Foreign-Related Financial Institutions Continue to "Suck Up" U. S. Excess Reserves

For your information, 0.4 percent of the banks in the United States, the largest 25 commercial banks, control 56 percent of the banking assets in the country. 

The smallest banks, banks less than $100 million in total assets, which make up 35 percent of the banks in the country, control 1.0 percent of the banking assets in the country.

The next size category, commercial banks with more than $100 million in assets but less than $1.0 billion in assets, make up 57 percent of the number of banks in the country.  These banks control another 9.0 percent of the banking assets in the country.

Consolidating these last two categories we find that 92 percent of the commercial banks in the country control only 10 percent of the banking assets of the country. 

Just thought you might want to know these facts.

Over the past year, the total assets in the banking system in the United States grew by a little more than $630 billion.

Over the past year, the cash assets in the banking system in the United States grew by a little more than $650 billion!

Thank you, quantitative easing!

Of the $650 billion increase in cash assets, over 75 percent of the increase went into the cash assets of foreign-related banking institutions in the United States.  And, over 85 percent of this increase went into the amount of liabilities due to the foreign offices of these foreign related banking institutions. 

Three cheers for the “call” trade!

And, what about stimulating loan demand in the United States to get the economy going?  The loans and leases at all commercial banks dropped by about $75 billion over the past year. 

Business loans (commercial and industrial loans or C&I loans) did rise by a little more than $55 billion during this time period but the increase largely took place at the largest 25 banks; business loans at the remaining 6,400 banks in the country stayed relatively flat. 

Over the latest 13-weeks business loans fell fairly dramatically at the smaller banks as the amount of assets in the smaller banks has actually declined. 

But, it is still the real estate area that continues to suffer.  Real estate loans on the books of commercial banks fell by about $175 billion over the past 12-month period.  Dollar-wise, the drop was roughly the same between the largest 25 banks and the rest of the banking system. 

The major part of the decline, however, came in the commercial real estate area, which declined by about $125 billion, again, with the largest banks and the smaller banks declining by about equal dollar amounts.

Over the last 13-week period, the decline in commercial real estate loans seemed to accelerate in the smaller banks relative to the larger banks.  This points to the fundamental problem the smaller banks are having with their lending in the commercial real estate area.  This in not supposed to get better in the near term.

The conclusions I draw from these data are: first, that the quantitative easing (QE2) of the Federal Reserve primarily went “off shore” and to this day remains “off shore.” 

Second, many of the smaller commercial banks in this country are in very serious financial condition and many of the problems are located in the commercial real estate area.  But, it seems as if there may be growing trouble located in their basic business loan portfolios.

Third, fundamental business lending seems to be picking up somewhat, but primarily at the largest 25 commercial banks in the country.  Commercial real estate lending at these banks, however, has not picked up and is unlikely to do so in the near future.

These statistics do not point to a banking system that is ready to underwrite a strong economic expansion.   

Response to "The Future of Banking" Comments

In response to two comments on my recent “Future of Banking” post (http://seekingalpha.com/article/287037-the-future-of-banking-looks-grim-again) I would like to make the following additions.

First, in terms of the number of employees in banks, I truly believe that the existing model of commercial banking is “legacy” and is in the process of changing.  The comment was made, for example, that “Until customers don't want to come into bank branches anymore, you will have to retain that model.”

In the past five years, I don’t believe that I have been in a bank branch in which there were more than three customers (including myself) at any one time.  And the branches are of similar size to the ones in which I was a teller back in the 1960s. 

I remember those days.  On a Saturday morning when the branch opened at 9:00 AM we would have eight tellers working eight tellers windows and lines of 10 to 15 people at each window constantly until 1:00 PM when the branch closed.  The weekdays were not so busy, but there was always a constant flow of customers through the banks.

I do not know exactly what the future of banking is going to be, but I am working on it as I write.  I have studied, written about, helped start up companies and worked with early stage companies in the area of information technology.  I am on the board of a newly formed bank and am in the process of starting up a credit union.  The use of information technology is constantly on my mind with respect to its application to the finance area. 

Everything I know and have experienced indicates that banking and finance is going through a quantum leap and, over the next ten years, will evolve into something we may not recognize as banking and finance, given the models we work with today.

