Please Listen: The Problem is Too Much Debt

For the past two years or so, my prediction for the cumulative debt of the United States government over the next ten years has been in the $15 to $20 trillion range.  This would more than double the current amount of government debt outstanding.

Since the events of the past few days in Washington, D. C., my prediction for the cumulative debt of the United States government over the next ten years is still in the $15 to $20 trillion range.

The most descriptive characterization of the “debt deal” that I have heard is that Congress (and the President) has just “kicked the can down the road.”

In this, the United States government seems to be in the same league as their “kin” in the eurozone.  One has to look hard to see any evidence of leadership. (See my post http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

As far as the Obama administration is concerned, in my mind, this “team” has observed the creation of three “camels” on its watch.  The first camel was the health care bill.  The second was the Dodd-Frank financial reform bill. (See my post http://seekingalpha.com/article/281090-the-future-of-banking-dodd-frank-at-one-year.)

The third camel is, of course, the just passed “debt deal”. 

The general comment about all three is that at the birth of all three, people were very unhappy with them. 

Never can I remember, except maybe under President Jimmy Carter, a President that exhibited less leadership in such important areas.  President Obama presented no “plan” to Congress in any of these efforts.  People say that the administration was responding to the “health care plan” rebuff experienced by the Clinton administration in the 1990s and wanted to involve Congress more from the start of any legislative attempt.  I believe that this was a gross mis-reading of the events surrounding the Clinton initiative. 

However, this strategy of holding back and letting Congress take the lead in proposing and disposing resulted in something more like chaos or anarchy than leadership.  And, this strategy has produced three camels that nobody really likes. 

And then people worry about jobs and the state of the economy.  How can you create smaller deficits through cuts in government spending without causing further danger to the health of the economy?

It seems like we are in some kind of situation in which everything that is proposed contradicts everything else.  President Obama, after the passage of the “debt deal” stated very clearly, that the issue now becomes one about jobs.  
In fact, the President plans a bus trip in the Midwest the week of August 15 as part of his new jobs push.  Whoopee!

To me, there is only one thing that ties all the different problems we are experiencing together.  It is the fact that there is just too much debt outstanding today…and, this debt load extends throughout the nation (and throughout Europe).  Consumers are still burdened with too much debt.  So are many businesses.  So are state and local governments.  And, so are sovereign nations. 

“Consumer Pullback Slows Recovery,” we read in the Wall Street Journal (http://professional.wsj.com/article/SB10001424053111903520204576483882838360382.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj).  Why are consumers not spending?  They are saving…they are paying back debt…to get their balance sheets in line.  They are not buying homes because of the problems with bankruptcies and foreclosures (http://professional.wsj.com/article/SB10001424053111904292504576482560656266884.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj).

Many businesses are not borrowing because of a decline in their economic value and the increased pressure this puts on the amount of liabilities they are carrying on their balance sheets.  (See my post http://seekingalpha.com/article/279506-debt-deflation-and-the-selling-of-small-businesses.)

And, the state and local governments are also getting headlines about their budget problems.  What about the city in Alabama that is declaring bankruptcy?  And the municipality in Rhode Island?  And, what about the problems in Harrisburg, Pennsylvania?  And, California?  And so on and so on?

This is the scenario called “Debt Deflation”.  Debt deflation occurs after a period of time in which credit inflation has dominated the scene.  Credit inflation eventually reaches a tipping point in which the continued inflation of credit can no longer be sustained.  Once this tipping point is reached, people, businesses, and governments see that they can no longer continue to operate with so much debt and so they begin to reduce the financial leverage on their balance sheets. (See my post http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation.)

This process is called “Debt Deflation” because it is cumulative.  As these economic units begin to reduce their financial leverage, it becomes obvious to them that they must reduce this leverage even further than first imagined.  Whereas “Credit Inflation” is cumulative and leads to people adding more and more debt to their balance sheets, the reverse process is also cumulative.

The only short-term way to avoid this debt deflation from taking place is to create the condition called “hyper-inflation.”  This is exactly what Mr. Bernanke and the Federal Reserve System has tried to do.  I say short-term because all hyper-inflations come to an end sometime.

We have had fifty years of government economic policy based on the Keynesian assumption that fiscal deficits and the consequent credit inflation that results from the deficits are good for employment and the economy.  This assumption has, to me, been disproved given that the compound rate of growth of the economy has averaged only slightly more than 3 percent over the last fifty years, about what was expected in the 1960s, and the amount of under-employment in the economy has gone from less than 10 percent of the workforce in the 1960s to more than 20 percent of the workforce, currently. 

Furthermore, the income/wealth distribution in the country has become more skewed than ever toward the wealthy during this time period.  This is because the wealthy can protect themselves against inflation and even position themselves to take advantage of it.  The less wealthy do not have similar opportunities.  And, in the current situation, some, the more wealthy, are doing fine because they are not as indebted as others and so can continue to prosper during these difficult times of excessive debt burdens.

Getting back to my projections for the cumulative federal deficit over the next ten years and the “debt deal”: I really don’t see a fundamental change in the underlying economic philosophy of the Obama administration (which includes Mr. Bernanke) and/or Congress.  They seem to see the current problems as a “temporary” aberration from the existing “Keynesian” credit inflation philosophy that underlies all that they do.  They seem to believe that once this “period of discomfort” is passed that business will continue on as usual. 

Until this attitude is changed, I see little reason to change my prediction for the cumulative federal deficit over the next ten years.

Credit Inflation or Debt Deflation?

The world never stands still.  It is either moving one way…or moving in another way. 

In terms of the macro-economy, the world is either experiencing a credit inflation…or a debt deflation. 

For the past fifty years or so the United States (and Europe) has experienced a period of credit inflation.  Now, with debt levels so high, there is a real possibility that the United States (and Europe) will experience a period of debt deflation.

The fundamental response of many is that the United States government must continue to “jack-up” economic stimulus and create even more dramatic extensions of the credit inflation that has put the United States in the position it now finds itself in. 

The still unanswered question in the current situation is whether or not credit inflation can continue to be extended or will it ultimately reach a position in which the economy is so saturated with debt that further credit inflation is unsustainable.

The further question that accompanies this question is whether or not we have currently reached the tipping point in which further credit inflation is unsustainable. 

