The "Next Greece" Again

The New York Times business section carries the headline, “Traders Turn Attention to the Next Greece”: http://www.nytimes.com/2010/03/04/business/global/04bets.html?ref=business.

“Is Spain the next Greece? Or Italy? Or Portugal?”

Sounds vaguely similar to another article on the topic, my post of March 1, “Where is the Next Greece?”: http://seekingalpha.com/article/191242-where-is-the-next-greece. But, the subject is in the air these days.

The New York Times article wades into the issue of whether or not the “banks and hedge funds” should be doing what they are doing.

“Indeed, some banks and hedge funds have already begun to turn their attention to other indebted nations, particularly Portugal, Spain, Italy and, to a lesser degree, Ireland.” Aha, the PIIGS, of course without the G.

“The role of such traders has become increasingly controversial in Europe and the United States. The Justice Department’s antitrust division is now examining whether at least four hedge funds colluded on a bet against the euro last month.”

The same concern has been expressed over short sales.

Little concern was expressed about the debt policy of nations, states, municipalities, businesses and consumers when they were piling on massive amounts of debt to their balance sheets.

Of course, nations, and others, have good reasons for loading up with debt. It stimulates the economy and everyone wants prosperity and full employment. Well, don’t they?

Everyone wants businesses to prosper. Everyone wants everyone else to own their own home.

All good reasons for piling on debt.

But, when do “good intentions” spill over into “foolish behavior”?

And, in an environment where excessive amounts of credit are being pumped into the economy (thank you again Federal Reserve)n to spur on housing or some other “good”, shouldn’t it be expected that “extra-legal” means will be used to “get the credit out”.

But, when does serving “societal goals” become fraudulent and hurtful?

The problem in both cases is that there is a very blurry line between the “good” and the “bad”. On the upside, of course, emphasis is placed on the “good” being done, and the “bad” is alluded to but quickly dismissed. A common theme in such periods is that “Things are different now!”

On the other side, however, great pain takes place. One can certainly sympathize with those who live in Ireland, and Spain, and these other countries.

This, however, is just where “moral hazard” raises its ugly head. There is a downside to the excessive behavior of nations, states, and so on! There is pain on the other side of the pinnacle.
And, eventually the pain must be paid for. Bailing out those that used excessive amounts of debt just postpones the situation and usually leads people to behave just the way they did before the crisis. That is, the lesson learned is the one can behave badly and, if there is the threat of sufficient societal pain, little or no cost will be carried forward because of the previous un-disciplined behavior.

The problem is that those in power get mad at the bankers and the hedge funds and try to prohibit them in some way from moving against those private or public organizations that are financially weak. But, in doing so they are taking away a tool that can be used to enforce discipline on those who have lived excessively. The same applies to short selling.

We have seen behavior like that exhibited by the “banks and hedge funds” in the past. The last time these predators were called “shadowy international bankers”, many of whom were pictured as living in Switzerland. In that time the “ bankers” attacked the currencies of profligate nations. France, under the leadership of François Mitterrand, is perhaps the best known example of such a situation. Mitterrand, the socialist, had to pull back from his grand plans and became a believer in fiscal discipline and an independent central bank. Similar cases are on record.

It is disconcerting to see the increased efforts to reduce or eliminate financial tools that help to bring discipline to the market place. If these investment vehicles get punished or face harsh controls and regulations then the world is so much the worse for it.

Yes, I agree, at this stage it looks like the strong are kicking the weak member of the party. But, in these cases we forget that many benefitted greatly on the upside, particularly the politicians that promoted goals and objectives that were underwritten by the undisciplined use of debt. And, the central banks were prodigal in underwriting this credit inflation.

And, now the piper is calling in the debt.

