What Can or Cannot Be Done About Economic Growth?

Over the past fifty years, the United States economy, as measured by real gross domestic product, has grown at a compound rate of growth of 3.1 per cent. 

Yes, there have been cycles in which economic growth substantially declined or expanded and in which unemployment rose and unemployment fell.

But, over this time period, the trend rate of economic growth remained relatively constant. 

Maybe we can’t do much about achieving greater trend economic growth in the United States.  Other countries are growing more rapidly over time than the United States but we used to talk about the convergence of growth rates.  Emerging or developing economies grew faster than the more developed countries, but as these countries matured their economic growth rates would converge to that of the more developed countries.

In this view there is not much that a “mature” country can do in order to achieve higher secular rates of growth.  Maybe the United States is “stuck” with a growth rate slightly in excess of three percent.

Another statistic that has caught my attention is the so-called under-employment rate.  Since the 1960s, this rate has grown dramatically to the point where one out of every four or one out of every five Americans of employment age (depending upon how you measure this condition) are either unemployed, employed part-time, or has dropped out of the labor force and is not looking for a job.

Of, course, the labor market has changed substantially.  For example, the participation rate in the work force has grown since the 1960s as more and more women have entered the work force, but even this number has dropped modestly.

These statistics came to mind this morning as I read (for the second day in a row) a very important article on the front page of the New York Times.  The article is “Companies Spend on Equipment, Not Workers.” (http://www.nytimes.com/2011/06/10/business/10capital.html?_r=1&hp=&adxnnl=1&adxnnlx=1307710996-gxrbDaAG3hw1i6zHqy/zcw)  “Workers are getting more expensive while equipment is getting heaper, and the combination is encouraging companies to spend on machines rather than people.”

But, this is not the whole story.  As one business owner is quoted in the article, “’People don’t seem to come in with the right skill sets to work in modern manufacturing,’ Mr. Mishek said, complaining that job applicants were often deficient in computer, mathematics, science and accounting skills. ‘It seems as if technology has evolved faster than people.’”

Another factor creating this divergence beyond just the evolution of technology, I believe, is the fact that the federal government has been spending lots and lots of dollars over the past fifty years to put people back into the jobs they lost either over the business cycle or as foreign competition grew.  Government spending to “keep the economy growing” or to protect US industries was good for the labor unions because it kept their base in tack, and it was good for the politicians because it kept the labor unions happy and kept the employees employed and happy.

But, it did nothing for the skills of the employment age people and it provided a promise to many joining the labor force that similar jobs would be available to them in the future and that their employability would be protected by this governmental policy.

Earlier this year, some test results of school age children around the world were released.  There was only one category that American students were first in the world in…”self-esteem.”  In almost everything else, the American student scored in the middle of the pack.  However, they believed they were the best.

Seems like we have a growing mis-match in the United States economy about what people expect about future employment opportunities and how young people are being educated to be prepared to work in the world of the twenty-first century. 

Stimulating the economy to put people back to work in the same jobs they lost is going to resolve only one problem…getting the politicians who proposed the stimulus re-elected.  As we have found out, this may be a “short-run solution” but it does not resolve the problem over time.  The attitudes in the society toward education must change and this is only a “long-term solution” that is not easily marketed in elections.

The same thing applies to “re-distribution” programs.  Housing and home ownership have been a major component of the economic policies devised by the federal government over the past fifty years.  Again, the justification for attempting to achieve these objectives…getting sitting politicians re-elected!

And, like the current disarray in the labor market, where is the housing market these days?

There are some things that can be achieved by economic policies and some things that cannot.  Over the past fifty years, the United States government has tried to force solutions on the United States economy that cannot be achieved. 

The effort to achieve higher rates of employment and home ownership over the last fifty years has resulted in a credit inflation that has produced the consequences we are now experiencing.  One of the reasons why this approach was taken was that there was not sufficient historical data or information available to provide insight into the problems and difficulties that such policies could produce.  This is one reason why Kenneth Rogoff and Carmen Reinhart conducted research over eight centuries to examine the “financial folly” that could lead to the justification for policies such as the ones that have been followed since the early ‘sixties.

One of the problems that come out of such “folly”, however, as Rogoff and Reinhart point out in their important book “This Time is Different,” is that a nation does not get out of such irresponsible behavior overnight.  

That is, a country cannot just “stimulate” itself out of the hole it has dug for itself. 

There are some things that a government cannot do with respect to generating more rapid economic growth.  Efforts to over-achieve in this area just result in longer-term misery.  Sometimes the prudent behavior is to stop digging the hole deeper.   

