Watching the Money Flow

There are signs here and there that the economy is gathering strength. Note especially the figures on industrial production and capacity utilization. Although we have not returned to the levels reached earlier, the movement in these measures is definitely up.



Unfortunately, we are not seeing this movement in the monetary statistics relating to individual and banking behavior. As has been reported in my posts bank credit extension continues to decline. And, the way people are handling their money does not indicate any change in how people are handling their assets.



For example, the year-over-year rates of increase in the various measures of the money stock indicate that people are still holding a great deal of their assets in transaction accounts in banks and continue to keep as liquid as they can. This kind of behavior is defensive in nature and can be interpreted as showing that the public remains so uncertain about the future that they want to be prepared for contingencies, like becoming unemployed.



As mentioned in an earlier post (http://seekingalpha.com/article/188703-keep-your-eye-on-the-money-flow), the public began moving large parts of their wealth into cash and transactions in the latter part of 2007 and into 2008. We can see this movement in the change in year-over-year growth rates in the M1 and M2 measures of the money stock. The M1 measure began to accelerate in early 2008 and the M2 measure began to grow more rapidly in the first part of 2009. Looking further into 2009 and 2010, however, we see that M1 money stock growth has remained relatively strong whereas M2 money stock growth tapered off substantially.

Two points can be made: first, the Federal Reserve was pumping reserves into the banking system throughout this period, yet given the performance of the banking system and the M2 measure of the money stock it is obvious that this injection in reserves did not account for the changes in money stock growth. The behavior of the banks and the public lead one to refer to this as a liquidity trap as banks piled up excess reserves during the time period to the total of about $1.2 trillion.

Second, and perhaps more convincing, there is evidence of massive shifts of funds from less liquid assets to the most liquid of financial assets throughout this time period. For example, in September 2009, the year-over-year decline in small denomination time and savings accounts at commercial banks and thrift institutions was about 5%. In February 2010, these accounts were declining by more than 21%, year-over-year. Retail money funds were declining at about a 16% rate last September; now, they are declining by more than 26% year-over-year. Institutional money funds are declining in February at almost 16% year-over-year whereas they were increasing last September.



The point of this is that people are moving these assets into accounts that are transaction accounts, like demand deposits and money market or checkable deposits. Most of these accounts are counted in the M1 measure of the money stock and not in the non-M1 portion of the M2 money stock. This is the reason for the divergence in the growth rates of the two measures of the money stock.



For example, demand deposits at commercial banks rose by more than 14%, year-over-year, in February. This is down from about 20% in September. Other checkable deposits at commercial banks rose by around 19% in February, up from about 16% in September. And, savings deposits (which include money market deposit accounts), at both commercial banks and thrift institutions rose by about 14.5% in both February 2010 and September 2009.



The conclusion: people are still scared about their future and continue to act in a very protective way. There is little or no borrowing going on, at least, not enough to cause the lending totals at commercial banks to rise. One can certainly argue that the lack of bank lending is due to a lack of demand as well as the unwillingness of banks to lend.



Furthermore, money stock growth has not come from Federal Reserve initiatives to expand the bank lending. The growth being experienced by both measures of the money stock are coming from people re-arranging their asset portfolios and not from monetary policy.



The big unknown still remains the Federal Reserve and its “exit” policy. If and when people begin to borrow again and begin to spend again, bank credit extension should start to accelerate. This will lead to real money stock growth. The question is, how will the “undoing” of the Fed impact this loan growth and any subsequent monetary growth. Obviously, if too many of the excess reserves previously pumped into the banking system by the Fed gets into the various measures of the money stock, there could be some serious long run inflationary problems.



Consequently, it is necessary to continue to watch these money numbers to see what people and the banks are doing.

Mr. Volcker Speaks

Former Fed Chairman, Paul Volcker spoke yesterday at the Peterson Institute for International Economics. All week I had been hearing comments about this speech and how people seemed to be waiting for Volker’s remarks. Yet, this morning, there was only one report on the speech which appeared in the New York Times (http://www.nytimes.com/2010/03/31/business/31regulate.html?ref=business) and then it was buried at the bottom of page B6 of the business section.

It seems as if Volcker didn’t really say very much. In fact, the discussion of his remarks was combined with a discussion of the words of Robert Gibbs, the White House Press Secretary. The bottom line: it is highly likely that the United States will get a re-regulation package for its financial system this year. Gibbs even said that “the Senate might move on the legislation by the end of May”.

