Post QE2 Federal Reserve Watch: Part 2

Excess reserves in the commercial banking system did not change much over the past quarter.  The two-week average for the banking week ending September 7, 2011 was $1, 569 billion.  At the start of August the total was $1,602 billion and at the start of June the total was $1,549 billion.  So roughly, excess reserves averaged around $1.6 billion over the past three months.

It’s kind of hard to appreciate the irony of saying excess reserves didn’t vary much over the past three months when in August 2008 the excess reserves in the whole banking system totaled only $2.0 billion. 

QE2 ended June 30.  So, we were not to expect the Federal Reserve to do too much to the banking system after this period of quantitative easing ended.  And, so far the Fed has done little or nothing.

This does not mean things were not happening in the commercial banking system. 

For example, the required reserves in the banking system rose by more than 20 percent from the banking week ending June 1 to the banking week ending September 7.  The rise was from about $76 billion to around $92 billion.  These are the reserves banks must legally keep on reserve to back up transaction and savings account balances.    

Most of the increase came in the last week of August and the first week in September when required reserves increased by more that $10 billion. 

The rise in required reserves came about due to a massive jump in the demand deposits held at commercial banks in August, which require the highest amount of reserves to be held by the banks! 

There also was a surge in savings deposits at commercial banks in August.  

The increases in demand deposits and savings deposits seemingly came about due to a large movement of funds from small savings accounts and institutional money funds. 

It was during this time that the Federal Reserve announced that it was going to keep short-term interest rates at very low levels for the next 24 months.  This announcement seems to have accelerated the movement out of short-term interest bearing assets to bank accounts…transaction accounts and savings accounts.  In a real sense the disintermediation continues. 

The point is that these movements on the part of wealth holders have influenced the money stock figures.  For example the year-over-year growth rate of the M1 money stock, the measure most affected by the shifts in money, the shifts toward demand deposits, has risen from about 12 percent at the end of May to just under 17 percent at the end of August. 

The M2 money stock measure has also risen but its growth rate remains under 50 percent of the growth rate of the M1 money stock.  Its rise has gone from about 5 percent to 8 percent over the same time frame. 

As I have pointed out for about two years now, the money stock measures appear to be growing because people are shifting out of short-term interest bearing assets because of the exceedingly low interest rates and are parking the funds in commercial banks in transaction balances and savings accounts. 

Some of this transfer is also occurring because people who are under-employed or having other financial difficulties want to keep their funds in accounts that can be accessed quickly to meet daily and weekly needs.      

The money stock growth is not occurring because the banking system in gearing up the lending machine and providing the loans needed for a more robust expansion of the economy.

I believe my interpretation of money stock growth is the correct one because this re-allocation of wealth balances from interest earning assets to transaction balances and other short-term bank assets has been taking place for two years or so and this movement has resulted in increasing growth rates for the money stock measures.  Yet, there has not been a real increase in bank lending during this time period and economic growth remains anemic with a stagnant labor market. 

Money stock growth is occurring but, one could say, for the wrong reasons.  The money stock measures are growing because people are protecting themselves and staying liquid while interest rates are so low.  This is not the behavior that drives the economy forward.  The money stock measures are not growing because of the monetary stimulus and this means that one cannot expect much economic growth from it.

The open market operations of the Federal Reserve have basically been operational over the past five weeks.  Federal Agency securities and Mortgage-backed securities continue to run off from the Fed’s portfolio and these run-offs have been replaced by US Treasury securities.  The off-set has been almost one-for-one, dollar-wise.

The interesting action on the Fed’s balance sheet has been a $34 billion increase in Reverse Repurchase Agreements with foreign official and international accounts.  Reverse repos take reserves out of the United States banking system.   In these cases, the Federal Reserve “sells” US Treasury securities under an agreement to buy them back at a later date. Over the past 14 weeks, reverse repos to foreign governments or their agencies rose by $43 billion.  One can only guess that these transactions have to do with the financial crisis that has been taking place in Europe.  More research needs to be done on this.

The net result of all this is that the Fed has done nothing overt since the end of second round of quantitative easing.  Economic activity continues to be stagnant and the under-employment situation does not improve.  Money stock measures continue to grow but for reasons not related to increases in bank lending and improving economic activity.  The question seems to be, where does the Federal Reserve go next?  Answers to this question are all over the board. 

Europe: More of the Same

I haven’t written anything recently about the Europe financial crisis because…little has changed.

Still the same old “kicking the can down the road.”

I am in the same place as Stephen King, chief economist at HSBC: “The totality of financial claims in now too big to be supported by the new economic reality.  In this world of economic permafrost, someone, sometime, will have to accept losses.  Will those losses accrue to taxpayers, recipients of public services, equity investors, bondholders, domestic debtors or foreign creditors?” (http://www.ft.com/intl/cms/s/0/c3451258-da07-11e0-b199-00144feabdc0.html#axzz1XSP5Pmbe)

His answer: “…any resolution seems a long way off.”