Regulation Never Works As Planned

One constant seems to run through my whole professional career.  The regulators impose some new rules…and within a reasonable period of time, the private sector finds ways to get around the new rules.  Then the regulators impose further new rules…and within a reasonable period of time, the private sector finds ways to get around them.

Back in the 1960-1971 period, I was in the Federal Reserve System and one of the main new financial innovations that the Fed was dealing with at the time was the Eurodollar deposit.  The “time lag” then was about six months. 

That is, the Fed would see some activity it wanted to get greater control of and it would impose new rules or restrictions on the activity.  The banks would then respond to the new rules or regulations.  About six months later the Fed would discover what the banks were doing to get around these new rules or regulations.  Then, the Fed would move into action once again.

At that time, however, we did not refer to the commercial bankers as “greedy bastards.”

In fact, any void seemed to call forth the ingenuity of the financial community.

The credit inflation, begun in the early 1960s, provided the incentive for the financial community to engage in more financial innovation over the next fifty years than ever before in human history. 

Restrictions on the interest rates that financial institutions could pay on deposit—Regulation Q—could not stand up to the inflationary expectations that got built into interest rates.

The consequent volatility in interest rates made it worthwhile to develop interest rate futures and interest rate options.

The desire to drive more and more credit into the housing market resulted in the government creation of the mortgage-backed security and the validation of “slicing and dicing” of the cash flows generated by financial instruments.

This slicing and dicing spread to government issues and we got the Treasury “Strip” securities...and more.

And, the continued credit inflation resulted in greater and greater amounts of risk taking and things like credit default swaps to hedge against risk taking.  We got more and more financial leverage and this required new ways to “cut things up” or hide things “off-balance sheet” or make things “synthetic” or deal only in “nominal” values. 

And, the beat goes on.

To me, this comes out in the rant of JPMorgan’s Jamie Dimon the other day against Ben Bernanke.   His blast, I believe, was one of pure frustration.  We want to be bankers, Dimon said, but the Fed…and Congress…and the Administration…force us to be financial innovators, constantly creating ways to get around the ill-considered new rules and regulations that continuously flow out of the government. 

He could have said, “If you want us to stop the financial innovating do two things.  First, stop inflating credit as you have done for the last fifty years and are continuing to do at this very minute!  Second, let things settle down and stop trying to regulate the very things you are causing us to do because of your inflation of credit!”

Will the government do this?  Not likely, and that is why Dimon is so frustrated.

My prediction: the financial system, over the next five to ten years, will be different in major ways from what we now see in front of us. 

The reason is that bankers…and the public…will create a new and different financial system. 

For, example, what about the “shadow-banking system” that was created in the past twenty years or so?  Maybe this “system” will become the preferred lender to business.

It is still there, thank you, and it is “filling in the current void.”  See the front page New York Times article this morning: “Bank Said No? Hedge Funds Fill Loan Void.” (http://dealbook.nytimes.com/2011/06/08/bank-said-no-hedge-funds-fill-a-void-in-lending/?ref=business)  “With traditional lenders still avoiding risky borrowers in the wake of the financial crisis, hedge funds and other opportunistic investors are stepping into the void.  They are going after mid-size businesses that cannot easily raise money in the bond markets like their bigger brethren.”   No telling where hedge funds…and others…will be found these days.  

And, this doesn’t even include what might be done electronically.

What is money?  What is finance?

As I have argued many times in previous blog posts, money…finance…is just information…just 0’s and 1’s!

“Concerns about the integrity of money have also seen a fundamental shift…While fraud is still a concern, the financial collapse of 2008 has called into question the competence of the central banks that are supposed to manage national currencies.  In this week’s technology special we examine how the internet is allowing groups of people to set up means of exchange that are independent of both the banks and the state.”

Hold on there…

What about gold or silver?

“Private currencies are nothing new, but novel possibilities such as bitcoin now beckon.  Though bitcoins are magicked out of nothing, money is what money does, and many people are happy to accept bitcoins as payment for real goods and services.  The bitcoins in circulation are now worth around $50 million in conventional currency.”

