Why This Economic Expansion is Going Nowhere

This economic expansion is now in its twenty-fourth month.  It is one of the weakest expansions on record.  And, it seems to be going nowhere.

One reason for this is that there is just too much debt still outstanding in the economy.  The economy is experiencing a debt deflation where more and more people and businesses feel over-burdened with the debt loads they are carrying on their balance sheets.

The government, especially the Federal Reserve, is trying to counter this by pushing hard on the credit inflation button to extend the fifty years or so of credit inflation we have already experienced.  The problem with this is that each new round of credit inflation puts more and more people and businesses into unsustainable positions so that expansions rely on a smaller and smaller proportion of the economy to drive further economic growth. (http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation)

 Debt takes time to work off or work out.  The bigger the debt-load the longer and harder it is for the people and businesses to climb out of their holes.  Repeated cycles of credit inflation not only end up with more people digging holes, it also contributes to some existing holes becoming deeper. 

Hence with every cycle recoveries become harder to achieve and the subsequent economic growth becomes less and less robust.

Another reason why economic growth is having trouble picking up momentum is because of the dislocations that exist within the economy.  Credit inflation causes many distortions beyond what it does to the balance sheets of people and businesses.

Most analysts concentrate on the unemployment rate.  Right now this figure rests just over 9.0 percent.  Analysts focus on this variable as the crucial one for the upcoming 2012 election. 

To me, a more important measure of the dislocation of human resources in the economy is the amount of under-employment we are experiencing.  This number includes those individuals that have left the workforce or are employed but are not fully employed.

The under-employment rate in the United States right now runs about 20.0 percent.  About one out of every five Americans is under-employed. 

This number was under 10.0 percent in the 1960s and has trended up ever since. 

The reason:  the number one goal of the economic policy of the United States government was to achieve high rates of employment…low rates of unemployment.  The best way to do this when unemployment arose was to stimulate the economy through the monetary and fiscal policies of the United States government to put people back to work in the jobs they have previously been laid off from.  This, of course, resulted in more and more of the human capital in the country being underutilized…a capacity utilization problem.

Adding to this was the shift in employment in the country with relatively more and more of the new jobs opening up being in finance and financial services and less and less in manufacturing.  Many “potential” workers find themselves limited in terms of opportunity either through geographic location or educational training.  Both of these results came from the governments attempt to achieve high levels of employment through credit inflation.

Finally, there is the problem of capacity utilization of physical capital.  As one can see in the accompanying chart, capacity utilization in American industry was in the 87.0 to 90.0 percent range in the 1960s.  As the proportion of human capital being used in this country trended downward from the1960s to the present, capacity utilization in manufacturing has also trended downward.  

One can observe very clearly in this chart the cycles of capacity utilization associated with each recession during this time period.  Also, one can not that with every cycle in capacity utilization that the “new” peak achieved is lower than the peak reached during the previous cycle…with the exception of the 1995-1997 experience.

Right now, United States manufacturing seems to be “peaking” out just below 77.0% of capacity, down from a previous peak of about 82.0 percent of capacity.  It has been stuck at this level for at least seven months now, through June.

My argument is that just as credit inflation is responsible for the growing under-employment in the United States work force, credit inflation is also responsible for the growing under-employment of the physical capital of the United States.  Credit inflation distorts business decisions and leads to a capital stock that is less and less productive over time.

So, here are three reasons why I place a low probability on the United States economy achieving a more robust economic recovery: the debt load on people and businesses; the dislocation existing in the labor market leading to high rates of under-employment; and the dislocation existing in the use of physical capital in the United States leading to low rates of capacity utilization. 

Note that credit inflation can only be a short run panacea for these problems.  Credit inflation leads to greater debt buildup adding to the unsustainability of the debt load being carried by people and businesses.  Credit inflation works to put people back into the jobs they recently lost but as the society changes, the old jobs go away.  And, credit inflation affects the productivity of the country’s physical capital making the existing capital stock less and less usable.  There are no good answers here.