Just a couple of comments on the issues that were mentioned in this article.

First, the article states that the legislation to “overhaul the nation’s financial system…is intended to prevent a recurrence of the conditions that led to the 2008 financial crisis and the government bailouts that followed.”

If this is what the legislation is intended to do, we have already lost the battle. As I have stated over and over again, the problem with regulatory legislation is that it is always fighting the last war.

Let me state this as bluntly as possible: We will never have “a recurrence of the conditions that led to the 2008 financial crisis!”

Financial crises do not repeat themselves.

I do agree with Carmen Reinhart and Ken Rogoff in their book “This Time is Different” that the buildup to a financial crisis is always accompanied by the cry of those riding the crest of the economic expansion that “This time is different!” This claim, however, refers to the belief of the perpetrators of the claim that no collapse will follow the buildup that they are going through.

When I say that financial crises do not repeat themselves I mean that the specific conditions preceding a financial collapse, the specific behavior of the financial institutions and the financial leaders, are always different from past collapses. There is new technology, new instruments, new institutional arrangements, and so forth. Things change significantly enough so that the new regulations put into effect at the end of the last financial collapse don’t quite apply to the conditions that exist before the next financial collapse.

This gets into my second point which addresses Volcker’s concern about the growth of the financial services industry relative to the growth in other sectors in the rest of the economy.

We are told that “Mr. Volcker was critical of the broad growth in the financial services industry in recent decades. Finance came to represent an ever-greater share of corporate profits, even as average earnings for most American workers did not rise.”

Volker is quoted as saying “The question that really jumps out for me is, given all that data, whether the enormous gains in the financial sector—in compensation and profits—reflect the relative contributions that sector has made to the growth of human welfare.”

The article continues, “He also asked whether the financial sector contributed to underlying imbalances in the economy, as Americans raided their savings and relied on a housing bubble to maintain excessively high consumptions levels.”

My response to this is that from 1961 through 2008, the purchasing power of the dollar declined by almost 85%. In this inflationary environment, many American families came to believe that the best way to “save” was to buy a house and watch the value of the house rise. In addition, they could further leverage the constantly rising value of their house to “maintain excessively high consumptions levels.”

Mr. Volcker, more than anyone else in the United States, recognized the problem created by the inflationary environment of the late 1970s and early 1980s and, during his tenure as the Chairman of the Board of Governors of the Federal Reserve System, fought inflation with all that the Fed could bring against this destructive dragon. He deserves major praise for what he accomplished at this time.

Still, over this 1961-2008 period, inflation was the major economic incentive in existence in the economy. By the end of the 1960s, commercial banks had innovated to the point that they became “liability managers” and created the ability to expand to any size that they wanted. This happened because the start of this inflationary period made it necessary for banks to have the flexibility to expand beyond the geographic and asset constraints that restricted their ability to compete.

In the early 1970s the mortgage-backed security was invented (by the government by-the-way) and in the middle 1980s the mortgage market became the largest component of the capital markets. As inflationary expectations rose and resulted in higher interest rates during this time, interest rate risk became more of an issue and the interest rate futures market was created.

Need I say more? Financial innovation thrived in the inflationary environment and, as a consequence, the financial industry grew! And, grew! And grew!

Did the “enormous gains in the financial sector reflect the relative contributions that sector has made to the growth in human welfare”? Did “the financial sector contribute to underlying imbalances in the economy”?

I think you know how I would answer both of these questions.

Another piece of the news this morning struck me. Citigroup is spinning off Primerica (http://www.ft.com/cms/s/0/cef26d7c-3c41-11df-b316-00144feabdc0.html). Primerica was one of the first companies purchased by Sandy Weill in the late 1980s that became part of the financial conglomerate Citigroup. Everything about financial innovation and the relative growth of the financial services sector of the economy during this inflationary period is captured in Weill’s wild ride to the top as he constructed Citigroup piece by piece.

And, now we have the dismantling of Citigroup. Is this picture the icon of the new age of finance?

Higher capital requirements can contribute to sounder financial behavior. More disclosure and increased audit standards can also contribute to sounder financial behavior. Still, we cannot build a regulatory structure that will prevent a recurrence of financial crises whether based on the 2008 experience or the experience of some other time period. Furthermore, we cannot prevent greedy politicians from supporting policies that create an inflationary bias to the economy in order to get re-elected.

Regulation of the “bad guys” on Wall Street is popular now. However, it won’t prevent a volatile future.