“Governments may want to clamp down on what they see as a way to evade taxes…”

“But the future of money, as so much else, may be shaped by the internet’s ability to bring interested parties together outside the ambit of governments or big companies. “

“Under a scheme operating in the city of Macon, Georgia, special bonds are issued to residents—but each person receives only half a bond, and can only redeem it by locating the person with the matching half.  Participants must seek each other out through online social networks such as Twitter, then decide together how to spend the cash.  Attempts to set up such ‘local currencies’ have been tried many times before, but have usually proven too difficult to co-ordinate and organize.  Social media offer such schemes a new lease of life.” (New Scientist, June 4, 2011)

The point is that regulation never works as planned because humans are just too ingenious and improved information technology and the spread of information eventually winout over time.  As a consequence, regulators…and politicians…are always fighting the last war.  Another way to phrase this is that regulators…and politicians…are always out-of-date!

European Banks Too Fragile To Afford Greek Default

Check this out...European Banks Too Fragile To Afford Greek Default...http://www.bloomberg.com/news/2011-06-06/european-banks-capital-shortfall-means-greece-debt-default-not-an-option.html.

And, read my post: http://seekingalpha.com/article/273108-on-european-and-u-s-credibility.

United States At Blame for Eurozone Problems?

Recommended read this morning, the op-ed piece by Kenneth Rogoff, “The Global Fallout of a Eurozone Collapse,” in the Financial Times. (http://www.ft.com/intl/cms/s/0/e66a3d7c-9073-11e0-9227-00144feab49a.html#axzz1OaJbLwdu)

“It is ironic that the euro…is suffering from having an overly strong exchange rate, particularly against the dollar, and at precisely the moment when a huge depreciation would be most helpful.”

“I think it would be more accurate to say that markets are more worried... about the US’s lack of a plan A than Europe’s lack of plan B.”

“Unfortunately…the euro is looking very much like a system that amplifies shocks rather than absorbs them.  The UK, which of course did not adopt the euro, has benefited from a sharp sustained depreciation of the pound.  The peripheral countries of Europe are meanwhile stuck with woefully weak competitive positions and no easy adjustment mechanism.  European leaders’ plans to achieve effective devaluation through major wage adjustment seem far-fetched.  The only clean rescue for Europe would be if growth far outstripped expectations.  Unfortunately, post-financial crisis growth is likely to continue to be hampered by huge debt burdens.”

The worst of all worlds for this crisis…stagflation.

And, the United States continues to pound away creating more and more credit inflation for itself and the world…both in terms of monetary and fiscal policies.  (See my post about the Fed’s feeding of world inflation: http://seekingalpha.com/article/273506-cash-assets-at-foreign-related-financial-institutions-in-the-u-s-approach-1t.) 

“The markets are more worried about the US’s lack of a plan A…”

To me the world is seeing the current leadership in Washington, D. C. as little different than any group of leaders in Washington, D. C. over the past fifty years.   For the past fifty years the government debt produced by the United States government has risen at a compound rate of growth of more than 8 percent per year.  Economic growth has averaged a little more than 3 per cent every year for this same 50-year period.  

This is “credit inflation.”

And, the value of the dollar?

In 1961, at the start of this binge, the value of the dollar was pegged to gold.  In August 1971, President Nixon floated the dollar.  With the open capital markets that arose in the 1960s, a country could not independently follow a policy of credit inflation and keep the value of its currency fixed. 

Since the dollar was floated, the general trend in the value of the dollar has been downward with three exceptions.  The first was in the Volcker years of the early 1980s; the second was when Rubin was Secretary of the Treasury in the late 1990s; and the third was in the world rush to quality during the financial crisis of 2008-2009. 

The leaders of the United States have not had a plan to halt the decline in the value of the dollar for the past fifty years.  And, the Obama Administration is no different from any of the other administrations that preceded it since 1961. 

United States government officials have stated their support for a “strong” dollar throughout this time and yet have done little or nothing to stem the decline.

Again, “watch the hips and not the lips!”

And, the longer-term trend in the value of the United States dollar is still downward.

However, in an interdependent world, actions have repercussions elsewhere.  And that is what Rogoff is calling our attention to.  The policy actions of the United States government impact others.  And, the blanket government policy of credit inflation followed by Republican and Democratic Presidents over the last 50 years has come to dominate the world. 

Not only is it exacerbating the sovereign debt problems of Europe, it is spreading inflation throughout the world as the US dollars pumped into the US banking system by the Federal Reserve flow almost seamlessly into commodity markets throughout the world. (Again, see my post from yesterday.)

The irresponsible creation of debt and more debt does come to a limit.  And, as one approaches the limit, the number of options available to the issuer of the debt shrink in number as the desirability of those options also lessen. (“Debt Ultimately Leaves You With No Good Options,” http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options.)