In teaching classes in information science, I suggested two places for the students to look for ideas about what the future would be like.  First, I said, look at what the military is doing.  They must be ahead of everyone else in their ability to keep secrets and to fight wars (kill people).  They must have the most advanced technology.  Second, I said, look at what the young people are doing the kids in the 8 to 14 age bracket.  What is ubiquitous to them will be “standard” in five to eight years. 

If your business does not take these two things into account in your operations then you will probably not be around to enjoy this future.

I know young people that have not been inside a bank or the branch of a bank for at least five years.  I seriously doubt that my grandchildren will see the inside of a bank or the branch of a bank more that just a few times in their life. 

Finance is information…and nothing more.  Hence, how information is stored, processed, and used will dominate the practice of finance. 

I hope I find out what the future of banking is going to be before others do. 

Whatever it will be, it will not be as people intensive as it is now.

The second comment had to do with “mark to market” accounting.  The comment correctly indicates that many bank assets are probably over valued and this fact will come to light in the future indicating that many banks are in worse shape in terms of capital than we presented think they are.

The comment concludes: “I have seen very few people focus on this in what I have read over the past 3 years, yet I think what I have spelled out here is a potentially looming 'largely unrecognized' further problem. “

I agree with this analysis but would add that over the past three years I have constantly argued in my posts  (you can look them up on Seeking Alpha) that the commercial banking industry needs to go to a accounting system that does a better job of “marking “ assets to market.  This, to me, is essential for the finance industry to be “open” and “transparent”.

In terms of my recent post, I just did not have time to get into this issue.  Of course, adding this issues to the other two does not make the future of banking look any rosier.

The Future of Banking--Once Again

Two recent newspaper articles, I believe, put into perspective the dilemma faced by commercial banks these days.  The first article is “Banks Face 2 More Years of Famine” in the Wall Street Journal. (http://professional.wsj.com/article/SB10001424053111903918104576500664173510794.html?mod=ITP_moneyandinvesting_9&mg=reno-secaucus-wsj) The second is “The Incredible Shrinking Banks” in the Financial Times. (http://www.ft.com/intl/cms/s/0/ce194584-c2b8-11e0-8cc7-00144feabdc0.html#axzz1Uj7mP9Rp)

The first article deals with the disappearing “net interest margin” at commercial banks and how the Fed policy of keeping the target Federal Funds rate in the 0.00 percent to 0.25 percent range until at least the middle of 2013. 

Commercial banks have historically made most of their money from the difference between the interest rates they charge on loans and the interest rates they pay on the funds they borrow.  This difference is called the “net interest margin”.   

This spread has, in general, been declining since the early 1960s.  Two factors have contributed to this decline.  First, one of the financial innovations of the 1960s was the movement of banks to engage of liability management.  Classically, commercial banks had been asset managers.  Bank liabilities were generally determined in local markets (because of the limitations on bank branching), were generally demand deposits, and were generally insensitive to interest rates.  Thus, banks were limited in the funds they had to lend by the amount of interest insensitive deposits they had on hand and the capital the bank had accumulated.  They did not manage this side of the balance sheet…it was a given.  Consequently, they were asset managers.

In the 1960s as capital began to flow more freely within states, between states, and between countries, banks, especially larger banks, could not live under the constraint of their liabilities and capital.  Loan demand began to exceed this constraint and so these large banks developed “market-based” liabilities that they could buy and sell at their will.  Thus, we had the creation of the negotiable Certificate of Deposit, the Eurodollar deposit, and the holding company issue of Bankers Acceptances.  Liability management took over at these banks. 

Liability management, early on, was limited to the largest banks.  But, as the financial system evolved, liability management migrated to smaller and smaller banks.  I must admit to some shock in that I just went through a training session on asset/liability management for commercial banks prepared for the American Bankers Association.  In this six-part program, the assumption was that every bank, even the smallest, engaged in liability management.  That is, even the smallest banks could go out and “buy” funds in the open-market and thereby fund all the loans that they might find.  Thus, the cost of their funds rose and well as their riskiness. 

