Could there be a glimmer of life in bank loans at Small Domestically Chartered Commercial Banks?
The latest figures released by the Federal Reserve on the Assets and Liabilities of Commercial Banks in the United States gives some indication that this is happening.
In the latest four weeks for which we have data, all Loans and Leases at commercial banks declined by $22 billion, but loans and leases at the smaller banks actually rose by $50 billion. And, this rise was across the board.
Note that over the last 13-week period, all loans and leases fell by $29 billion so that lending is down for the last quarter’s worth of data we have, but the figures reported above represent a movement in the right direction.
Furthermore, the increase in lending was across the board: commercial and industrial loans at these small banks rose by about $19 billion; real estate loans rose by $18 billion; and consumer loans increased by almost $17 billion. All these figures are down for the last 13-week period except for consumer loans that show an increase of about $14 billion for this longer period.
Are we getting a break in the ice barrier at the smaller banks? We’ll just have to wait and see.
Just an interesting side note on this: cash assets held by these same smaller banks actually declined by $17 billion during the last four weeks.
This occurred as the commercial banking system became even more awash with cash during this time period. Cash assets at Large Domestically Chartered banks rose by $88 billion and cash assets held by Foreign-Related Institutions rose by $192 billion. Total cash assets reported in the banking system reached a new high in the weeks of October 21 and October 28 of about $1.3 trillion while Reserve Balances with Federal Reserve Banks rose to $1.08 trillion on this last date and excess reserves averaged $1.06 trillion, a new record, for the two weeks ending November 4.
While the smaller commercial banks were increasing their loan portfolios during the last four weeks, large banks and foreign-related institutions were reducing theirs. For example, in the last four week period, large commercial banks reduced total loans by almost $52 billion. For the last 13-week period these banks have reduced all loans by $139 billion. And the decreases were all over the balance sheet: commercial and industrial loans were down by $27 billion; real estate loans were down by $40 billion; and consumer loans were down by $10 billion.
The only offsetting item on the balance sheets of the larger banks was an increase in securities held. This item rose $29 billion in the latest 4-week period; and was up by $68 billion over the last 13 weeks. This may be related to the fact that the largest reported area for earnings in the larger banks over the last calendar quarter or so came in the area of securities trading.
The securities portfolios of the smaller banks and the foreign-related institutions declined, both for the 4-week period and the 13-week period.
Overall, total assets in the banking system rose by $184 billion in the latest 4-week period, but that can be accounted for by the increase in cash assets. Total bank lending did not increase, and commercial and industrial loans and real estate loans continued to decline.
In this period, when everyone is looking for signs of a recovery, the fact that the lending at smaller commercial banks has shown some positive growth is encouraging. We will have to keep an eye on this area of the economy. Obviously, the lending at the smaller banks needs to pick up if the economy of “Main Street” is going to get started.
Furthermore, there has been great concern over possible solvency problems among the smaller banks. If these smaller banks are beginning to lend again and if they are drawing down their cash balances to do that lending, then that could indicate some increasing confidence within this sector that asset balances are beginning to stabilize. This would really be good news!
I don’t want to be premature on this, but, the increased lending of the smaller banks is a surprise and, possibly, a hopeful sign.
Yet, there are the larger banks. There is no indication that the decline in lending at the larger banks is going to stop. And, in one sense, why should it. Many of the larger banks are making lots of money off of security trading. The ones that are not in as good a shape continue to “down size” and contemplate which assets they want to sell off or which asset they can sell off. Apparently, continuing to stockpile cash assets and excess reserves is a good strategy for them. This, to me, is continuing evidence that the problem in these banks is one of solvency because the value of their assets cannot be determined.
The best news is still that things on the banking front are relatively quiet. Again, this is a sign that the banks are working through their problems. Yes, there is a bankruptcy here and a bank closing there. This news will not stop for another 12 to 18 months. Let’s just hope that things continue to stay quiet and these events proceed peacefully.
Monday, November 9, 2009
Friday, November 6, 2009
Has the Fed (and other central banks) Made a Mistake?
The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.
I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.
I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.
If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.
But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.
Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.
The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.
A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.
First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.
And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.
The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.
To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.
Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.
Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?
And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.
To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.
One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!
I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.
I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.
If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.
But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.
Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.
The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.
A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.
First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.
And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.
The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.
To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.
Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.
Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?
And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.
To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.
One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!
Wednesday, November 4, 2009
Building an Exit Strategy at the Federal Reserve--Part Two
Yesterday, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.
In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?
How about the fiscal deficits that the government is in the process of producing?
The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.
The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.
A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!