It is a rule of life: those in power that create a given situation are often the most vocal opponents of those that respond to the consequences of what the powerful have created. If you create an inflationary environment fueled by excessive credit expansion then, sooner or later, the price must be paid.
Greece, Spain, Italy, Ireland, Portugal, England, and others are now facing the downside of so many years of “good intentions.” Let’s not just blame, or punish, the “bankers and hedge funds” for creating the situation we now face

"Risk-taking at banks will soon be larger than ever"

A new report has been released by the Roosevelt Institute and has been announced by ABC News:
http://abcnews.go.com/Business/economists-warn-financial-us-economy/story?id=9990828. The chief economist of this institute is the Nobel prize-winning economist Joseph Stiglitz. Also, on the panel that produced the report is Elizabeth Warren of Harvard and head of the congressional group that is overseeing the spending of the TARP funds, Simon Johnson of MIT, Robert Johnson of the United Nations Commission of Experts on Finance and Peter Boone from the Centre for Economic Performance.

A major forecast of the report is that “Risk-taking at banks will soon be larger than ever.”

I am shocked!

Aren’t you?

In my view, risk-taking at commercial banks, big commercial banks, was going strong by the summer of last year. It has grown since.

Why?

Thank you Mr. Bernanke and the Federal Reserve System!

Over the past year or so, we have seen the largest subsidization of the banking system in the history of the world!

No, I don’t mean the bailout money. I mean the money the banks have access to that costs less than 50 basis points!

There is, of course, a reason for the low interest rates. The small- and medium-sized banks in the country are is serious difficulty. See my posts, “The Struggles Continue for Commercial Banks,” http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “Reading Between the Lines on Bernanke’s Testimony,” http://seekingalpha.com/article/191159-reading-between-the-lines-on-bernanke-s-testimony. The concern here is that if the Fed began to remove reserves from the banking system, the great “undoing”, it would precipitate even more bank failures than are projected now, given the number of banks, 702, that are on the FDIC’s list of problem banks.

The large banks, however, the top twenty-five of which make up almost 60% of the commercial banking assets in the United States, are making out like bandits. And, why not when they can borrow for almost nothing and lend out at spreads of 350 basis points or so…risk free.

And, the dollar-trade continues to prosper internationally.

But, this is not regular bank lending, lending to businesses or consumers. Regular bank lending supports the expansion of the economy and employment of workers. That lending has been declining for months and it appears as if that lending will not pick up for many more months in the future.

The large banks were too big to fail and now the large banks produce huge profits because the Fed believes that the other 40% of the banking system is “too big” to fail.

And, what are these big banks doing?

I’m not sure that there is anyone else that knows the answer to this other than the banks themselves. I have said this over and over again beginning last summer. The big commercial banks are way beyond the regulatory system in terms of what they are doing, perhaps more so now than in normal times.

Regulation is ALWAYS behind the regulated. This is just a law of nature. The issue always is, how far behind the regulated are the regulators?

When I was in the Federal Reserve System, the estimate we used was that the Fed was about six months behind the commercial banks. The banks would try something to avoid regulations and the Fed would then have to find out what the banks were doing. Once the Fed found out they would then have to bring the “regs” up-to-date to close the loop-holes.

Last summer or so, I surmised that the commercial banks, after they had paid back the bailout money, moved ahead rapidly to take advantage of the subsidy they were receiving from the Federal Reserve in terms of exceedingly low interest rates. The subsequent profit explosion at the large banks seemed to justify my suspicions.

By the fall of 2009, I was convinced that these large banks were way ahead of the regulators in terms of what they were doing. For one, the regulators still had a financial crisis on their hands and were diverted from the “new” activity. Second, as is always the case, the politicians decided to fight the last war. Their battle cry: “We have got to stop the commercial banks from doing what they were doing.” Of course, that is why regulation is seldom very effective.

The Roosevelt Institute report calls for more financial reforms: re-regulate. Of course, Joe Stiglitz is one of the leaders in crying for new, more stringent regulation. Elizabeth Warren is there also. But, the picture I have just painted contains with it the conclusion that regulation never really is that effective because it is always behind the curve. However, if the rules and regulations are excessively restrictive then innovation and change may be delayed. (How long did it take to get the Glass-Steagall Act removed?)