If credit inflation cannot continue then debt deflation must take over…it is either one or the other.

The reason for this conclusion is that credit inflation…and debt deflation…are cumulative movements.  That is, credit inflation builds on itself…just as debt deflation builds on itself. 

The basis for credit inflation is that the creation of more and more debt in the economy exceeds the possible growth of the whole economy, in the aggregate sense, or exceeds the possible growth within a sector, in the case of bubbles like the housing bubble in the decade of the 2000s.

For the economy as a whole, the gross public debt of the United States government rose at a compound rate of growth of more than 8 percent over the past fifty years.  The real economy was able to grow at a rate slightly in excess of 3 percent.  This is the foundation for the credit inflation that took place over this time period.

The cumulative effect of the credit inflation can be seen in the increased risk-taking that occurred over this time period as actual inflation “buys out” dumb decision making through price increases.  Financial engineering prospers during such a time as financial institutions and business firms benefit from more and more financial leverage and the assumption of interest rate risk.  Furthermore, one finds financial innovation thriving during such times as more and more opportunities present themselves for the “slicing and dicing” of cash flows.  Finally, finance triumphs over manufacturing as companies devote more and more resources to financial transactions.  In the 1960s, who would have thought that General Motors and General Electric might, at some time in the future, earn more than two-thirds of their profits from their financial wings?

Private sector debt, depending upon the series used, grew at a compound rate of 10 to 12 percent over the past fifty years.

The cumulative build up of debt on balance sheets results in two things.  First, economic recoveries become weaker and weaker over time as more and more people fight to overcome their debt burdens in order to “get spending again.”  Second, the economy bifurcates into two groups, one that is over-burdened with debt, and, one that is in control of its finances.  As the cumulative effects of credit inflation pervade the economy, the proportion of people in the first group grows relative to the proportion of the people in the second group.  This change makes it harder and harder for the economy to recover over time. 

A recent article by Amir Sufi, Professor of Finance at the University of Chicago, titled “Household Debt Is at Heart of Weak Economy” (http://www.bloomberg.com/news/2011-07-08/household-debt-is-at-heart-of-weak-u-s-economy-business-class.html) makes this very point.  “From 2001 to 2007, debt for U. S. households increased to $14 trillion from $7 trillion, and the ratio of household debt to gross domestic product was higher in 2007 than at any time since 1929.”

William Galston writes on this dilemma in The New Republic (http://www.tnr.com/article/the-vital-center/91856/economy-recovery-foreclosure-housing-prices): “To understand the burden this imposes on households, let’s took at a key measure: the ratio of household debt to disposable income.  Between 1965 and 1984, the ratio remained steady at 64 percent.  Between 1985 and 2000, it rose virtually without interruption to 97 percent.  And then, it shot into the stratosphere, peaking at 133 percent in 2007.  Four years later it has come down only modestly…118 percent of disposable income.”

But, many businesses, especially small- and medium-sized ones, at in similar straights. 

How many commercial banks in the United States are going to fail or be merged out of business?

And, what about many state and local governments?

And, what about the federal government?

The start of this period of credit inflation began in the early 1960s.  The philosophy behind this period of credit inflation is Keynesian, although a corrupted Keynesianism because Keynes argued that the government should balance its budget over the credit cycle, creating budget surpluses during the “good times” to balance out the budget deficits that were needed during the “bad times.”  The “bastardized” Keynesian approach argued for continuous budget deficits to create higher and higher rates of economic growth. 

Robust economic recovery becomes harder and harder to achieve as the cumulative credit inflation continued.  The burden of the financial leverage built up in the past becomes heavier and heavier.  At some point, this burden becomes too great and the continued efforts of the government to inflate credit become unsustainable. 

Evidence that we have reached this point or are getting closer and closer to the point is abundant.  First, we see that the fiscal stimulus programs of the United States government have achieved very little over the past four years or so.  Second, the massive failure of the Federal Reserve to “jump start” the economy through QE1 and QE2 is also an indication that credit inflation may not be working at this time. 

If we are going to enter a period of financial de-leveraging in spite of the efforts of the government, what does this mean for the stability of the economy and financial markets? 

It means that there will be a fundamental restructuring of the economy.  Those people and businesses that have been financially prudent up to this point will prosper.  Those that have not still have a bunch of pain to go through.  There will be a substantial restructuring of industry as those that have will take advantage of those that don’t have.  Also, there is still a major restructuring to come of the banking industry. 

A period of restructuring means opportunities.  I see a substantially different America in the next five-to-ten years.  The goal is to identify where the opportunities are.

Debt Ultimately Leaves You With No Good Options

The economies of Europe are hurting, unemployment is too high, and the social nets are under attack.  The economy of the United States is hurting, unemployment is too high, and the social net is under attack.

Options for the governments in each area are decreasing and despair is growing. 

This is exactly what piling on the debt eventually does to you.

I sympathize with the unemployed.  I sympathize with the under-employed.  I sympathize with the labor unions…public sector and private sector…that are losing members and popular support.  I wish there were more for everyone.

Taking on debt, in the beginning, looks like it frees one up…provides opportunities to do more things…own more things…live a better life. 

Eventually, debt does exactly the opposite…limiting your options…constraining your life style…and exerting pressures that are unwelcome.

I sound like a preacher from the early part of the twentieth century…don’t I?  This is exactly what they used to say. 

Except this is just what we are seeing. 

Taking on debt in the early stages of financial leveraging does allow you to do some things that you cannot do without debt.  And, in these early stages, more debt can seemingly “buy” you out of difficulties. 

As we have seen, more debt then becomes the solution to the problems created by debt.  And, it works for a time.

The thing that people don’t see in continually using debt as a panacea for their problems is that the more and more debt they add to their balance sheets, the fewer and fewer options they have. 

Finally, the obligations created by the debt result in a reduction in the options leaving the debtor with very few choices…and, with most of the choices undesirable ones.

So, the government of Greece is faced with selling assets, and tightening up its budget even further, reducing government employment, and cutting social services. 

Portugal is now under the knife although it believed for a long time that it would escape the “cure”.

And, who are becoming the hard-nosed critics that are pushing these governments to take on more radical solutions?