The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book “This Time is Different”, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”
Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?
The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.
The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”
Let’s look what seems to happening right now.
Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.
The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)
To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.
If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?
As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”
Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)
Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly”, pain cannot be avoided once financial folly has been committed.
Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.
In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?
How about the fiscal deficits that the government is in the process of producing?
The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.
The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.
A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!
The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book “This Time is Different”, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”
Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?
The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.
The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”
Let’s look what seems to happening right now.
Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.
The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)
To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.
If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?
As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”
Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)
Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly”, pain cannot be avoided once financial folly has been committed.
Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.
Tuesday, November 3, 2009
Building the Exit Strategy at the Federal Reserve
Interest continues to grow about how the Federal Reserve is going to remove all of the reserves that it has injected into the banking system. The articles are getting personal now. See, for example, the article in the Wall Street Journal this morning that actually brings us a name, Brian Sack, who is the head of the markets group at the Federal Reserve Bank of New York and the person responsible for developing the “exit strategy” that the Fed will use to remove the $1.0 trillion, more or less, excess reserves that reside on the balance sheets of the country’s commercial banks. (“Brian Sack Engineers Big Moves at Fed,” http://online.wsj.com/article/SB125720947716624249.html#mod=todays_us_money_and_investing.)
The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.
The first question that arises is exactly what date do we go back to? Do we go back to the week before the week of September 15, 2008 when the financial collapse became paramount? Or, do we go back to the middle of December 2007 when the Bear Sterns deal was cut? Around this latter date we get the creation of the Term Auction Facility (TAF) that was a first innovation of the Fed to meet the financial crisis that was in its early stages. Let’s use both dates to see if there is any substantial difference between the two.
I have made three, rough calculations about the “excess” funds that the Fed needs to remove from the banking system if we are to get back to a Fed balance sheet that looks something like either the ones that existed on either December 19, 2007 or the September 10, 2008. I use the actual Wednesday data and not the averages of daily figures for the banking week ending on those dates.
The three rough numbers are $1.3 trillion to get back to the balance sheet of the earlier date and $1.1 trillion to get back to 2008 date. My third estimate is generated by assuming that the Federal Reserve balance sheet would grow from December 19, 2007, at a (generous) 10% annual rate up to the current reported figure for October 28, 2009. This third figure is $1.1 trillion. All these numbers are rounded off so as to produce general targets so that we have a rough idea of the magnitude of the task.
So, given these estimate the Federal Reserve needs to remove approximately $1.1 to $1.3 trillion from its balance sheet.
Now, there are two parts to the removal of these funds from the balance sheet. The first has to do with very specific responses to the crisis, either in terms of particular markets or in terms of particular institutions. In terms of particular institutions, I am referring to the “line items” on the balance sheet that relate to the Bear Sterns and the AIG deals. In terms of particular markets, I am referring to the facilities set up for Primary Dealers and Broker-Dealers, Commercial Paper Funding, Money Market liquidity funding, Central Bank liquidity swaps and so forth.
The current strategy of the Federal Reserve with respect to these specific “line items” is to let the dollar amounts decline at their own speed as the need for them dissipates or as the assets are worked off. This strategy is already reflected in the balance sheet results examined in my series on the Federal Reserve Exit Watch: see http://seekingalpha.com/article/167300-federal-reserve-exit-watch-part-3, and, http://seekingalpha.com/article/162274-federal-reserve-exit-watch-part-2.
The total of these accounts, as of October 28, 2009, is $412 billion. These accounts seem to be declining on a regular basis and there is really little or nothing that the Fed can do to speed this decline along. In fact, you want these accounts to be reduced at their own pace because as the need for the assistance goes away, the accounts will fall to zero. True, some of the accounts could remain on the books for an extended period of time, but these will be minor relative to the whole balance sheet.
If you remove these numbers from the shrinkage that needs to take place on the Federal Reserve balance sheet you are left with numbers in the $700 to $900 billion range. The total of Mortgage-Backed securities on the balance sheet as of October 28, 2009 is $774 billion. Federal Agency securities totaled $142 billion on that date. Thus, the “active” strategy for reducing the Fed’s balance sheet relates to these specific security portfolios.
This is where the proposed program called “reverse repos” comes into the picture. Obviously, the Fed cannot just dump $774 billion in mortgage-backed securities on the financial markets. (There is even some concern that Congress may want the Federal Reserve to hold onto a large portion of these securities so as to continue to support housing in the United States. That, however, raises other issues.)