The Euro and the European Union

When have you last heard that the dollar might drop into the $1.05 to $1.15 range? This morning we are trading at about $1.34.

The lower number is projected if some country leaves the European Union or if there is a national default in the euro area.

The cost of protecting debt from default over the past six-months has risen dramatically in several of the major European countries: Greece leads the world in this category. But, Portugal is right behind as credit-default swap data, compiled by Bloomberg, indicate an increase of about 150% in the last six months. (Remember the debt rating of Portugal was just reduced by Fitch last week.)

Major increases in the cost of protecting debt from default have also been registered against the debt of Spain, Italy, Belgium, England, and France.

The bottom line: governments cannot just spend and spend and spend expecting either the bond markets or the central bank to bail them out. Social programs or not, a democracy has to balance the competing ends within a country and if the social programs cannot be financed through sound finance then they will just have to wait. The lesson is very clear.

Historically, it is government spending that drives the finances of a country and not the central bank. Remember the European Central Bank and the Bank of England have been much more conscious “inflation targeters” than was the United States. Also, governments, historically, were always the leaders in financial innovation and not the private sector. The late 20th century is no exception to this rule. (See Niall Ferguson’s “The Ascent of Money” and also http://seekingalpha.com/article/120595-a-financial-history-of-the-world.)

In the past, if a country over-extended its finances then they would generally have to devalue their currency and then proceed into the future. With a common currency, the euro, a country loses the choice about devaluation because that country is now one among many and so must accept its position in the community. The poor country that has over-extended itself must bring its budget back into line, a very painful process as Greece is now experiencing. This is tough medicine to take.

What about the countries that were prudent and disciplined? Their emphasis on sound finance is now being called a vice by some because they do not want to be overly generous to those countries that were not prudent and disciplined. (One prominent critic has been Martin Wolf of the Financial Times: http://www.ft.com/cms/s/0/924b4cc0-36b7-11df-b810-00144feabdc0.html.)

And, the current crisis is bringing out those that are or have been opposed to the European Union as it is now constructed. For example, an op-ed piece in the New York Times “Euro Trashed” by a German professor, captures some of the tone of this side of the argument: http://www.nytimes.com/2010/03/29/opinion/29Starbatty.html?ref=opinion. A suggestion is made that the “strong” governments could pull out of the current arrangement and form a bloc that would “fulfill the euro’s original purpose” and would not have to worry about “laggard” high-debt states.

The betting is against the euro right now. John Taylor, the chairman of the currency hedge fund, FX Concepts Inc., argues that “Those people who are calling for the euro to go up are thinking the stock market is going to continue higher and that the euro zone problem is not going to spin out of control. I disagree with both of these things.” So, of the three areas that have experienced, in the recent past, the most negative vibes concerning the value of their currencies, the United States, Japan, and the euro zone, the pointer has rotated to the euro zone, taking the pressure off the other currencies, at least for the short run.

This could change. The reason for the current focus is that the euro zone faces the most current difficulties that have to be dealt with. But, this focus could be altered overnight because of the things happening in United States financial markets. The first has to do with the Federal Reserve signaling that it will honor its statement that its purchases of mortgage backed securities will end as March 2010 ends. The 10-year U. S. Treasury issue has bounded up to a 3.85% yield again, a level it was at in June 2009, August 2009, and January 2010. The concern by some is that yield could accelerate through 4.00% in the near term.

Why is this of concern? Well for one reason, upon the reaction in the bond markets, mortgage rates have moved above 5.00% with the expectation that they could go higher as the liquidity in the mortgage area of the capital markets declines. Banks and mortgage banks have already put a hold on committing to mortgage rates in the near term because of the uncertainty connected with the future level of mortgage interest rates. This, of course, is problematic because of all the variable rate mortgages or teaser mortgages that must re-price over the next 12 months.

There is also the concern about how easy it will be to place the upcoming quantity of the federal debt coming to the market over the next six to nine months. How much added pressure these new amounts of debt will have on interest rates is highly uncertain at the present time.

And, then what about the Fed’s exit strategy, the Great Undoing? How is the Fed going to act or react to all these market pressures? The exit strategy is planned to take place in an orderly financial market. What if the financial markets don’t cooperate and become dis-orderly over the next year due to everything else going on in the world? Just how is the Fed going to accomplish its Great Undoing in such an environment?

