dollar from Mr. Wolf

Another commentary on the state of the dollar, well worth reading, is that written by Martin Wolf and presented by the Financial Times this morning (see “The Rumours of the Dollar’s Death are Much Exaggerated”: http://www.ft.com/cms/s/0/9165b8b0-b82a-11de-8ca9-00144feab49a.html.)

Wolf begins by stating that “It is the season of dollar panic.” He then specifically lists two, gold bugs and fiscal hawks that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”

I presume that Mr. Wolf would classify me as a “fiscal hawk”, but I do not believe that “Hyperinflationary collapse is in store.”

I do believe that the dollar will remain weak as long as the fiscal stance of the United States government remains as it is, so that the trend in the value of the dollar will continue to be downward. I do not believe that a “hyperinflationary collapse” is imminent.

The reason I believe that this will be the case is that the international investment community will continue to be on the sell side of the dollar as long as the United States government continues to run the size of deficits that it is now running and has no credible plan to bring future deficits under control.

I believe this for the same reason that was stated by Robert Altman, former deputy US Treasury secretary, in his commentary in the Financial Times yesterday (see “How to Avoid Greenback Grief”: http://www.ft.com/cms/s/0/8bdc802e-b675-11de-8a28-00144feab49a.html.) Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies.

And, this response on the part of international investors was a common thread in the latter part of the 20th century. France, as well as a dozen or more other countries can provide similar stories.

And Altman argues that “the dismal (US) deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”

I support Wolf’s reading of the recent decline in the value of the dollar. He states: “In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar's fall is a symptom of success, not of failure.”

Note, however, Wolf’s statement, I believe, that the mother, the United States, “did so much to cause the crisis” through “her mistakes” needs to be clarified. What he doesn’t say is that United States monetary and fiscal policy contributed a decline in the value of the United States dollar of about 40 per cent ending in July 2008! I agree with Wolf that the jump of 20 percent came about due to the fact that “In the recent panic the children ran to their mother.”

The subsequent decline in the value of the dollar, in a perverse way, is therefore “a symptom of success” because through the actions of the United States government (as well as many other governments throughout the world) the financial panic ended and so “failure” was avoided.

To me, the return to a declining value for the dollar is nothing more than a return to the pre-crisis situation in which the world investment community is concerned with the huge deficits being produced by the United States government and the fact that there is really no credible scenario being presented by the leaders of the government that these will be in any way reduced in the future. The connected concern with this fact is that, historically, governments cannot contain the underwriting of these deficits by the nation’s central bank over the longer haul. It’s not the fact that the international investment community sees hyperinflation coming down the path, just that historically the evidence is not in place to have a strong belief that an independent monetary authority will be able to offset the substantial increases in debt that are forecast.

I also agree with Mr. Wolf’s assessment that nothing, at the present, can replace the dollar. Whereas I don’t have the space in this post to go into the very cogent discussions that are presented by Mr. Wolf on this issue, I can come out where he does, without having travelled exactly the same road that he has followed.

I believe that over time the global role of the dollar will lessen. I believe with Mr. Wolf that “the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong.” I agree that the reason that a different role for the dollar is needed is because the current role “impairs domestic and global stability.”

I would just like us to get to this new system by a different path than that proposed by Mr. Wolf or by his colleague at the Financial Times, Gideon Rachman (see my post of October 6, 2009: “The G20: Time for a US Attitude Adjustment”: http://seekingalpha.com/article/165088-the-g20-time-for-a-u-s-attitude-adjustment.)

The world has changed and will continue to change. The United States and the United States dollar will continue to be powerful; they just will not be as relatively powerful in the future as they have been in the past. This has to be taken into consideration by the United States government as it goes forward, but the new system must not be negotiated with the United States government reeling and in a defensive position from continued pressure on the value of its currency.

It's the Dollar, Stupid!

“A nation’s exchange rate is the single most important price in its economy.” Paul Volcker

The value of the United States dollar is heading to the lows it reached in the summer of 2008. My belief is that the value of the dollar will reach these lows in the fall and then proceed to even lower levels in 2010.

The reason given for the current decline? The U. S. economy is getting stronger and the recession (Bernanke) is “very likely over.” In other words, uncertainty and, consequently, the financial market’s perception of risk are declining. A simple measure of the risk the financial market perceives is the interest rate spread between Baa-rated bonds and Aaa-rated bonds. The near term peak, 338 basis points, in this spread occurred in November 2008, a time when all hell was breaking lose in the financial markets. In recent weeks this spread has narrowed to about 120 basis points, a level that has not been seen since January 2008, one month after the current recession is said to have begun.

