Struggling With A Great Contraction

Martin Wolf of the Financial Times recently returned from vacation.   It is interesting to see where this “top” economic commentator stands after taking off from his weekly writing for a full month. 

His view on his return: The major economies of the world are “Struggling with a great contraction.” (http://www.ft.com/intl/cms/s/0/079ff1c6-d2f0-11e0-9aae-00144feab49a.html#axzz1Wbu6HxQ0) His concern is not with the possibility of a “double dip” recession, but with something more sustained.  He asks, “How much deeper and longer this recession or ‘contraction’ might become.  The point is that, by the second quarter of 2011, none of the six largest high-income economies had surpassed output levels reached before the crisis hit, in 2008.”  Hence, the great contraction.

The turmoil in financial markets that was seen in August, he contends, tells us, first, that “the debt-encumbered economies of the high income-countries remain extremely fragile”; second, “investors have next to no confidence in the ability of policymakers to resolve the difficulties”; and third, “in a time of high anxiety, investors prefer what are seen as the least risky assets, namely, the bonds of the most highly-rated governments, regardless of their defects, together with gold.”

A pretty succinct summary…what?

There is too much debt around which means that all the efforts that governments are making to get the economy moving again face the up-hill battle of over-coming the efforts people, businesses, and local and regional governments are making to reduce their debts. (http://seekingalpha.com/article/285172-when-debt-loads-become-too-large)

While national governments deal with their own excessive debt loads and deficits, their central banks have responded with undifferentiated policies to flood banks and financial markets with sufficient liquidity in order to provide time for banks, consumers, businesses, and local and regional governments to “work out” their positions as smoothly as possible. (http://seekingalpha.com/article/290416-quantitative-easing-theory-need-not-apply)

The hope seems to be that “time will heal all things.”

Whereas there is too much deb around, there is too little leadership.  I will quote Wolf on this: “In neither the US nor the eurozone, does the politician supposedly in charge—Barack Obama, the US president, and Angela Merkel, Germany’s chancellor—appear to be much more than a bystander of unfolding events.” (http://seekingalpha.com/article/285658-if-the-economy-is-a-football-game-we-need-new-strategies)

If there are no leaders, then policy decisions tend to be postponed as long possible, and then, when a result is finally forthcoming, the outcome is more like a camel, something that appears to be an inconsistent piecing together of incompatible parts.

And, this is supposed to produce confidence?  To quote Mr. Wolf again: “Those who fear deflation buy bonds; those that fear inflation buy gold; those who cannot decide buy both.” 

The point being that it is not a time to commit to the future, to invest in real assets or investments.  Hence, the economies of the “high-income” nations stagnate, unemployment remains excessive, and public confidence continues to be depressed.   

Such a general condition argues for a continuance of the economic malaise and not a more robust recovery any time soon.  Hence, the great contraction.

Mr. Wolf still has hope: “Yet all is not lost.  In particular the US and German governments retain substantial fiscal room for manoeuvre…the central banks have not used up their ammunition.”  

But, this hope is based on the existence that leadership in these governments will arise.  Policy makers will come to their senses: “The key, surely, is not to approach a situation as dangerous as this one within the boundaries of conventional thinking.”  

Therein lies the problem.  Mr. Wolf is looking for the hero to ride in on her/his white stallion and provide the leadership necessary to clean up the mess and get things going forward on the right path. 

He has just argued, however, that that leadership does not seem to exist.  So, where is the leadership going to come from?

With all the debt loads outstanding, just how much can be done to overcome the drag on the spending and the economy coming from the efforts of many to de-leverage. 

The Federal Reserve and the European Central Bank have flooded the world with liquidity.  Their effort here is to give banks, consumers, businesses, and governments time to work out their bad debts.  This also provides time for banks and others to fail, consolidate, and/or raise capital without causing major disruptions to the whole financial system. Banks in the United States continue to fail, banks in the US and Europe continue to consolidate, and banks in the US and Europe continue to raise capital. 

Since debt seems to be the major problem here, the only other major suggestion that has been made that could relieve the credit crisis is to relieve debtors of some of their debt burden.  This would mean that some parts of the debt would need to be written off.  Whereas many have suggested such a program, the difficulty of creating such a problem is in the details and no one seems to have come up with any acceptable details of such a program.  Some have suggested that inventing such a workable and just program of debt reduction is nearly impossible.

So, we are back to square one…there are no “good” options.  And, when there are no “good” options, potential leaders tend to disappear into the woodwork.  It is easy to “lead” when you can create credit without end and encourage everyone to own a house and attempt to guarantee people jobs for their lifetime.  But, real leaders are the ones that can stand up and lead when there are no good options.

It is just that few want to be “out front” when none of the options are nice and comfortable.      

Housing and the Economic Expansion

The Great Recession is over. Remember, the recession ended in June 2009 getting close to two years ago.

To many, it sure doesn’t feel like it. Since the second quarter of 2009, over the last six quarters, real GDP has grown by 4.5%. The average year-over-year growth rate for the five quarters since the recession ended is 2.3%. This is way below historical experience.

The reason: housing usually leads the economy into a recession, and, housing usually leads the economy out of the recession.

Not so this time.

And, this is why we are in the mess we are in. Housing is not going to rebound any time soon.

For one thing, banks and thrift institutions (what are they?) really don’t want to provide financing for mortgages. They really don’t want to hold mortgages. For another, the mess with Fannie Mae and Freddie Mac is so uncertain and confused and uncomfortable that they want to have as little to do with mortgages as possible.

In order to understand this I had to go through the mortgage process myself last year. I have no problem getting a loan. I went to the bank where I do most of my business and asked about getting a loan. Sure, they said, and arranged a meeting with the mortgage banker they do business with who approved my loan and all of a sudden my mortgage is with Fannie Mae and I am making payments to the mortgage servicing subsidiary of a major bank somewhere far to the west of Philadelphia. Never in my life have I had a mortgage in the hands of Fannie Mae. Oh, well…

This is, to me, the paradigm of the banking industry. Banks, especially smaller banks, don’t want to hold mortgages on their balance sheets. And, this is just what we wanted it. In the late 1960s and early 1970s when I was in Washington, D. C. and we were creating the mortgage-backed security the idea was to get mortgages out of the commercial banks and thrift institutions and into the hands pension funds and insurance companies who needed long-term assets. Then the depository institutions could lend more.