Debt Deflation and the Selling of Small Businesses

The Wall Street Journal carries the story, “Sales of Small Firms Are Up”. (http://professional.wsj.com/article/SB10001424052702303406104576444062140022104.html?mod=ITP_marketplace_4&mg=reno-secaucus-wsj)  “Sales of businesses with roughly $350,000 in annual revenue rose 8% from a year earlier…”

“The main driving force is the acceptance among owners that their businesses are no longer worth what they once were.  Many sellers cut their asking prices and agreed to finance a significant portion of the deals themselves.

This is the other side of the last fifty years of credit inflation.  People are in debt, business is not good, and valuations have dropped substantially. 

How do you like the story of the individual who bought a 200-seat casual restaurant in 2002 for $200,000 and “is finally selling it for just $75,000, and he is lending the buyer 25% of the selling price”?

More and more information is now coming out on the situation in the world of small- and medium-sized businesses. 

But, this has been the case in the residential housing market.  People are in debt, unemployed, facing lower incomes, and property values have plummeted.

This is also the situation in the banking industry among the small- to medium-sized commercial banks.

The FDIC has only closed 51 commercial banks through July 8 of this year, but this figure does not include banks that were acquired by other institutions.  Through March 31, 2011, there were 77 fewer insured banks in the banking system than there were on December 31, 2010.  (In all of 2010, there was a net decline in the banks in existence of 290 even though the FDIC closed only 157.)  With 888 commercial banks on the problem list the likelihood that there will be 300 or so fewer banks in existence at the end of this year is highly probable. 

My point is that this is a part of the debt deflation process going on in the economy and it is a natural progression from the fifty years of credit inflation that preceded it. (“Credit Inflation or Debt Deflation,” http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) 

Of course, the Federal Government is doing all it can to offset the forces of debt deflation by continuing to pump more and more debt into the economy.  Yesterday, Fed Chairman Bernanke, in Congressional testimony, argued that the Federal Governments needed to get its “act together” on the federal budget.  Bernanke followed this up by saying that the Fed will “do what it has to do” if the economy remains weak.

This was immediately interpreted by the “market” that the Fed will throw QE3 on the fire if it believes it is necessary.   Gold prices rose to a new record.

Today, Bernanke backed off and said the Fed was not “prepping” for a new edition of quantitative easing.   Gold prices dropped.

The problem with the effort of the federal government to offset the debt deflation going on in the economy by more and more rounds of credit inflation is that much of the liquidity the government is pumping into the system is going offshore…that is, it is going into world financial and commodity markets! (See “Federal Reserve Money Continues to Go Offshore,” http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.)  This is doing little or nothing to stimulate the American economy and is doing lots to inflate world commodity markets. 

And, in this condition of debt deflation we see one of the real confusing issues connected with credit inflation and debt deflation. 

To take a specific example, in the 2000s there was a terrific increase in the price of houses and the value of small- and medium-sized businesses, in asset values.  Yet, price inflation, which is measured in terms of flow price…rents and business cash flows…did not increase at the same rate.  Hence, it looked as if consumer price inflation was being kept quite low.

Now, we see just the opposite happening.  Price inflation seems to be picking up, yet the value of assets like homes and small- and medium-sized businesses are declining, sometimes quite precipitously. 

In a period of credit inflation, asset prices tend to increase more rapidly than “flow” prices and this dis-connect must ultimately be corrected.

In a period of debt deflation, asset prices tend to decrease more rapidly than “flow” prices and this tends to continue until they are brought back more nearly into line (or over adjust).

The actions of the federal government and the Fed seem to be having little or no effect on asset prices.  Owners of businesses (and houses) are forced to accept “that their businesses (and homes) are no longer worth what they once were.” 

Further rounds of credit inflation may moderate the downside of this move…but, continuation of aggressive credit inflation will only just postpone the adjustment that is needed in the economy until a later time.    

Credit Inflation or Debt Deflation?

The world never stands still.  It is either moving one way…or moving in another way. 

In terms of the macro-economy, the world is either experiencing a credit inflation…or a debt deflation. 

For the past fifty years or so the United States (and Europe) has experienced a period of credit inflation.  Now, with debt levels so high, there is a real possibility that the United States (and Europe) will experience a period of debt deflation.

The fundamental response of many is that the United States government must continue to “jack-up” economic stimulus and create even more dramatic extensions of the credit inflation that has put the United States in the position it now finds itself in. 