Furthermore, the Federal Reserve is very cognizant of the events of 1937. The United States economy had recovered from the Great Depression (or Great Contraction) and was experiencing relatively satisfactory growth at that time. The commercial banking system, however, was holding onto a large amount of excess reserves (not unlike the current situation). In order to tighter their control over credit, the Federal Reserve, in all its wisdom, raised reserve requirements.
The result was disastrous! The bankers wanted those excess reserves and the removal of them caused the banking system to contract even more and the amount of credit and money in the economy contracted as well. The 1937-1938 depression was the result.
The Federal Reserve does not want to duplicate such a mistake. Consequently, they are going to try and “ease” the funds out, not “yank” them out. This, seemingly, is the reason why the Fed is looking at the “reverse repos’ program as an alternative. Because “reverse repos” would represent the “temporary” removal of funds from the banking system and because they would be undertaken through market transactions, the Fed would not get “ahead of the curve” in removing reserves from the banks. That way, they would constantly be “in the market” and be able to determine if there was any resistance to the removal of funds. In that way, they could proceed incrementally toward selling the securities and then, as the markets allowed, actually sell them outright from their securities portfolio.
The Federal Reserve is in a delicate position. They know that they will need, at some time, to remove the excess reserves from the banking system. However, they don’t want to move too fast and create another financial crisis, as happened in 1937. But, the Fed knows that at some time it is going to have to remove the excess reserves as quickly as it can.
Let me repeat, the Federal Reserve is in a delicate position! In talking about “exit strategies” in the public domain, Fed officials hope to keep the financial community informed and prepared for what might be done and at the pace it at which it will be done.
The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.
The first question that arises is exactly what date do we go back to? Do we go back to the week before the week of September 15, 2008 when the financial collapse became paramount? Or, do we go back to the middle of December 2007 when the Bear Sterns deal was cut? Around this latter date we get the creation of the Term Auction Facility (TAF) that was a first innovation of the Fed to meet the financial crisis that was in its early stages. Let’s use both dates to see if there is any substantial difference between the two.
I have made three, rough calculations about the “excess” funds that the Fed needs to remove from the banking system if we are to get back to a Fed balance sheet that looks something like either the ones that existed on either December 19, 2007 or the September 10, 2008. I use the actual Wednesday data and not the averages of daily figures for the banking week ending on those dates.
The three rough numbers are $1.3 trillion to get back to the balance sheet of the earlier date and $1.1 trillion to get back to 2008 date. My third estimate is generated by assuming that the Federal Reserve balance sheet would grow from December 19, 2007, at a (generous) 10% annual rate up to the current reported figure for October 28, 2009. This third figure is $1.1 trillion. All these numbers are rounded off so as to produce general targets so that we have a rough idea of the magnitude of the task.
So, given these estimate the Federal Reserve needs to remove approximately $1.1 to $1.3 trillion from its balance sheet.
Now, there are two parts to the removal of these funds from the balance sheet. The first has to do with very specific responses to the crisis, either in terms of particular markets or in terms of particular institutions. In terms of particular institutions, I am referring to the “line items” on the balance sheet that relate to the Bear Sterns and the AIG deals. In terms of particular markets, I am referring to the facilities set up for Primary Dealers and Broker-Dealers, Commercial Paper Funding, Money Market liquidity funding, Central Bank liquidity swaps and so forth.
The current strategy of the Federal Reserve with respect to these specific “line items” is to let the dollar amounts decline at their own speed as the need for them dissipates or as the assets are worked off. This strategy is already reflected in the balance sheet results examined in my series on the Federal Reserve Exit Watch: see http://seekingalpha.com/article/167300-federal-reserve-exit-watch-part-3, and, http://seekingalpha.com/article/162274-federal-reserve-exit-watch-part-2.
The total of these accounts, as of October 28, 2009, is $412 billion. These accounts seem to be declining on a regular basis and there is really little or nothing that the Fed can do to speed this decline along. In fact, you want these accounts to be reduced at their own pace because as the need for the assistance goes away, the accounts will fall to zero. True, some of the accounts could remain on the books for an extended period of time, but these will be minor relative to the whole balance sheet.
If you remove these numbers from the shrinkage that needs to take place on the Federal Reserve balance sheet you are left with numbers in the $700 to $900 billion range. The total of Mortgage-Backed securities on the balance sheet as of October 28, 2009 is $774 billion. Federal Agency securities totaled $142 billion on that date. Thus, the “active” strategy for reducing the Fed’s balance sheet relates to these specific security portfolios.
This is where the proposed program called “reverse repos” comes into the picture. Obviously, the Fed cannot just dump $774 billion in mortgage-backed securities on the financial markets. (There is even some concern that Congress may want the Federal Reserve to hold onto a large portion of these securities so as to continue to support housing in the United States. That, however, raises other issues.)