Why did we create the mortgage-backed security? So, politicians could get re-elected. If more families in America could own their own home through things the government did, then they would be more likely to vote back into office the people that were responsible for their owning their own home.

Likewise with lower income housing, after all, the number one job of politicians is to get re-elected.

So, the United States government got into the business of inflating the housing sector so that
more-and-more American families could own their own home.

How successful was this? Well, in the early 1970s, no mortgages were traded on any capital market in the world. Michael Lewis’ incredible book, “Liar’s Poker”, related to the middle- to late-1980s, and was a large part about the market for mortgage-backed securities which had become the largest component of the capital markets. And, as they say, the rest is history.

But, housing was always the fulcrum on which economic cycles turned. The basic reason was that housing construction could easily be started up and stopped and started up again. The longest post-World War II recessions (before the Great Recession) were one year and 4 months in length and there were only two of them. In order to slow down economic growth and fight inflation, the Federal Reserve would raise interest rates and this would cause mortgage lending to slow down or stop for a time. After sufficient time the Federal Reserve would lower rates once again, mortgage lending would pick up and economic growth would expand once more.

Business lending always lagged the movements in mortgage lending.

It seems as if mortgage lending and housing construction has tapped out. The credit inflation of the housing industry of the last sixty years cause sufficient dislocations that it is going to take a while for the United States economy to re-structure so that the housing industry can pick up once again.

Financial institutions are still facing major, major problems related to the housing industry, not counting the major problems relating to commercial real estate. Commercial banks are slowly accepting the fact that they are going to have to buy back many troubled mortgages, especially mortgages that were sold to Fannie Mae and Freddie Mac. Bank of America has paid back a little, but more is expected. JPMorgan Chase also has a large exposure. What is the hole? Standard & Poor’s has estimated that banks will have to buy back around $60 billion in bad mortgage loans which they sold to others. Some estimates place this total as high as $150 billion. (http://dealbook.nytimes.com/2011/02/09/banks-could-face-60-billion-tab-on-bad-loans/?ref=todayspaper)

In addition to this, the latest statistics indicate that more than one in four mortgages outstanding are underwater, that is, these mortgages are on homes that have a market value less than the amount owed on the mortgage. Homeowners facing this situation are still walking away from their obligations. Who picks up the difference? And, housing prices still remain weak in many markets within the nation.

About one in four individuals in America are either unemployed or under-employed. Savings can only go so far in keeping up payments on the home mortgage. And, 30 states have run out of money in their unemployment trust funds and are borrowing from the United State government to cover the shortfall. How long is this going to continue to be covered?

Manufacturing businesses are only running at three-fourths of capacity, up slightly from historical lows. With so much idle capacity, businesses are not interested in purchasing more capital and hiring more workers to create jobs and incomes. Purchasing seems to be very skewed…basics and luxuries…and computers. This is not very encouraging for a near term pickup.

With little or no housing pickup, expectations for a strong business pickup are pretty low. And, the Fed’s QE2 is not going to have a major impact on the reduction in unemployment or under-employment!

People have one way out of this dilemma in the short run. Inflation!

Inflation may not put the people back into a job, but it can cause housing prices to rise and this can buy them out of the underwater situation. Still, commercial banks, I believe, want to have as little to do with holding mortgages as possible. And, if they originate, or get their mortgage banking friends to originate mortgages, who are they going to sell them to?

Even so, all this will just postpone the housing problem until another time, just like we have done for the last sixty years. We just see high levels of under-employment, low levels of capacity utilization, high amounts of inflation, more debt and more debt, and where does this end?

The Great Recession is over. However, the Great Recovery is nowhere in sight.

Interpreting the Recent Behavior of the Monetary Aggregates

All research seems to indicate that, over time and everywhere, inflation is a monetary phenomenon. If this is true then we need to take some account of monetary aggregates in the short run so as to better understand what is taking place and what the current situation implies for the future. Also, it seems as if interest in the monetary aggregates might be surfacing once again. (See my post, http://seekingalpha.com/article/217598-monetary-targets-a-fresh-take.)

Let’s look at the current situation beginning with the quarter that followed the start of the Great Recession, the first quarter of 2008. If one looks at the year-over-year growth rate of the M2 measure of the money stock, things look relatively benign. Growth remained modestly above 6% through the first nine months of

the recession, but rose to over 10% by early 2009. However, this did not signal that monetary policy was working even though the end of the recession has been dated as July 2009. In fact, in looking at all the other monetary measures one could discern some troubling behavior that might indicate a deeper recession and a very slow recovery.

For example, the behavior of this measure certainly did not track the performance of bank reserves or the monetary base. Through the first nine months of 2008, total reserves in the banking system averaged a little under 5%, year-over-year. In the second quarter of 2009, the rate of increase was over 1,800%! The monetary base performed in a similar fashion. For the first nine months of 2008, the monetary base grew around 2.5% year-over-year. This increased to more than 100% in the beginning of 2009.

Of course, we know the reason why these reserve aggregates grew so rapidly while the money stock measure picked up only modestly. Excess reserves in the banking system went from less than $2 billion in the second quarter of 2008 to over $800 billion in the first quarter of 2009. The Federal Reserve was supplying funds to the banking system. However, the banking system was just holding onto them!

There was another movement within the monetary aggregates that was also of interest during this time period. The growth of required reserves, the reserves the banks had to hold behind their deposits, rose throughout 2008 but not nearly at the pace of total reserves or the monetary base. Note, however, that the growth rate of the non-M1 component of M2 remained relatively constant throughout 2008 and 2009 which indicated that a lot must be happening within the M1 measure of the money stock.

Here we see that through the first six months of 2008, the M1 money stock hardly grew at all. However, starting in September 2008 which marked the beginning of the financial crisis, this measure took off and was growing by almost 17% in early 2009. Growth was mainly in the demand deposit component of M1.

Two things were happening here. First, interest rates fell dramatically in 2009; keeping money in interest bearing accounts at banks and thrift institutions did not make much sense. Second, as people lost jobs and the economic environment became more and more uncertain, people and businesses moved assets from less liquid vehicles to transaction balances (demand deposits and other checkable deposits) so as to be able to buy necessities and to pay bills.

