How Long will the United States Dollar be a Safe Haven?

“The U. S. dollar is recapturing its role as the primary safe-haven currency, eclipsing the yen and the Swiss franc, as tensions in Korea and Europe escalate.

That re-emergence as the ultimate sanctuary for those fleeing risk will likely result in continued strength against major rivals in the next few weeks, analysts expect.

‘Recent events just reinforce the underlying message that during times of turmoil, almost no matter what the source, the U. S. dollar is seen as a safe harbor for investors,’ said Doug Porter, an economist at BMO Capital Markets in Toronto.” (http://professional.wsj.com/article/SB10001424052748704008704575639022158300444.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)

The question is “how long will the U. S. dollar remain a safe haven?

Twice in the past three years, the United States dollar has served as a “safe haven” for the world. Once, following the financial collapse in the fall of 2008, the value of the United States dollar against the currencies of major currencies rose from a trough in March 2008 of 70.3 to a peak of 84.0 in March 2009.

The next trough came in November 2009 at 72.2, but the sovereign debt crisis in the Euro-Zone in early 2010 caused the value of the dollar to rise again as a “safe haven”, peaking at 79.0 in June of that year.

After June the dollar, once again, continued to decline, falling to 71.0 in the first full week of November 2010. As mentioned above, the value of the United States dollar is now climbing.

Most analysts, including myself, believe that the long term trend in the value of the dollar is down. The United States government is basically un-disciplined with little or no self-control. This is not a slam against the Democratic Party because I believe that the Republicans have acted in a similar way. Fiscal deficits have led to mountains of federal debt, and the example set by the federal government has been emulated by the public at large over the past fifty years building up more-and-more debt over time. The Federal Reserve has supported this credit inflation and has even underwritten a large portion of it…and promises to underwrite a whole lot more.

The consequence of this lack of discipline and self-control has been reflected in the decline in the value of the dollar over the past forty years, since President Nixon floated the dollar. The chart below just shows us what has happened over the past ten years where the primary culprit has been the Republican Party.

From the peak value reached in February 2002 the dollar reached a trough in March 2008, 37.3 percent below the earlier peak. The dollar became a “safe haven” in the fall of 2008 and moved from its March trough to a short-term peak in March 2009, rising by 19.4 percent. Once this move was over, the value of the dollar dropped once again, this time by 15.5 percent.

The point is, the long-term pressure on the value of the United States dollar is to decline. This can be observed very clearly in the accompanying chart.

Since the value of the dollar was floated and the current data series began, January 1973, the dollar has declined by about 34.4 percent. So, the general trend of the value of the dollar since it was set free has been downward. Over the longer haul, nothing has really changed much in the way of American economic policy.

The bottom line to all of this is that nothing has changed in the past fifty years as far as the fundamental philosophy behind the economic policy of the federal government. The long run prospect for the value of the dollar is down!

There will be upswings, flights to the “safe haven”, but the basic trend will be downwards.
But note, the 2008 recovery in value of the dollar went on for about one year before the decline set in again. Therecovery in value associated with the euro-zone sovereign debt crisis lasted only seven months before the movement down began once more. The short-term peak reached in 2010 was 6.0 below the previous peak in 2009.

How long will this move into the dollar “safe haven” last and how high will the value of the dollar reach?

My guess is that the value of the dollar will move upwards for several months. The peak will be somewhere in the neighborhood of the March 2009 peak and the June 2010 peak. But, the decline will begin once again.

And, the longer run? As the periphial countries in the euro-zone get their acts together and become stronger over time, attention will look for other countries that need to be chastized. After Greece, Ireland, Portugal, Spain, Italy, and possibly France…will the focus of the financial markets turn to the Unitred States…and not as a “safe haven”?

The European Situation and the Financial Markets

Are the financial markets the WikiLeaks of economics?

Politicians and economists and business people ignore what financial markets are saying at their peril.