Furthermore, the Federal Reserve is very cognizant of the events of 1937. The United States economy had recovered from the Great Depression (or Great Contraction) and was experiencing relatively satisfactory growth at that time. The commercial banking system, however, was holding onto a large amount of excess reserves (not unlike the current situation). In order to tighter their control over credit, the Federal Reserve, in all its wisdom, raised reserve requirements.
The result was disastrous! The bankers wanted those excess reserves and the removal of them caused the banking system to contract even more and the amount of credit and money in the economy contracted as well. The 1937-1938 depression was the result.
The Federal Reserve does not want to duplicate such a mistake. Consequently, they are going to try and “ease” the funds out, not “yank” them out. This, seemingly, is the reason why the Fed is looking at the “reverse repos’ program as an alternative. Because “reverse repos” would represent the “temporary” removal of funds from the banking system and because they would be undertaken through market transactions, the Fed would not get “ahead of the curve” in removing reserves from the banks. That way, they would constantly be “in the market” and be able to determine if there was any resistance to the removal of funds. In that way, they could proceed incrementally toward selling the securities and then, as the markets allowed, actually sell them outright from their securities portfolio.
The Federal Reserve is in a delicate position. They know that they will need, at some time, to remove the excess reserves from the banking system. However, they don’t want to move too fast and create another financial crisis, as happened in 1937. But, the Fed knows that at some time it is going to have to remove the excess reserves as quickly as it can.
Let me repeat, the Federal Reserve is in a delicate position! In talking about “exit strategies” in the public domain, Fed officials hope to keep the financial community informed and prepared for what might be done and at the pace it at which it will be done.
Monday, November 2, 2009
The Upcoming Banking/Financial Regulation
New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there is a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.
Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.
From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.
There are three topics that seem to be missing in every discussion about new regulation or re-regulation.
First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?
The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.
Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.
I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.
Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!
Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: http://www.ft.com/cms/s/0/ea9f6964-c57a-11de-9b3b-00144feab49a.html) or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”: http://www.ft.com/cms/s/0/a43d96f0-c74e-11de-bb6f-00144feab49a.html).
Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.
Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?
Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.
Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.
The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.
We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.
My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.
Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.
From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.
There are three topics that seem to be missing in every discussion about new regulation or re-regulation.
First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?
The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.
Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.
I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.
Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!
Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: http://www.ft.com/cms/s/0/ea9f6964-c57a-11de-9b3b-00144feab49a.html) or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”: http://www.ft.com/cms/s/0/a43d96f0-c74e-11de-bb6f-00144feab49a.html).
Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.
Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?
Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.
Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.
The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.
We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.
My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.
Thursday, October 29, 2009
More Talk About Credit Bubbles
Bloomberg put up a headline this morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says”, http://www.bloomberg.com/apps/news?pid=20601110&sid=a.YErMIwMYKA. Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”
We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.
“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”
“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”
According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.
Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.
How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?
In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.
Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)
Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.
According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.
A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)
Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.
Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”
This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.
Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.
We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.
“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”
“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”
According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.
Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.
How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?
In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.
Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)
Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.
According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.
A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)
Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.
Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”
This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.
Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.
Tuesday, October 27, 2009
Ecomonic Stimulus: Do We Need More?
When the history of the recent financial crisis and Great Recession is written, the basic conclusion that will be presented is that a financial crisis can be ended and a major recession turned around if the government throws massive amounts of money at the economy.
And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, http://www.nytimes.com/2009/10/27/opinion/27tue1.html. The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.
Spending is addictive. Once you start, it is hard to stop.
Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.
Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.
So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?
And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, http://online.wsj.com/article/SB125659862304009151.html#mod=todays_us_page_one. The conclusion of the author of the article is not encouraging.
Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!
And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!
Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.
However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.
Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”
The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.
Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?
For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”
More! That’s the answer!
And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!
But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?
Should we stop talking about the deficit?
Or should be consider that maybe, just maybe, more is not the answer.
And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, http://www.nytimes.com/2009/10/27/opinion/27tue1.html. The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.
Spending is addictive. Once you start, it is hard to stop.
Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.
Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.
So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?
And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, http://online.wsj.com/article/SB125659862304009151.html#mod=todays_us_page_one. The conclusion of the author of the article is not encouraging.
Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!
And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!
Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.
However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.
Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”
The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.
Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?
For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”
More! That’s the answer!
And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!
But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?
Should we stop talking about the deficit?
Or should be consider that maybe, just maybe, more is not the answer.
Subscribe to:
Posts (Atom)