The still unanswered question in the current situation is whether or not credit inflation can continue to be extended or will it ultimately reach a position in which the economy is so saturated with debt that further credit inflation is unsustainable.

The further question that accompanies this question is whether or not we have currently reached the tipping point in which further credit inflation is unsustainable. 

If credit inflation cannot continue then debt deflation must take over…it is either one or the other.

The reason for this conclusion is that credit inflation…and debt deflation…are cumulative movements.  That is, credit inflation builds on itself…just as debt deflation builds on itself. 

The basis for credit inflation is that the creation of more and more debt in the economy exceeds the possible growth of the whole economy, in the aggregate sense, or exceeds the possible growth within a sector, in the case of bubbles like the housing bubble in the decade of the 2000s.

For the economy as a whole, the gross public debt of the United States government rose at a compound rate of growth of more than 8 percent over the past fifty years.  The real economy was able to grow at a rate slightly in excess of 3 percent.  This is the foundation for the credit inflation that took place over this time period.

The cumulative effect of the credit inflation can be seen in the increased risk-taking that occurred over this time period as actual inflation “buys out” dumb decision making through price increases.  Financial engineering prospers during such a time as financial institutions and business firms benefit from more and more financial leverage and the assumption of interest rate risk.  Furthermore, one finds financial innovation thriving during such times as more and more opportunities present themselves for the “slicing and dicing” of cash flows.  Finally, finance triumphs over manufacturing as companies devote more and more resources to financial transactions.  In the 1960s, who would have thought that General Motors and General Electric might, at some time in the future, earn more than two-thirds of their profits from their financial wings?

Private sector debt, depending upon the series used, grew at a compound rate of 10 to 12 percent over the past fifty years.

The cumulative build up of debt on balance sheets results in two things.  First, economic recoveries become weaker and weaker over time as more and more people fight to overcome their debt burdens in order to “get spending again.”  Second, the economy bifurcates into two groups, one that is over-burdened with debt, and, one that is in control of its finances.  As the cumulative effects of credit inflation pervade the economy, the proportion of people in the first group grows relative to the proportion of the people in the second group.  This change makes it harder and harder for the economy to recover over time. 

A recent article by Amir Sufi, Professor of Finance at the University of Chicago, titled “Household Debt Is at Heart of Weak Economy” (http://www.bloomberg.com/news/2011-07-08/household-debt-is-at-heart-of-weak-u-s-economy-business-class.html) makes this very point.  “From 2001 to 2007, debt for U. S. households increased to $14 trillion from $7 trillion, and the ratio of household debt to gross domestic product was higher in 2007 than at any time since 1929.”

William Galston writes on this dilemma in The New Republic (http://www.tnr.com/article/the-vital-center/91856/economy-recovery-foreclosure-housing-prices): “To understand the burden this imposes on households, let’s took at a key measure: the ratio of household debt to disposable income.  Between 1965 and 1984, the ratio remained steady at 64 percent.  Between 1985 and 2000, it rose virtually without interruption to 97 percent.  And then, it shot into the stratosphere, peaking at 133 percent in 2007.  Four years later it has come down only modestly…118 percent of disposable income.”

But, many businesses, especially small- and medium-sized ones, at in similar straights. 

How many commercial banks in the United States are going to fail or be merged out of business?

And, what about many state and local governments?

And, what about the federal government?

The start of this period of credit inflation began in the early 1960s.  The philosophy behind this period of credit inflation is Keynesian, although a corrupted Keynesianism because Keynes argued that the government should balance its budget over the credit cycle, creating budget surpluses during the “good times” to balance out the budget deficits that were needed during the “bad times.”  The “bastardized” Keynesian approach argued for continuous budget deficits to create higher and higher rates of economic growth. 

Robust economic recovery becomes harder and harder to achieve as the cumulative credit inflation continued.  The burden of the financial leverage built up in the past becomes heavier and heavier.  At some point, this burden becomes too great and the continued efforts of the government to inflate credit become unsustainable. 

Evidence that we have reached this point or are getting closer and closer to the point is abundant.  First, we see that the fiscal stimulus programs of the United States government have achieved very little over the past four years or so.  Second, the massive failure of the Federal Reserve to “jump start” the economy through QE1 and QE2 is also an indication that credit inflation may not be working at this time. 