So, the emphasis is all on the euro right now and the political problems being dealt with by the nations of the European Union. Except for Germany’s Chancellor Merkel, the current batch of European leaders seem extremely weak at the present time. The weakness claim extends to the Prime Minister of England as well. What comes out of this mess is anybody’s guess right now, but it would seem that a country, like Germany, who is in relatively good fiscal shape and with a leader that can command some significant backing from her people, can be pretty adamant about what they want. The other countries in the EU may not like what Merkel is advocating, but they are not in the strongest position to suggest alternatives.

If this is the case, then it would seem as if the European Union will continue to battle on, but the debt-heavy countries that are now experiencing significant difficulties obtaining funding will have to get their houses in order for the Union to continue to function. Otherwise, as suggested in the New York Times this morning, we might see a move to one bloc of countries with a single currency who are relatively sound, financially, and all of the others who will re-establish their own currencies once again.

Politicians in the United States should pay attention to what is going on in Europe and take some lessons about their own fiscal responsibilities.

The Mortgage Market and More Plans to Aid Homeowners

There is still no better place to observe the consequences of the credit inflation of the last fifty years than the housing market.

Politically, this is democracy at work. Every wave of political change in the post-World War II period has focused on the housing market and putting “Americans” in their own homes in order that the new majority in Congress can get re-elected.

I was in Washington, D. C. during the time period that the mortgage-backed securities were being designed. The rationale for this innovation? Almost all mortgages were made in local depository institutions at that time. But, insurance companies and pension funds had lots of money to invest in longer term securities. If an instrument could be constructed that would allow local depository institutions to sell their mortgages to these companies that wanted long term investment vehicles then the local depository institutions would still have funds available to make more mortgages and put more “Americans” into their own home. And, the incumbent politicians could show their constituents the role they played in not only helping people acquire a home, but also how this effort helped to stimulate the local economy through additional home building. This surely would help the incumbents to get re-elected.

Economically this effort seemed to be sound because it would provide for an almost continued stimulus to the economy, spurring on economic growth and raising employment. A little “inflationary bias” along with this was not bad because almost all the economic models used at this time period showed a positive relationship between inflation and higher levels of employment. Inflation was good for the country!

And, these basic efforts were supplemented by the activities at the Department of Housing and Urban Development, the Federal National Mortgage Association (Fannie Mae) along with the creation of Freddie Mac and Ginny Mae and the work of the Federal Housing Authority, the Federal Home Loan Bank System, and other initiatives forthcoming from both presidential administrations and the Congress. Who could be opposed to such a worthwhile idea?

What we see is that maybe inflation was not all it was said to be. Maybe inflation, in the longer run, can actually be harmful to many of the people it was supposed to help. Maybe one of the “lessons learned” from application of the economic philosophy that dominated Washington in the last fifty years is that you can’t artificially “force” people into situations that are not fundamentally sound on an economic basis.

The efforts of the federal government over the last fifty years or so culminated in the Greenspan/Bernanke credit inflation of the 2000s. The United States experienced a housing bubble during this time period that really capped off the government’s effort to promote homeownership. Asset prices were artificially “forced” to rise further and further. And, as we saw, in the longer run the run-up in housing prices was unsustainable. So the bubble popped!

The consequence? The New York Times reports that “About 11 million households, or a fifth of those with mortgages” are underwater (http://www.nytimes.com/2010/03/26/business/26housing.html?hp). One in five homeowners with a mortgage faces a mortgage that is larger in value than the market price of their home! In addition, many of these homeowners have lots and lots of other debts which they assumed in the Greenspan/Bernanke period of credit inflation. Thus, the default or bankruptcy problem does not exist just in the mortgage area.

Inflation, in the longer run, does not help the lower income brackets and it does not help the middle class. Most people cannot protect themselves against inflation, as can the wealthier classes in society, and the tendency is for those that are not of the wealthy classes to “stretch” their budgets, especially during periods of inflation, to acquire more than they can comfortably carry, financially. Furthermore, as we have seen, inflation tends to increase those that are underemployed in the economy as well as those that are unemployed. When the music stops, the family budget problems extend beyond just paying a mortgage.

This is the dilemma faced by the government in attempting to create a program that will prevent or slowdown defaults and foreclosures. It is not just the fact that the homeowner is underwater. The problem is that the mortgagee is over-extended in other areas and has a real cash flow problem.

The initial effort to provide relief to these troubled borrowers was to reduce interest payments that would reduce monthly mortgage payments. Over the past 12 months over 50% of all mortgages modified in this way defaulted, according to a report just released by the Comptroller of the Currency and the Office of Thrift Supervision. Mortgages that are at least 30 days late climbed to about 58% over the last twelve months. This seems to be evidence that the problem is more than just one of meeting mortgage payments. (See http://www.bloomberg.com/apps/news?pid=20601010&sid=aVYxPZ56vjys.)