The problem is, however, that deposits that are insensitive to interest rates pay a very low rate of interest.  Funds that are purchased in the open market pay “market rates” and are very sensitive to competitive rates.  Thus, the cost of funds for commercial banks rose relative to the interest rates on loans.  The “net interest margin” of commercial banks fell.  It thus became harder for banks to earn the returns they used to earn on “classical” banking business.

A second factor that contributed to the decline in banks “net interest margin” was the increased competition that came about over the last fifty years, both nationally and internationally.  “Good” borrowers could now go outside the banks limited banking region and find better and cheaper banking relationships.  As the limits on branching broke down, this competition for “good” customers increased.  As this competition increased, the “net interest margins” earned by the banks dropped even further. 

So, commercial banks, for years, have been facing falling “margins.”  Now, as the Wall Street Journal article proclaims, the Fed put even greater compression on interest margins over the past couple of years by reducing its target Federal Funds rate to the 0.00 percent to 0.25 percent range.  With the new policy decision to keep this target so low for another 24 months the Fed has basically “locked in” exceedingly low “net interest margins”.  The article supports this claim by looking at Treasury yields: the spread between the two-year Treasury yield and the 3-month Treasury yield is just 19 basis points (this spread was 46 basis points three weeks ago); the spread between the five-year Treasury and the 3-month Treasury is less than one percent (a month ago this spread was 150 basis points).

“For the biggest banks, this decline in the net interest margin cuts into profits from lending as well as crimping investing and trading income.  Smaller banks face the added challenge of often having to pay more to attract funds.”

The thing that struck me about the Financial Times article is this: the British bank HSBC and Google have roughly similar market capitalizations.  “The striking difference is that Google generates these number with fewer than 30,000 employees—not even as may people as HSBC is laying off.”  HSBE recently announced that it is laying off a 10^th of its workforce, 30,000 redundant employees. 

Both companies deal with “information”.  Finance (money) is just information.  Whether it be paper or gold or 0s and 1s, it is just information.  The “value” of the paper or gold or 0s and 1s comes from the ability of this paper or gold or 0s and 1s to acquire something that we want to buy.  This is why information technology is such an important part of commercial banking.

What do I see for the future?  I have written about this many times in many places over the last five years.  You can find many of my blog posts on Seeking Alpha. (http://seekingalpha.com/author/john-m-mason?source=search_general&s=john-m-mason)

And, the author, Frank Partnoy, makes this point in his Financial Times article.  Commercial banks deal with information and Google deals with information.  Yet in the case of HSBC we see that Google has a workforce of less than one-tenth of that of HSBC and they both have the same market capitalization.  The question is, why does HSBC have such a large workforce? Partnoy adds: “Facebook’s equity is worth more than that of most banks, yet it has just 2,000 employees.”  Where is the adjustment going to come?

Because commercial banks have experienced falling net interest margins and because they have a business model that is way out of date with the existing technology, commercial banks have had to do other, riskier things to “make their money.”  The commercial banks have “expanded into riskier and more complex activities, including structured finance, derivatives trading and regulatory arbitrage, which can allocate capital in distorted ways.”  In essence banks have had to make up for their inefficiencies by taking on more financial risk, increasing financial leverage, and through financial innovation. 

The consequence?  Commercial banks, in Europe as well as in the United States, are troubled.  Many banks are selling at discounts from their book values, something at substantial discounts.  The inherited banking model does not seem to be working and something new must take its place.  What will the new model be?   

Obviously, we are in the process of working this out.  One thing seems sure to me. Banks in the future are going to employ a lot fewer people per dollar of assets than they have in the past.  I don’t know whether Google or Facebook are the models of the future, but information technology will have a dramatic effect on the finance industry over the next five years or so.  Furthermore, banks can’t live off of recently experienced or current net interest margins.  Here we might get a bifurcation of the banking industry into something like commercially orientated banks and consumer oriented credit unions.  We’ll see.   