Financial markets are relatively calm and so market participants can direct their attention to some of the longer term issues that still have to be addressed in the world.

Of particular interest is the economic policy stance of the United States and not just the recent reprieve from economic collapse. The crucial elements? First, there is the massive amount of government debt that is projected to accumulate over the next ten years: maybe $10 trillion in additional debt; maybe $15 trillion; maybe more. Second, there is the Federal Reserve balance sheet that currently shows over $2 trillion in assets, substantially more than the $840 billion in asset the Fed held as late as August 2008.

This is a tremendous cloud hanging over the financial markets!

We know that the value of the United States dollar rose in late 2008 because of the crisis in world financial markets. Almost everyone concerned contends that this move came about as financial market participants moved to what they considered to be less risky assets, and that move brought them to U. S. Treasury securities and the U. S. dollar. This concern over risk was exhibited in the Baa-Aaa spread.

But, now with the strengthening of the U. S. economy and other economies around the world and with the calming of the financial markets, investors are moving their money out of dollar denominated assets. And, they are once again focusing upon the fundamentals of the economic policy of the United States government.

And what are the fundamentals? Just looking at the numbers one would have a difficult time telling the difference between what the Bush 43 administration did and what the Obama administration is doing. During the Bush 43 administration, there were massive increases in the federal debt and the Federal Reserve kept interest rates extremely low for an extended period of time. Now in the Obama administration we are seeing massive increases in the federal debt and the Federal Reserve is keeping interest rates extremely low for an extended period of time.
This is not a financial mix that participants in international financial markets like.

Let’s take a look at the historical record. We start during the Nixon administration because until August 1971 the value of the dollar was fixed in value relative to other currencies. But, once the value of the dollar began to fluctuate we saw some very consistent behavior in the currency markets. During the Nixon administration the gross federal debt increased at an 8.5% annual rate. The value of the dollar declined by 12.7% during this time period.

In the period between 1978 and 1992, the gross federal debt rose at a 12.6% annual rate. The value of the dollar only declined by 4.6%, but we must remember that during this time there was the period that Paul Volcker was the chairman of the Board of Governors of the Federal Reserve System and short term interest rates were pushed above 20%. As a consequence, the value of the dollar actually rose during the early part of the period even though the federal debt was continuing to increase. However, it was all downhill for the value of the dollar after 1985.

The exception to the other periods of time examined here was the 1992 to 2000 period. During that time the gross federal debt rose at a miserly annual rate of 3.6% and the value of the dollar actually rose by 16% during this period. By the end of the Clinton administration, the federal budget was actually showing a surplus.

Now we get back to Bush 43. During the 2001 to 2009 period the gross federal debt rose at an 8.5% annual rate. From January 2001 through to January 2009, the value of the dollar declined by 23.0%! (Through one stretch, the value of the dollar actually declined by more than 40%.)

With substantial budget deficits forecast into the foreseeable future, the Obama administration is causing the gross federal debt to continue to increase at annual rates that are relatively high by historical standards. The result? Since January 20, 2009, the value of the dollar against major currencies has declined by about 10.5%; the value of the dollar against the Euro has declined by more than 12%

I don’t believe that the current declines in the value of the dollar are just a result of the strengthening of the United States economy. To me, the fall in the value of the dollar is just a continuation of the market’s response to the general economic and fiscal policies of the latter part of the 20th century. Since at least 1971, the United States government has consistently deflated the value of the dollar.

In 1971, President Richard Nixon, as he embraced deficit spending, said that we had all become Keynesians. Unfortunately, he was right then and I fear that he is still right about the policy makers now in charge in Washington! Because of this I cannot see any long term relief in sight for the dollar. The debt of the federal government will continue to increase at a very rapid pace and the value of the dollar will continue to decline.

Deficits and the Declining Value of the Dollar

One of the questions that has arisen from the posts I have put up over the last several months has to do with my statement that the international financial community doesn’t like government deficits and tends to believe that a lack of fiscal discipline will result in an increased monetization of the debt. The feeling that the central bank of such a country cannot, in the longer run, overcome the fiscal imprudence of its national government and act independently of that government has resulted, time and again, in a decline in the value of the currency of the country being examined. The dollar is no exception.