It is very important to identify this behavior because it explains a lot about how people were using their wealth at this time and what kinds of pressures they were feeling. This information helps us understand why the economy is performing the way it is and what implications this kind of behavior has for the future.

Taking this analysis into 2010 we see that the growth rate of M2 drops off drastically to less than 2%, yet M1 continued to incease at rates in excess of 5%. This is because people continued to transfer funds from interest-bearing accounts into transaction accounts. This is supported by the information on the growth rate in required reserves which was still above 10%. Note, that because of this the Federal Reserve has needed to continue to supply more reserves into the banking system to handle this increase in required reserves yet maintain the extraordinarly high levels of excess reserves in the banking system, reaching more than $1.0 trillion in the fourth quarter of 2009.

What this indicates to me is that the behavior of people and of the business community has not changed much over the past two and one-half years. People are still scared. Because of the tepid economy, high unemployment, and the uncertainty about the future, economic units still prefer to put their funds into transaction accounts so that they can facilitate their needed expenditures. This kind of information does not give one much confidence.

Furthermore, this kind of behavior is not what is seen before economic recoveries pick up steam. And, with the M2 measure of the money stock growing below 2%, year-over-year, one can only conclude that money is not entering the economy in a way that will stimulate future business expansion. Only when bank loans begin to increase and, consequently, M2 begins to expand more rapidly, then, maybe, confidence in the recovery will grow.

To me, monetary information is very valuable in trying to understand what is happening in the economy and where the economy might be going. However, the analysis of monetary aggregates must not be the kind of “cookie-cutter” analysis done in the 1970s and 1980s. Good analysis of the monetary aggregates is very complex and must include some historical analysis with it.

A Walk on the Supply Side

Keynesian demand-side economics still rules the minds of the policy makers in Washington, D. C. Their actions and their analysis continually point to their focus on aggregate demand and the “green shoots” that are expected to accompany an economic recovery based on the stimulus of spending.

For over a year I have been arguing that more attention needs to be given to the supply side of the equation. Yes, the growth rate of real GDP has been going down and the rate of employment has been going up. But, the rate of inflation, as measured by the rate of increase of the GDP price deflator has not declined since the fourth quarter of 2007. If it were just a demand side problem, this would not be the case.

I focus on the rate of increase in the GDP implicit deflator because of some of the measurement problems associated with the Consumer Price Index, such as the treatment of housing expenses and energy. Certainly, the CPI should be watched, but in dealing with economic aggregates, I prefer the former.

My point has been that if the problems in the economy were all tied to a substantial fall in aggregate demand, then there should have been a more substantial lessening in the rate of price increases. Consequently, my argument has been that something has happened on the supply side of the economy for the numbers to have been reported as they have been.

I would like to point to two areas of the United States economy that indicates that the problems of recovery may be more difficult to overcome than if the dislocation in the economy were just one of inadequate aggregate demand. The first area is that of industrial output; the second area is the labor market.

In terms of the industrial base of the economy I would like to focus upon industrial production and the industrial utilization of capacity. Industrial production has been declining steadily since the start of the recession in December 2007. At that time, industrial production was growing at about a 2.0% year-over-year rate of growth. By April 2008 the year-over-year rate of growth had become negative. The figures for 2009 are
January -10.8
February -11.3
March -12.6
April -12.7
May -13.4

This certainly shows a continuing weakening in the economy. However, taken by itself I don’t think that it carries more meaning than does the decline in the rate of growth of real GDP which has been declining as well.

Combine this performance with the figures on capacity utilization and one gets a different picture. As expected, total industry capacity utilization has dropped substantially in this recession. In December 2007, the figure stood at a little over 80.0%. In May 2009, capacity utilization had fallen to about 68.0%. This is the largest 18 month decline in the post-World War II period.

But, this is not all. The peak in capacity utilization in the past ten years was only slightly more than the December 2007 figure. But, this peak of the last ten years was substantially below the level of capacity utilization for most of the 1990s which was below the peak utilization in the 1970s which was below the peak utilization in the 1960s. That is, it appears as if we have been using less and less of our capacity on a regular basis since the 1960s.

The structure of our industrial base is changing. We can see that in autos, in steel, and in many other parts of our manufacturing base. It appears as if the weakness in our economy is composed of two things: first the cyclical swing in business; but this weakness is on top of a secular decline in our productive ability. The economy is in the process of restructuring!

This shift is also showing up in labor markets. The civilian participation rate in the labor force for the United States rose from the late 1960s into the 1990s when it peaked a little above 67.0%. The civilian participation rate has declined since late 2000 and has remained below 66.2% since 2004. In terms of the number of people who are not participating in the labor market any more, this represents a large number. People have left the labor force in the last five or six years and this trend has, of course, been exacerbated by the recession. Over the past forty years the rise in the participation rate has slowed down or stopped during recessions, but at no time did it decline as it did in the in the past six years.

Of further interest, the Labor Department reported that separations from jobs in April remained relatively constant as they have for the past two years, but the rate of hiring continued to be quite low. In early 2008 the percentage of the labor force that were separated from their jobs was about equal to the percentage that were being hired. Since then separations have exceeded hirings, as might be expected, causing the unemployment rate to rise.

In terms of those that were separated from their jobs, there was a dramatic shift between those that quit their jobs and those that were laid off or discharged from their jobs. The percentage of layoffs and discharges rose dramatically from April 2008 to April 2009 whereas quit levels dropped substantially. That is, although separation rates did not change much at all during this time, the composition of those being separated from their positions experienced a tremendous shift. This is an indication that there is a structural shift in what is happening in the labor markets.

This information leads me to believe that there is a substantial restructuring taking place in the United States economy. And, a structural shift is a supply side issue and not a demand side issue. In fact, demand side responses can just make a bad situation worse by trying to force people back into positions that companies and industries are attempting to eliminate because the world has changed.

The figures on industrial production and capacity utilization seem to indicate that industry is changing and the numbers from the labor market reinforce that conclusion. Pumping up aggregate demand is an attempt to stop this restructuring or, at least, slow it down.

The problem that policymakers’ face is that they, or we, do not know what the new industrial structure is going to look like. It is impossible for anyone to know. People can make guesses, but that is all they are—guesses. And, in situations like this, it is more likely that the guesses will be wrong rather than being right. It’s just that the future is unknown. The need for the United States economy to restructure just adds another “unknown, unknown” to our list of “known unknowns” and “unknown, unknowns.” My guess is that this restructuring is going to take some time and could be sidetracked by huge government deficits and a supportive monetary policy.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bail Out or Wimp Out?