If we are going to enter a period of financial de-leveraging in spite of the efforts of the government, what does this mean for the stability of the economy and financial markets? 

It means that there will be a fundamental restructuring of the economy.  Those people and businesses that have been financially prudent up to this point will prosper.  Those that have not still have a bunch of pain to go through.  There will be a substantial restructuring of industry as those that have will take advantage of those that don’t have.  Also, there is still a major restructuring to come of the banking industry. 

A period of restructuring means opportunities.  I see a substantially different America in the next five-to-ten years.  The goal is to identify where the opportunities are.

Federal Reserve Money Continues to go Off-Shore

Yesterday in my post I reviewed the consequences of QE2 on the Federal Reserve balance sheet. (http://seekingalpha.com/article/276674-qe2-watch-no-qe3-in-sight)

The bottom line: “The ‘net’ increase in securities held outright by the Federal Reserve has been $589 billion, pretty close to the $600 billion ‘net’ increase promised.

Reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, have increased by $584 billion to $1,594 billion over this time period. Actual excess reserves in the banking system averaged $1,610 billion for the two-week period ending June 15, 2011.”

Cash assets (excess reserves) at commercial banks in the United States rose by about $800 billion from December 29, 2010 to June 15, 2011 and closed slightly below $1,870 billion on the latter date. 

Basically the Federal Reserve pumped all these reserves into the banking system and there they seemingly sit.  Yet, the amazing thing is that of the almost $800 billion increase in cash assets in American banks, almost 85 percent of the increase, or about $670 billion, ended up on the balance sheets of Foreign-related Institutions in the United States. 

And, what increased on the other side of the balance sheet?

Net deposits due to related foreign offices.  These balances rose by almost $500 billion since the end of last year. 

In essence, it appears as if much of the monetary stimulus generated by the Federal Reserve System went into the Eurodollar market.  This is all part of the “Carry Trade” as foreign branches of an American bank could borrow dollars from the “home” bank creating a Eurodollar deposit.  This Eurodollar deposit could be lent to foreign banks or investors and this would not change the immediate dollar holdings of the American bank.  This lending and borrowing in Eurodollar deposits could then multiply throughout the world.  And, the American bank might be the ‘foreign-related” institution mentioned above and included in the statistical reports.

Note that the original dollar deposit created by the Fed is still recorded as a deposit at one Federal Reserve bank no matter how much shifting around the borrowing and lending in the Eurodollar market occurs.    

Thus, it appears as if the Federal Reserve pumped one-half a trillion dollars off-shore since the end of 2010!

And, this is going to stimulate spending and getting the economy to grow faster?

Cash assets at the smaller banks remained relatively flat over the last six months…and over the last three months.  Thus, the reserves the Fed was pumping into the banking system were not going into the smaller banks. 

And, although the largest twenty-five banks in the country increased their cash assets by about $130 billion over the last six months, these banks have been reducing their cash balances (by a little more than $30 billion) over the last three months. 

What have the domestically chartered commercial banks been doing over the last six months?

Basically, the twenty-five largest domestically chartered commercial banks have been modestly increasing their loans to businesses, both in the three-month period and the six-month period.  Commercial and Industrial loans as well as commercial real estate loans have been increasing at the largest banks over the past three-month period. 

However, business loans continue to “tank” at the smaller banking institutions.  For example, Commercial and Industrial loans at the smaller institutions dropped by almost $5.0 billion from March 30 to June 15.  Commercial Real Estate loans took an even bigger hit of almost $35 billion. 

Also, at the smaller banks, residential mortgages continue to decline…by a little over $9.0 billion since March 30 and by almost $35 billion over the last six months. 

The real lending by commercial banks is not taking place in the United States.  The lending is taking place off-shore, underwritten by the Federal Reserve System and this is doing little or nothing to help the American economy grow. 

It does seem to help produce inflation elsewhere which gets translated back into the United States in the price of imports.

The Fed has not yet gotten bank lending going, it has not yet caused an increase in the money stock measures, and it has not yet stimulated the economy to any degree. 

The Fed may have helped the FDIC close banks in an orderly fashion and it may have helped raise the prices of commodities world-wide. 