The next effort, promised to be released by the White House today, will focus more on writing down the value of mortgages. It is expected that this will prove to be more beneficial to homeowners because it will result in a greater reduction in monthly payments and will reduce the psychological effect of having to pay off something that is larger than the underlying value of the asset it is financing. Another portion of the effort will be to have the F. H. A. insure mortgages that are re-written with lower loan balances, a risky effort for a tax-payer supported institution that is already facing financial difficulties.

There are several problems associated with such a program. First, if financial institutions re-write or re-finance underwater mortgages, the issue becomes one of the solvency of the underwriter. Almost one in eight banks in the United States is either on the problem list of the FDIC or near to being on this list. Can these banks afford to be forced to write off these losses in the near term?

Analysts argue that one of the things the initial effort did (the effort to reduce interest rates) is that it just “spread out” the banks having to deal with foreclosures and capital write-downs over several years. This, at least, allowed the banks to slow down the write-off process allowing them to continue to “stay alive” while they worked out their loan problems. This new program threatens these banks: the losses on these loans would have to be written-off sooner rather than later. Could this accelerate the closing of banks?

Another issue relates to whether or not these problems of “underwater” mortgages are connected to bigger issues than just the foreclosure on houses. It is the case that many of the people that purchased these houses were “stepping up” to a higher living standard and doing so created other payment obligations connected with the higher living standards. Many of the people that are underwater now re-financed in the years before the financial “collapse” and took out a lot of the equity built up in their homes to finance other purchases, perhaps a second home or an addition on the home or some other expenditure that allowed them to “step up.” Without the credit built up through the inflation in their home price they would not have been able to afford the purchases out of their cash flow, even if they continued to remain employed. In these cases the cash flow problem is more than just the difficulty in covering the monthly mortgage payment.

The point is that when a person, a business, or a society attempts to live beyond their means, events will, sooner or later, catch up with them. Inflation incents people to live beyond their means. We are observing the consequences of such behavior in the problems being experienced in the housing market.

Audits and Auditors

I would like to recommend to the readers of this post the column by Jennifer Hughes in the Financial Times this morning. The title of the article is “Lehman Case Revives Dark Memories of Enron”: http://www.ft.com/cms/s/0/c9516dea-3792-11df-88c6-00144feabdc0.html.

The issue at hand is the relationship between a firm and its external auditors. The reason for the attention given to this issue by Hughes is the examination of the collapse of Lehman Brothers by Anton Valukas. Although not a major thrust of the review, questions did arise in the study concerning the role of Lehman’s external auditor Ernst & Young in the accounting practices adopted by the firm.

Ernst & Young began auditing Lehman Brothers in 1994 and two Lehman of Chief Financial Officers came from this external auditor. One, David Goldfarb, joined Lehman in 1993 and became CFO of the firm in 2000. The other, Chris O’Meara, joined Lehman in 1994 and was the CFO from 2004 to 2007. It was under Goldfarb that the accounting policy with respect to “Repo 105” transactions was developed.

To Hughes, this brought up memories of the accounting relationship between Enron and the external auditing firm Arthur Andersen. Again, a very close relationship had been established between the two organizations and many Andersen staff worked for Enron over the years.

I am not out to just criticize the accounting profession and the good and proper working relations that exist between many companies and their external auditors. However, the relationship between companies and their auditors can become too cozy and can present the opportunity to do things with company books that are, let’s say, not quite what the owners would like them to pursue.

My interest in this relationship comes from my experience as a senior executive, including President and CEO, of several publically traded banking companies. Each case was a turnaround situation.

In such a situation it is vital to get the accounting books in order and presentable to shareholders and the investment community for their close scrutiny. Internally, it is good to have “fresh eyes” to perform such a review. In a troubled institution it is problematic to have the same people, from inside as well as from outside the organization, performing this exercise. The first reason for this, of course, is that these same people watched the organization become troubled and they have a self-interest in defending the status quo. This is neither good for the company nor the shareholders and, thus, certainly not good for the executives hoping to turn-around the firm.

But, this pointed me to the problem that the financial controls that had existed were not sufficient for the company or for the executives in charge to prevent the firm from collapsing into a troubled institution. So, either the work was not getting done adequately or the executives that had been in charge did not want the work to get done adequately. Either way, the situation was not a good one for the institution or the shareholders.