Let’s look at the following information.

Average Yearly Increase in Gross Federal Debt (in billions of dollars)

Nixon/Ford $49.5

Carter $90.2

Reagan $258.6

Bush 41 $359.3

Clinton $232.1

Bush 43 $541.1

Now let’s look at the decline in the value of the dollar from the start of an administration to the end of that administration. I will use the trade weighted index of the United States dollar versus major currencies. The series begins in January 1973. Up until August 1971 the United States had a fixed exchange rate. At that time President Nixon announced that he was allowing the dollar to float in foreign exchange markets and was taking the United States off of the gold standard.

He also announced that “We are all Keynesians now!” meaning that he was going to stimulate the economy with budget deficits (so that he could get re-elected) and to protect against inflation he was freezing wages and prices. He created the Cost of Living Council and the Committee on Interest and Dividends to administer these controls as well as controls on interest rates. As can be seen from the above figures, the Gross Federal Debt increased by an average of almost $50 billion every year during the Nixon/Ford years. This compares with those spendthrifts John Kennedy and Lyndon Johnson who introduced Keynesian economic policies to the United States and who only increased the Gross Federal Debt by an average of less than $10 billion per year.

Change in the value of the dollar (as measured against major foreign currencies).

Nixon/Ford - 1.0 %

Carter - 10.4 %

Reagan - 5.7%

Bush 41 - 1.9 %

Clinton + 16.6%

Bush 41 - 21.6%

Note that the only administration to see a rise in the value of the dollar over the past forty years was the Clinton administration. Note, too, that the only break in the continued increase in the Gross Federal Debt outstanding was during the Clinton administration. As you may recall, the last four years it was in office, the Clinton administration ran budget surpluses.

Also, one can remember the accolades received by Paul Volcker, when he was the Chairman of the Board of Governors of the Federal Reserve System, for bringing inflation under control. Volcker was Chairman from August 1979 until August 1987. Volcker did bring inflation under control and early on this effort was reflected in a rise in the value of the United States dollar. The value of the dollar reached a short term bottom in July 1980 and then, accompanying the decline of inflation in the United States, the dollar rose in value by 55 percent to peak out on March 1985. However, even Volcker could not hold out against the massive deficits that the Reagan administration was piling up and the value of the dollar fell from that peak by 31 percent through the month at Volcker left his position at the Fed. Even someone as strong as Paul Volcker could not fight against the increasing deficits that were being posted by the Reagan administration. The value of the dollar closed lower at the end of the Reagan years than it was at the start.

The only conclusion one can draw from these data is that participants in international financial markets do not like the currency of countries that lack discipline over their fiscal affairs. This, of course, has very strong implications for the Obama administration. With the possibility that the Gross Federal Debt is on a trajectory in which the debt will increase in the $1.0 trillion range per year, at least for the near term, the implications seem clear. There will be continued pressure on the value of the United States dollar in the upcoming years.

The specific argument for this relationship is that increased federal deficits will result in increased monetization of the debt. Increased monetization of the debt will result in an increased rate of inflation. An increased rate of inflation will cause the value of the currency to decline. So, the question being posed by skeptics right now is “where is the inflation?” The time seems more right for deflation rather than inflation.

In the short run it is hard to argue against this logic. The only thing one can fall back on to answer this question is the fact that when budget deficits increase and there is no relief from substantial increases in the debt of the country, participants in international markets tend to sell the currency. What we have seen in the past is that any inflation that results from the massive increase in the debt outstanding can come in many forms that are not all registered in the computed price indices like the Consumer Price Index. Something like the CPI is an estimate, a guess at what is happening to prices. The important thing to remember about massive increases in debt is that they have to go somewhere and where ever they go they will have large consequences. We hope that we can measure these consequences and measure them in a timely manner. However, that does not always happen.
And, where else are we seeing action? India has now joined China and Russia and Brazil in calling for a discussion at the upcoming G-8 conference of the place of the United States dollar in the world’s monetary system. China is tired of continuing to support its currency against the United States dollar. Given the likelihood of a further decline in the value of the dollar, China faces the need to buy more and more dollars and invest in more and more securities from the United States. This, in the longer run, is not in China’s best interest. Nations, other than England and those from the Eurozone, are getting tired of the United States abusing its privilege of having the only reserve currency in the world. Although nothing is going to be done to change the monetary system at this time, this talk is going to get stronger and stronger. And, if the value of the dollar continues to decline in the future, the arguments are going to resonate more and more with others in the world. The basic approach to fiscal policy in the United States over the past 50 years has not been the most productive one in terms of maintaining a sound dollar currency.