Our Two Choices

It seems as if our policy choices have been reduced to two.  First, our basic problem is that there is too much debt outstanding, debt of consumers, debt of businesses, and debt of governments…state, local, and national.  According to Ken Rogoff of Harvard (and co-author of the book “This Time is Different”), “By far the main problem is a huge overhang of debt that creates headwinds to faster normalization and post-crisis growth.” (http://www.ft.com/intl/cms/s/0/1e0f0efe-c1a9-11e0-acb3-00144feabdc0.html#axzz1UdDrJfzK)

During the past fifty years of credit inflation, the incentive existed for economic units to increase financial leverage.  Consequently, we have reached an extreme position of financial leverage, one that many believe is unsustainable.  As Rogoff claims, people attempting to reduce this “huge overhang of debt” will not borrow, will not spend, and this will result in a period of time in which economic growth and the expansion of employment will be modest at best, and downright slow at worst.

The resulting policy choice, therefore, is to allow the debt reduction to take place and let the economy adjust to more “normal” levels of debt.  This “adjustment” is going to have to take place some time and the best thing for the future of the economy is to let it adjust naturally for this adjustment must take place sooner or later.  By not allowing it to take place, we just postpone the final day of reckoning.

The second policy choice is to pursue a significantly aggressive program of credit inflation, one that would force people and businesses to return to borrowing and hence to spending.  Such a policy would help to accelerate economic growth and put people back to work.

This argument is based on the assumption that the United States cannot afford the consequences of a long, slow period of debt reduction and a lengthy period of mediocre economic growth.  The cost of following a “do-nothing” policy in terms of human suffering due to the unemployment and social dislocation created by such a policy would be unacceptable.

The second policy has been the approach taken by the Obama administration, arguing for a resumption of credit inflation, both in terms of government deficits and in terms of expansionary monetary policy.  The question that supporters of this policy debate about is the degree of the credit inflation.  The Obama administration, itself, has tended to follow a more modest level of credit inflation whereas its liberal critics have argued the Obama team has been too timid in how much credit inflation should be imposed on the economy.

Here we get into a debate over timing.  The first policy is needed, according to its proponents, because that is the only way the United States will regain its competitiveness and be able to go forward with the finances of its people in a strong position.  Following the second policy would only postpone the adjustments needed and leave the “day of reckoning” somewhere out there in the future.

The supporters of the second policy argue that we cannot allow economic growth to be so low and unemployment stay so high because of the human cost.  We need to address this now and worry about the debt re-structuring problem later.

The concern over the second policy program has to do with the “tipping point.”  Let me explain.

Right now, the debt overhang appears to be the predominant force in the economy.  Consumers, at least a large portion of them, are not borrowing and spending because of the debt loads they are carrying. (The wealthier consumers seem to be going along fine, thank you.) They are increasing savings in an attempt to get their balance sheets back in line.  Small- and medium-sized businesses are not borrowing to any degree, are not hiring people, and not expanding much at all because they have too much debt on their balance sheets and are trying to keep their heads above water.  Many state and local governments are facing real budget crunches and are cutting back on employment and capital expenditures because of their legal obligations. 

The government fiscal stimulus programs initially attempted by the federal government have been ineffective and disappointing, at best.  The efforts of the monetary authorities to generate bank lending have also been exceedingly ineffective despite historically extreme injections of liquidity into the banking system. Those people supporting the “second policy” continue to call for even more credit inflation whether it be for an new round of “quantitative easing” on the part of the Fed or some other innovative uses of monetary policy. 

The problem with the “tipping point” is this: how severe the tipping point will be if/when the new efforts at credit inflation overcome the efforts of economic units to restructure their balance sheets and eliminate the “debt overhang” connected with the past fifty years of credit inflation. 

The current policy makers seem to believe that the “tipping point” can be managed and the adjustment from debt restructuring to further borrowing can become incremental.  That the trillion or so dollars injected into the banking system by the Federal Reserve can be smoothly removed from the banks once borrowing from them picks up steam.   In this way, faster economic growth could resume again and employers could begin hiring workers at a speedier pace.  

The alternative view is that the “tipping point” cannot be “managed” and that once the gates are open, borrowing will only accelerate and credit inflation will get “out-of-control”, given the magnitudes of liquidity already pushed into the financial system.  Does this mean hyper-inflation?

This discussion leads to a question about whether or not the current policy makers can recognize the “tipping point” (let alone anticipate it) and whether or not they can then smoothly remove all the excess liquidity that has been forced into the banking system.