The United States is experiencing this difficulty as we speak.  There are “things” the government would like to get into but can’t because there is no fiscal room for anything more, and there are “things” the government must get out of but don’t want to because they are in political favor. 

In a world of excessive debt, there are no good choices…period!

Rogoff goes on to talk about whether or not the world will succeed in forming a co-reserve currency system.  This would happen as the benefits of the co-reserve currency system were observed which would result in a trend towards the consolidation of currencies throughout the world. 

The current period of stress, Rogoff argues, is a period of learning.  “Having a smaller number of currencies is a phenomenon that makes a lot of sense economically, economizing on transactions’ costs and leveraging economies of scale.  The real question is whether common currency is sustainable politically.  My guess is that if the current slow patch in global growth does not quickly subside, we will not have to wait long for an answer.”

Cash Assets at Foreign-Related Financial Institutions in United States Approach $1.0 Trillion!

The Federal Reserve continues to pump reserves into the commercial banking system and the majority of these reserves are getting into the hands of foreign-related financial institutions and then heading offshore. 

On May 25, 2011, cash assets on the books of foreign-related financial institutions was just under $950 billion, up about $200 billion from April 27, 2011.  On May 4 cash asset at foreign-related financial institutions were 50 percent of all the cash assets held by commercial banks in the United States.

Now, on May 25, 55 percent of all the cash assets held by commercial banks in the United States were held by foreign-related financial institutions.

Please note, that on December 29, 2010, before QE2 really swung into action, these foreign-related institutions held only about one-third of all the cash assets on the balance sheets of commercial banks in the United States.

The increase from December 29 to the present has been roughly $590 billion. 

During this same period cash assets at all commercial banks rose by just under $660 billion, so that almost 90 percent of the cash assets pushed into the banking system by the Federal Reserve has gone into the coffers of foreign-related financial institutions!

From the Fed’s own balance sheet we see that Reserve Balances with Federal Reserve Banks, which closely tracks the excess reserves in the banking system, rose by $572 billion.  Almost all of this increase in excess reserves in the banking system has come about through the Fed’s acquisition of over $500 billion worth of U. S. Treasury securities. 

And, what have these foreign-related financial institutions done with the funds?

There is an account called “Net (Deposits) Due to Related Foreign Offices.”  On December 29, 2010 this account, on the reported statistics was a negative $420 billion.  That is, this was not money due to “related foreign offices” it was the money that “related foreign offices” had allocated to the United States office.  That is, it was an asset of the bank and not a deposit liability. 

On May 25, 2011, this negative number had turned into a positive number, it became a liability of the United States branches to “related foreign offices”, and this number was slightly over $86 billion.  This represented a swing of $506 billion!

In essence, cash assets at these foreign-related institutions rose by about $590 billion since December 29 and $506 billion of this increase went to “related foreign offices.” 

This looks a lot like the “pump” for the “carry trade”. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)

And, where do we pick up some of the results of this “carry trade” action?

Check out the Wall Street Journal last week, “Big Banks Cash In On Commodities,” (http://professional.wsj.com/article/SB10001424052702304563104576359704074143190.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) “Wall Street is tapping a real gusher in 2011, as heightened volatility and higher prices of oil and other raw materials boost bank profits.” 

“A group of 10 large bans saw their commodities revenues increase by 55% in the first quarter. “

And, who says that the Federal Reserve is not underwriting world commodity inflation?  And, who says that the Federal Reserve is not underwriting the profitability of the big banks and producing even bigger banks that are too big to fail?

This is my July edition of the QE2 Watch, following up my June edition, see http://seekingalpha.com/article/268809-qe2-watch-banking-system-still-not-fully-engaged.  The Fed continues to do what it said it was going to do, purchase about $600 billion in U. S. Treasury securities by June 30, 2011. 

From December 29 through June 1, the Fed has purchased $516 billion U. S. Treasury securities.  Roughly $105 billion of these have gone to offset the decline in the Fed’s portfolio of Federal Agency Issues and Mortgage-backed securities.  Thus, the net increase in the Fed’s portfolio of securities has only been about $415 billion. 

But, the United States Treasury has drawn down $195 billion from its deposit account at the Fed related to “Supplemental Financing Account and this has put $195 billion of reserves into the banking system over the last five months.

The combination of the two, $415 billion and $195 billion, comes to $610 billion and accounts for all of the increase in reserve balances at Federal Reserve banks, the proxy for excess reserves, of $570 billion. 