The Obama administration is going to have to make a decision soon…is it going to try and commit to a program that will actually do something for banking and other financial institutions or is it going to extend the waffling on this issue that began last fall?

People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.

All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.

Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.

In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.

And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.

The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.

My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.

The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.

There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.

Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?

Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.

Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.

My question to this is…aren’t they bankrupt…kaput…out-of-business…already?

The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?

This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”

In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!

Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?

A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.

Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.

The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.

So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!

How Effective Might the Stimulus Plan Be?

The Obama stimulus plan totals $825 billion. This plan is a combination of spending plans and tax relief. The dollar amount needed to be large, we are told, because the American economy is tanking and a lot of effort needs to be exerted to stop the decline and re-establish positive growth once again. Of course, we were told similar things when the legislation relating to the TARP was introduced. We have also been told that the number needs to be large because we don’t really know how much stimulus will be needed to jump-start the economy so we need to throw a lot of cash at the problem in hopes that the effort will be large enough to do the job.

The problem is…how much extra spending will $825 billion of stimulus create in the economy. In the simple Keynesian model this $825 billion will generate something more than $825 billion as new investment and new spending is created from the initial stimulus. The word going around is that the Obama economists are using a “multiplier” of 1.5. Thus, $825 billion in new spending and tax cuts will actually result in another $412.5 billion in spending raising the total affect on the economy to $1.2375 trillion…a hefty sum.

On Thursday, the Wall Street Journal printed an opinion piece by Harvard economics professor Bob Barro (http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion)
who argued that the “multiplier” might be something different from 1.5 and might even be as low as zero! Barro contended, supported by his research, that even in times that are most favorable for the multiplier to be toward the higher end of this range, war times, the multiplier comes out to be no higher than 0.8. That is a stimulus plan that totaled $825 billion, could only expect to produce about $660 of real Gross Domestic Product not $1.2375 trillion. But, he adds, this estimate of 0.8 is probably optimistic.

Why would the final impact of the stimulus package be less than the amount of the stimulus package itself? There are several reasons. For one, the government expenditures could be expected to be a substitute for private investment or other private expenditures. Furthermore, whether or not the tax cuts are spent is another question. In the recent Bush43 tax rebate program much of the rebate money either went into savings or it went to pay off existing debt. In a poll released in the middle of last week, pollsters found that, on average, people would apply 70% to 75% of any tax relief from the stimulus plan to savings or to paying off existing debt. So there are arguments…and empirical support…for the contention that the “multiplier” may not be as high as 1.5 and might realistically be below 1.0.

The threat to save or pay back debt is real…not only for consumers…but also for businesses. Some economists who have studied recessions and depressions talk about a period of time called a debt/deflation. In periods like these the future looks bleak…and economic units…consumers and businesses…try to pull back and restructure themselves on a sounder financial basis. That is, they want to reduce the leverage that is on their balance sheet and get away from owing money. The first concern has to do with being unemployed or faced with going out of business…economic units want cash or, at least, near-cash items so as to be able to bridge a period when cash inflows might be low. And, if there is a possibility of deflation, people want to reduce the amount of debt on their balance sheets because the real value of debt and debt payments increase when prices are falling.

Some “Keynesians” have tried to incorporate these ideas about debt/deflation into their economic models. Hyman Minsky was one of the most prominent economists to explicitly discuss the impact of the capital markets on economic expansions and contractions. However, most of the empirical models used by policy makers do not take account of capital market effects on economic activity. (For a discussion of the economic model used for policy forecasting in the Federal Reserve see “Ben Bernanke’s Fed: The Federal Reserve After Greenspan” by Ethan S. Harris, Harvard Business School Press.) It is hard to contemplate “multipliers” as high as 1.5 if one considers these capital market issues.

For people to spend or borrow (if they could borrow) they need to have at least a somewhat optimistic view of the future (even for the possibility of inflation) to maintain or increase spending by either reducing savings or by borrowing. The obvious psychological impact hoped for from the stimulus package is that economic units will have enough confidence in the future or will even be willing to borrow and pay back loans with cheaper real dollars to keep spending or even increase spending. The Obama team is intending to use the rest of the TARP funds released by the Congress ($350 billion) to get people borrowing again.

Of course the concern about achieving this latter effect is the concern over the creation or the re-enforcement of moral hazard in the economy. If the government continues to “bail out” not only financial institutions but businesses, families, and other economic units, these economic units will continue to take on more and more risk in the future because they know that the government will supply a safety net to protect people from their foolish bets. The economists who argue from the viewpoint of the debt/deflation hypothesis contend that sooner or later the economy will take on so much debt that the debt/deflation cannot stop until people finally work off their extreme financial imbalances and return to more normal debt loads and positive amounts of saving. Some of these economists believe that this time has arrived and the economy cannot be turned around until economic units have worked off their excessive debt burdens and taken on a more conservative view of their economic future.

To get a zero multiplier (see the Barro article and Barro’s textbook “Macroeconomics: A Modern Approach” published by Thomson South-Western) one must argue that economic units will anticipate the increased real economic costs, real future taxes, or inflation that result from the way in which the stimulus package is financed and re-arrange their economic and financial activities to be able to cover the future government levies. A zero multiplier means that for every $1.00 the government puts into the stimulus plan, economic units will remove $1.00 from the spending stream. Thus, the $825 billion stimulus plan would increase real Gross Domestic Product by…ZERO DOLLARS!

What is the alternative to the type of stimulus plan proposed by the Obama administration? Barro argues that things must be done to encourage business commitment and innovation. His favorite idea is to eliminate the federal corporate income tax. If people are to be put back to work again…businesses must be hiring. In order to do this the energy and the foresight of the American business community must be put back to work again. The concern with massive public-works programs is that they will just substitute for the innovation and entrepreneurial leadership that still exists in the country and could produce real growth but needs to have the appropriate incentives.

So, what will be the impact of the Obama stimulus plan? You take your guess…I’ll take mine. My guess is that the multiplier is less than 1.0 and is maybe as low as 0.4. A reason for this pessimistic view of the multiplier is that we are at the stage where people/families and businesses finally have to fully restructure their finances to get balance sheets back into some form of conservative position. After many, many years of chasing dreams through betting on rising inflation with increased leverage and new financial instruments…the economy finally needs a break…needs to catch its breath and settle down for awhile.