The financial markets have not responded well to the “rescue” package for Ireland put together by the European Union. The news out of London: “The euro continued to slide Tuesday, falling to a 10-week low under $1.30 as Italian, Spanish, Portuguese and Irish bond-yield spreads all continued to widen relative to Germany.” (http://professional.wsj.com/article/SB10001424052748704679204575646211228101600.html?mod=WSJ_Currencies_LEFTTopNews&mg=reno-wsj)

“The euro had started the European day with a rally, helped by regular month-end flows in its favor. However, things turned sour again as it became apparent that the risks of contagion remained as strong as ever and that Italy is now being affected by the lack of investor confidence in the euro zone.

Like the debtor countries on the periphery, Italy watched the yield on its bonds rise relative to those of Germany as investors demanded greater returns for holding Italian debt.”

The Financial Times writes: “it is still hard to see how Ireland can repay all the debt it has now taken on. So it is unsurprising that the market sensed a fatal combination: governments lacked the means either to nix moral hazard or end the crisis by writing an enormous check.” (http://www.ft.com/cms/s/3/8540ea0a-fb9f-11df-b79a-00144feab49a.html#axzz16locxnQW)

The European banks still remain a problem. Not only do the banks have serious solvency issues facing them, the eurozone’s banking system is a much bigger proportion of the economy than the proportion found in other countries, especially the United States.

The financial markets are flashing a warning signal that the cost of insuring a bank default has risen severely in Europe and in Spain. Plus, given how large the banks are relative to the size of the economy, questions have arisen about the ability of these countries to continue to provide bailouts. The situation in the banking sector of Greece looks positively “great” relative to Ireland, France, Spain, and Portugal.

Yet people continue to ignore what the financial markets seem to be telling them. It is very easy to claim that the markets don’t really understand a situation or that the blame for a situation rests elsewhere. See, for example, the op-ed piece in the Financial Times, “Spain is threatened by a crisis made in Germany”: (http://www.ft.com/cms/s/0/bb515190-fbf2-11df-b7e9-00144feab49a.html#axzz16lsMDit2). Every time the author makes an argument that Spain stood up for Germany in earlier times, he only talks about individuals, not what was happening in the market place. He now makes the argument that Germany, out of short sightedness, is hurting Spain. There is nothing about markets or what markets are doing. It’s all personal, not business!

Spain has problems and the problems are of their own doing. Now they need to get their books in order. (See my post “Is the Euro Bad News for Spain,” http://seekingalpha.com/article/239065-is-the-euro-bad-news-for-spain.)

In the vast majority of cases I am familiar with, the people who ignore the information being generated by the financial markets end up losing. One needs to have an overwhelmingly strong case that the market is wrong before one places a bet. In fact, betting against the market is like setting up one-way bets for traders. (See my post “Interventionists are setting up one-way bets for traders”: http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders.)

Furthermore, when talking about the banks, we still find a lot of people not really understanding the difference between a liquidity problem and a solvency problem. A liquidity problem is a short-run problem pertaining to “asymmetric information.” Something happens, a bankruptcy in the case of the Penn Central situation, and the “buy-side” of the market begins to question the situation of other high-grade customers that have issued commercial paper. In cases like this a central bank provides liquidity to the market so that the buyers will return as prices begin to stabilize. But, this is a short-run event.

A solvency problem is much longer-term and the state of the organizations, banks in this case, is known in the marketplace. And, that is a problem as far as raising funds is concerned. Firms in this situation cannot raise funds because no one wants to lend to them due to their extremely weak financial condition. But, this is not a liquidity crisis, it is a solvency crisis. People would lend to the organization if they were not financially challenged.

Yet, this is what we read in the New York Times with respect to the European financial crisis: “Ireland’s banking problems are only the latest example of how seemingly solvent institutions can be brought to the brink because they cannot in the short term raise the cash needed to finance themselves. Only four months ago, Allied Irish Banks and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they stressed solvency, not liquidity, although that may be remedied next year.