It became my rule that any organization in which I was the CEO would put the job of external auditor out for bids in the fifth year of an engagement. I felt this was necessary for me to keep on top of what was going on in the organization and to have “fresh eyes” review the books and the accounting procedures on a regular basis. Furthermore, doing this periodically encouraged the openness and transparency on the part of the employees that I believed was necessary for the shareholders and the investment community.

This “rule” of mine may have been a little severe, but I was doing turnarounds at that time and the tighter time schedule seemed important to me then. Perhaps a seven year turnover of external accountants would be better, except in cases where the CFO of the company happens to be a former employee of the accounting firm doing the external auditing.

Hughes mentions in her article that Italy, among other countries, have limits on audit firm tenure. There the length of time allowed is nine years. Other countries require that the “lead partner” from the accounting firm be changed every five years. Also, there are rules about hiring individuals from the external auditing firm, rules that require a “cooling off” period for anyone joining an audit client.

To me, this requirement seems of particular importance to banks and other financial institutions. Yes, the banks are examined by the regulators and this should provide a check on what banks are doing. But, this is not enough in my mind.

When I was a bank President and CEO, I wanted the bank to have stricter requirements on what it did than the regulators. The reason is that I wanted the company to control the position of the bank and not the regulators. This also applied to the safety and soundness of the bank. That is why I wanted to ensure that the external auditors were truly independent of me and the staff of the bank. Having the external auditor “turnover” on a regular basis was one way to help achieve this goal. To my mind, any CEO that has the best interests of his/her shareholders in mind would want this to be the case.

I know that this is not the case of all CEOs in all industries. That is why some regulation of company/external auditor relationships is important. This is true especially for the commercial banking industry. Any regulatory reform that is passed should have some statement about the presence of an external auditor and the regular replacement of external auditors. This is a first round effort to insure the safety and soundness of the banking system and should, if it existed, ease some of the burden placed on the examination efforts of the regulatory agencies. It is a part of the openness and transparency that should be required for all companies, but especially for those related to banking.

I know that there is little academic research, as Hughes reports, connecting “audit, or auditor tenure, and the quality of the work.” I know that most situations and people work out well. I know the value that hiring someone familiar with your books is a “good thing” because of the complexity and sophistication of accounting practices today.

Still, I always wanted to be on top of things and continually have “fresh eyes” looking over the operations and the books. I always wanted to be challenged to do things in the best way possible. I always wanted people to push me to do better. Openness and transparency never bothered me. To me, performance always went back to how well you executed your game plan and not on how much trickery or deception you needed to win.

To me, it all comes back to fundamentals and ability. If you lack one or the other or both…I guess you need to rely on other means, like “cooking the books”, to come out on top.

The United States Dollar, Europe, and England

I have been a “Dollar Bear” for most of the 2000s. For the long run, I continue to be a “Dollar Bear”, at least with respect to many currencies in the world. Right now, against the Euro and against the British Pound, the investment community is telling me that Europe and the U. K. are in worse shape, fiscally and politically, than the United States and therefore I need to alter my stance with respect to these currencies.

The play in international currency markets is, of course, a relative one. How is XYZ nation doing relative to LMN nation? So, one country might be doing miserably, yet another country might be in even worse shape, and, hence, the price of the currency of the latter relative to the former will decline.

This relative price, to Paul Volcker, “is the single most important price in the economy.”
Consequently, “it is hard for any government to ignore large swings in its exchange rate.” Or, at least, it should be!

Right now, the price of the Euro and the price of the British Pound are saying that the governments in Europe and the government in England should be concerned. Things are not going right and it is costing them and their people.

Of course, there are many monetary and fiscal problems that exist in the United States. But, the markets seem to be saying that, currently, attention needs to be focused elsewhere. And, in Europe and England, the problems are both economic and political.

In Europe, the major focus has been on Greece and the unfolding soap opera that is taking place in the European Union over how the fiscal problems that Greece faces will be overcome. Verbal recognition has been given to the problems faced by Portugal, Italy, Ireland, and Spain, but until yesterday they were being put to the side.

Then, Fitch Ratings reduced the credit grade of Portugal’s debt. The problem, according to a spokesman from Fitch, was that Portugal would struggle to meet its debt commitments in the face of “macroeconomic and structural weaknesses.”

This downgrade, others said, just reflected the concern over “the underlying problems in the European Union. People are worried about the fiscal situation in the southern European economies and the prospects for those economies.”