The bottom line on this is that the Federal Reserve and the Treasury Department are seeing to it that the financial system is awash with liquidity…even though the largest amount of the funds are going offshore. 

European Credibilty

In a solvency crisis, the question of credibility always arises.  The issue is one of trust…who can one trust?

The European Banking Authority (EBA), which opened for business this year, is now under the gun.

One of the jokes of the earlier European sovereign debt meltdown was the stress test that was administered to European banks.  The “stress” of the tests were not that stressful and the results were dismissed as irrelevant.

One goal the EBA set out to achieve was to administer a stress test that was credible and would provide a “realistic” view of how European banks would weather a new round of financial distress.

The tests were begun in March…the results of the stress tests were to be released in June.

The EBA has now asked banks to resubmit their information because “The EBA is currently assessing and challenging the first round of results from individual banks.  This will mean that another round of data will be required…Errors will have to be rectified and amendments made where there are inconsistencies or unrealistic assumptions.”

That is, there are “concerns that some countries and institutions made mistakes or used overly rosy assumptions.” (http://www.ft.com/intl/cms/s/0/cf770d00-8c6f-11e0-883f-00144feab49a.html#axzz1O1hWLIwZ)

But, there seems to be another problem imbedded in these European stress tests.  “As with 2010, the EBA has also failed to include the possibility of a sovereign debt default, in spite of bail-outs in Greece, Ireland, and Portugal.”

What?

Much of the discussion surrounding the issue concerning what the European Union should do about Greece and the restructuring of Greek debt hinges on the inability of European banks to handle a write-down of Greece’s sovereign debt. 

I quote from my Tuesday morning post:

“Moody’s Investors Service estimates the European banks hold about €95 billion in Greek sovereign and private debt—and could lose one-third of it in a worst case scenario.”

European banks hold some €630 billion in Spanish debt. If Greece defaults in any way, shape, or form, the question is, “What about Ireland? And, Portugal? And, Spain? And, Italy? And…?” (See http://seekingalpha.com/article/272549-how-long-will-the-bailouts-continue.)

Where is the credibility in the stress tests, even if the banks use more pessimistic scenarios in the information they resubmit to the EBA?

And, as I suggested yesterday, leaders in America should be paying attention to the lessons being generated by the events now going on in Europe. (http://seekingalpha.com/article/272746-european-choices-continue-to-narrow-more-debt-is-not-the-solution)

The monetary and banking authorities are facing a situation in which one out of every seven commercial banks in the country is on the FDIC’s list of problem banks.  About one out of every four commercial banks in the country is “troubled.”  The number of banks in the banking system dropped by 320 banks in 2010 and we are on track for the number of banks to decline in 2011 by about the same number, which is about 5 percent of the commercial banks in the United States. 

The American banking system is not that healthy.  And, as a consequence, commercial banks, as an industry, are not lending.  The housing market continues to sink.  And, commercial real estate continues to be listless.  There are big pieces of the economic picture missing.

Maybe the leaders in the United States need to admit to these problems.  Maybe they need to learn something from the European situation in which the severity of the banking problems are hidden in incomplete stress tests while the whole “relief” program for Greece…and others…are being based upon the weaknesses in the banking system. 

The credibility of the European leadership is not doing well in the face of their lack of transparency.

The credibility of American leadership is facing similar shortcomings.

Maybe this is why Sheila Bair is leaving the FDIC…the end of her term of appointment being just a convenient excuse.  Maybe Sheila Bair knows something that the current administration does not want out in the public domain. 

My friends tell me that if the way a person talks does not match up with the way a person walks…then there is a credibility problem!  That is, watch the hips…not the lips!

I see this problem in Europe.

I see this problem in the United States.  President Obama and others in his administration, Ben Bernanke and Tim Geithner, are explaining their actions in ways that do not seem to be consistent with the facts.  The result is public and investor confusion, uncertainty…and discontent…with their policies.

Europe does not seem to have anyone that can provide the leadership it needs…and this does not bode well for its future.

One keeps hoping that Obama will step up and provide the leadership for the United States.  But, I am afraid that this will not happen.  After all the number one responsibility of any government official is to get re-elected.  And, we are in that season.      

European Choices Continue to Narrow

On May 24, my post stated that debt ultimately leaves you with no good options. (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options)

Martin Wolf in the Financial Times reduces the choices now available to the European Union to two: “The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support.  The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged.” (See “Intolerable choices for the eurozone,” http://www.ft.com/intl/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ.)

The “original” design of the union, Wolf contends, is for all purposes, dead.  That could only be achieved by removing some of the countries now in the union.