For all the efforts exerted in QE2, the results are not very encouraging.

NOTE: As mentioned in my post yesterday, I will not be posting anything for about a week or so.

Federal Reserve QE2 Watch: Part 8

I usually do the “QE2 Watch” post in the first week of the new month, but in this coming month I will be a little tied up.  I am having hip replacement surgery on June 28 and will be a little preoccupied for a few days.  I will also write a post on the condition of the banking system that I will post tomorrow.  Then I go “on vacation” for a while.

Chairman Bernanke and the Federal Reserve have signaled that QE2 will definitely end on June 30 and they have indicated that QE3 is not in the works…at least at the present time. 

The stated plans for QE2 included the new purchase of $600 billion in Treasury securities and the purchase of a possible $300 billion more in Treasury securities to replace securities maturing in the Fed’s portfolio of Federal Agency issues and the Fed’s portfolio of mortgage-backed securities. 

From Wednesday, September 1, 2010 to Wednesday, June 22, 2011, the Federal Reserve’s holdings of United States Treasury issues have risen by roughly $816 billion.  During this time period, the dollar volume of Federal Agency issues on the Fed’s balance sheet has dropped by $38 billion and the dollar volume of mortgage-backed securities has declined by $189 billion…a combined total of $227 billion. 

The “net” increase in securities held outright by the Federal Reserve has been $589 billion, pretty close to the $600 billion “net” increase promised. 

Reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, have increased by $584 billion to $1,594 billion over this time period.  Actual excess reserves in the banking system averaged $1,610 billion for the two-week period ending June 15, 2011.

Almost all the increase in excess reserves can be attributed to the Fed’s purchase of United States Treasury securities. 

Other factors affected reserve balances within this time period but they tended to be minimized over the period as a whole.  For example, in the first quarter of 2011, the United States Treasury Department reduce its “Supplemental Financing Account” at the Fed by $195 billion, a not inconsequential amount of funds.  This reduction added reserves to the banking system.  However, over time, this movement was offset by other factors and hardly had any net effect on the total amount of reserves being supplied to the banking system.

And, what was the total impact of QE2 on the commercial banking system?

All the reserves the Fed crammed into the banking system went into excess reserves!

Yet deposits in the banking system continued to increase. 

Demand deposits in particular rose at a very rapid pace.  From the second quarter of 2010 when demand deposits at commercial banks increased at a 6.3 percent rate year-over-year, these accounts rose by 8.5 percent in the third quarter and 14.3 percent in the fourth quarter.  But this rate of acceleration jumped to 20.4 percent year-over-year in the first quarter of 2011 and in the month of May was showing a rate of increase of almost 27 percent!

What is happening here?

Demand deposits at commercial banks are increasing at a very, very rapid pace, yet commercial banks do not seem to be lending much at all (more on this tomorrow) and everything the Federal Reserve is pushing into the system seems to be going into excess reserves.  What’s going on?

Basically, what’s going on is the same thing that has been going on for the last 18 months or so.  Because of the poor economic climate and because of the excessively low interest rates people and businesses are moving funds out of interest bearing accounts and into transactions accounts.  These latter accounts are where people are locating their “liquidity” these days so as to pay for necessities and other important things to keep on living. 

For example, Institutional money funds are still losing money…perhaps not as fast as they were a year ago, but they are still contracting by more than 5 percent, year-over-year.  Retail money funds are still declining at a rate in excess of 8 percent year-over-year and small time accounts are declining by more than 20 percent, year-over-year. 

All non-M1 money stock money included in the M2 money stock measure has risen only modestly over the past 12 months and most of this has come in the money market deposit account s included in the aggregate category titled savings deposits.

The result is that the M1 money stock measure is increasing rather rapidly at around a 12 percent year-over-year rate in the last three months.  The M2 money stock measure is increasing by less than 5 percent over the same time period.  The rate of growth of the M2 money stock measure has only increased modestly over the last four quarters. 

People are putting their money into accounts from which they can transact.  They are moving their money into these accounts because they need to stay liquid in order to pay for their daily needs. 