The response from the international capital markets?  Fear!

Yesterday the ten-year government bond of Germany closed at 1.88 percent; the ten-year United States Treasury bond closed at 1.99 percent.  Never thought I would see rates like this in my lifetime.  

The fear is driving investors into the safest things that they can get their hands on.  And, within this “flight to safety”, Europe…and the United States…just plods along with business as usual. 

Although we don’t agree with his prescribed remedy, Mr. King and I agree with what was written by Martin Wolf this past week. (http://www.ft.com/intl/cms/s/0/079ff1c6-d2f0-11e0-9aae-00144feab49a.html#axzz1Wbu6HxQ0)  Mr. Wolf argued that the major problem behind all the “pussy-footing” around is that there is a substantial lack of leadership on the world scene. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)

This lack of leadership comes out in so many ways.  Just take the case of Greek bonds and the value at which these bonds are carried on the balance sheets of European banks.  It seems as if these European banks can do just about anything they want to in terms of writing down the value of the Greek bonds they hold.

Floyd Norris writes in the New York Times: “British banks were most willing to swallow bad medicine and admit the bonds were worth far less than par value. Some German banks were equally forthcoming, but others were less so. Italian banks seem to have done as little as they could, but did take write-downs. French banks went the farthest to find ways to act as if Greek bonds were just fine.” (http://www.nytimes.com/2011/09/09/business/european-banks-apply-slippery-standards-on-greek-bond-valuations.html?ref=business)

So much for the “strong” rules and enforcement actions of international accounting and banking standards supposedly coming out of Europe.

Oh, yes, these are the European regulators that gave us the “stress” tests that were such a laughable matter.

The reason, to me, that no politician wants to stand up and take a strong position is that there are no good short-run solutions to the problems at hand.  The difficulty in taking a strong, longer-run position is that people are currently in pain and politicians must focus on “muddling through” to prepare themselves for the next election.

After all, the number one job of the politician is to get himself or herself re-elected. 

The difficulty faced by the politician is captured in the sub-heading of the New York Times article “Europe Steers Into a Zone of Uncertainty.   This sub-heading reads, “Path Out of Debt Crisis Involves Pain and Time.” (http://www.nytimes.com/2011/09/09/world/europe The /09europe.html?_r=1&ref=todayspaper)

Imposing more “pain” is not a good way to get re-elected and taking too much time to achieve results does not match the timing of the politician’s next election.

And, where does the pain start?

Let me quote King once more:  “someone, sometime, will have to accept losses.”

Many of the governments in Europe are fragile because of the sovereign debt crisis.  Many of the banks in Europe are fragile because of the sovereign debt crisis.  There is rioting in the streets in Europe because of the efforts of governments to cut back budgets or raise taxes.

Yet, these same governments and public officials will not accept the reality of the situation…and so the crisis continues.

Steven Erlanger, tin the New York Times article just mentioned writes the following: “most experts agree that Europe’s crisis will persist until it adopts a far tighter fiscal and monetary union, expels weaker economies or divides into two, with different currencies. 

The hope among experts and economists is that the changes, if carried out with skill, may allow Europe to further isolate Greece and its unsustainable debts from other countries, reducing the risk of contagion and buying time for other countries to fix their budgets and work on how to better centralize control of fiscal policy. Though abstract on the surface, the changes will provide more flexibility to bail out or further restructure Greek debt, to aid Italy and Spain with their bond sales and even to recapitalize some European banks, weakened by their exposure to sovereign debt in the form of Greek, Portuguese, Spanish and Italian bonds.”

Notice three things: first, the reference to “experts”; second, the statement “if carried out with skill”; and third “though abstract on the surface.”  Sounds like success is just around the corner. LOL

It took fifty years or so to create this financial crisis.  We are not going to get out of it “overnight” and we are not going to get out of it without more pain. 

Again, “someone, sometime, will have to accept the losses,” regardless of what the “experts” say.

This is what happens when you become a “debt junkie.’

Wil Bernanke Policy "Destroy Credit Creation"? Bill Gross is Worried It Will--The Role of Financial Innovation

Yesterday I discussed the concern Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years.  The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates.  Gross sees the efforts extending to the seven- and eight-year maturity range.

The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous fifty years of credit inflation.  Gross, in his Financial Times article (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6), argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this fifty year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs. 

The positive slope to the yield curve provided the mechanism for this credit creation through three channels that I have written about on a regular basis.  First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates.  The mis-matching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.

Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin.  To paraphrase Warren Buffet…if credit inflation tide is rising, it is hard to tell bad assets from good assets.  Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit.   Tell me about the sub-prime mortgage mess…

Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage.  And, if competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets. 