In this world, the world of the Information Age, innovation and change is going to take place somewhere because, as I have said before, finance is just about 0s and 1s. (See my post “Financial Regulation is the Information Age,” http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) My feeling is that regulation can delay but it cannot stop the changes the bankers want to make. If regulation delays the ability of commercial banks to innovate and change, the innovation and change will take place elsewhere in the world. And, funds will flow to where the innovation and change is taking place.

If the conclusion of this report is that “Risk-taking at banks will soon be larger than ever,” my question to the authors of this publication is: “Where have you been?”

Who is going to be the next Greece?

This seems to be the major question asked by most commentators in most media outlets. Is it going to be Spain? Japan? The U. K.? Italy? Portugal? Just who might it be?

Might it be California? Or New York? Or some major city?

Who are the hedge funds attacking this week? Where is the bailout going to come from? What about the IMF, what role is it going to play? And so on and so forth?

As far as the United States is concerned, thank goodness for all the attention being paid to the problems being experienced by these other countries, and states, and cities. At least others governmental units are getting the headlines about the debt problems going on in the world, and not the U. S. government.

And, the nice thing about the problems going on in the rest of the world is that investors still consider the dollar and dollar-denominated securities to be the least-risky of the lot. Flee to the dollar! Flee to U. S. Treasury securities!

Sometimes it is good to rank things on a relative basis. The person who receives a grade of D can save his own self-respect and place in the world when compared with the rest of the class who received a grade of D-. Doesn’t say much, however, about the whole class.

The United States dollar, a currency under attack until the financial crisis of 2008-2009, once again finds itself gaining strength as the financial condition of other countries come under attack and their currencies come under selling pressure.

The value of the United States dollar, which was once again under attack in the late summer and fall of 2009, has risen by more than 6% against major trading partners since the beginning of December as investors “flew to quality.” The United States dollar has done even better against the Euro as it has risen by about 18% versus the Euro over this same time period.

And, what are central banks doing under these circumstances?

They are still primarily operating under the umbrella of “quantitative easing.” That is, the central banks cannot drive interest rates any lower so they continue to provide reserves to their own banking systems in order to keep those banking systems afloat.

For the vultures circling over the scene it seems to be banquet time. The big banks, the big hedge funds, and others seem to be prospering in this environment of close to zero borrowing costs. These organizations are earning record profits! Not so, of course, for the small- to medium-sized financial institutions that are hanging on for their lives.

There are no good solutions! Every path out of this situation is full of difficulty and pain. And the strong get stronger and the weak, weaker.


The problem faced by politicians is that they must appear as if they are being active in the attempt to resolve the problems that their countries are now facing. Yet, to increase stimulus packages only exacerbates already stretched budget deficits. But, to cut spending, because revenues are down due to the weak economic conditions, only causes greater misery and social unrest. The fiscal conservatives attack those that push for more economic stimulus; the social liberals attack those that push for more budget restraint.

The central bankers worry about what will happen when interest rates begin to rise and asset values and business expectations start to fall again.

The world is in a tough spot when the basic question being asked becomes “who is going to fail next?”

It seems as if all these countries (states and cities) can do is attempt to reach a balance between improving the fiscal discipline being demanded by investors and voters and between the safety-nets that need to be created to cushion the difficulties being faced by many of the people within their domains.

With no “good” solutions available, governments must “muddle through” as best they can. There is no panacea.

The thing that should be avoided, but, in the distress of the moment, will, in all likelihood, not be avoided, is to create programs or solutions that will not be helpful once the crisis period is over. Politicians and others tend to “rush in” during “crisis” times and create programs, rules, regulations, or laws. (As Rahm Emanuel has stated, ““You don’t ever want a crisis to go to waste; it’s an opportunity to do important things that you would otherwise avoid.”) Once on the books, however, these programs, rules, regulations, and laws remain in practice for a lengthy period of time, and, over the longer-run, many fail to achieve the positive effects that was desired when implemented.