If one is to look at the record of Chairman Bernanke and the Federal Reserve system one cannot have very much confidence that they will be able to recognize a turning point let alone manage their way through the “tipping point”.  Historically, Chairman Bernanke has had trouble recognizing bubbles, stays with a policy stance far too long and then over-reacts.  Take a look at what happened before the financial crisis of 2008.  The “housing bubble” and the “stock markets bubble” in the middle 2000s were not recognized by Bernanke or the Fed.  Bernanke and the Fed fought the “fear of inflation” for too long into the initial stages of the financial collapse.  And, then Bernanke and the Fed had to over-adjust to the financial crisis they contributed to by “throwing open the windows…and the doors…and whatever…at the Fed” in order to “save the world”. 

Managing a “tipping point”, I would argue, is not one of Ben Bernanke’s strengths.  But, governments, I would argue, are not very good at managing “tipping points.” 

Where does that leave us?  Between a rock and a hard place. 

The government will continue to try to alleviate the suffering of those that have been hurt in the Great Recession and its aftermath.  The Obama administration and the Democrats and the Republicans will compromise on a policy that can still be labeled credit inflation.  The Federal Reserve will continue to look for ways to stimulate bank lending.  And, the only way I can characterize this situation is one of HIGH RISK.  Volatility is going to continue to dominate the financial markets over the next two years or so for the very reasons I have cited above. 

The reason for this is the timing of the “tipping point.”  The private sector is going to continue to push for balance sheet restructuring.  The government is going to continue to push for more and more credit inflation.  This leaves the future highly uncertain.  Consequently, markets will move this way and that way until some leadership and stability are brought into the picture.

Winning Strategies

Good teams find ways to win even when the calls go against them, even when the weather is bad, and even when their opponents change their strategy. 

Bad calls are a part of sports…and business…and politics.  You have to go on.  It is a part of the game.  Yes, the ref missed the call, but you still have to play out the rest of the game.  Sure, Standard & Poor’s may have not handled the ratings adjustment and timing in the best way possible, but the Obama administration knew that the government’s bond rating might be changed and it also knew that the United States had fiscal problems, political problems, and economic problems. 

The announcement on Friday evening was not a surprise.  Yet, the administration chose to claim that Standard & Poor’s was “incompetent and not credible.”

To some this puts the United States right up there with Greece…and Portugal…and Spain…and Italy.  The blame rests elsewhere.  This is what losing teams do.

The weather, the external environment, is a part of games…and business…and politics.  Yet, your opponent, others, has to face the same external environment that you do.  The snow or wind or rain made playing rough, but the game continues.  Sure, the economic conditions being faced by the United States are difficult, but the Obama administration has been facing them for two and a half years, as have many other countries, and blame cannot continually be placed upon the Bush(43) administration or the rest of the world. 

Again, losing teams put the blame on somebody or something else, like speculators, like rating agencies, like previous Presidents.  And, then they keep on doing just what they have been doing in the past.

Opponents change their strategies during games, or, they may change personnel.  Given the refereeing, given the weather, given the strategy you are pursuing, your opponents may alter the way they do things in order to take advantage of your strategy or your personnel or the weather.  Yes, the Republicans won the mid-term elections, sure the Tea Party advocates came on very strong, and sure the economy did not respond the way that the Obama administration expected, but that is not a reason to blame these factors as a reason why the Obama team didn’t succeed. 

President Obama relied on the same strategy and game plan established at the start of his presidency.  Every issue was addressed by a speech after which the construction of a plan, whether for health care, financial reform, or debt control, was turned over to Congress.  The opponents of President Obama changed how they played the game and largely succeeded in their efforts because the Obama team played the game exactly as they had in the past.      

Losing teams always seem to blame other factors, like their opponents changing strategies for their failures. 

It is obvious that there is great concern in the world over the financial affairs of governments in the United States and Europe.  Yet, these governments continue to claim that others are imposing the problems upon them.  And, as this attitude continues, we all are worse off for it.  This is the way losers play the game. 

The conditions are what they are.  The people in power need to make adjustments to their game plans…they cannot continue to follow the same strategies they have been pursuing in the past.  When is it going to become obvious to these people that what they are doing is not working.  When are they going to realize that the past is the past and that maybe they need to listen to new voices?   Politicians are supposed to be pragmatic…so let’s seem some of that pragmatism.