Spain…and Italy…and Belgium….

Why?  Well, because these latter countries are now feeling the potential for the “contagion” to spread in the European continent. 

Spain, who seemed to be getting its house in order, observed a massive shift in voting on Sunday as the long ruling socialist party was basically removed from office.  There is great fear that the accounting in regional governments has been understating the debt of the country and this will have to be recognized and dealt with by the incoming governments.  Whoops!

Italy has a national debt equal to 120 percent of its gross domestic product and is experiencing sufficient economic dislocations that its future was called into question by a bond rating agency.

Belgium is now also coming up on the radar screens of the investment community.  The interest spread on 10-year Belgium debt over 10-year German debt jumped to a near term high on Monday.  Belgium, too, is looking anxiously at what Greece…and Portugal…do to avoid becoming one of the falling dominoes.

Yet there are still calls for these countries to increase their spending and create more debt to solve the employment and social services problems for the countries experiencing such suffering.

Foremost among those calling for more spending and more debt is the fundamentalist preacher Paul Krugman.  To him more debt seems to be the solution to any problem an economy faces. 

Yes, people are hurting, but, as he seeks to achieve a reduction in the “official” unemployment rate, some of us see the increase in the under-employment of our workforce throughout the past fifty years, the period of credit inflation, as the consequence of those, like Krugman, who profess the gospel of governmental deficit spending as the way to put people back to work in their legacy jobs.

Krugman criticizes those concerned with the massive debt levels achieved by  European governments…and by the United States government…and claims that those worrying about these debt levels are like some that are claiming that the end of the world is near.

Yet, Krugman, himself, sounds like a profit of doom, when he claims that the world as we know it will end if governments don’t increase spending and create more debt!

The problem we now face is one in which there seems to be very few choices left for us.  The amount of debt that people and nations have created is acting like a noose around our neck that is getting ever tighter.  We can do as Krugman suggests, and goose up stimulus spending some more creating more debt, but, as we have seen, the outcome of this would be to provide us with even fewer choices in the future.  The noose will just get tighter.

Eventually, the options will run out, leaving us no choices.

It seems to me that we must deal with the choices that are now available to us, even though they may not be very pleasant ones, and act in a way that will allow us more and better choices in the future.  If reducing the debt outstanding at this stage is the only way we to increase our options, then it seems as if this is the way we must go. 

Given the limited choices that are available to us at this time…I would hate to see our options become even more constricted.         

Time For Policymakers To Change Economic Models--Got That Portugal?

 Government policymakers just don’t seem to get it!

The economic philosophy governments have been using as the foundation of their budget and monetary policy since World War II isn’t working.  Governments need to change direction.

Most governments in the developed world need to do a “turnaround.”  But, turnarounds are only successful when the organizational model is changed.  Often this change requires a new management team.

For the past fifty or so years, the governmental leadership in most countries in the developed world have assumed, basically, the same economic philosophy.  And, as in the American case, both political parties have assumed the same fundamental economic model. 

This economic model got us to where we are, and, as in the case of most turnaround situations, the old model must be re-placed before the turnaround can be achieved. 

The financial markets understand this!

The governments involved don’t seem to get it…yet!

We have several “case studies” going at this time.  These “case studies” are called Ireland; Greece: and Portugal. 

Of course, the initial response of these governments when financial markets began to become skeptical of their performance was…the market behavior was driven by speculators…it is not our fault.

The next response was the attempt to bail out these countries.  And, what does a bailout achieve?  A bailout “buys” time with the assumption that given time these governments will be able to get through this period of turmoil. 

Not once do we hear of the possibility that these governments might be operating with a philosophy of government that doesn’t work!

And, the financial markets don’t respond positively to these efforts.  The leaders of these governments shrug their shoulders, get a puzzled look on their faces, and ask why the financial markets continue to punish them and their people.

Portugal cuts a deal with the European Union and…”Portugal was forced to pay a higher interest rate to raise  1.12bn in short-term debt on Wednesday, shortly after announcing a  78bn bail-out agreement.” (http://www.ft.com/cms/s/0/1cb74060-7642-11e0-b4f7-00144feabdc0.html#axzz1LTb4L5XR)

The financial markets seem to be saying…”Nothing has changed!”

Portugal, you still are living off the same model.  You have not really altered anything!

And, this dance has been going on since the beginning of 2010.  Yet, no one seems to think that they need to do anything differently.

Is Spain next?

That, of course, is the question that everyone is asking.  And, some analysts are saying that Spain has gotten the message.

The question is…has Spain really gotten the message?

If not, then, who is next?

As I wrote yesterday and the day before…some things have changed.  The world is in a period of transition.  The next fifty years is going to be remarkably unlike the past fifty years. 

Assumptions are going to have to change.  Leaders are going to have to adopt new models and new philosophies.  And, as we are seeing, the transition is not going to be easy.

The ultimate question relates to the United States…when, along the chain of dominoes, is its turn?

A major problem of the transition will be the speed at which it can occur. 

When a company gets into serious problems, a turnaround specialist can be brought in to change the operating model of the company, enforce discipline, and execute the new plan.  The new leader has substantial authority to make these changes.   

The owners, the shareholders, give the turnaround specialist the authority to make the changes needed.  And, the changes are imposed, not on the owners, but on the employees of the company.  

In democratic governments, executing such a turnaround is not as feasible because the people that do the voting are the people that will bear the brunt of the changes.   It is hard for people to vote in favor of their own pain. 

So, the transition will not be over until it is over.  The future of the governments in the developed world will probably be very much like the last sixteen months have been.  Band aids in order to keep things afloat…but a failure to really get to the heart of the problem.  We will continue to try and “muddle through.”  

Will the Financial Industry Dance Alone?

Last Wednesday, February 23, I argued that “The Music’s Begun Again..” (http://seekingalpha.com/article/254474-the-music-s-begun-again-time-to-start-dancing), and I fully believe that to be the case.

The economy has been growing. Since its low point in the second quarter of 2009, real Gross Domestic Product (GDP) has risen by 4.4%. The compound rate of growth has been approximately 0.7% per quarter which works out to an annual rate of roughly 2.9% per year. So the economic recovery continues.