It is important for leaders, in my mind, to appear as if they are in control during times like these. In essence, all of these leaders are heading “turnaround” situations. These leaders must be pragmatic in practice. They must re-establish discipline in all that is done under their watch. They must not be the slaves of some ideology.

What these leaders do will not be pretty, but they need to be strong in order to bring people behind them. These leaders need to build support and trust. The worst thing that they can do is to look as if they are not in control for the vultures will jump on this appearance and dominate events.

What do the markets seem to be saying in response to the efforts of current leaders?

The headlines we are now reading in the newspapers and hearing on newscasts indicate that governmental leaders are not in control. It appears as if the future is being driven by hedge funds and others who are taking advantage of the feeble conditions in the various political units around the world. No one seems to be in charge and no one seems to be rising to the task!

Bernanke's Testimony: Reading Between the Lines

Chairman Ben Bernanke gave testimony this past week on the Fed’s semiannual report on monetary policy to the United States Congress. I believe that Mr. Bernanke’s report can be summarized in two sentences. First, the United States economy is recovering, but the recovery will be quite slow. Second, the Federal Reserve will continue to keep its interest rate target at current levels.

This testimony came during a time in which the Federal Reserve has been attempting to reveal and explain how it plans to exit from its current position, a position that includes a banking system with almost $1.2 trillion in excess reserves. Fundamentally, the Fed is ready to begin to “undo” what it has done over the last year and a half. (See, for example, my posts http://seekingalpha.com/article/189547-back-to-business-at-the-fed, and http://seekingalpha.com/article/189547-back-to-business-at-the-fed.)

The implicit contradiction in all of this is that the Fed’s “undoing” is to take place as the economy recovers, but, the Chairman in not willing give a hint as to when the economy will be strong enough to allow the Federal Reserve to start raising its current target level of the Federal Funds rate.

To me, the message that is being conveyed between the lines is that there are still some things so wrong with the economy (that the Federal Reserve is aware of) that the Fed cannot take a chance, even give a hint of a chance, that the target Fed Funds rate will be raised.

And, what is the basis of this fear?

Will, we can start with the state of the banking system. The Federal Deposit Insurance Corporation (FDIC) produced its quarterly report last week and indicated that 702 commercial banks were now on the list of problem banks at the end of 2009. This is up from a total of 552 banks that were on the problem list at the end of September 2009. And, the FDIC closed 2 to 3 banks per week during the fourth quarter of the year.

Given the current list, the expectation is that about 235 banks, one-third of the current total on the problem list, will close over the next 12 to 18 months, a rate of 3 to 4.5 banks per week for this time period.

Remember that there are about 8,000 commercial banks in the United States, with the top 25 accounting for well over one-half the assets in the banking system. Thus, the banks that are failing tend to be small and they tend to be “local” in nature and a failure can cause quite a disruption on “Main Street.”

The problems in the banking system go deep. The insured banks charged off 2.9% of outstanding loans in the fourth quarter of 2009. This is the largest charge off rate in the 75-year history of the FDIC.

At the end of the fourth quarter, 5.4% of all loans were at least 90 days past due, a near-term high. Specific areas of the loan portfolios are showing a large amount of stress. For example, data on construction loans to build single-family loans indicate that about 40% of the loans are either delinquent or have totally been written off. Mortgage loans still remain a problem where about 12.5% of the loans outstanding are past due.

Commercial real estate loans are the looming giant in terms of providing dark clouds for future bank loan performance. Elizabeth Warren, head of the Congressional team that oversees the TARP funds has stated that about 3,000 commercial banks face the possibility of a “tidal wave” of commercial real estate loan problems. At the end of the fourth quarter of 2009, over 6% of these loans were classified as a problem in some way.