The difficulties, however, go deeper than that. What has surfaced over the past few weeks is the political problems of running a single currency in a region where there is no single government. This situation could be workable if all the countries within a currency area followed the same fiscal policies.

As is now apparent within the EU, this is not an easy thing to do. Different countries have different national make-ups. They have different histories and experiences. And, they have political parties that are at different places in the political spectrum. The chance that all the countries will follow similar paths with respect to economic policy is “slim” and “none.”

Currently, Germany is getting bashed for the disciplined and prudent policies that it has followed in recent years. No one is doing a better job at bashing the Germans than is the columnist Martin Wolf. (See “Excessive virtue can be a vice for the world economy,” http://www.ft.com/cms/s/0/924b4cc0-36b7-11df-b810-00144feabdc0.html.) The logic of this is beyond me. Germany has worked hard, kept up its discipline, produces high quality goods, and has an export surplus and should now give up what it has worked so hard for because others have over-promised, over-spent, and mortgaged their future? As Wolf argues, the virtue of Germany is a vice in a world economy? Come on, Mr. Wolf!

The European Union is facing a political crisis resulting from its adoption of a single currency. To the most pessimistic, this was always in the works. Paul Donovan, the deputy head of global economics at UBS Investment Bank, stated that Greece “is going to default at some point” because of the political problems of the EU. He goes on: “If Europe can’t solve a small problem like this, how on earth is it going to solve the larger problem, which is the euro doesn’t work.”

England is also facing economic and political problems. First of all, it has a serious budget problem and very little is being done about it at the present time. This is because of the second problem which has to do with the upcoming election. The Prime Minister, Gordon Brown, doesn’t want to do anything relative to the budget that would further upset the electorate right before the election. However, the Conservative candidate seems to be so inept that he cannot seem to be able to forge some kind of sensible budgetary policy in order to overtake a very unpopular Mr. Brown. World markets seem to have very little confidence with what is going on in the United Kingdom at this time.

The consequence of all this? The Euro is trading around $1.33 per Euro this morning, down from around $1.51 toward the end of 2009, almost a 12% decline. The British Pound is trading around $1.49 per Pound this morning, down from around $1.68 in November 2009, about an 11% decline.

The odds seem to be in favor of additional declines in these currencies until some satisfactory resolution is reached on both the economic and the political fronts.

United States officials can enjoy having someone else being in the spotlight for a while. Still, nothing has really changed for the good in terms of economic policy for the United States. Fiscal deficits are large and are expected to remain so for the upcoming decade. The monetary authorizes still have to “undo” what they have “done”. The political situation does seem to be a little more stable in the United States than in either Europe or England.

The value of the United States dollar does continue to decline against the currencies of other trading partners, especially against those currencies in the “emerging nations.” Here the trend seems to be for the dollar to continue to decline. The near-term declines continue against the Brazilian Real, the Canadian dollar, the Japanese Yen, the South Korean Won, the Swiss Franc, and the Australian dollar.

The United States dollar is not “out-of-the-woods”, by any means. And, as we have seen, world investors can turn on a country very quickly. Six months ago, the Euro and the British Pound were doing quite well, thank you. Government officials need to beware that they still have a long way to go before the investment community can look on the United States dollar with real confidence.

Right now the dollar gets a respite. How long this will last is uncertain at the present time. It is still my belief that over time the United States dollar will come under selling pressure again. It would be best if the Obama administration used this time to re-establish some form of discipline in both monetary and fiscal policy. But, I am not assuming a very high probability that this will happen in the near future, especially with the direction Congress seems to be heading.

The Chances for a Double Dip

I believe that the probability that we will have a double dip in the economy, a second recession following on the Great Recession, is relatively small and growing smaller all of the time.

The reason that I would give for this is that economies only change directions when there is some kind of shock to expectations. To use the words of one famous pundit with respect to an uncertain future, we just don’t know when something will change with respect to an “unknown” unknown. Even in the cases of “known” unknowns, we know where a change might occur; we just don’t know the magnitude of the change.

A liquidity crisis occurs when something happens in a market, generally a financial market, and the buyers on the demand side of the market decide it is best if they just go out and play a round of golf until the market settles and they know where prices will stabilize. The job of the central bank is to provide liquidity to the market so as to achieve this stabilization of prices. The length of a liquidity crisis is usually no more than four weeks.