The two biggest Irish banks did not have a large enough base of stable retail deposits. The loan-to-deposit ratios at Allied Irish and Bank of Ireland stand at just above 160 percent, which made them excessively dependent on wholesale money from other banks and big investors. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.” (http://www.nytimes.com/2010/11/30/business/global/30views.html?ref=todayspaper&pagewanted=print)

Maybe, just maybe, the stress tests were not strong enough, as many have claimed. Certainly “the markets” did not think that the banks were healthy. This is even admitted in the article: the banks were “excessively dependent on wholesale money” and “when that dried up” real problems ensued.

Come on…wholesale money is very sensitive to the financial condition of the banks. The banks may have passed the stress tests but they failed the market test. Who is kidding who? You believe the stress tests? I’ve got a bridge to sell you!

This is why many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry!

Is the United States Making the Emerging Nations Stronger?

Why is the rate of inflation so low in the United States when the government has pumped huge amounts of debt into the country and the Federal Reserve has loaded the financial system with large amounts of liquidity?

The same question was asked in the 1990s. Where was the United States inflation?

The answer for the 1990s…and for the present time period…is that the United States has exported inflation to the rest of the world…more specifically…Asia. As the accompanying chart shows, inflation seems to be heading up in Asia…as it is also heading up in many other emerging nations.

As reported in the LEX column of the Financial Times yesterday, global inflation has seemingly bifurcated. In the developed countries the current inflation rate is below 2 percent (Australia and the UK are exceptions). Morgan Stanley expects a 1.5 percent rate of growth for the wealthier countries in 2010. “By contrast, the emerging market inflation rate is about three times higher—expected at 5.4 percent in 2010…” (http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK)

The post-financial crisis stimulus is now feeding the inflation in the emerging countries. “A significant portion of the river of cheap money flowed into commodity markets. The initial price recovery caused no problems, but the trend now threatens to create a vicious circle.”

There is also the “carry trade” which takes United States dollars throughout the world seeking higher interest rates. This flow is certainly not insignificant.

In these days, it seems like it is very difficult to contain the international flows of capital. Maybe policy makers need to give this a little more weight in their policy discussions.

There is an argument that central banks, in some Asian countries, kept their interest rates “appropriately low” over the past year or so because of “concerns about the strength in their developed-market trading partners” especially the United States. Now, with inflation threatening to get out-of-hand in the emerging nations, these same central banks are faced with the need to raise their domestic interest rates higher and higher. (See “Emerging Wild Card: Inflation”: http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK.)

The article continues: “One conundrum for investors is how more aggressive tightening would play out in the currency markets. Most investors have been operating on the assumption that with the Fed keeping interest rates at zero for the foreseeable future, any moves by emerging-market countries to raise interest rates would attract even more money from yield-hungry investors.”

This seems to reflect a cumulative problem. By keeping interest rates low in the United States, dollars are flowing out into the rest of the world. This out-flow is threatening to bring about greater amounts of inflation in the emerging nations of the world. In order to combat this rising level of inflation, the central banks in emerging nations are raising interest rates. But, in raising interest rates, more United States dollars flow to these emerging nations.

And the flow of money into dollars from Europe as a “safe haven” has kept the value of the dollar stronger than it otherwise would be in such a situation which just enhances the return to investors from moving into the interest rates in the emerging countries.

So, the Federal Reserve continues to inject large amounts of reserves into the banking system, hoping to get the United States economy going again. But, individuals, families, and small businesses do not seem to want to be borrowing. Only large, healthy companies seem to be borrowing and piling up cash reserves. The money the Fed is printing seems to be going off-shore.

Therefore, instead of stimulating the United States economy, the Federal Reserve seems to be stimulating the emerging countries of the world. The two results of this seem to be that the United States is not getting stronger, but it is helping the rest of the world to get relatively stronger. The rest of the world needs to keep inflation under control, but the emerging nations feel the relative shift in power within the world and are taking more and more advantage of this increased power. See reports on the recent G-20 meeting. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)
Only strong, self-disciplined countries come out on top. Right now, the United States is anything but self-disciplined and it is finding that its relative strength is slipping away. The unfortunate thing is that in its lack of self-discipline, the United States is feeding the rising relative strength of the emerging nations in the world. This is our fault, not the fault of other nations within the world.