Before these problem loan areas can be resolved, the economy must begin to get stronger, people must return to good paying jobs, and real estate values must cease falling. Discouraged workers must return to the workforce and manufacturing firms must increase the utilization of their resources. There is little evidence to indicate that these factors are, in fact, improving to the extent needed to strengthen the loan portfolios of commercial banks.

The Fed, obviously, has a good seat to observe all of these facts. And, I believe, they are very, very concerned. And, I also believe, that bankers are very, very concerned.

Why?

Because the bankers are sitting on their hands and holding onto any type of asset that will not deteriorate in value…cash or deposits at Federal Reserve banks and short term government securities.

Yes, we can say that businesses and homeowners with very good credit are not borrowing. And, we can say that consumers are not borrowing.

I don’t think this is the answer.

I believe that this situation is more like the one that was experienced in the period around 1937. Commercial banks were holding a lot of excess reserves at that time too. Also, there was no lending to speak of during that period. And, the Federal Reserve raised reserve requirements to “sop up” those excess reserves.

And, what did the banks do at that time? They withdrew even further. The banks wanted those excess reserves. They did not want to lend them out. They just wanted the protection and security of having those reserves in their hands. By taking the reserves away, the Fed caused the banks to restrict credit even further in order to return excess reserves to a level more consistent with the safety the banks wanted on their balance sheets.

Ben Bernanke, the student of the 1930s, knows what happened back then. He is, therefore, fighting on two fronts in the current climate. First, there are those that are afraid that the excess reserves the Fed has injected into the banking system will eventually be lent out and this will cause the money stock to expand and this, given the size of the $1.2 trillion level of excess reserves, will result in a higher than desired level of inflation in the United States economy.

Bernanke and the Fed must do enough, talking and maneuvering, to satisfy this crowd. Hence the exit strategy and the efforts to get Federal Reserve’s operations back into a more normal environment.

Second, however, is the fear that the excess reserves in the banking system are “desired” by the banking system and any effort to substantially reduce them in the near future could lead to a further contraction in the banking system that would ensure a “double-dip” Great Recession.

My guess is that Bernanke is not willing to take a risk on generating a further contraction in the banking system by removing bank reserves at this time. This, to me, is the message between the lines of the Chairman’s testimony in front of Congress this past week.

The Fed is ready for the great “undoing” of its balance sheet, but is not going to begin this “undoing” until it is sure that the commercial banks are willing to let go of the $1.2 trillion in excess reserves.

The Fed and the Treasury Maneuver

Yesterday, the Treasury announced that it will borrow $200 billion from the Federal Reserve and leave the cash on deposit with the Fed. As it initially goes on the Fed’s balance sheet the transaction is a wash.

The Treasury has two accounts that show up on the Federal Reserve sources and uses statement. (These data can be found on the Federal Reserve release H. 4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.) The first is called the U. S. Treasury, General Account, and this is primarily used to manage the Treasury’s cash position and flow of expenditures and tax receipts.

When taxes are collected, the funds flow into government tax and loan accounts at commercial banks. This transfer of funds from the private sector to the public sector causes no disruption to bank reserves because the funds stay in the banking system. (The data on U. S. Government deposits at commercial banks can be obtained in the Federal Reserve release H.6, Money Stock measures, Table 7.)

The Treasury does not draw funds out of its accounts in the commercial banking system until it begins to make payments out of its balance in the General Account at the Federal Reserve so as to cause as little disruption to the reserves held in the banking system. That is, government funds come out of the banking system and go into the Fed account, but the Fed account is being drawn down with payments to the private sector that will be deposited into commercial bank deposits.

For example, government demand deposits at commercial banks averaged $1.3 billion in December 2009. However, in January, as tax collections flowed into the government, these balances rose to $1.6 billion in the banking week ending January 4 and increased to $2.3 billion, $4.3 billion, and $5.1 billion, in the next three weeks, respectively. In the banking week ending February 1 the balances fell to $1.8 billion and then dropped to $1.3 billion in the following week as the Treasury paid out funds to the private sector.