I could be wrong. The American government could throw so much money at the economy that rising inflation and increased leverage becomes “the thing” again. If such is the case…then we are just postponing for another time, dealing with the monster that the government has created in the first place.

The Collapse of Citi

Banking is a commodity business. Banking deals with information…I am holding $100.00of yours in something called a transaction account…I am holding your IOU for $1,000,000.00. Whereas, historically, these sums had to do with a physical quantity…something like gold…now all banking is basically conducted in 0’s and 1’s.

Banking is just information and the movement of information. Banking is a commodity business.

Yes, there are some other products and services connected with the banking business. There is safe keeping…you can get coin and currency back from you transaction account. We will clear payments for you though the banking system so that you can pay people from your account without the use of coin and currency and you can receive payments from other which will be put into your account. That is, we clear transactions through the banking system. We will do your accounting for you and send you a monthly statement. We will make loans to you and provide many different kinds of services for you connected with your loan. And there are many other products and services that banks provide their customers…individuals, businesses, and governments.

Banks used to get paid for these services primarily in interest payments or in deposit balances that were kept at the bank. In the 1980s, however, we got another idea. We can isolate these products and services, account for them, and then charge the customer fees for these particular products and services they use and then we, the banks, won’t have to build in payment for them in the interest rates charged on the loans or by means of the deposit balances that the customer had been required to keep at the bank.

Fees are good because they don’t depend upon loan or deposit balances, but depend upon other products or services rendered.

In the 1980s depository institutions found another way to generate fee income. In the 1970s the government had invented a new financial instrument called a mortgage-backed security that could help financial institutions make more money available to people who wanted to own homes and the depository institution could make these mortgage loans, securitize them so they could sell them and not hold them on their balance sheets, and collect fees for originating and, possibly servicing them. Furthermore, the banks would not have to worry about the interest rate risk that came from holding assets with long term maturities like mortgages and support them with deposits that were available on demand or had short-term maturities.

Banks liked fees and started to build businesses based on fee income. They looked farther and farther in an effort to find more sources of fee income. They built or acquired subsidiaries that generated fee income. And banking companies grew and became diversified…even conglomerate in nature.

But, the banks saw that more than just mortgages could be securitized and they saw that these securitized loans could be traded and in so doing more and more fees could be generated, but they also found that they could make trading profits from dealing in these securitized loans. And so banks began trading in securitized loans…otherwise called derivatives…and developing arbitrage strategies to take advantage of market discrepancies. But, to take advantage of market discrepancies they had to increase the amount of leverage they used so as to earn competitive returns.

Yet, the nature of banking did not change. Banking is a commodity business.

Not only is the business of borrowing money in the form of deposits and lending that money out to businesses and consumers in different kinds of loans a commodity business, the banks found that competition made all the products and services they offered into commodities as well. And, trading…well no one makes money over the longer haul on trading…because it, too, is composed of transactions in commodities.

Banks can earn a return on capital that is equal to what the capital can earn elsewhere given the normal risk a bank assumes. But, banks cannot mold themselves into institutions that can produce and sustain competitive advantages over other firms and industries. The business model they tried did not work. Yet, like other firms and other industries that come to believe in a business model that doesn’t work, their continued efforts to make the business model work only exacerbated the problem. Generally, this extra effort meant taking more and more risks and then even using extra-legal means to produce the results wanted.

I am not saying that banks committed fraud, but I have very serious concerns about the off-balance sheet practices along with other accounting efforts that the banks used in an attempt to generate the higher returns they felt they had to earn. However, the competitive pressure to perform does push people and organizations to walk the edge of ethical practices.

Citi…whatever…had a business model that did not work. And, this model was tested over about a decade…and it never worked. The investment community realized this and was only luke-warm about the company’s stock. Yet, management stuck with the model and tried all the tricks to make its business model work. They were true believers.

No one stood up, however, and mentioned that the emperor didn’t have on any clothes.

Banking is a commodity business. Citi…whatever…is said to be cutting back its organization by a third…and this is from the reduction in size that had already been achieved. They are supposedly getting back to fundamentals…into areas in which they have a core competency. Supposedly, its management has a better appreciation of the markets it will be working in. Let’s hope so.

And so the debt deflation goes on. The example of the banks…and of Citi-whatever…shows why it is so difficult to achieve a turnaround in the financial system and the economy during a time such as this. In the previous forty years or so, many companies, like Citi-whatever, took advantage of the almost continuous expansion of the economy and the government support of that expansion. Now the re-construction of these companies must take place.

The big question on the table right now concerns the stimulus plan being put together by President-elect Obama and his team. With companies…like Citi-whatever…drawing back and restructuring, how much effect can the stimulus plan have on the economy? The stimulus plan must not only attempt to reverse the economic down-term but must overcome the impact of the companies that are deleveraging their financial structure or are withdrawing from markets. The administration is shooting at a target that is moving away from it.

Lessons on How to Beat Deflation Trap

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

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

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

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

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

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

Why is it important to understand this?

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

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

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

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

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

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

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

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

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

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

Financial Indicators of the Deteriorating Real Economy

More and more we see concern being expressed about the deteriorating real economy and less emphasis being placed on the crises within the financial sector. The concern about the growing weakness in the real economy points to a longer and deeper recession than had been anticipated.

The current recession, as defined by the NBER, is in its 12th month and trails two other recessions which lasted 16 months as the longest post-World War II downturns on record. As economists revise their forecasts, most seem to believe that the 16 month period will be exceeded and many are saying that the current recession will reach the 20-24 month time span.

Economists only have to point to the daily release of employee layoff announcements to support their increasing pessimism. Companies are restructuring and these efforts are accompanied by reductions in workforce by 5,000 and 10,000 and more, per firm. AT&T announced today that they are going to lay off 12,000 employees and are taking a $600 million charge in the fourth quarter to cover severance payments. And, given recent experience, there will be two or three other companies announcing layoffs today. There will be more tomorrow…and Monday…and…

Then these layoffs must work their way through the rest of the economy. Lower spending…credit card defaults…additional decline in sales…more layoffs…and so on and so on. The effects are cumulative.

The policy problem is how to stop the cumulative contraction so that the downward spiral is broken.