The Euro is "Bad News" for Spain!

Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)

It’s that Trilemma thing again!

The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.

Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.

Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.

If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.

The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.

This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.

That leaves one prong of the Trilemma hanging…independent economic programs.

This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.

And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.

Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.

Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.

What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?

The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.

Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.

Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.

Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!

Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”

America can create debt and inflate its currency all it wants to and no one else can do anything about it!

Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”

Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.

Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)

Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.

The conclusion to this story is far from over.

The Number of Problem Banks Rise in the Third Quarter

The number of problem banks, as listed by the FDIC, continued to rise in the third quarter of 2010. The number went from 829 at the end of the second quarter to 860 in the third quarter.

Forty-one banks failed in the third quarter, an average of about 3.2 banks per week. A total of 149 banks have been closed through the first three quarters of 2010, an average of 3.8 per week. Thus, the pace of bank closings has been relatively steady throughout the year, somewhere between 3 and 4 banks per week.

The total number of FDIC-insured commercial banks in the system was 7,760 at the end of the third quarter. This is down from 7,830 at the end of the second quarter and 8,195 at the end of the second quarter of 2009. So, the number of banks in the system dropped by 70 banks in the third quarter. Since June 30, 2009, the number of banks in the system has fallen by 435.

The decline in the number of banks in the banking system is not all failures as some banks are merged into other banks before the bank is closed by the FDIC. For example, in the third quarter of 2010, 30 mergers took place.

So, the industry is shrinking by bank failings and by the consolidation of healthy banks with banks that are not in very good shape. From June 30, 2009 to June 30, 2010, the number of banks in the banking system dropped by 365 banks, an average of 7 banks per week. In the third quarter of 2010 the number of banks dropped by 70 banks, an average of about 5.5 banks per week.

This fact raises concerns not only about those banks that are listed on the problem list, but what about those banks that are in serious trouble but do not “qualify” to be on the FDIC’s problem list?

How many surprises are out there?

Wilmington Trust, in Wilmington, Delaware, was considered to be doing OK. Then, the bombshell hit. Wilmington Trust ended up being sold at a 45% discount. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.)

How many more banks in the system are facing the same fate as Wilmington Trust?

Earlier this year Elizabeth Warren told Congress that as many as 3,000 commercial banks were facing real problems over the next 18 months.

My prediction is that the total number of banks in the banking system will drop to 4,000 or so over the next five years. This is down from 7,760 at the end of the third quarter of 2010, a reduction in the number of banks of 3,760 banks or of approximately 750 banks per year for the next five years.

There is good news:
“Banks and savings institutions earned $14.5 billion in the third quarter, $12.5 billion more than the industry’s $2 billion profit a year ago, the FDIC said yesterday. The third-quarter income was below the $17.7 billion and $21.4 billion reported in this year’s first and second quarters, but agency officials said the shortfall was attributable to a huge goodwill impairment charge at one institution.

A reduction in loan-loss provisions was the primary factor contributing to third-quarter earnings…. While third-quarter loan-loss provisions were still high, at $34.3 billion, they were $28 billion -- or 44.5 percent -- lower than a year earlier. Net interest income was $8.1 billion -- or 8.1 percent-- higher than a year ago, and realized gains on securities and other assets improved by $7.3 billion, officials said.”

This was from the American Bankers Association release, “Newsbytes”.

But, the good news was not for all sectors of the banking industry. As I have been reporting in my posts, the largest twenty-five banks continue to prosper at the expense of the smaller banks. One must report that the “good news” presented above is for the industry as a whole. For the largest twenty-five banks, the news is “good”. For the other 7, 735 banks…the results are really “not-so-good”.

And this is why the worry is focused on the smaller banks.