These movements just represent operational procedures that have been established over the years to avoid major movements of funds into and out of governmental accounts. Hence, this is called the “General Account.”

On September 17, 2008, the Treasury Department announced something called the “Supplementary Financing Program”. Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

Thus, the Fed’s holdings of U. S. Treasury holdings would go up on the “asset” side of the balance sheet (this being a debt of the Treasury) and the U. S. Treasury Supplementary Financing Account would rise on the “liability” side of the balance sheet (this being an asset of the Treasury).

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.

On February 17, 2010, the Federal Reserve had a little less than $800 billion of U. S. Treasury securities on its balance sheet. Commercial bank reserve balances, mostly excess reserves, with Federal Reserve banks stood at slightly more than $1.2 trillion.

If the Fed is going to remove reserves from the banking system by open market sales of U. S. Treasury securities, then it needs to have a sufficient amount of them on hand to be a credible seller of these securities.

Although the Federal Reserve is expected to have $1.25 trillion of mortgage-backed securities in its portfolio in March, it is expected that the Fed will not want to sell these off in any large amounts because it does not want to destabilize the mortgage market and force mortgage rates to rise too fast.

Also, the Fed’s portfolio of Federal Agency debt securities is too small, about $165 billion, to help much in any exit strategy.

Thus, adding $200 billion to the Fed’s portfolio of U. S. Treasury securities will bring the total Treasury securities on hand to approximately $1.0 trillion and this may be sufficient to allow the Fed to “undo” its portfolio and reduce the amount of excess reserves in the banking system without having to sell mortgage-backed securities. That is, if the Treasury does not write any checks against its Supplementary Financing Account.

The Fed is attempting to get as much ammunition in place before the “battle to exit” begins. Over the past several months and weeks, the Federal Reserve has moved to position itself to “undo” its massive injection of reserves into the banking system. Last week it announced that it was returning the “primary loan” function to its pre-crisis operating procedures. (See my “Back to Business at the Fed”: http://seekingalpha.com/article/189547-back-to-business-at-the-fed.) This week, the Treasury is pumping up its Supplemental Financing Account. Next week, well who knows.

This process will continue over the following weeks as the Fed does all it can to prepare for its “undoing.”

Commercial Banks Continue to Struggle

The Federal Deposit Insurance Corp. presented us with the new list of problem banks. As of December 31, 2009, there were 702 commercial banks on the problem list of the FDIC. At the end of the third quarter of last year, the total stood at 552. If 3 to 4 banks failed every week, then roughly 39 to 52 banks failed last quarter. Thus, at least 200 new names were added to the list in the fourth quarter about 36% of the number on the list at the end of the third quarter.
The rule of thumb that I have heard used on bank failures is that approximately one-third of the banks on the problem list will fail over the next 12 to 18 months. If this holds true then about 234 banks will fail during this time period, roughly an average of 3 to 4.5 banks per week!

Right now the quarterly net loan charge-off rate and the number of loans at least 3 months past due were at the highest levels ever recorded during the 26 years that these data have been collected. As I have said many times, the important thing is that these charge offs are occurring in on orderly manner. The banks seem to be able to absorb these loses without substantial disruption to their operations. Also, the closing of so many banks by the FDIC seems to be taking place in an orderly manner without substantial disruption to the banking business.

The banking system, as a whole, continues to be risk-averse at this time as banks continue to reduce the amount of loans of their books. In this the FDIC data are consistent with the call report data released by the Federal Reserve in that the total loan balances on the books of the banking system continue to decline.

The economy may be recovering but the outlook for the banking industry remains dark. Other news released this morning point to a continued dismal future. The Gallup organization released information that suggested that 20% of all workers in the United States are underemployed.
This is a larger number than put out by the labor department and is attributed to the fact that the Gallup data are not seasonally adjusted.