Where should they start?   

I believe that the United States government needs to change its economic objective.  For more than fifty years, the primary economic objective has been to achieve high levels of employment…a low unemployment rate.  Under this objective, the percentage of people working in labor force has dropped to an historic low of about 55 percent and the underemployment rate has risen to about 20 percent of those of employment age.  Furthermore, pursuing this policy objective has resulted in an income/wealth distribution skewed more toward the rich than ever. 

To continue to maintain this policy as the number one priority of the United States government is like a football team continuing to run the same play over and over again even though the opponent has stacked the defense to stop that very play.

To me, the primary objective of United States economic policy should be the maintenance of a strong dollar.  Although every presidential administration for the past fifty years has supported a “strong dollar”, the policy of credit inflation followed by both Republicans and Democrats to achieve high levels of employment for the past fifty years has achieved exactly the opposite end.  First, the United States dollar was taken off the gold standard on August 15, 1971 and its value was allowed to float.  Next, the credit inflation policies followed by these Republican and Democratic administrations have resulted in a decline in the dollar in world markets of about 40 percent since 1971.

The game plan of credit inflation to achieve low levels of unemployment has not succeeded and the standing of the United States in the world has suffered for it.  That game plan needs to be changed. 

A strong dollar is the foundation for a strong economy because the emphasis is placed upon the competitiveness and innovative capabilities of the businesses and workforce of the economy.  The government must be concerned with education and training, with the ability of companies to innovate and change, and with incentives for people to start and grow companies.  High levels of employment and labor participation are achieved in this way. 

Putting all the emphasis on credit inflation to ensure high levels of employment works against the things mentioned in the previous paragraph.  Credit inflation works to put people back in their old jobs rather than encourage innovation and training to raise productivity and change.  Credit inflation puts emphasis on financial leverage and financial innovation and leads to the financial sectors of the economy becoming more important than the manufacturing sectors.  And, credit inflation results in the income/wealth distribution becoming more skewed toward the wealthy. 

If the basic philosophy of the Obama administration continues to be one based on the further application of credit inflation to the economy it will have fundamental problems going forward.  One, economic growth will continue to stagnate.  Two, the administration will face greater and greater opposition, first, from its opponents because they will see that nothing has changed in the game plan and that the game plan is not succeeding; and second, because its supporters will become more and more dissatisfied with its performance.  Three, potential outside opponents, like China, Russia, Brazil, and so forth, will prepare much more aggressive game plans against the United States because they can smell the weakness.  Note the responses of China, Russia, and others, to the Standard & Poor’s downgrade. 

Winning teams focus on building strong organizations with the best personnel for the times and with the best game plans for the game they are playing.  They adjust with the conditions.  They find ways to win.  And, they do not make excuses.  

Post QE2 Federal Reserve Watch: Part I

Should there be a QE3 or not?

This seems to be the debate now going on given the sluggish performance of the United States economy.  Not only have most of the recent statistical releases been relatively weak, the government also released revised figures for real growth during the two years of economic recovery since July 2009 that were revised downwards from the previously released mediocre data. 

There is no joy in Mudville. 

President Obama is talking up jobs and infrastructure investment and business innovation, but his “room to maneuver” given the debt wars going on is “little” or “none”.  And, the White House is not feeling really good going into the re-election season.

Only a small minority seems to be calling for substantial fiscal stimulus at this time and they do not even seem to be a part of the current discussions going on.  They are like “voices calling in the wilderness” but few are listening. 

Thus, attention is focusing once again on the Federal Reserve and its increasingly unpopular Chairman Ben Bernanke.  Mr. Bernanke seemed to be the savior of the financial system at one time but now seems to be talking about a different world than the one most people live within.  His efforts at stimulating economic growth have achieved very little with the exception of providing liquidity for world commodity markets and stock markets in emerging countries. 

Yet, people keep looking for more “guns” or “tools” to address the economic malaise that we are now going through.  The FED seems to be the only game in town.  So, are we going to get QE3?