The potential effects of this downward spiral in the real economy are being translated into the financial markets and the warnings are rather severe. For example, take the article in the Financial Times, titled “Record number of companies at risk of default”: http://www.ft.com/cms/s/0/490a8668-c154-11dd-831e-000077b07658.html. This article focuses on the Markit iTraxx Crossover index which measures the cost of protecting junk-grade companies against default. This index rose above 1,000 basis points for the first time ever indicating that “a record number of companies are on the verge of default because of deepening financial problems.”

The authors also write that “Some of the world’s leading investment-grade companies look in danger of default, according to CDS prices.” The point being that the future shows nothing but dark clouds now. As these firms continue to restructure to avoid default on their debt the situation, at least in the short run, can only worsen because the layoffs lead to lower incomes which results in lower spending which results more restructuring and so on.

This deterioration in the real economy is also being transmitted to the government sector. There are two concerns being expressed in terms of the government securities. First, at local and regional levels…state and local governments…there is a restructuring gong on as government revenues drop and attempts are made to bring government budgets into balance…or at least into manageable level of deficit.

Second, governments at the national level are attempting to protect financial markets and combat the deterioration in their real economies. As a consequence, national deficits are ballooning and concern is being raised over the possibility of default on the part of sovereign nations. Another article in the Financial Times speaks to this concern: “Sovereign CDS prices soar as debt mounts”: http://www.ft.com/cms/s/0/c441907a-c1a3-11dd-831e-000077b07658.html. “Credit default swaps, which insure against bond defaults, rose to all-time highs on the US, UK, France, Spain, Italy and Germany yesterday…The dramatic rise is due to investor concerns over the amount of bonds the government will have to issue to bail out the banks and stimulate the economy.” The concern relates not only to the current economic and financial difficulties but also to the possibility that these governments will not be able to stem the downswing and will have to issue more and more bonds in the future.

Retail sales figures for November have just been release and the story reads that November retail sales are amongst the weakest in many years.

The difficulty that any government faces in attempting to compose a monetary or fiscal policy that can turn this situation around is that it is in the best interests of most economic units in the economy, individual, family, business, or non-profit, to get back to basics, to restructure what they do, to cut back their living standard, and to reduce debt. Consequently, government efforts are like “pushing on a string”…there is nothing to push against.

Trying to Understand the Recession

It is official now…the United States has been in recession since December 2007! Right now the current recession is the third longest recession since World War II and most economists believe that this recession will at least tie the other two recessions in terms of duration…a period of 16 months.

Among the major factors behind such a belief is that housing prices are still declining, housing sales are still falling, layoffs have just started to takeoff and financial institutions are still reluctant to lend…even if people and companies are willing to borrow. Some feel that the real recession is just starting to hit.

Growth-wise, real GDP rose, year-over-year, at a 0.7% rate in the third quarter of 2008, down from 2.8% in the third quarter of 2007 and 2.3% in the fourth quarter of that year. Real GDP declined in the third quarter of 2008 from the second quarter of 2008 and is expected to decline once again going from the third quarter to the fourth quarter.

The extent of this recession has even got some people talking about deflation!

Now that is something! It is something because the year-over-year rate of change in the Implicit Price Deflator of GPD, although it drops when there is a recession, has only become negative once since World War II and that was in the 1948-49 recession. (See chart from the Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=GNPDEF&s[1][transformation]=pc1.) Over the past seven quarters the Implicit GDP Price Deflator has averaged a 2.5% year-over-year rate of increase and increased by 2.6% in the third quarter of 2008 over the third quarter of 2007.

It is important to talk about what is happening to prices at the same time one is talking about what is happening to economic activity because that gives us a clue as to what factors are dominating economic activity. If both prices and output move in the same direction then one can say that demand factors are dominating the market. If prices and output move in opposite directions then one can say that supply factors are dominating the market. To understand what is happening in the economy, one must get some feel for which side of a market is dominating.
As the rate of growth of the economy has dropped from the rate of expansion that took place in the four quarters ending in the third quarter of 2007 (2.8%) to the four quarters ending in the third quarter of 2008 (0.7%), the rate of inflation for the same periods remained roughly constant or has declined modestly. To get such a result the drop in the demand for goods and services would have had to been roughly matched by the decline in the supply of goods and services over this time period. That is, neither side of the market strongly dominated the behavior of the economy over the past year or so.

As I have written in several posts over the past year, supply factors seem to be just as important as, or even more important than, demand factors in the current slowdown. That is, an adjustment is taking place on the supply side of the economy that must be reckoned with if we are to fully understand what is going on in the economy and respond to the situation as effectively as possible.

A possible reason for the shift in supply is that transitions are taking place in the economy or need to take place in the economy and this is impacting cost structures and organizational patterns in a way that is altering how people do business. For example, the increase in the cost of oil during the 2007-2008 period may have caused the transportation and energy industries to begin adjusting to a new world of alternative products and services that rely less on fossil-based resources. The subsequent reduction in the cost of a barrel of oil may have little impact on decisions because of the ‘price shock’ that people absorbed through the summer of 2008. The problems in the automotive industry are just one consequence of this. And, we are seeing a lot more adjustments coming in different segments of the transportation area that are not getting such a high profile. Also, new efforts to build ‘green’ industries may result from this.

Another transition is occurring in the financial industry where thousands of people are being laid off due to the downsizing that has resulted from the collapse of the financial markets. Financial institutions, I believe, are going to go through a substantial restructuring that will be based on information technology. In the past thirty years, the financial industry has shown how it can use the computer to design financial products. Now, along with the call to restructure the regulation of financial institutions, the financial industry is going to have to use the emerging information technology to control risk and enhance the openness and transparency of the industry. In moving in this direction the financial industry will become a real leader in the creation of information markets on which the rest of the economy will model itself.

Information technology continues to transform itself and in so doing will continue to create opportunities for other industries to transform themselves. The spread of information is going to accelerate with search being an integral part of this expansion along with greater and greater connectivity between users throughout the world. Computer networks will more and more become decentralized rather than centralized.

Another area where substantial transitions are taking place is in the area of State and Local governments. The model that has been used in this arena developed after World War II and is in need of a vast overhaul. In all likelihood, the current financial difficulties are going to result in these governments modernizing their function and structure while at the same time they help rebuild the infrastructure.