Is Treasury's TARP Debt Already Monetized? Part III

The discussion continues for one more post. I ended the last post with these words:

“The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!”

On this issue, let me point out the post by Jonathan Weil on Bloomberg this morning, “Crisis Won’t End Until Balance Sheets Get Real” (http://www.bloomberg.com/apps/news?pid=20601039&sid=azsX7o.atu7U). After presenting interesting data on the state of commercial bank balance sheets he argues the following:

“Banks and insurers got Congress to browbeat the Financial Accounting Standards Board into making rule changes that will let them plump earnings and regulatory capital. There also was Fed Chairman Ben Bernanke’s line in March about “green shoots,” which sparked a media epidemic of alleged sightings.

For all this, we still have hundreds of financial companies trading as though the worst of their losses are still to come. Just imagine what their prognosis might be if the government hadn’t pulled out all the stops.”

And, then Weil closes:

“Truth is, there’s no way to know if the economy has turned the corner, or if last quarter’s market rally will prove sustainable. Yet when this many banks still have balance sheets that defy belief, it means the industry probably hasn’t re- established trust with the investing public.

Trust, you may recall, is the financial system’s most precious asset. On that score, we still have a long way to go before we can say this banking crisis is over.”

This is the short run problem and it is the one that is going to determine whether or not the Federal Reserve is going to be able to shrink its balance sheet. This has been the point of my last two posts. And why are we facing such uncertainty at this point? Because the Mark-to-Market rule was pulled and because there is not enough openness and transparency in the public financial reporting of financial institutions. If there are going to be regulatory changes in the future, a lot is going to have to be changed as far as the reporting requirements for financial institutions is concerned.

But, this is just the short run problem.

The longer run problem is the projected budget deficits of the Federal government. Even if things work out as the Federal Reserve has planned as far as bank reserves are concerned and Federal Reserve credit retreats back to where it was in August 2008, there is the massive problem facing the country about how prospective government deficits are going to be financed. The bet is that the Fed will finance a substantial portion of the deficits to come. Let the printing presses roll!

The fear? Inflation.

But many say, we are in a severe economic contraction now. The fear should be deflation and not inflation.

The only response to this counter argument is that in the latter half of the 20th century, any nation that has run substantial deficits has, sooner or later, run into problems related to inflation. Monetary authorities are never so independent of their central governments that imprudent fiscal policies are not in one way or another underwritten through some form of monetization. And, since this happens time after time, how can the international investing community sit on the sidelines and do nothing? Yes, the United States is in a severe recession right now, but what are your odds for the monetization of a lot of the Federal debt over the next three years? Over the next five years? Over the next ten years?

Where do you look for such for an indication of market sentiment on this? Look at the value of the United States dollar. The dollar fell by about 15% against major currencies in the latter part of the 1970s as the Carter budget deficits seemed to get out-of-hand. As we know, Paul Volker played the savior there by conducting a very restrictive monetary policy to bring the value of the dollar back in line. However, the Reagan budgets became so severe by 1985 that the value of the dollar began to plummet. In the face of continuing deficits and the realization that this would continue to result in a weak dollar, Volker gave up the reins of the Federal Reserve in August 1987. The dollar did not pick up strength again until fiscal restraint was returned to Washington with the Clinton administration as the value of the dollar rose over 25% from April 1995 until the end of 2000. The massive budget deficits of Bush 43 were translated into another precipitous decline in the value of the dollar which fell by almost 40% between the middle of 2002 to March 2008.

The fiscal policy of a nation does matter to the international investment community!

But, you say, look at all the other major countries having economic problems and their budgets are out of balance as well. Look at England, Germany, Italy, France, and others.

The response to this? This is not the case for many of the major emerging countries of the world, specifically the BRIC countries. Perhaps one leaves Russia out of this, but China, India, and Brazil are going to emerge from this period much stronger relative to the United States than could have been thought even a year ago or so. So is Canada and several other important countries. This world crisis is going to shift world economic power in a way that has not been seen since the shifts in world power that took place in the 1920s and 1930s. And, international investors are realizing this!