The other indicator of this behavior is the rapid increases that have been made in the demand for coin and currency.  In the second quarter of 2010, the currency in circulation was rising by only about 3.5 percent, year-over-year.  This steadily increased through 2010 until it reached a total of over 7.0 percent in the first quarter of 2011.  That is, the coin and currency in circulation more than doubled its growth rate over this time period.  In May 2011, the year-over-year rate of increase in the currency component of the money stock was rising at almost 9.0 percent year-over-year. 

In the slow economic growth climate we are in, people do not increase their holdings of coin and currency in order to generate new spending.  They increase their holdings because they need these funds to buy necessities in the face of unemployment, foreclosure, and bankruptcy!

The information from the financial system is not very encouraging.  The Fed has tried to push all the funds it can into the banking system.  The banking system is not lending it…both because the banking system is still not in that good of a shape…and because people are not in very good financial condition and are not borrowing.  Thus, reserves pile up at commercial banks. 

If QE2 was supposed to get the economy growing faster, it has failed miserably.  If QE2 served other purposes, like allowing the FDIC to close banks in an orderly fashion, then it has succeeded.  If the Fed used the economy as an excuse to explain QE2 while it was assisting the FDIC in its efforts to close banks in an orderly fashion then it was duplicitous.  It might have done this to avoid people getting overly worried about the condition of the banking system.

But, the more I think about this last statement the more I chuckle because I don’t think that the Fed is that good.

Greece: Please Take More of the Medicine That Has Already Failed to Treat the Disease

With respect to the Greek sovereign debt situation, two statements reported this morning stand out.  First, Simon Tilford, chief economist at the Center for European Reform in London is quoted as saying: “The Greeks have been told to accept more of the medicine that has already failed to treat the disease.”  The consequence of this is that Greece has already entered a “death trap.” (http://www.nytimes.com/2011/06/23/world/europe/23greece.html?_r=1&hp)

The other statement deals with how the European banks will deal with some of the cost of a second bailout of Greece: “The trick will be for the private sector to take losses on Greek bonds, without Greece being declared in default.” (http://professional.wsj.com/article/SB10001424052702304657804576401471860518598.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The problem: “If the banks are forced to accept losses, ratings companies likely will declare a default.  Even if the banks act voluntarily, Greece could still be considered in default on some of its debts.” 

For more on this issue you might check the column by Satyajit Das in the Financial Times, “Final arbiter in Greek saga is an untested private body.”  Das is referring to something called the Determinations Committee, a group set up by the International Swaps and Derivatives Association.   This body may be the one that determines whether of not Greece goes into default or not.  (http://www.ft.com/intl/cms/s/0/95e3131a-9bf9-11e0-bef9-00144feabdc0.html#axzz1Q6N7EfJG)

Marty Feldstein, the Harvard economist, considers the dilemma facing European leaders: “If Greece were the only insolvent European country, it would be best if its default occurred now…But Greece is not alone in its insolvency and a default by Athens could trigger defaults by Portugal, Ireland and possibly Spain. (http://blogs.ft.com/the-a-list/2011/06/22/postponing-greeces-inevitable-default/)

Oh, oh!  The “I” word!

So, Greece is insolvent.  Portugal is insolvent.  Ireland is insolvent.  Possibly Spain is insolvent. 

And the European leaders are forcing Greece (and these other countries) to just continue taking more of the same medicine.

But, we can’t have insolvency squared or insolvency cubed?  Or, can we?

And the determination of whether or not a default takes place seems to depend upon a private organization that has never rated any debt before and must, it seems, determine what the definition of “is” is. 

This seems like a scene out of an old Peter Sellers movie!

This is nothing more than a Ponzi scheme being enacted by a bunch of comedic characters.  The Ponzi scheme: borrowing more and more money to pay the interest on the growing body of debt. 

This is the “death trap” mentioned above.

My belief is that the financial markets will be the final arbiter of this picture.  I believe that the “leaders” of Europe are creating a “risk-free” bet that many hedge funds and other investors with lots of money are waiting anxiously to exploit.  Governments seem to have a penchant for creating such “risk-free” bets.  Just ask George Soros.

Marty Feldstein has declared Greece insolvent.  So have a lot of other people. 

The financial markets will take care of this.