QE2 ended on June 30, 2011.  In the first six months of 2011, the Fed caused Reserve Balances with Federal Reserve Banks to increase by $642 billion reaching a total of $1.66 trillion on July 6.  (Just a note: on August 6, 2008, before the deluge, Reserve Balances with Federal Reserve Banks totaled less than $4.0 billion.)

As we know, most of these reserve balances were held as excess reserves, the growth of bank lending in the United States over this time was non-existent.

In July, the Federal Reserve “backed off” from its program of aggressive security purchases with almost all purchases of United States Treasury issues going to offset the run-off of Federal Agency issues and Mortgage-backed securities from its portfolio during the month. 

The only real activity that took place at the Federal Reserve in July was “operating” transactions, basically balance shifting between Treasury accounts and commercial banks.  These “operating” transactions generally “netted” out close to zero and did not result in much change in reserve balances with Federal Reserve banks. 

So, we watch and wait and listen. 

Will the Federal Reserve do anything more?  And, if they plan to do anything…what will it be?

In my analysis, so much of the county has too much debt that people, businesses, and state and local governments are attempting to de-leverage their balance sheets.  Too many financial commitments have been made relative to cash flows that there is a substantial effort increase savings and re-structure balance sheets. 

This is why people, businesses, and governments are not borrowing…and are not spending. 

The efforts of the Fed to stimulate bank lending has failed to this point because the banking system is, itself, still retrenching, financial institutions are still going out-of-business in a steady stream, people aren’t borrowing to buy houses, small- and medium-sized businesses are not hiring and are not borrowing to expand their operations, and state and local governments are downsizing and trying to keep themselves solvent. 

The economy is not growing because too many are trying to get back on their feet, they are trying to keep from drowning, and adding on more spending and more debt is not on their agenda.

Here is where the paradox comes in.  The massive shift in the income/wealth distribution in the country has put a huge burden on the less wealthy while those with more wealth can continue on.  We hear that the “expensive” stores are doing very well…and the dollar stores are not doing all that well.  We hear that there is a pickup in the sales of the more expensive homes, yet sales in the rest of the market continue to decline.  And, so on and so on.

In such an environment of “debt deflation” for a large proportion of the population (see http://seekingalpha.com/article/279283-credit-inflation-or-debt-deflation) it is extremely difficult for the government’s economic policy to overcome the drag on spending created by the restructuring of balance sheets. 

Keynes interpreted such a situation as a “liquidity trap”, a situation where the central bank could not drive interest rates any lower because people would just as soon hold cash as hold interest-bearing debt. See David Wessel’s column in Saturday’s Wall Street Journal: http://professional.wsj.com/article/SB10001424053111903454504576490491996443926.html?mod=ITP_pageone_2&mg=reno-secaucus-wsj.

Wessel presents one case for getting out of this trap…a period of (hyper)inflation that would substantially lower real interest rates.  This, one could argue, is what the Fed (unsuccessfully) tried to do in QE2 and it is what would be the objective of following QE2 up with QE3.  But, the strength of QE3 would have to be great enough to get over the “debt deflation” efforts of the people, businesses, and governments that are trying to get their balance sheets back in order. 

Wessel writes, “Failure to arrive at the correct diagnosis, in economics as in medicine, prolongs the illness; so does refusing the remedies. There's a reason the Great Depression lasted for more than 10 years.”  But maybe the correct diagnosis is that the problem is not a liquidity problem but is a solvency problem.  And, the people of a society may take a long time to deleverage their balance sheets when it took fifty years of credit inflation to get them in their current position.
If this is true, having the central bank create a policy of (hyper)inflation will not really resolve the issue but only postpone it for another day…something politicians are very good at.
And, as we contemplate the possibility that the Fed will engage in another round of monetary easing, word comes that the European Central Bank (ECB) is going to engage in the purchase of the sovereign debt of several European nations so as to support eurozone commercial banks and the newly proposed severe budgetary policies of Italy and Spain.  The ECB announcement came after several European commercial banks wrote down the value of the Greek debt on their balance sheets everywhere from 21 percent to 50 percent. 
To the ECB, it seems, the situation in Europe is still a liquidity problem.  But, if this is the incorrect diagnosis, as it may be for the United States, the ECB may have the same success as the Fed’s QE2 had.  Keep watchin’.  