Yes, the dollar will still be used as the reserve currency of the world…for a while longer. The Chinese, and the Russians, and the Brazilians, and the Indians all realize this. And, even though they keep talking about establishing a new reserve currency, they seem to back off and say that the dollar cannot be replaced right now. Yet, the Chinese have called for the Group of 8 to talk about a new reserve currency at its upcoming meeting. The issue IS on the table and my guess is that it is not going to go away.

Which brings me back to the deficits. In my mind, the budget deficits of the United States government are out-of-control right now and there is great concern that this administration will not be able to regain control of them in the near future. There is no “reversal” mechanism that is built into these budgets as the Fed has attempted to build in a “reversal” mechanism in its efforts. As a consequence, great pressure will be put on the monetary authorities over the next several years to monetize a substantial portion of the debt that will be created. The history of the past fifty years or so is that the Fed will not be able to avoid the pressure. This is perception that the international investing community will be bringing to the market when it place its bets. This can be translated into higher long term interest rates in the United States and a continuation in the decline in the value of the United States dollar.

Known Unknowns

It is still too early to think that we are near or past the bottom of this economic downturn. However, in my mind, we are in the “working out” stage of the downturn, especially in the current economic restructuring we are going through, and we cannot expect this stage to be a short one.

The problem with many analysts and policy makers is that they continue to see our economic problems in Keynesian terms and think that the difficulties being experienced in banking and financial markets as a liquidity issue. Hence the search for evidence pointing to “green shoots” and for an “easing of credit.” Every day we hear when new statistics are released that the numbers just presented are “less bad” than before and this indicates that the economy is getting worse at a slower pace. An obvious sign that we are near the bottom!

In my mind, the two major issues facing the United States (and the world) are the structural problems in industry and finance and the debt problem. I have said all along that the basic cause of the financial collapse and the following economic dislocations comes more from the supply side of the economy than from the demand side as assumed by the Keynesians. And, because our problems are primarily supply side problems, governmental stimulus plans and deficit financing are not the incentives needed for restructuring the economy and putting people back to work.

In fact, demand side stimulus can even exacerbate the problems and slow down the changes that need to be made. Furthermore, treating the debt problem as a liquidity problem, as the Federal Reserve and the Treasury seem to be doing, can do the very same thing.

The “good news” is that most organizations and institutions have identified the major problems they will be facing in the near future. However, the “bad news” is that no one knows the depth or breath of the problems. The difficulty facing these organizations and institutions going forward is that these problems must be “worked through” and “worked out”. This “working through” and “working out” will take time and, since the problems are related and interconnected, the outcomes will be dependent on just how systemic and cumulative they are.

For example, greater unemployment due to structural reductions in the workforce who were employed making cars, producing parts, or selling cars will lead to more foreclosures on “prime” loans. (See “Job Losses Force Safer Mortgages to Foreclosure” in New York Times, http://www.nytimes.com/2009/05/25/business/economy/25foreclose.html?_r=1&em.) This will have further ramifications for the financial sector, housing construction and so on. The repercussions will continue on throughout the economy.

In the area of foreign trade, declining incomes lead to reductions in imports, but these imports are the exports of other countries. Countries that have built their economic growth and prosperity on their export trade face worsening times because of the decline in their exports. And, with the slowdown in these countries world trade declines. (See “Trade and Hard Times” in the New York Times, http://www.nytimes.com/2009/05/26/opinion/26tue1.html?ref=opinion.) There are more and more calls to prevent, if possible, further reductions in foreign trade in the world, especially relate to tariffs and other means of protectionism.

These are just two examples of situations where problems exist but where there is no real understanding of how far the cumulative interactions will take us. Many more situations like these exist at the present time. They are not problems that will be resolved through fiscal stimulus and the creation of government debt. There are three major problems with this response.

First, fiscal stimulus does not eliminate structural dislocations in the economy. The government (or no one else for that matter) does not know what the future structure of the economy will look like. Existing organizations, including financial institutions, can “re-tool” themselves, but this takes time and the exploration of different models for companies to find what works best. In terms of innovation, governmental funds can be made available for the next generation of energy sources and transportation systems and so forth, but no one knows exactly how these sources and systems should be put together. Restructuring and creative innovation take time and experimentation. One cannot “will” the right structure or the best innovation.

Furthermore, who wants to invest in something the government is the driving force in? Current events attest to emerging problems related to governance, decision making, and “the rule of law” when the government gets involved with a company or an industry.