To achieve the second of the two choices he mentions above is going to require a contortionist.  First, Wolf argues, European banks cannot remain national.  Whoa!  Second, he argues that the current system of European System of Central Banks (ESCB) must be eclipsed by a “sufficiently large public fund” that manage “cross-border” financial crisis.  Double Whoa!  And, third, the finance of the “weak countries” must be taken out of the market for years, “even a decade.”  Whoa! Whoa! Whoa!  What would result would be something Wolf calls a “support union.”

This certainly is “deeper financial integration and greater fiscal support than was originally envisaged” by the creators of the European Union. 

The question is, “could this ‘support union’ ever be achieved short of all countries in the eurozone coming under a common government. 

But, even so, I do not see that this “solution” reflects any change in the underlying economic philosophy of the current leaders of Europe concerning the propagation of the credit inflation that the leaders of Europe have perpetrated for the last fifty years or so.  With no basic change in philosophy, I cannot see how this second choice achieves anything except the postponement of the “day of reckoning” in which the range of options available to the European Union drops to one. 

Does this mean that the European Union will eventually be providing investors with a “sure-fire”, riskless investment similar to the one given George Soros by the British government in 1992?

It seems to me to be a real possibility.

John Plender, who also writes for the Financial Times, argues that the European Union can “Muddle along for now; but a Greek default is inevitable.” (http://www.ft.com/intl/cms/s/0/21922f88-8ba4-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ)

Plender writes that the burden of the policies imposed upon the Greek government by the IMF will only produce “great demands on the population” which is already enduring a deep recession.  Greek workers will have to ‘endure wage deflation” so as to restore the competitiveness of the Greek economy and the privatization program being discussed will put the transfer of Greek assets in the hands of an external agent. 

However, the other option, debt restructuring, is not currently acceptable to Plender, either.

He sees it as the only real choice for the time being: “If a package is agreed in June, which seems probable, the challenge will be to bring Greece to a primary budget surplus...” and “at that point, it would be sensible for Greece to bow out of the monetary union and take advantage of currency devaluation.” 

He goes on, “For that to work, though, European banks would need in the interim to have bolstered their capital.  And the execution risks are phenomenal.  This is policymaking on a wing and a prayer.”

The leaders of the United States need to absorb this lesson.  No matter that the United States is richer and deeper in resources than Europe.  No matter that the United States is bigger.  No matter that the United States has the reserve currency of the world.  The debt burden catches up with you.  As, as the debt burden is catching up with you…your options become fewer in number and they become less and less desirable.

The United States is not exempt from this outcome…unless it changes course before all the options go away. 

In all financial crises, the initial response of the central bank and the government must be to provide sufficient liquidity to keep the banks open and to avoid cumulative downturns in companies and the economy.  Bailouts and quantitative easing may be appropriate…for the short run.

But, there is a difference I have written about many times, between a “liquidity” crisis and a “solvency” crisis.  A liquidity crisis is a short-run phenomenon, which gets an economy over the short-run shock of a financial event. 

The longer-run problem is the solvency problem.  And, solvency is tied up with debt…debt loads that must be worked off.  And, working off debt loads takes time…lots of time.  And, working off debt loads cannot really be achieved by flooding the financial markets with more credit and more liquidity.  This is a “postponing” strategy.

To solve the “debt” problem and to prevent it occurring again in the future, leaders must change their basic economic philosophy about the creation of debt.  Credit inflation always leads to debt problems, and further credit inflation aimed at solving debt problems only leads to diminishing options and eventual collapse.  Insolvency cannot be solved by more debt. 

It should be obvious that more debt is not the solution to a problem if the options one has decline in number and the desirability of the options also declines.  To continue to pile on more and more debt is like the person in the hole, digging the hole deeper and deeper in an effort to get out of the hole. 

Europe is finding this out.  It, apparently, must be the case that the United States will have to learn this lesson as well.

If anything is going to give the emerging countries of the world the chance to close the gap on the developed countries it is a continuance of the credit inflation policies of Europe and America.  The ironic thing is that the shoe used to be on the other foot…the developed countries had control over their credit inflation whereas the emerging nations were reliant on excessive amounts of credit inflation.  This relative performance was given as an important reason why the developing countries could not hope to catch up with the developed world. 

China is catching up with the west faster than most analysts believed it would.  So with India…and Brazil….  If the European Union…and the United States…continue to push the edge of debt creation and continue to shrink their options, the tipping point  to this emerging world might occur sooner than most of us imagine.