We keep getting bits of news like that reported in the NYTimes this morning, “Large Banks Still Have a Financing Advantage” (http://www.nytimes.com/2010/11/24/business/24views.html?ref=todayspaper):

“What happened to ending ‘too big to fail?’ That was one objective of the financial overhaul bill, the Dodd-Frank Act, that was passed this year. Central to the legislation were rules intended to make big banks less exciting and safer. It also created an authority meant to smoothly wind down even the largest institutions without greatly disrupting the financial system.

Five months after the bill’s passage, big banks should have lost at least some of their financing advantage over smaller rivals. But as the latest quarterly report from the FDIC shows, too big to fail is still very much alive and well.”

The point being made is that the average “cost of funding earning assets” for commercial banks in excess of $10 billion (109 banks out of the 7,760 banks in the system) was 0.80 percent. The average cost of the 7,651 smaller banks was an average of 1.29 percent so that the bigger banks had a 49 basis point advantage over the smaller banks. (Note that the gap was 69 basis points a year ago.)

The average cost of funding earning assets was even lower for the largest 25 banks in the country!

It seems like everything the policy makers are doing is benefitting the largest banks in the country.

And, what is being done for the smaller banks…the other 7,735 banks?

The Federal Reserve is pumping plenty of liquidity into the banking system so that the FDIC can reduce the number of banks in the banking system as smoothly as possible. (See my post “The Real Reason for Fed Easing”: http://seekingalpha.com/article/237834-the-real-reason-for-fed-easing-debasement-inflation.)

In reducing the number of banks in the banking system we don’t want disruptions and we don’t want panic. If this is the goal of the Federal Reserve and the FDIC, then they are doing a good job. The bank closure situation has, so far, neither resulted in major disruptions to the financial system or the economy or panic over the state of the banking industry.

The dismantling of the former United States banking system is going quite smoothly, thank you.

The future United States banking system is going to look entirely different. What might that banking system look like? Try the Canadian banking system or the banking system in Great Britain…a few very large banks dominate these systems. Is that what the United States system is going to look like?

Bailouts or Defaults?

This question is the defining question in finance and economics today.

Yet, the predominant approach used in macroeconomic policymaking does not include debt and the possibility of defaults in its model. So, the policy answer is obvious. The policy makers must “bailout” individuals, banks and businesses, and governments.

Well, forget individuals, let them default!

But, we need to save banks and businesses…and governments. Provide them with cash grants. Provide them with excessive amounts of liquidity. Defaults of banks and businesses and governments are not a part of our theoretical picture of the world.

Look through the book “”Ben Bernanke’s Fed” written by Ethan Harris, a former research officer at the Federal Reserve Bank of New York and published by Harvard Business in 2008. Chapter 2 is called “How the World Works: a Brief Course in Macroeconomics.” Here we get a picture of the basic model the Federal Reserve uses in its analysis of the state of the world.

“Getting into the head of the Fed requires a basic primer on how the economy and monetary policy works, Harris writes, “Nonetheless, a relatively simple framework underlies much of the discussion at central banks today.”

The foundation of the Fed’s analysis, according to Harris is something called “the Phillips Curve” which supposedly captures the tradeoff between inflation and unemployment. This, of course, incorporates the two government policy objectives written into law in 1978 and affectionately referred to as the Humphrey-Hawkins Full Employment Act.

Harris continues that “Bernanke is a proponent of the ‘financial accelerator model,’” which brings the credit market into the picture. “The idea that strong financial and credit conditions and a strong economy can reinforce each other to create economic booms (and that weak conditions can interact to create busts). During booms, both firms and households have stronger incomes and their assets are worth more, encouraging relaxed lending rules. Easy lending makes the economy even stronger and that, in turn encourages even easier lending standards.”

In other words, Bernanke, and people within the Fed, believe that pumping credit into the economy produces “stronger incomes” and “assets are worth more.” Thus there is a wealth effect. But, as long as inflation is “in check” there will be no problems on the “real” side of the economy and unemployment will be reduced. BINGO!

However, within this view of the world, there are no problems with debt loads, foreclosures, and bankruptcies. Piece of cake…just throw more spaghetti against the wall! (See “Bernanke’s Next Round of Spaghetti Tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.)