These are just a few of the major transitions that are taking place in the economy right now and that predominantly affect the supply side of the economy rather than the demand side. In all the efforts to “get the economy going again” we must not restrict or prevent these changes. That is, the government programs that are designed to stimulate the economy must not “lock us into” the old way of doing things. A bailout of the auto industry that keeps things “as they are” will not be helpful in the longer run.

It could be that the economy of the United States, and the world, is now going through a major restructuring, a restructuring that seems to occur every 60-80 years or so. In a sense, we are going from one age into another. One could say that the United States went through another major restructuring in the 1930s when the country was transitioning from an economy based predominantly upon agriculture to one that was based predominantly upon manufacturing. Maybe this is the time of transition from manufacturing to (you insert your term for it). Maybe the world of the ‘manufacturer’, and all that supports it, has significantly passed its peak and government props can no longer sustain it.

Two things can be drawn from this. First, government programs that just rely on stimulating demand will not prove to be very effective. The transitions must take place. They will take place relatively rapidly or they will take place at a much slower pace if the government supports the status quo. We…the government…must be careful here.

Let me state this again…the adjustments are going to take place…whether or not the government slows them down!

Second, these areas of transition are going to create major new opportunities for investment to those that are lucky enough…or wise enough…to choose the right companies. Referring to the 1930s once again, one can reference many investments that provided exceptional returns to those that sought them out and committed to them during the period in which the economy was adjusting to the brave new world that was coming. It is my belief that there will be numerous such opportunities available to us in the near future.

A Time of Transitions

Let’s start with the bad news first. I believe that we are in for an extended period of economic adjustment. This will take time for we are at a point where the foundation for the world economy has to be restructured so as to bring us to the start of a new era.

The good news is that the adjustment is taking place in a relatively orderly fashion. Yes, there still remains a lot of work to be done on repositioning portfolios and on the structure of industries. Yes, there will still be some surprises along the way. But, people are systematically working things out. People have, by-and-large, stopped hiding things and are finding out that within the current environment it is best to identify problems, disclose them, and then get to work on them. It just seems that the issues are deep and broad and will take an extended period of time to fully accommodate them.

In the United States, and some other developed countries, a lot of wealth has been lost. Layoffs are taking place or will take place in many major industries…I’m thinking of financial services and motor vehicles as starters. The housing industry is depressed and some experts think that house sales and the decline in housing prices may continue in and through 2009. Prices for oil and other commodities continue to rise. Consumer confidence has reached a 16-year low. This is a time of transition.

Perhaps the greatest transition underway is that in the field of energy. Transitions always hurt a lot of people. Major transitions are just that much worse. Yet, many agree…this transition has to take place…sooner or later. The United States, and much of the world, has done almost everything it can to postpone the day of reckoning, have band-aided the existing system here and there, and have protected the current economic structure as much as it could. Maybe that day is here.

Transitions hurt. Did I say that before? It is going to hurt many, many people to move on to the new way to power the world but maybe it is time for the United States, and others, to deal with the energy problem seriously and encourage the transition. Humans are problem solvers. Humans are great innovators. Look what has happened in terms of Information Technology over the past 50 years! Look what has happened in terms of the biological and physical sciences over the past 50 years! We can only be optimistic about what humans can do to solve problems.

Yet, over the last 50 years, politicians have provided incentives to the energy industry to maintain existing energy platforms. In doing so, they raised the “switching costs” of moving on to other energy platforms because the incentives have been structured away from innovation and change. Sure, the day would come when new sources of energy would be forthcoming, but the politicians creed is to keep getting re-elected in the current environment…the transition to these new sources and the disruption accompanying the transition will come on someone else’s watch.

Maybe we should celebrate oil selling for $135 per barrel. Maybe we should celebrate gas at the pump selling in excess of $4.00 per gallon. Maybe we should hope that prices go even higher! The transition is here! Let it happen!

My concern is that efforts will be made to alleviate the short run pain of the energy problem and drug the world once again so as to maintain the status quo for a little longer. It seems that the United States, and the world, only move on issues like this when there is a crisis. It seems as if times like this are the only times when pain is sufficiently wide-spread to gain the attention of politicians and others in positions of leadership. Do we really want to provide another narcotic release from the pain and postpone attacking the real problem? Drugs are addictive but if health is to be achieved the addiction must somehow, sometime be broken.

The new energy platform…whatever that platform will be…will result in a substantial change in the way people live their lives. I can’t predict what the new platform will look like. I don’t believe that anyone can predict what the new energy platform will look like. As an economist all I can say is that relative prices will change, incentives will be altered, and innovation will take place. What exactly this will mean for life on this planet is currently a mystery.

Individuals, as early as the 18th century talked about computing machines. But, who predicted the changes in life that the mainframe computer brought about in the 1950s and 1960s? Who predicted the creation of the personal computer and how it would alter how people worked in the 1980s? Who predicted the development of the Internet and how it would change how people lived and worked in the 1990s and beyond? And so on, and so on…

This adjustment will take time and the transition will be painful for individuals, for businesses, for industries, and for governments. I talked about a 50-year periods in terms of other transition cycles. Maybe…just maybe…we need to bite-the-bullet and move on into the future.

There is another transition that needs to take place and this is as good a time as any to accept the need for it and move forward with it. This is the transition the United States must make to become a full economic partner of other nations in the world of the 21st century. Other nations have gone through the transition the United States must go through and it is painful. But, why should the people of the United States postpone this adjustment if it can be accomplished from where we are now? Why can’t the United States move from where it is and change its way of conducting economic policy?

The period of the liquidity crises has been passed in this policy cycle. It appears that further adjustment of portfolios and expectations are proceeding in an orderly fashion. However, the full adjustment back to robust economic health is expected to be slow and painful. The United States government must not disrupt this transition back to health. But, it must act in a way that allows this adjustment to take place while bringing discipline back into its operations. The value of the dollar must be protected and supported, especially during this time when other central banks throughout the world will probably be raising their short term interest rates. Thus, the Federal Reserve must walk a fine line between not further disrupting the economic re-alignment going on and fully supporting the value of the United States dollar. Trust must be re-established in international financial markets that the Federal Reserve is fully cognizant of its responsibilities with respect to its currency and will fight the good fight against inflationary pressures. The relatively weak economy should help in this fight although the battle against worldwide commodity inflation will make the adjustment just that much more difficult.