However, capacity utilization of the manufacturing industries remains low, at 76.1% in its latest reading, substantially below the previous peak of around 82%. Even this peak was the lowest peak since the 1960s when the series was originally constructed.

My calculation for under-employment still hovers above 20%, again a high for the period following the 1960s

And, this, of course, raises the fear of a period of economic “stagflation” for the United States. Although the economy is recovery, one certainly could not apply the term “robust” to describe it.

From the credit side…more and more evidence comes in every day that the credit inflation that began in the 1960s continues. Although the world is going through a massive re-structuring, our leaders in the government continue to cry…more of the same…more of the same.

As with the last fifty years, credit inflation begins with the Federal government. The national debt is set to more than double over the next ten years and none of our leaders seem to be really seriously concerned about it.

For the debt to double over the next ten years, government debt would need to increase at a compound rate of about 7.2% per year during this time period. This is not too different from the compound rate at which the gross federal debt increased annually over the fifty years which began in January 1961.

During this period of time, the United States saw the biggest buildup in private financial leverage in the history of the country and also saw the biggest spurt of financial innovation ever to take place in the world.

Aided by advancements in information technology, the world of finance seemed to take on a life
of its own, separate from what was going on in the real economy. Employment in finance rose to approach 50% of all employment in the country as the number of financial institutions and the number of financial instruments traded ballooned.

We were getting a glimpse of the future.

Thanks to our leaders in Washington, D. C., and elsewhere, the “music” is playing again and, as we read daily, people have begun to dance once again in earnest. We read that auto sales are up because the auto companies have gotten auto finance to step up to the dance floor.

But, sovereigns are also leading the charge. Check out a lead in the Financial Times, “Sovereigns Turn to Pre-crisis Financial Wizardry” (http://www.ft.com/cms/s/0/53b445a0-4045-11e0-9140-00144feabdc0.html#axzz1FMM69iWr). It seems as if Portugal, and others, are getting back to “structured finance technology” with the use of Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) to help themselves climb their way out of the current crisis in the sovereign debt market.

What else?

Did I hear someone say that issues of mortgage-backed commercial real estate securities are back? They are, and in a fairly big way. (See http://dealbook.nytimes.com/2011/02/28/commercial-real-estate-breathes-life-into-a-moribund-market/?ref=business.) Morgan Stanley and Bank of America have recently completed a $1.55 billion deal while others have sold roughly $5 billion in mortgage-backed securities so far this year. And, more is on the way.

The quote I like…from Brian Lancaster, as securitization specialist at the Royal Bank of Scotland…”Things have going from vicious to virtuous.”

It seems that car loans and collateralized loan obligations “are showing signs of life.”

And, the trading platforms built on the latest technology are beginning to fight for “territory.” GFI, a London interdealer broker, launched a swaps trading platform in advance of what is being done in the United States. (See http://www.ft.com/cms/s/0/e107d684-4369-11e0-8f0d-00144feabdc0.html#axzz1FMM69iWr.) Whereas firms in the United States are having to wait on the Commodities Futures Trading Commission for the new rules and regulations forthcoming from the Dodd-Frank legislations, others are getting a head start on them.

Technology booms ahead…while the regulators scramble to catch up to 2008. The Financial Crisis Inquiry commission just released information that the Office of the Comptroller of the Currency questioned several aspects of how Citigroup valued certain troubled securities way back in February 2008: seems as if “weaknesses were noted.” The question concerns whether or not Citigroup should have reported this information in its public documents. (See http://www.ft.com/cms/s/0/3b673370-4399-11e0-b117-00144feabdc0.html#axzz1FMM69iWr.)

My point is that we are still re-hashing what went on or what went wrong two or more years ago. The world has moved on since then. Information technology has moved on since then.

Note the headline in the New York Times: “For South Korea, Internet at Blazing Speeds is Still Not Fast Enough.” (http://www.nytimes.com/2011/02/22/technology/22iht-broadband22.html?scp=1&sq=for%20south%20korea,%20internet%20at%20blazing%20speeds%20is%20still%20not%20fast%20enough&st=cse) South Korea is seeking to have every home in the country connected with speeds of one gigabit per second. And, this is for homes.

One should also read about the changes that are coming to banking for individuals and families in places like India and Africa! This, while American banking is constrained by archaic restrictions that is causing it to lag behind much of the rest of the world in terms of customer delivery.

And, if all this is happening for the consumer, what is taking place in the biggest, most sophisticated financial institutions? Anyone for some science fiction? And, we are just worried about “flash trading”?

Regulation always lags behind the private sector. In the credit inflation of the last fifty years, the gap widened considerably. But, in re-fighting the last war will Congress and the regulators drive more business “off shore”?

The music has begun to play again. Credit inflation is underway. Further financial innovation is right on its heals. The economic recovery is underway…but, I fear, finance is going to go its own way again.

The Obama Debt Machine

My estimate for the cumulative deficit over the next 10 years before the Obama budget was announced this week: in excess of $15 trillion.

My estimate for the cumulative deficit over the next 10 years after the Obama budget was announced this week: in excess of $15 trillion.

I see no leadership coming from this administration (or the Congress) to achieve anything different in the future. There is no evidence of the will to take leadership on the United States economic ship.

We have arrived at this position through the actions of both Republicans and Democrats. There is no evidence that this condition will change in the near future.

Everything is the same, with one exception: we are heading full steam into the 2012 presidential election.

Our history: We have had 50 years of credit inflation that has brought us to this position.

Forecast: credit inflation will continue for the foreseeable future.

Mr. Bernanke and the Fed Don't Know What is Going On!

Recently, the Federal Reserve has held 43 meetings around the country on the financing needs of small business. These meetings began February 3, 2010. Yesterday, Mr. Bernanke hosted a forum on small business lending at the offices of the Board of Governors of the Federal Reserve System in Washington, D. C.

The conclusion of all these meetings about the financing needs of small business?

“Mr. Bernanke’s remarks,” on Monday, “suggested that the Fed was not sure why lending had contracted.” (See “Small-Business Lending is Down, but Reasons Still Elude the Experts,” http://www.nytimes.com/2010/07/13/business/economy/13fed.html?_r=1&ref=business.)

Now there’s a confidence builder.

The Federal Reserve and its Chairman don’t know!