Remember, Keynes won and Irving Fisher lost the battle for the hearts and minds of the economics profession. To resolve economic downturns just create more and more debt. Forget about the fact that debt has to be paid off. Just toss more liquidity into the markets.

Defaults are not considered in the model because the assumption is that the problem is one of liquidity, not solvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

Therefore, individuals, banks and businesses, and governments can issue all the debt they want and the Federal Reserve, the European Central Bank, the United States government, or the European Union can step in and solve any discomforting situations that arise through bailouts and loose monetary policy.

However, debt does matter! And, defaults should not just fall on individuals and families. Foreclosures and bankruptcies are very common into the world today.

Yet, governments continue to try and sweep solvency issues “under-the-rug” when it comes to banks and businesses…and to governments.

The only time we really hear about problems of this sort within these institutions is the weekly list of bank closings overseen by the FDIC. But, this information tends to end up on the fifth or sixth page of the business section of the newspaper and rarely, if ever, gets into the radio or television news. Maybe this news, week-after-week, is too boring. However, the FDIC is closing three to four banks a week and they have been doing this for more than a year. Still there are nearly 900 banks on the FDICs list of problem banks, and this does not include a thousand or more banks that are sliding into this problem bank list but have not reached the “statistical” test of being on the list.

This has to be the case within the sector of non-financial businesses. How many small- to medium-sized firms are still on the brink of insolvency? My guess is…a lot. It seems like every week there are more and more empty spaces in the strip malls and other business buildings.

And, then there are the state and local governments. The municipal bond market is in a mess!

In the banking week ending November 19, 2010, the Federal Reserve reports that the average yield on State and Local bonds was 4.72 percent. In the same week 30-year U. S. Treasury bonds yielded 4.30 percent. And, State and Local bonds are not taxed.

WHEN HAVE YOU SEEN AN INTEREST RATE RELATIONSHIP LIKE THIS BEFORE?

Now we get into sovereign debt. Let me just start listing the problems: Greece, Ireland, Portugal, Spain, Italy, France…

Need I say more?

And, what about the United States? On September 30, 2009, the Gross Federal debt outstanding was almost $12 trillion; the Federal debt held by the public was about $8 trillion on that date. And, what if the Gross Federal debt more than doubles over the next ten years as I have been predicting? How acceptable will the debt of the United States government be in the world?

DEBT MATTERS!

Why isn’t debt included in the models the policy makers use? We can’t continue to operate under the assumption that debt doesn’t matter and that all we need to do, policy wise, is throw more spaghetti against the wall.

People, other than individuals, families, small businesses, and small banks, must come to realize that there is a penalty for taking on too much debt. That penalty is default followed by bringing one’s books under control. People must learn that the solution to issuing debt is not issuing more debt!

The Short Term Myopia of the United States

Working in urban neighborhoods can be a very disheartening experience. There are so many problems that at times they can seem overwhelming.

One of the most discouraging problems that one runs into over and over again is the myopia that exists within some of these communities, a myopia that results in people making decisions as if there is no tomorrow.

Often these decisions can be captured within the context of game theory, specifically the “Prisoner’s Dilemma” game. The solution to a one-shot, simultaneous Prisoner’s Dilemma is for all players to default to the action that results in the worst decision for each player.

Researchers will explain the deterioration of housing within certain neighborhoods in terms of this kind of Prisoner’s Dilemma game. No one maintains, or “keeps up” their house because that is not the best decision given how they expect everyone else to act. And, there is no communication between actors so that people fail to “co-operate.”

People within the United States, as a whole, have become very myopic. This myopia grew in the latter part of the 20^th century and stands behind many of the problems we face today. We constantly read about two areas that have produced damaging results in the United States, yet, as with most one-shot, simultaneous Prisoner’s Dilemma games, most are barely aware of the role that this myopia plays. I would contend that these two major areas have to do with employment and the environment.