Second, when the solvency problem is treated as a liquidity problem, the issue of solvency does not go away. The “toxic asset” program (P-PIP) developed by the Treasury and the efforts by the Federal Reserve to shore up various segments of the financial markets is just a “round-about” way of allowing the federal government to pay for the bad debts that are on the balance sheets of financial institutions. That is, the programs just allow the financial system to transfer financial losses to the government so that the tax payer will eventually end up with the bill for any insolvency that exists. Still, the question of the solvency does not go away.

Third, the government assumption that both problems, those related to economic restructuring and the amount of debt outstanding, can be solved by creating more and more debt is laughable if it were not so potentially tragic. International financial markets understand that in one way or another and at some time in the future, excessive amounts of government debt will end up being monetized. How this monetization works out in each particular case cannot be foretold. History has shown, over and over again, that at some time this connection between large amounts of debt and money creation becomes a reality. It cannot be avoided; it is just the timing that is uncertain.

The conclusions that can be drawn from this analysis are very straight forward. First, economic growth, even when it becomes positive again, will stay low for an extended period of time. My reading of the 1930s has lead me to believe that this decade was a time of industrial and financial restructuring (not helped very much by the government) and technological change. It was not a time that demand-side stimulus could help very much. The restructuring had to take place and World War II did not contribute to the recovery because of the added spending but because of the re-focus and restructuring of industry it forced on the nation. I believe that, like the 1930s, we may be facing an extended period of time in which we need to re-focus and restructure industry. One hopes that we do not need a world war in order to finally achieve this re-structuring.

Second, the continued creation of debt is not going to help. The government debt is going to be monetized at some time. The realization of this, I believe, has become a reality to the bond markets and the foreign exchange markets. To me, the yield on long term U. S. Treasury securities will continue to trend upwards in the foreseeable future and the value of the U. S. dollar will continue to trend downwards. The trends will continue unless some financial “miracle” takes place that eliminates the projected upcoming deficits in the government budget—perhaps an amazing recovering in tax receipts or massive savings discovered in the health care industry.

Third, whereas paper assets from the United States will not be that desirable internationally, physical assets will. For much of the two years or so ending in August 2008, the weak dollar allowed foreign countries and investors to buy U. S. companies at a record pace. With the rising strength of China, India, and Brazil, I believe that with the continued slide in the United States dollar, more and more U. S. companies and their physical assets will come into foreign hands. That is, until the U. S. Congress bans such transactions.

Structural Changes in the Economy, Unemployment, and Inflation

A new concern about the economy has surfaced recently. This new concern has to do with the changing structure of the economy and the impact this change might have on the outcome of government policy.

Specifically, the argument is that the United States economy, and that of the world, is currently going through a transitional change that only occurs once or twice every century. This is the transition that takes place in the productive structure of the economy—a sort of “tipping point”.

There is no doubt that the structure of automobile production is going to be different in the next ten years from what it was over the past fifty years or so. This shift will affect dealers, suppliers, and many other companies that are peripheral to the car-making process. But, changes are also taking place in the way that different forms of energy are going to be provided. Information technology continues to change and we still don’t know what the future looks like in this area. And, these are just a start.

The point is that the world has changed. People that are facing unemployment due to the collapse of the auto industry are not going to find the same employment opportunities in the future that existed in the past, even if the stimulus and bailout packages work. There will be a different focus in energy with new types of jobs becoming available and the old types being less plentiful. Openings in health care are going to be different. And, what about employment in financial services? New jobs might be much more plentiful in government service. And some people are calling for a re-instatement of the military draft.

This changing structure is going to impact many, many people who will need to change jobs, change where they live, and change skills. During times like these, what is called the non-inflationary rate of unemployment tends to increase. This is because the structure of employment has changed and the industry and the economy need to adjust to accommodate this change. Whereas, the non-inflationary rate of unemployment for all workers over the past ten years may have been around 5.0%, this rate, looking forward, may be at 6.0% or more depending upon the restructuring that needs to take place.

What is the problem created by this shift?

The models used by the federal government in determining what monetary and fiscal policies are appropriate for achieving “full employment” contain the lower estimate for the non-inflationary rate of unemployment. These models are based upon historical data and the “historical data” don’t include the adjustments that are now taking place in the actual economy.

The consequence of using an unemployment figure that is too low?

Deficits will be greater than expected because government tax revenues will be lower than initially projected and the choices for monetary policy will be too expansionary for the new structure of the economy. That is, the employment situation will be worse than expected and the pressure on prices will be greater than expected.