And, they held 43 meetings around the country plus the one on Monday and they haven’t a clue?

I have been writing about the decline in business lending at small banks (in fact at all banks) for 18 months now. Did the Fed just become aware of this fact early this year and are now just trying to understand what is going on?

Go back to your equations, Mr. Bernanke!

The Federal Reserve, the federal government, most economists like Mr. Bernanke, and politicians don’t understand debt. Their models don’t include debt and their thinking doesn’t include debt. They seem to believe that debt is something that can be issued without fear of having to pay it back and if one does get into trouble because of the debt that was issued in the past then they can just issue more debt and that will get them out of their problem.

The banks, particularly the 8,000 banks that are smaller in size than the largest 25 domestically chartered banks in the country, face three factors that are particularly troublesome. First, many of these banks have troubled assets on their balance sheets, especially commercial real estate loans that must be re-financed over the next 18 months or so. Debt can go bad and those that hold the debt must reduce their net worth, their capital, when they write the debt off.

Second, the business environment, both in the United States and in the rest of the world, is very uncertain. The future is very unpredictable and this makes balance sheets extremely fragile. This situation makes banks very unwilling to commit to create more debt on their balance sheets and it also makes businesses, very reluctant to add more debt to their balance sheets. In fact, there are plenty of incentives for these organizations to actually reduce the amount of debt on their balance sheets.

Third, banks need capital, not more debt. About one out of every eight banks in the United States is on the list of financial institutions that are facing severe problems as determined by the Federal Deposit Insurance Corporation. My guess is that maybe three other banks in eight in the United States need a capital infusion. And, with new financial reform legislation about to be enacted, commercial banks will be facing higher capital ratios and a more diligent examination of bank capital positions. Banks are going to be very careful about creating more additional debt that place them in a precarious position relative to the new capital requirements.

What is there not to understand?

And, the headlines read, “Bernanke in call for banks to lend more,” (See http://www.ft.com/cms/s/0/c40445b2-8e07-11df-b06f-00144feab49a.html.)

The Federal Reserve is keeping its target rate of interest between zero and 25 basis points and has injected $1.0 trillion of excess reserves into the banking system! This is to provide incentives to banks to lend.

And, the fundamentalist preacher Paul Krugman shouts at the top of his lungs about “The Feckless Fed” who is “dithering on the road to deflation.” (http://www.nytimes.com/2010/07/12/opinion/12krugman.html?ref=paulkrugman)

Krugman and his whole fundamentalist crowd not only believe that additional spending and more debt on the part of the government is needed at this time but that we need the forgiveness of consumer debt so that consumers can start borrowing and spending again, and we need the Fed to force commercial banks to support more borrowing on the part of businesses so that they can invest in inventories and plant and equipment. Then we inflate the real value of the debt away so that issuing debt is not so painful.

Isn’t this just the attitude that got us into the situation we are now in?

Unfortunately, this attitude seems to have prevailed in history as arrogant governments over time have lived off of issuing more and more debt and then inflating their way out of their responsibility to pay it off. On this issue see the books by Rogoff and Reinhart, “This Time is Different,” (http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff) and Niall Ferguson, “The Ascent of Money,” (http://seekingalpha.com/article/120595-a-financial-history-of-the-world).

There was another time, in the spring and summer of 2008, when Mr. Bernanke and the Federal Reserve didn’t seem to know what was going on. The consequence of this ignorance has been pretty severe.

To think that people can say that Mr. Bernanke and the Federal Reserve don’t know what is currently going on in the banking system they oversee and regulate is downright scary. The American people deserve better!

The Problem is "Out There"! It's China!

The quote of Stephen Covey that continues to resonate with me is "As long as you think the problem is out there, that very thought is the problem."

With all the fuss over the movement by the Chinese to allow the value of their currency to rise we hear, once again in the background, that the real problem is that the imbalances in the world are really a consequence of “an entrenched savings excess” in China. (See the article by George Magnus, “We Need More from China than a Flexible Renminbi,” http://www.ft.com/cms/s/0/4f19ced4-7d4a-11df-a0f5-00144feabdc0.html.)

There we have it!

And, the support for this theory goes as far as Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, who came up with this idea to provide Alan Greenspan with an excuse to keep interest rates excessively low in the earlier years of the 2000s.

The problem is “Out There”!

Those Chinese just save too much! Let them be like the Americans who reduced their savings to close to around one percent of disposable income earlier this decade. The Chinese bought a large proportion of the bonds going to finance the huge deficits of the United States government and this kept interest rates so low that the Federal Reserve could reduce their target interest rates to levels that created a bubble in the United States housing market.

As Magnus writes, the Chinese do have an unreformed rural sector, an immature social security and financial system and a one-child policy. But, China is transforming. It is just not doing it at the pace that the Western world would like it to in order to reduce or eliminate the imbalances that exist internationally.

The Chinese, however, are not going to change their social policy overnight. This is one of their “no-no’s”! They saw what happened in Russia and Eastern Europe as the social order unraveled when the Communist governments in these areas fell. They vowed to keep a lid on things, culturally, as China modernized. They will not back off this controlled approach as they move toward a state capitalism and a society that is more open to the world.

But, this is not what created the huge government budget deficits in the United States. The total amount of United States debt outstanding rose at a compound rate of over 7% from early in the 1960s through the end of 2008. This was not the fault of the Chinese!

Nor is it the solution to the low personal savings rates in the United States and the huge government budget deficits going forward. The personal savings rate in the United States stayed above 7% for most of the period between the late 1950s into the late 1980s. It exceeded 10% at times!

What eventually got to the American saver was the steady erosion of the real value of the savings put aside during this time. And, as the American saver moved into the 1990s, the personal savings rate began to fall and continued to fall into the 2000s. Consumer prices in the United States rose at a compound rate of around 4% from January 1961 through the summer of 2008. The purchasing power of a 1961 dollar dropped during this time to about $0.15.

If anything may accelerate the decline in the personal savings rate in China it may be the rising rate of inflation that is being experienced there. If the real value of savings takes a precipitous drop, even the rural Chinese may begin to adjust their behavior.

The real problem in this picture is the massive amount of United States debt that is outstanding. And, the amount of debt that is outstanding is the fault of no one but the United States. But, this problem puts a lot of pressure on other countries, especially on China.