The United States has such a short-run view of employment that its governments throw billions of dollars into efforts to put people to work “right now” or to put people back to work “right now”. The emphasis on achieving “full employment” in the United States going back into the 1930s and 1940s has tended to get people employed as early in their lives as possible and to keep them in their same jobs throughout their working careers.

The consequence of this emphasis is that unemployment and underemployment have trended upwards in the latter half of the last century. Now, roughly one out of every ten individuals of working age are unemployed and one out of every four is underemployed.

The current solutions for reducing this unemployment and underemployment just advise “more of the same.” That is, more fiscal stimulus and printing more money.

These are just myopic attempts at resolving employment problems, myopic attempts that result from the myopic behavior of the politicians. After-all they have to get re-elected every two years…or every four years. So they must continue to pump up the economy.

But, this behavior just exacerbates the problem. And, it creates massive amounts of debt or money for the economy to absorb.

It has taken us a long time to get where we are and it will take a long time to get us out of this mind-set and out of this situation. A lot of what needs to be done relates to education and to everything that surrounds education…parents and teachers…and society itself.

Thomas Friedman has written several columns in the New York Times about the situation that exists in the education front in the United States and how it not only impacts us internally but how it impacts of relative to other nations. (His latest can be found here: http://www.nytimes.com/2010/11/21/opinion/21friedman.html?partner=rssnyt&emc=rss.)

Friedman reports of a speech from the secretary of education Arne Duncan: “One-quarter of U. S. high school students drop out or fail to graduate on time. Almost one million students leave our schools for the streets each year.” And Duncan comments on a report from a group of retired generals: “75% of young Americans, between the ages of 17 to 24, are unable to enlist in the military today because they have failed to graduate from high school, have a criminal record, or are physically unfit.”

America’s youth are now tied for ninth in the world in college attainment.

How are these young people going to fill jobs in companies that must face competitors that draw from a better prepared and better educated body of potential employees? How are companies going to develop and train people throughout their careers that do not have the appropriate base of skills? And, if these people do not seem to be coming along the pipeline, why shouldn’t the companies “outsource” to other countries where they have the educated workforce and will even have a more prepared workforce in the future?

Continual efforts to re-stimulate the economy and put under-employed people back into the jobs they formerly held is no solution to either the employment problem or the happiness of the worker. Unfortunately, the solution is a longer-run solution. For another look at the situation see “The Baseline Scenario” https://mail.gv.psu.edu/exchange/jmm27/Inbox/[BULK]%20%20The%20Baseline%20Scenario.EML?Cmd=open.

And, the same myopia applies to treatment of the environment and the efforts to develop sustainable business practices. Businesses are forced to focus just on the near-term, on their ability to grow and produce continually increasing profits. And, in doing so these businesses “mortgage” the future. Again, we have another one-shot, simultaneous Prisoner’s Dilemma game where most of the players default to the actions that will produce the worst results for all.

A great deal of the effort to produce a “green” outcome also, in my mind, tends to produce short-term fixes and look as if they just add costs to the accounting for the firm.

Again, education is crucial in environmental understanding. We are not talking here about knowing what the ecological problems are. We are talking about understanding what decisions are available and the externalities and network effects that surround the decisions we make.

But, as with the education, the consequences of our actions extend over many years and our decisions must take this future into account.

It is my experience that the decisions and actions surrounding these longer term decisions produce better results over time and also produce better managements because they take more factors into the making of decisions and the taking of actions.

In both of these cases, the emphasis on the “short-run” end up hurting individuals as well as hurting the economy. We get into situations like the one surrounding the resolution of the government debt problem. The argument is made that we need to spend more creating more debt so as to put people back to work. Yet, the additional deficits just create a “debt crisis” that interferes with putting people back to work.

Speeded up spending on solutions to ecological problems is a top-down approach that seems to substitute for companies changing their own behavior and decision-making processes.

Short-run America is losing out on the longer-term competitive battle. As Friedman continually reminds us, we continue to slide in all the measures of what makes a modern economy more competitive and live-able. The chances for becoming more competitive? Highly unlikely given the myopic behavior of our politicians.