However, this does not seem inconsistent to me with the information, also released this morning, that consumer confidence dropped precipitously in February from a revised 56.5 to 46.0. Furthermore, consumer expectations for economic activity over the next six months fell from a revised 77.3 to 63.8. In addition, the people that are expecting more jobs in the near future fell while the proportion of those expecting fewer jobs rose. More than 17% of the respondents expected their incomes to fall over the next six months, while 9.5% expected their incomes to increase.

This is not good information to the banks as foreclosures and bankruptcies continue to increase. Furthermore, there is more and more information about people walking away from properties after allowing their loans to go delinquent, even though they might be able to pay the loans. It seems as if more people are arguing that the decision to abandon a house is a “business decision” and not a decision about whether or not to leave a “home.” If the price of the “home” is less than the mortgage, then the “home” becomes a “house” and is abandonable.

But, banks, and others, still face several other serious shortfalls in the future. The commercial real estate situation is well known and Elizabeth Warren, head of Congressional oversight on the TARP funds has claimed that 3,000 commercial banks face a potential torrent of defaults on commercial properties.

State governments continue to teeter on the fiscal edge as state tax collections declined in the fourth quarter of 2009 for the fifth quarter in a row. State governors, meeting in Washington, D. C. this last weekend, warned Washington, as well as the nation, that the fiscal year beginning in July 2010 will be the most difficult of any met so far during this financial and economic crisis.

City and municipal governments also have their backs against the wall with many of them now considering the pursuit of Chapter 9 bankruptcy. This, too, is not a good sign for the banking community.

Both the cities and the states are soliciting Washington, D. C. for more and more stimulus money cover their needs. They obviously do not see their salvation coming from the private sector. But, what about the federal government? Is there any hope here?

One answer comes from the likes of Joe Stiglitz, Paul Krugman, and others with a similar leaning: the federal government has erred on the side of not spending enough. Washington just has to spend more and more and more until jobs stabilize, incomes begin to rise, and confidence turns upward once again.

The other side? The other side is represented by Bob Barro who has another op-ed piece in the Wall Street Journal this morning. (See http://online.wsj.com/article/SB10001424052748704751304575079260144504040.html.) Barro has contended all alone that the spending and taxing multipliers used by the Obama economics team far overstates the real effect that the government fiscal stimulus program has on the economy. To quote his results: “Viewed over five years, the fiscal stimulus package is a way to get an extra $600 billion in public spending at the cost of $900 billion in private expenditures. This is a bad deal.”

Add to this the fact that the deposit insurance fund fell by $12.6 billion in the fourth quarter of 2009 to $20.9 billion; and the only proposal on the table being to assess the banking system to replenish the fund. It looks inevitable that the federal government will have to provide some sort of assistance to help keep the fund solvent. Oh, and then there is the upcoming costs related to Fannie Mae and Freddie Mac (http://online.wsj.com/article/SB10001424052748704259304575043573979877134.html?mod=WSJ_Opinion_AboveLEFTTop). But, the addition to the deficit from these outflows relates to things that have happened in the past, there is no stimulus or job creation here but some fairly sizable price tags.

None of this is good news for the banking system. Is it possible for the list of problem banks to reach 1,000? Probably not at the end of the first quarter of 2010, but maybe in the second quarter. Remember that there are only slightly more than 8,000 commercial banks in this country. Can you imagine if one out of every eight banks were on the problem list?

Inflation is in the News

There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” http://seekingalpha.com/article/188351-doesn-t-anyone-understand-inflation. The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.

This morning we see an opinion piece by Wolfgang Münchau in the Financial Times, http://www.ft.com/cms/s/0/9776aeb0-1ef2-11df-9584-00144feab49a.html; an article by Sewell Chan in The New York Times, http://www.nytimes.com/2010/02/22/business/22imf.html?ref=business; and another article by Jon Hilsenrath in the Wall Street Journal, http://online.wsj.com/article/SB20001424052748704511304575075902205876696.html#mod=todays_us_page_one. All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.

The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”

In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.

The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!

It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.

The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.

Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.

The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”

The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.

The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.

Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.

Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.

The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.

I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.

The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.

This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.