China holds about 70 percent of its foreign exchange reserves in dollars, mostly in United States Treasury securities. This accumulation began in the 1990s and accelerated into the 2000s. The United States dollar was the reserve currency of the world and United States Treasury securities were the most secure investment around in terms of risk.

I remember working with a group from China in the early 1990s that represented Chinese pension funds. This discussion took place at the University of Pennsylvania. I was not teaching at the time, I was the president and CEO of a bank.

Chinese pension funds had a very large amount of money, yet because they could only invest on Mainland China they had limited capabilities of earning a decent return on their monies and were very limited in terms of their ability to diversify their investment holdings. This group was investigating investing pension fund monies “off-shore” and they were interested in foreign exchange risk and how this risk could be hedged. And, these discussions were a part of the general discussion going on in China at the time about investing more and more of their monies and international reserves in the rest of the world.

The point is that the early 1990s represented a time in which China was opening up and investigating how it could participate in global financial markets. Being very cautious, the Chinese were learning about how to diversify into the world but keep its risk exposure low both in term of credit risk and foreign exchange risk. I don’t see much of a change in this attitude at the present time.

Magnus mentions, in his article, that because of China’s creditor status it must play a role in helping to fix the global financial imbalances. Specifically, he argues that China cannot “back away” from these world imbalances—as the United States did in the 1920s and the Japanese did in the 1980s—because, in the end, backing away will neither help the world, or themselves.

My guess is that the Chinese will not “back away” and “dump” United States Treasury securities. This is one of the reasons why the Chinese do not want to see the value of the Yuan rise too rapidly. A “quicker revaluation would act as a stealth monetary tightening not only in China but also the US.” This is because it would have a negative effect on US equity prices and also result in higher US interest rates. (See the Lex column in the Financial Times: http://www.ft.com/cms/s/3/9db857ea-7d45-11df-a0f5-00144feabdc0.html.)

However, President Obama’s administration and the United States Congress continues to press for China to change the behavior of its government and the savings habits of its people. Yet, many of the major imbalances in the world today result from the undisciplined behavior of the United States over the past fifty years or so. The huge amounts of United States government debt outstanding are not the result of the government of China or the Chinese people. Why, then, should the Chinese bear the brunt of any adjustment that is to take place?

As long as the United States government and the people of the United States think the problem is out there, the problems and imbalances will not be resolved. The only one we can control is ourselves, so if anything is going to be accomplished, we are going to have to do it…not the Chinese.

China is Changing the World

Earlier, on March 25, I raised the question “Why Should China Change?” in my post, “Why Should China Change?” (http://seekingalpha.com/article/193689-why-should-china-change)
The thrust of the post was captured in the following:

“The world has changed and we in the United States have not accepted the fact.

Why should China change direction at this time?

China is growing stronger and stronger. The United States, and most of the rest of the west, is in a weakened state. The United States, and most of the rest of the west, has gone through a very severe financial crisis and the worst recession since the 1930s.”

The United States is still the number one power in the world, both economically and politically, but its relative position has changed. And we continue to see that in our relationship with China (and India and Brazil and Russia).

The current ‘high-level’ meeting in Beijing of representatives from China and the United States highlights the changing relations between the governments of China and the United States. As reported in the New York Times, “the opening session laid bare a recurring theme…the United States came with a long wish list for China…while China mostly wants to be left along…” (http://www.nytimes.com/2010/05/25/world/asia/25diplo.html?ref=business)

China is “turning into an economic superpower” according to the Times article and wants to continue along on its merry way. The United States, other than initiating an all out trade war, seems incapable of slowing down the Chinese economic machine or even getting the attention of the Chinese leaders.

Chinese President Hu Jintao did pledge to continue reform of China’s currency, but then repeated the standard operating response: “China will continue to steadily push forward reform of the renminbi exchange-rate formation mechanism in a self-initiated, controllable and gradual manner.” That is, we will change things when we want to change things and no sooner.

Secretary of the Treasury Geithner graciously replied: “We welcome the fact that China’s leaders have recognized that reform of the exchange rate is an important part of their broader reform agenda.” What else could he say?

The United States, and most of the rest of the west, is in a weakened state. But, this weakened state goes beyond the short-run. The United States is facing longer run, structural problems it must deal with. Economic growth and financial strength are important factors in world economic power. However, when a nation extends itself and stretches itself too far due to over-commitment and over-leverage, thinking it can do too much, it exposes itself to other nations that are not in a similar position.

It is the United States, the number one world power that is asking China to change. China is in a position where it does not feel the need to cave into the American requests. China is strong and disciplined. The United States is strong, but undisciplined. Therein lies the difference.

And, the (supposed) allies of the United States are little or no help. Europe is attempting to resolve the problems it created for itself. As a consequence it is slowly fading into the background. The G-7 group of nations, the United States, Canada, France, Germany, Italy, Japan, and England, is losing relevance in the world. The G-20 includes the seven, but more importantly includes several emerging nations that are more strategic to the future than is the “old boyz club” from Europe.

De-emphasize the G-7 and raise up the G-20!

The ultimate problem of the United States is its lack of discipline. For the past fifty years or so, the United States has lived for “the short-run” because, we have been told, that “in the long-run we are all dead.” The economic policy of the United States has been designed to combat short-run increases in unemployment with a constant pressure to achieve high rates of economic growth. But, this creates an inflationary bias in economic policy. Because of this the United States has seen the purchasing power of its dollar drop 85% from January 1961 until the present time, underemployment has grown to about 20% of the working age population and the capacity utilization of its industrial base has declined to less than 75% at present (but rose to only slightly more than 80% in its most recent cyclical peak).

These are not signs of economic strength. Furthermore, the value of the dollar over the past forty years has dropped by approximately 35%. Huge amounts of United States debt, both public and private, have been financed “off shore”. These developments do not put America in a very strong bargaining position.

China thinks in decades. The United States thinks in terms of the next election. Discipline does matter.

There are still many economists in the United States who argue that the government must spend more and create more debt to get the country going once again. Their fundamentalist view of how the world works blinds them to the fact that it was the loss of fiscal discipline, the exorbitant creation of huge amounts of government debt and the subsequent credit inflation that this encouraged, that put the United States into the position it now finds itself.