An aside about the situation in the United States: the Congressional Budget Office just released new projections for the federal budget.  In the new projections, the interest paid on United States debt will increase from around 2 percent of Gross Domestic Product in 2011 to over 9 percent in the year 2035. And, this is with relatively benign projections on interest rate movements. (http://professional.wsj.com/article/SB10001424052702304657804576401592689113956.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

Is this just another rendition of the “death trap”?

Another Sign of a Weak Economy: Stock Buy Backs?

Over the past year or so, I have been arguing that the substantial build up in the cash balances of many large United States corporations has been for the purpose of merger and acquisition activity.   And, earlier this year, M&A activity seemed to be proceeding aggressively. (See my post “The Latest Merger Binge and the Economy,” http://seekingalpha.com/article/269056-the-latest-merger-binge-and-the-economy.)

Now, it seems as if these cash balances may be trending into more stock buy-backs than into the buying of other companies, at least in a relative sense. “US companies are buying back their own stock at the fastest pace since 2007…” (http://www.ft.com/intl/cms/s/0/381e8c26-9c14-11e0-bef9-00144feabdc0.html#axzz1Q0PX4bjp)  

Today’s attention on stock buy-backs has been caused by the announcement made yesterday by electronics retailer Best Buy of a proposed $5 billion buyback program. (http://professional.wsj.com/article/SB10001424052702304070104576400062744226034.html?mod=ITP_moneyandinvesting_10&mg=reno-secaucus-wsj)

Analysts have been wondering what these large corporations were going to do with the huge cash balances on their balance sheets.  These companies were producing profits, they were able to borrow at ridiculously low interest rates, and ample liquidity seemed to be available to them around the world.  Also, there were a lot of other companies or divisions of companies “out there” that were really struggling and seemed to be possible “sitting ducks” for growth hungry large corporations. 

Of course, one of the reasons for the build up of cash in some of these companies was the tax implications associated with bringing monies earned around the world back into the United States.  But, this was not really the major reason.  For example, Microsoft, a cash rich company, did not have to go out and borrow more than $10 billion in the United States, the first time Microsoft has even made use of the bond markets in its history. 

Many economists were hoping that this build up of cash would result in a boom in corporate investment in physical capital, a stimulus to further economic spending and subsequent economic growth.

This physical investment has not yet surfaced. 

My belief has been that this cash build up was for acquisition purposes.  The companies that had the cash were strong and were “on the hunt” for their weaker brothers and sisters hoping to build their economic base by acquiring companies that were not in good positions, had too much debt, and were struggling to make ends meet.  What a way to build markets and enlarge the company’s footprint!

This seemed to be happening…and I believe will continue to go forward.

However, the world economy seems to be stalling.  Perhaps economic growth will not be as robust as originally thought…even three months ago.  Thus, even though the merger binge may continue to some degree, the pickings may not be as lush as once thought. 

And, the stock markets seem to have reached a near term peak.  All the major indices, the Dow, the S&P 500, and the NASDAQ, peaked at the end of April.  Many analysts are saying that with the stagnant economy and the high levels of under-employment, the chances are not very great that the stock market will show much resilience in an upward direction. 

Thus, there is some drop off in the corporate enthusiasm for more and more acquisitions.

So, what does a company with a lot of cash on hand and with dwindling appetite for acquisitions do with all their loot?  Managements with so much cash around and with very little hope that the economy will become more robust, just does not see these excess balances as a good use of resources.

The only viable alternative is to buy back their stock.  They see this as the “best” investment available to them.  And, so they buy back their stock.

Neither one of the latter two uses of the cash really do anything for the economy and the acquisition path could even result in worse economic results…at least in the short run.

Acquisitions, of course, can lead to plant closings, layoffs, and other efforts to combine firms, which increase productivity in the longer run, but does not contribute to capital investment or human employment in the short run.  Obviously, these outcomes are not what the policymakers are looking for.

Stock buy-backs also do not stimulate capital investment or a reduction in unemployment in the short run and may not achieve either of these goals in the longer-run.

Therefore, if the economy is weak and more and more corporations seem to believe that the “best” investment of the cash they have accumulated is to buy back their own stock.  it would seem that this is evidence that more and more corporations are not seeing a very bright economic future ahead of them.  In my mind, this is not very good news.