This third component of the growing risk exposure of a period of credit inflation can only succeed if the banks and other financial institutions are “liability managers”.  In terms of the last fifty years, financial institutions became liability managers through the process of financial innovation.  Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.

Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive.  Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage”.  (See a review of Tilman’s book “Financial Darwinism” at http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.) Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay very low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high.  Thus, the banks worked with nice interest margins that were relatively stable and reliable. 

Liability management came into pay through the financial innovation of the 1960s.  Negotiable CDs and Eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to “local” constraints on the choice of funding sources.  Funding sources became world wide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate. 

In essence, commercial banks could now “leverage up” as much as regulation…or accounting rules…would allow!

And, as regulation eased up, banks and other financial institutions got into other financial and organizational innovations.  Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.” (See http://seekingalpha.com/article/289579-let-s-move-on-from-keynes-and-accept-the-new-liquidity.)

The result? Bill Gross nails it in his article: “Thousands of billions of dollars were extended…” It seems as if capital requirements were non-existent.  Credit could expand almost without limit.

And, why are we interested in credit inflation and not price inflation?  Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices…”flow” prices.  “Flow” prices relate to the prices paid for goods and services that are consumed in a relatively short period of time.  “Flow” prices are to be differentiated from “asset” prices. 

“Flow” prices are in many ways “constructed” prices.  For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset.  The “flow” of housing services is what people consume and the “price” of this flow of services is called “rent”.  In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated.  And, as it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.

Theoretically, the price of an ‘asset” (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services).  In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind. 

This is true of other asset categories like equity shares that are traded on the stock markets (take for example the Internet bubble of the 1990s).

Thus credit and credit inflation are of crucial interest to the behavior of prices…all prices…in the economy.  And this is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” (thank you Mr. Bernanke) that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy. 

The problem seen by Mr. Gross, however, is that the monetary policy now being followed by the Mr. Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place.  One could also argue (ala Mr. Gross) that the situation created by recent financial innovation, the “new liquidity”, will further add to the volatility of the whole situation. 

Will Bernanke Policy Actually "Destroy Credit Creation"?

PIMCO’s founder and co-chief investment officer Bill Gross presents an interesting perspective on the US government’s policy of credit inflation policy over the last fifty years in the Financial Times this morning. (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6)

“Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance.” 

This statement captures two of the three major fundamental components of the government’s policy of credit inflation that has existed since the early 1960s.  The first is that in a period of credit inflation, financial institutions are willing to take on “riskier” assets because the inflation that is created helps to “buy” them out of riskier deals. 

The second fundamental component is that the financial institutions finance these “longer and riskier yields” with “short-term” funds “at a near risk-free rate.”  That is, the financial institutions mis-match credit risks and maturities on their balance sheets. 

Gross does not ignore the third component: this component is financial leverage.  This financial leverage can, of course, turn a modest yield spread that is present in the yield curve into a very lucrative return on equity.  And, the more leverage used the higher the return on equity can become.

The consequence?

“Thousands of billions of dollars of credit were extended on this basis, some of it as short as a one-week or one-month maturity extension, but all of it—almost everywhere , nearly all the time—on the basis of a positive yield curve…”

And, there you have the scenario for the credit inflation of the last fifty years. 

Mr. Gross points out that the post-Keynesian economist Hyman Minsky identified this problem in the model developed within the Keynesian “neo-classical” synthesis.  Minsky’s concern, and this was one reason he is considered to be a post-Keynesian economist and not a Keynesian economist, was that leveraging this way resulted in a build up of excessive amounts of debt in the economy.  In this Minsky drew on the work of the economist Irving Fisher who wrote about credit inflations and debt deflations. 

Minsky, like Fisher, argued that during the period of credit inflation the cumulative build up of debt would at some point become unsustainable and the debt load would have to be reduced.  This would lead to a cumulative contraction of debt, or the period of debt deflation.  

That is, regardless of the fiscal policy of the government, the build up and contraction of credit in the economy would cause major economic restructuring, both on the upside and the downside.  That is, credit cycles would result from a government policy that supported s positive slope to the yield curve. 

Within this framework, the financial collapse of the 2008-2009 period can be thought of as the culmination of the “credit inflation” cycle.  Debt burdens became excessive and, with the ultimate break in the cycle, the period of de-leveraging began. 

We now find ourselves in the period of financial de-leveraging…the period of debt deflation. 

What is of concern to Bill Gross is that the Ben Bernanke and the Federal Reserve may be acting in a way that might exacerbate the period of debt deflation. 

Whereas Bernanke has attempted to avoid a second Great Depression by throwing everything he and the Fed could against the wall to see what stuck and to avoid a second 1937-38 depression by throwing everything he and the Fed could against the wall to see what stuck, (http://seekingalpha.com/article/290416-quantitative-easing-theory-need-not-apply), Gross is arguing that Bernanke and the Fed may be doing just the opposite in the latter case.