What does this mean for the results that we will be seeing? Well, it means that unemployment will remain higher than what is desired and inflation will also remain higher than desired, even though the pressure on wages will be downward. That is, there will be a greater fall in real wages than expected and this will further dampen consumer spending and cause additional foreclosures and personal bankruptcies.

This can have further repercussions in financial markets as increasing federal deficits and rising unemployment puts additional pressures on the Federal Reserve to monetize the debt. Long term interest rates will not fall under these circumstances even though real resources are seemingly under-utilized.

What is happening here?

To me, what is happening is confirmation of what I was writing about last summer and through the fall and winter. First, the shift in economic activity is coming from the supply side of the economy—and not from the demand side! Most economists (and this is especially so with the reincarnation of the Keynesian school of thought) interpret a slowdown in economic activity as a deficiency of demand. Hence the monetary and fiscal policies that are created aim at restoring sufficient demand to return the economy to full or near-full employment levels.

If the slowdown in economic activity is coming from the supply side, different monetary and fiscal policies are needed to confront the state of the economy. A slowdown in economic activity coming from the supply side needs policies that deal with the structural changes in the economy and these require efforts much different from demand side policies.

Demand side stimulus, in cases like this, often exacerbates the problems because all the demand side stimulus seems to do is try and force the unemployed people back into their old jobs which are no longer available. If the structure of production and employment has actually changed, then these old jobs have disappeared and there is no way that demand stimulus will bring them back into existence. Hence, too much money is chasing too few goods—even though unemployment has increased.

The second factor I have discussed before is that there is too much debt outstanding and that this problem must also be dealt with before economic expansion can begin again. But, if there has been a structural shift in the economy, this situation becomes more problematic because a higher rate of non-inflationary unemployment means that previous debt loads are even more out-of-line with what people can handle than at the rate that was being used before. That is, the debt problem is worse than previously anticipated.

The Federal Reserve and the Obama administration still seem to believe that the problem in the financial markets is one of liquidity. However, the problem is one of solvency and this is a structural problem and not one that is temporary and handled by buying more and more different kinds of securities. The focus on the liquidity available in different segments of the financial markets and on the balance sheets of banks is misplaced. Individuals, businesses, and governments have too much debt outstanding relative to the state of the economy. The auto industry is “painfully” shedding some of its debt. The Treasury Department is attempting to help the banking industry shed some of its debt. Still, there too much debt outstanding and the federal government is adding more and more to this total.

The bottom line is that the changes that have taken place in the United States economy are structural in nature and must be dealt with as such. Unfortunately, the policy makers in Washington, D. C. don’t seem to see it that way. As a consequence, the policies that have been forthcoming may only add to the dislocations that exist in the economy and result in a rate of inflation that only adds to these problems.

Even with the substantial decline in real GDP in the first quarter of 2009, the GDP deflator rose at a 2.9% year-over-year rate of increase. This is worrisome. But, when output falls and inflation rises or stays relatively constant, this is an indication that the supply side of the economy has shifted and not the demand side.

Concerns about the Obama Stimulus Plan

As the Obama Stimulus Plan becomes more and more of a reality, many different people are asking many different questions about it. To me, there are four basic issues that need to be debated very seriously before any such plan is passed by Congress. The first question is…how fast do we really need to move in passing such a plan? Second…how big does the stimulus package really need to be? Third…how is all the debt created by such a plan going to be financed? And fourth, can the stimulus really be withdrawn once the crisis is over?

In terms of speed of enactment we hear over and over again that speed is of the essence. Things are really bad…and things are going to get a lot worse. We need to get into the game and do something as quickly as possible!

We heard this argument before, not too long ago. It was reported in the Wall Street Journal, that “Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17.” Bernanke was reacting to things falling apart in the financial industry. He called Treasury Secretary Hank Paulson and said that the administration had to move. Thursday September 18. Paulson responded that he was “on board”. Bernanke insisted that Congressional leaders had to be assembled…which Paulson set up for that Friday evening. Bernanke read them the riot act at that meeting and insisted that a bill…what became TARP…be enacted no later than Monday or everything would fall apart. (For more on this see my post on Seeking Alpha of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?”) The bill was not enacted that Monday and the last half of the TARP money was not released until just recently.