When Debt Loads Become Too Large

Debt loads become unsustainable when people, businesses, and governments have to make choices…when they cannot just “have it all”.

A case in point comes from a story about the world famous philosopher Winnie-the-Pooh.  In this particular story, Winnie-the-Pooh is presented with the choice: “What would you have, Bread or Honey?”

To this Winnie-the-Pooh replies, “Both!”

During the earlier periods of credit inflation, people, businesses, and governments are able to reply “Both” to all choices and are able to get away with it because the credit inflation “buys” them out of the implied limitation on resources.

Credit inflations are cumulative because choosing almost all alternatives and financing them with debt just builds and builds the expansion.

The problem with credit inflations is that they one day come to a halt…that is the cumulative build up of debt becomes unsustainable and choices have to be made.  “Both” is not a viable answer any more.

The only possible means of extending the period of credit inflation once the debt loads become unsustainable and a “tipping point” is reached is for the monetary authorities to take the credit inflation to another level, a level that might be called “hyper-inflation.”  Hyper-inflations, however, do not have happy endings

Many governments, as well as individuals and businesses, have reached the point where decisions have to be made.  Budgets cannot just continue to be “wish lists” where all parties are satisfied.  Governments cannot create across-the-board job programs because of the need to substantially reduce their budget deficits.  In addition, raising taxes to cover these “wish lists” is just another effort to achieve a “both” outcome.

Keynesian stimulus plans are built on the presumption that the government can harmlessly attain “both” of the consequences of such policies: issuing unlimited amounts of debt and economic vitality.  This type of credit inflation can only succeed for a period of time and then the accumulation of debt catches up with the government.  In the case of the United States it seems as if the successful period of accumulation lasted for about 50 years.

And, we see that governmental hands can be tied in other ways.  President Obama was not able to commit much in the way of resources to the situation in Libya.  He dropped the ball to NATO.  And, the Libyan battle drags on.  And, President Obama cannot get caught up in the conflict in Syria.  In fact, American foreign policy is finding itself short on resources in many cases, a situation not faced by this county in the post-World War II period.

In addition, many state and local governments have promised way beyond their capacities on pensions, water projects, and other large capital expenditures and now face the dire prospect of not being able to cover their commitments.  We are seeing situations over and over again where debates about pension plans were put into arbitration in order to reach a settlement and those deciding the case had the sole objective of getting people back to work as soon as possible.  Thus, generous pension plans were put into place and the governmental unit could justify the “largesse” of the plans by passing on the responsibility for the decision to the arbitration panel.

People in Europe and the United States are now experiencing the very difficult position of having to choose.  And, as we see, having to choose is very painful.  As we are observing every day, politicians and governments will do almost anything they can to avoid having to make a decision. 

The consequence of such behavior?  Decisions get postponed into the future. 

The feeling: “Maybe if we postpone things long enough the problems will go away.”

The world, unfortunately, does not allow you to postpone the day when decisions have to be made indefinitely.  In most cases, if decisions are not made, the time comes when the crisis becomes so bad that decisions “have” to be made.

And, the problem with this is that the burden of the adjustment becomes even greater on those that can least bear them at the “crisis” date than the burden would be had the decisions been made at an earlier time. 

Politicians, however, are too concerned about their own re-electability to worry about this later time.  But, this is true of executives and their teams and of individuals and families.  People have a tendency to cling to the past and put off taking hard decisions.   

So the battle becomes a “war” between those that want to preserve as much of the “wish list” as possible,like Winnie-the-Pooh they want "both" or "all" of the choices, and those that claim that priorities have to be set and decisions have to be made.   

All to often the decision-making is postponed and postponed and postponed…until it becomes necessary to choose. 

The consequence of this in the financial markets…is volatility.  The uncertainty created by the postponement of resolving the situation is the extreme movement of market prices as traders are moved this way and that way by the most recent information. 

Value investing takes a back seat in such an environment for the achievement of long-term objectives requires extreme confidence and patience.  The draw of short-term trading returns is heady…yet extremely risky.      

Right now, there is very little hope for us to see a much better future.  To see an improvement in the future would require some real leaders to emerge from the crowd and I don’t see anyone yet that fits that description.