The new President and his administration must also bring fiscal discipline back to the government. Again, this will be difficult and cannot be fully achieved in the near term. It is hard to see how the Bush tax cuts can be rescinded within the current environment. It is hard to see how other tax cuts can be implemented anytime soon. New programs? Well, prudence must rule the day. Any new president is going to be limited in what can be accomplished in the near term if this fiscal discipline is going to be achieved. If the transition is going to be made, however, it should be done now and not postponed indefinitely.

The reality of the situation is one in which the United States is going to have to work with others in the world. It cannot act independently of other nations in either energy policy or in terms of economic policy. Our period of transition is here…in many areas. The past is no guide at this time and we must not try to hold onto it. We must be open to the future while helping people through the pain of change.

The Bermuda Triangle?

Is the United States flying into a period of economic turmoil that one can only describe as a Bermuda Triangle? Financial institutions are not out-of-the-woods yet in terms of cleaning up their balance sheets. The economy has surprisingly remained stronger than expected, yet there are layoffs in the airline industry, the car industry, the housing industry, and other industries that are bound to contribute to future weakness. And, there is talk within central banking circles that interest rates may need to be raised in upcoming months.

Furthermore, there seems to be some uncertainty among the pilots flying the monetary ship in the United States. After leading the Federal Reserve through a period of historically massive reductions in the Fed’s target Federal Funds rate, the introduction of major innovations in the way the Fed conducts its monetary policy, and after intervening into areas of the financial sector in ways that are reminiscent of the Great Depression (of which he is a major academic scholar), Chairman Bernanke has stated that maybe the Federal Reserve better look out after the decline in the value of the United States dollar.

But, now several other members of the Federal Reserve leadership have expressed doubts about how the Federal Reserve has acted in recent months. On June 5, Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond has come out and expressed concerns about the Federal Reserve lending to major securities firms. Charles Plosser, the president of the Federal Reserve Bank of Philadelphia has also spoken out defining more clearly the boundaries of what the Federal Reserve System can and should do. Both raised concerns about whether or not the Fed should actually be doing these things.

But, these are not the only voices that have expressed concern. Two other presidents of Federal Reserve banks have expressed similar thoughts. Gary Stern, president of the Federal Reserve bank of Minneapolis, discussed, in April, the expansion of the Fed’s authority, while Thomas Hoenig, president of the Kansas City Federal Reserve bank discussed the threat of moral hazard in the financial system due to the Fed’s actions.

On the other side, Ben Bernanke, vice chairman of the Board of Governors of the Federal Reserve System, Donald Kohn, and Timothy Geithner, president of the Federal Reserve Bank of New York, have defended the recent actions taken by the Fed.

I cannot remember a time when there has been so much discussion, in public, about what the Federal Reserve is doing or has done by the individuals within the Federal Reserve System that have responsibility for making the policy decisions that the Fed executes. The Federal Reserve does no usually “wash its dirty linen” for the whole world to see. Just what is going on here?

One final point: the timing of the departure of Governor Frederic Mishkin to return to his teaching position at this time raises a question mark. This is a very delicate time for the Federal Reserve System because the departure of Mishkin will reduce the number of openings in the ranks of the Governors to four…out of seven. This, of course, is not Mishkin’s fault because the administration has made appointments for the other three positions. It is just that the Democratically controlled confirmation process has held up the confirmation on these other three appointments for over a year. But, Mishkin’s resignation is tremendously awkward at this time. I don’t want to make too big a point out of this, but the timing, given the internal debate within the Fed and with the shortage of Governors on the Board, the timing of the departure is curious.

But, let’s return to the other points mentioned above. First, the condition of the financial system. Foreclosures remain high and will probably continue to rise. Bankruptcies have increased and probably will increase. Charge offs of credit card debt are high and rising. There remains the question about further charge offs at major financial institutions. And, if the economy is going to get softer, delinquencies and other financial dislocations are going to increase. The question still remains…how stable are the financial institutions of the United States, particularly if short term interest rates need to rise?

Second, the state of the economy, although it has been stronger than expected, shows signs of growing weakness. It is kind of like watching this whole thing evolve in slow motion. The bad news piles up, yet the economy seems to be hanging in there. However, the unemployment figures are up and the impacts of the higher oil and gas prices seem to be spreading to more and more major industries. The unexpected strength in the economy has allowed Chairman Bernanke to express concern about the weakness in the value of the United States dollar, but one really wonders about how much can be done in this election year to actually combat its falling value if the economy gets softer and financial institutions remain in a tenuous state.

Finally, there is the reality that the United States is “out-of-step” with the rest of the world in terms of where it is policy wise. On June 5, the European Central Bank and the Bank of England, both left their target interest rates at their current levels, but, especially Jean-Claude Trichet, the president of the European Central Bank, they both stated that there was a strong possibility that these target interest rates would need to be raised in the future. The focus of these central banks on inflation remains firm in spite of weakening economies. These central banks are earning their reputation for trying to keep inflation in their areas under control.

The direct effect of this effort has been to cause renewed weakness in the value of the United States dollar and a rebound in the price of oil. And, this points up the main dilemma facing the United States government and the Federal Reserve. Policy wise, the United States is in a different place than is much of the rest of the world. The “go-it-alone” attitude of the Bush administration which thumbed its nose to the international community in foreign relations as well as in its economic and financial policies has now left it at odds with much of the rest of the world and isolated it in terms of what it needs to do. Whereas the United States seemingly cannot act to protect the value of the dollar because of the fragility of its economic and financial system, other major players in the world now are indicating that they, in all likelihood, will raise interest rates in the future. If others do raise interest rates this can only put the United States in a more difficult position because if the Fed does need to act to further protect the economy or even if it does not move from the targets it now has, the weakness in the value of the dollar will only continue. The actions of others will place the dollar in a relatively worse position than it is now

Once again, we see the problem of a major nation going off on its own path. Now, when the United States is reaping the consequences of its past actions, the only way others can contribute to helping it resolve its difficulties is to weaken their own discipline and act in a way that is not consistent with the long term welfare of their own people. The future direction of the United States economy and the health of its financial system is heavily dependent upon what others might have to do to maintain the health and welfare of their countries. We have already seen the United States president “beg” for relief on the oil front. Will he also need to “beg” for other relief?