A credit crisis occurs when something happens in a market, generally a financial market, and the holders of assets must significantly write down the value of their assets. Banks and other financial organizations may go out of business during the credit crisis because they don’t have sufficient capital to cover all the write downs that must take place. The job of the central bank is to provide stability to the financial markets so that the financial institutions can take their charge-offs in an orderly fashion so as not to cause multiple bank failures. The length of a credit crisis can extend for several years as the financial institutions work off their problem loans and those organizations that have to close their doors do so with the least disruption to “business-as-usual.”

In both cases, something unexpected happens and expectations about asset prices have to be adjusted. Extreme danger exists as long as bankers and investors persist is retaining the old expectations about prices and fail to make the moves necessary to adjust their thinking to a more realistic assessment of the situation. However, as these bankers and investors adjust to the “new reality”, they become more conservative and risk-averse in their decision making and work hard to get asset prices into line with the new financial and economic environment they have to deal with.

As the adjustment to the “new reality” takes place, things remain precarious, but, as long as no new surprises come along, the process of re-structuring can continue to lessen the problem and even strengthen the recovery. This is the state in which the United States is in right now.

The thing that needs to be avoided is a “new surprise”. What this can be of course is “unknown”…an “unknown” unknown.

In the 1937-1938 depression, there was an “unknown” unknown in the form of a policy change at the Federal Reserve System that is credited with “shocking” the financial and economic system into the second depression of the 1930s. The shock here was an increase in the reserves the banking system was required to hold behind deposits in banks, an increase in reserve requirements. The argument given for the increase was that there were a lot of excess reserves in the banking system and for the Federal Reserve to be effective at all during the time, the excess reserves had to be removed: hence the increase in reserve requirements.

The problem was that the banks wanted the excess reserves and with the increase in reserve requirements the banks became even more conservative causing another massive decrease in the money stock. This, of course, has been given as a reason for the “double-dip” that took place in the 1930s.

There are, as is well known, a lot of excess reserves in the banking system at the present time, almost $1.2 trillion in excess reserves. The Federal Reserve knows that they are going to have to remove these reserves from the banking system at some time. Hence, it has developed an “exit” strategy.

Banks and investors know that the Federal Reserve is going to have to remove these reserves from the banking system at some time. How the Fed is going to accomplish its “undoing” is, of course, the big unknown!

The fact that these reserves are going to be removed from the banking system is a “known” unknown!

But, how and when the reduction in reserves is going to take place, not even the Fed knows. Bernanke and the Fed have worked hard to keep the banking system and the financial markets aware of the “undoing” so that although there are still many unknowns connected with this undoing, the fact that the “undoing” is going to be done is a “known.”

The effort here is to avoid a policy “shock” coming from the central bank as in the 1937-1938 experience.

There are a lot of things going on in other sectors of the economy and the world, but these all seem to fit into the category of “known” unknowns: like the problems in Greece and the other PIIGS, Portugal, Italy, Ireland, and Spain. There are the problems of states, California, New York, New Jersey, and so on, and municipalities, like Philadelphia and others, but these are also “known”.

There are over 700 commercial banks on the problem list of the FDIC. But these are “known” and are being worked off in an orderly and professional way that seems to be the model of the world. (See the article by Gillian Tett, “Practising the last rites for dying banks,” http://www.ft.com/cms/s/0/00b740a2-350e-11df-9cfb-00144feabdc0.html.) The FDIC closed seven banks last Friday bringing the total for the year to 33. This is right on my projection of closing at least 3 banks a week for the next 12 to 18 months.

And, what about the United States deficit? Well, I would contend that this is a “known” unknown as well. The deficits over the next ten years or so are projected to be in the range of $9-$10 trillion. I believe that they will be more around $15-$18 trillion, but that is just a minor difference. But, the deficits are “on-the-table” even if the amounts are not quite certain. The deficits will be large and this will be a problem, but they are not going to be a surprise.

This is one reason, I believe, why the Obama administration made the effort they did to talk about the budget deficits publically, particularly with regards to the health care initiative. They are talking about the budget, whether one agrees with their projections or not.

And, just the passage of the health care legislation, I believe, will change the temper of things. This thing has been done and I think just this fact will change the environment…for the better.

There are always “unknown” unknowns lurking. There could be a blow up in the Middle East leading to a full-scale war…or in the east. There could be a political move to boost the price of oil. There could be a lot of things. But, as far as the economy itself and the financial markets: I believe that things are being worked out and things will continue to improve. Thus, the probability of a Double Dip has lessened.