More spending and more debt are not going to make the situation any better. I examined this issue in my May 13 post “Government Deficits and Economic Activity”: http://seekingalpha.com/article/204948-government-deficits-and-economic-activity. My basic conclusion was that in the present situation where the Federal Reserve has pumped so much liquidity into the banks that big banks and big companies can play games in world financial markets and cause major problems for areas like the euro-zone. The continued creation of deficits and more government debt is not going to solve this problem for Europe…or the United States.

Until it gets it act under control and in order, the United States will be the one asking China to change the way it does things. China, given the present circumstances, will continue to do things in their own interest and at their own speed. In addition, it is my guess that other, emerging nations will begin to exert themselves in similar ways. And, the United States will not be in a position to resist their efforts.

As I said earlier, “The world has changed and we in the United States have not accepted that fact.”

All we can really control is ourselves and if we fail to do that we give up the chance to influence others.

Government Deficits and Economic Activity

Something is different this time. There is high unemployment, about 10% in the United States, and the politicians are crying that the political issue is jobs, jobs, jobs.

The resultant policy should be to increase government spending and increase fiscal deficits. Right?

Doesn’t seem to be.

What’s going on?

The international financial community is in charge this time and they are exerting their will.

The international financial community is doing very well, thank you! Central banks have subsidized the big financial institutions and big financial players with their “Quantitative Easing.” These large institutions have plenty of money and so they are not running scared. And, this money can appear and disappear all over the world without being controlled. And, they are using the money. See “The Banks’ Perfect Quarter” at http://seekingalpha.com/article/204617-the-banks-perfect-quarter.

In the past, the big institutions like JPMorgan, Goldman Sachs, and Bank of America and so on would have to wait until the Federal Reserve eased monetary policy by providing the financial markets with sufficient liquidity. Then their performance would begin to increase as the economic recovery progressed. But, even then, they never reached the heights that they are attaining now.

In addition, as the Federal Reserve began to stimulate the economy, it kept interest rates in line. That is, the Fed kept interest rates low, but did not let interest rate spreads get excessively “out-of-line” because that might cause the Fed to lose the sense of the financial markets they were operating within. The idea was to loosen but keep the market “taut” so that it could continue to monitor where market pressures were coming from.

The concept of “taut” came from sailing: if I am sailing a boat and I have a small craft attached to the boat with a rope, the idea is to keep the rope “taut” but not too “tight” or not too “loose.” The reason being is that if the rope is “taut” you know where the small craft is. If the rope is too “loose” you do not know where the small craft is; if the rope is too “tight” the rope can snap if the small craft is subject to another force. You want the rope attachment to maintain just the right amount of pressure, so that you know where the small boat is but not too tight so that the small boat breaks away from your ship and you lose it.

But, keeping money markets taut did not provide many trading opportunities, at least, not trading opportunities like the ones that exist today.

Today large financial institutions, internationally, are facing a bonanza market for raking in huge profits. The central banks have provided them with this opportunity to trade and it is almost risk free. And, the central banks have let the markets know that this situation will exist for an extended period of time! Wow!

Putting this in prospective, however, we see that the European Union and the governments of the U. K. and the U. S. have, over the past 50 years, created an inflationary environment that has created massive financial institutions that thrive on trading, not on what was formerly known as banking. These governmental institutions have, themselves, led the move toward financial innovation through the creations of Fannie Mae, Freddie Mac, Ginnie Mae, and the Mortgage-backed securities. These were not private sector initiatives.

The incentives that existed in this world of credit inflation promoted trading and arbitrage and further innovation. Forget the fact that the profits that come from trading activities is a “zero-sum” game in which there is someone that loses exactly what someone else wins.

Trading worked for the “big guys” and they learned how to do it very well.

That is exactly what is going on right now. The large, international financial interests are scouring the world in search of “targets”. And, no one is a better target than a government that has lived way beyond its means for many years. But, governments like these are crying “foul” because they feel they are being taken advantage of even though they were the ones that got their country in the position it is in through long periods of undisciplined, profligate behavior.

What is different this time is that these huge, financial giants are being subsidized by the central banks and they are traveling the world to use what has been given them.

I believe that we will look back on this time and say that the Obama Administration was perhaps the largest contributor to an unequal distribution of income the world has seen.

How can I say this? Well, we are seeing a major bifurcation of the world today, more so than the one that existed relative to the Bush 43 tax cuts. Major amounts of wealth are being created in most major financial markets. And, the traders love volatility. These people are getting everything they want and need. So are other many firms in other areas or sectors of the market.

But, those unemployed are not building up their wealth, and those people who are underemployed are not building up their wealth, and those individuals that are foreclosed on are not building up their wealth, and the small businesses that are going into bankruptcy or cannot get a loan from their local bank are not building up their wealth.

Seems a little unfair, doesn’t it?

The Federal Reserve states that it is keeping interest rates low, waiting for the economic pickup to spread into the distressed sectors of the economy. The longer the Fed holds to this stance and explains it’s reasoning in terms recovering economic growth, the longer I look for other reasons for such a policy.

My conclusion: there are many banks that are smaller than the biggest 25 that are in deep trouble. In addition, there are many businesses that are in deep trouble that might even put these “less than giant” banks in more trouble. Also, the Fed quickly encouraged the European Central Bank to move to “Quantitative Easing” and then supported this move by re-opening the swap arrangements the Fed had with other central banks. The rumor is that this re-opening of the swap window will postpone even further the “extended period” of time that the Fed will keep its target for the Federal Funds rate at its current level. Seems like we have a massive “solvency problem” in the world and not just in the United States.

What is different now? Large financial institutions around the world have enormous amounts of funds they can deal in and excessively large interest rates spreads to work with and large amounts of market volatility to trade off of and a promise by the central banks that interest rate risk will not be a problem. Given this ammunition, governments that are or have been undisciplined in running their fiscal affairs, are “sitting ducks” for these traders.

So governments are being forced to reduce spending and not increase it, to reduce deficits and not increase them. To get re-elected politicians may want to focus on jobs, jobs, jobs and health care programs and other social welfare initiatives. However, they may not be able to do that this time!