Now we are hearing the call again. We must hurry. The Obama Stimulus Plan has been put on the fast track…and the pressure is on to get the plan enacted by Congress by President’s Day, February 16. But, does this plan really need to be enacted that quickly? Is it better to have any plan by President’s Day or is it better to have a plan that works?

It seems to me that the pressure to get something done quickly has important implications for the second question asked above. Since so little is known about how effective the plan will be…the issue becomes…MORE IS BETTER! Given the uncertainty of how the plan will work, it is important to throw as much as possible against the wall in the hopes that some of it will stick.

Wow! What a way to run a government! But that is what Bernanke/Paulson did.

And, this approach gives rise to the new justification for the program…confidence. The argument goes that “If the government shows that it is serious in ending the recession and this seriousness is reflected in the size of the stimulus package…this will spur on an increase in confidence…which is just what the economy needs right now!”

Let me get this straight. It doesn’t really matter whether or not the stimulus plan works…what is important is that the stimulus plan be very large…so that people will regain confidence.

And, if this is the underlying theory behind the stimulus plan…how is this going to raise the confidence of the world wide investment community…which relates to the third question presented above…to invest in the debt of the United States government?

Oh, well…the United States dollar is the world’s reserve currency and the United States debt is the place for world investors to go when there is a “flight to quality” in world financial markets. Given this fact, people will continue to flock to United States Treasury issues. No doubt about it!

As Alice Rivlin, economist of the Brookings Institution, former member of the Board of Governors of the Federal Reserve System, First Director of the Congressional Budget Office, and Director of the Office of Management and Budget (a cabinet position and appointed by President Bill Clinton a Democrat) recently testified before Congress…”We seem to be counting on the Chinese to keep investing to pay for this (the U. S. deficits) and we’re assuming that the rest of the world isn’t going to lose confidence once we use this moment to spend on a whole range of programs. And, I’m not sure that’s the right assumption.”

Rivlin also has something to say about the fourth question…the question about what happens in the long run. She states that “Because we’re doing this outside the budget process, it means that no one has to talk about what the long-term effects of any of this might be.” That is, what is going to happen beyond the short run if much of this expenditure is still going into the economy as the economy begins to grow again. No one is anticipating how this situation might be dealt with.

As Niall Ferguson, who shares his time between Harvard University and Oxford University, stated recently at Davos…and I am paraphrasing…the new administration seems to believe that by creating an impressive amount of new leverage that it can resolve a financial crisis created by an excessive amount of leverage.

So, I go back to the first question…do we really need to rush so quickly? Yes, I agree with President Obama…he won…he gets to set the table. But, does he want to do it right…or does he just want to do it?

The Congress is supposed to be a deliberative body…it is supposed to mull things over…kick them around…debate and dialogue with one another. Isn’t it better to get something right…than to not do something well…or to do something that may not work?

Projects should not just be put into a stimulus plan…just because they are a “good idea” or because “they are something we want to do and they are available.” Projects, to be included, need to have some real justification for their inclusion in such a plan…the benefit of the project (the whole flow of benefits accruing from the project) should exceed the social cost of the project. Questions should be asked about the timing of the project and when the expected benefits are expected to be received. The Congress should be very intentional about what it is going to do…how much it is going to spend. Success of execution should be the key criteria as to whether a project gets included in the plan…not just the speed of passing the bill.

If Congress were to judge the plan…the whole plan as well as the components of the plan…in this fashion, then something more specific could be said about the size of the plan. Given that every element of the plan could stand up to some form of cost-benefit analysis then the size of the plan would be less of an issue. We would have some rationale for the size of the plan…it would not be a question of hoping some of the material thrown against the wall would stick! The parts of the plan would be chosen because they work…not because they make the plan “large”.

There still will remain questions about financing a stimulus plan. A plan constructed as suggested above would still result in the creation of a lot of new debt the United States government would have to issue. But, the investment community would have more justification to “trust” the plan because the Congress has done its homework…and, if the Congress had done its homework there would be something to say about how the debt will be financed and paid down in the future. That is, the United States government would be acting like a responsible steward of its fiscal responsibilities, something world financial markets have not seen for eight years or so.

To me, this is a crucial issue the Obama administration and the United States government has to deal with…restoring confidence in the fiscal credibility of the United States…something that Bush43 fell far short of doing. Rushing into the fray with a hastily constructed, ill-conceived stimulus plan, one that relies on the Chinese and the rest-of-the-world to finance with no thought for the future is not going to resolve the financial and economic mess we are now experiencing.