"Sharing the Pain: Dealing with Fiscal Deficits"

Over the past week or so, I have spent a lot of time on sovereign debt and the problems being faced by various nations across this planet with respect to their budget deficits. I suggest the article “Sharing the Pain” in the March 4, 2010 edition of The Economist as a good compilation of issues relating to the situation many countries are now facing. This piece is contained in the briefing, “Dealing with Fiscal Deficits,” http://www.economist.com/business-finance/PrinterFriendly.cfm?story_id=15604130.

We can separate the discussion into three categories: the problem, the pain, and the pragmatic response.

First, the problem. History shows us that when economies slow down, budget deficits appear or widen. Revenue growth declines as the needs to increase outlays rises. Put this general movement on top of decades of undisciplined management of government budgets and you can get “one hell of a problem”

The Economist article states that “deficits in several countries have increased so much and so fast during the economic crisis of the past 18 months or so that it is generally agreed that remedial action will be needed in the medium term. Deficits of 10% or more of GDP cannot be sustained for long, especially when nervous markets drive up the cost of servicing the growing debt.” It continues, “when markets do lose confidence in a government’s fiscal rectitude, a crisis can arise quite quickly, forcing countries into painful political decisions.”

Second, the pain. History shows, according to Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, that it is highly unlikely that the “rich countries” of the world will experience a burst of rapid and prolonged growth. “Sluggish growth is more likely” and “the evidence offers little support for the view that countries simply grow out of their debts.”

“So, short of debt default or implicit default via inflation, that leaves just two other ways of closing the deficit. Spending must be cut or taxpayers must pay more.” Hence the pain!

Here we can point to the situation in Greece where much of the effort to return some fiscal discipline to the country is falling on cuts in government wages and in social benefits. This has resulted in substantial personal retrenchment and civil unrest. Today we read of a second general strike in the nation that closed all public services. See, “New Strike Paralyzes Greece,” http://www.nytimes.com/2010/03/12/world/europe/12greece.html?ref=business.

The deficits are so large in most of the affected countries that minor adjustments to spending or taxes will have little or no impact. The budget adjustments that must be made are quite substantial: hence the depth and breadth of the pain.

In recessions that are relatively minor, government monetary and fiscal stimulus seems to restore economic growth, thereby rectifying the situation and minimizing the pain. But, in a recession of the magnitude of the Great Recession the government does not seem to be able to “buy” itself out of the trouble. Hence, the spread of the pain.

Furthermore, there is an added difficulty that enters the picture in the more extreme cases. Those that are more affected by the recession and by the adjustments that need to be made in government budgets may come to see the changes as a break in the “social contract” of the country. This government that saw to their welfare, put them to work, and sustained them through the minor crises of the past, now seems to be abandoning them. And, for whom? The international financial community!

Obviously, if we get into this state of affairs, the emotions can become quite high, as in Greece.

This leads us into the third category which has to do with what government can do in such situations. The problem with the situation brought on by large budget deficits and a growing national debt is that there are no good solutions. Anything the government does in an attempt to get the budget under control while encouraging the economy to recover hurts someone.

This is why governments must be very pragmatic in what they propose. Doctrinaire approaches just do not seem to work. There are only two suggestions from the historical perspective that seem to have borne some fruit in the past. The first is that there needs to be some “social cohesion” in the country to achieve some success in the effort to get the country’s budget under control. The second is that governments “should focus on spending cuts rather than tax increases.”

The article in The Economist points to two instances where successful government tightening has taken place in recent memory: Sweden and Canada. In both cases the crisis in the country became acute enough and the ruling governments acted in a sufficiently pragmatic way so that voters finally got behind the efforts. However, this social cohesion was not always achieved on the first attempt.

Some of the social cohesion can be gained by raising some taxes, especially on the “better off”. This may be the “quid pro quo” for the less well off to accept the other things that need to be done. The downside to this is always that the “better off” have more escape hatches that will allow them to avoid any imposition of taxes they feel are excessive. And, many countries in the past twenty years or so have built up reputations as “low tax havens” to attract business. Ireland, for example, lowered its corporate tax rate to just 12.5% and is very reluctant to increase this and harm the climate they benefitted so much from. If taxes go up on these people and businesses, they can be very mobile and move to less oppression environments. Also, tax evasion can be a huge problem especially against sales or value-added taxes.

So, the burden of fiscal tightening falls on the spending side but this is not an easy road either. And, when one looks at the “big” targets for cuts, good arguments for not making cuts abound. Military spending is not a major item in many countries needing budget cuts, but it is in the United States. Here, there are two wars being fought and the need to maintain the world’s “top” military machine and keep it current through research and development makes the budget almost non-touchable.

The next major item that comes up on the list to consider is government employment. Over the last 50-60 years, governments throughout the world have exploded in terms of providing employment. Over the last several years the rate of government hiring has gone up, especially in the United States, in an effort to deal with the financial crisis and the Great Recession. Is it realistic to think that governments will shrink in size or in terms of payroll expenses? This is where Greece and Ireland and Portugal and Spain have promised to do something. And, of course, this is where much of the civil unrest has come from.

Next, social programs, a huge item in many government budgets and the primary cause of the expansion of government budgets in the post World War II period. (For more on this see Niall Ferguson’s book “The Ascent of Money: A Financial History of the World.) The Economist suggests that one area that can be rationalized here is the pension system in these countries.
And, there are other ideas available.

The thing the article (implicitly) points out is that the way out of the fiscal dilemma is not easy. But, I suggest three further things that need to be considered. First, leadership. The countries facing the problems discussed here need to have someone out in front that is understood and trusted. The only way out of this situation is pragmatic: not progressive, not conservative, not liberal, not socialist, or any other dogmatic approach. But, to achieve the “social cohesion” necessary for success, there must be leaders that draw people together.

Second, the proposed solutions cannot just force people back into the way things were. One reason for the depth and breadth of the Great Recession is the changing structure of the society and culture. (For more on this see my post, http://seekingalpha.com/article/192713-the-trouble-with-recovery.) If this is true, then the leadership must be forward-looking rather than serving just entrenched interests.

Finally, this will not be easy. As The Economist article closes: “There are many battles over deficits to come. Well chosen policies that foster growth may make them less fierce. They may be bloody even so.” Amen.