In essence, Gross is arguing that in attempting to keep interest rates so low for such a long period, the Fed is creating a “flat” yield curve and this, according to the ideas presented by Minsky, may result in the further de-leveraging of the financial system which would be detrimental to an economic recovery.

In other words, “the posit of American economist Hyman Minsky of an unstable financial system based on the leveraging of a positively sloped yield curve—and de-leveraging when it was not—would be obvious for all to see.”

“The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years (through an interest-rate “twist” policy) the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.” 

Carrying this argument one step further, Gross could be arguing that by following its policy of extremely low interest rates for an extremely long period of time, Bernanke and the Federal Reserve are risking a second dip in economic activity akin to the 1937-38 depression. 

Mr. Bernanke and the Federal Reserve want to preserve the commercial banking system and get the banking system lending again.  Their policy efforts have been to flood the financial system with so much liquidity that bank failures can be handled effectively and smoothly without disrupting the whole banking system and that so much liquidity will be around that commercial banks will eventually begin to loosen up their lending again. 

What Gross is arguing that the banking system will not begin lending in an aggressive way with the yield curve as flat as it is and if the flatness of the yield curve extends out to seven and eight years, very little lending will take place at all.  Taking on riskier loans just does not pay in such an environment and the mis-matching of maturities produces only a minimal spread.  In order to achieve competitive returns on equity, given these spreads, financial institutions would have to take on massive amounts of leverage…something that the banks themselves don’t want to do right now and something that the regulators would not allow them to do.

Mr. Gross closes by saying that Mr. Bernanke needs to be careful keeping interest rates so low and trying to “twist” the yield curve to reduce longer-term yields to the levels now seen in the short-term end of the market.  The fear is that Bernanke may produce, not a “take-off” but a “crash.”

Labor Day Highlights the Need for American Restructuring

The world has changed!

Of course, entrenched interests fight the change.

An instance is the United States Postal Service:  we heard over the weekend that the Post Office faces the possibility of bankruptcy.

The high profile cause of this situation: email.

The cause that gets a lesser play is the position of the labor unions connected with the Postal Service.  The Postal Service is the nation's second-largest civilian employer, after Wal-Mart. As of 2011, it employed 574,000 personnel, divided into offices, processing centers, and actual post offices.  The employed are served by four major labor unions, the National Association of Letter Carriers being the largest. 
 
Offices have continued to be kept in existence in spite of declines in business and expenses, including wage and pension costs, have continued to grow relative to the services provided.  Now however, cuts are being proposed: proposed cuts include eliminating Saturday mail delivery, closing up to 3,700 postal locations and laying off 120,000 workers — nearly one-fifth of the agency’s work force — despite a no-layoffs clause in the unions’ contracts.  

In terms of the labor situation, Steven Greenhouse writes in the New York Times that “decades of contractual promises made to unionized workers, including no-layoff clauses, are increasing the post office’s costs. Labor represents 80 percent of the agency’s expenses, compared with 53 percent at United Parcel Service and 32 percent at FedEx, its two biggest private competitors. Postal workers also receive more generous health benefits than most other federal employees.” (http://www.nytimes.com/2011/09/05/business/in-internet-age-postal-service-struggles-to-stay-solvent-and-relevant.html?pagewanted=1&_r=1)

There are, of course, many different plans that are being floated around relating to what can be done to “save” the post office.  But these plans all point to one thing…the U. S. Postal Service must be restructured.  It cannot go on as it has been going on.

Resistance is expected: “The post office’s powerful unions are angry and alarmed about the planned layoffs. “We’re going to fight this and we’re going to fight it hard,” said Cliff Guffey, president of the American Postal Workers Union.”

This is just one high-profile example of what is going on all over America. 

The world has changed.

Entrenched interests reject the fact that they must change as well.

Let me just point out three major changes that are impacting the work force these days which have, I believe, massive implications for the future re-structuring of the United States economy.

First, the majority of labor unions no longer reside in the manufacturing sector.  Most employees that belong to labor unions work in the public sector.  The public sector, as we know, has vastly over extended itself, fiscally, in many areas of the country.  The existing economic problems connected with slow economic growth, high rates of under-employment, and a depressed real estate market have put government finances in these areas in bad straits.  Existing relationships are being re-worked as these governments try to get themselves back in control of uthe situation.

The relative growth rates in manufacturing employment dropped off beginning in the 1970s, and now growth in the public sector is seemingly dropping off.  This is a re-structuring problem.

Second, there has been a demographic shift in the workforce.  As reported in ‘The Slow Disappearance of the American Working Man,” (Bloomberg Businessweek, August 29—September 4, 2011) “The (economic) downturn has driven the share of men who have jobs lower than any time since World War II.”

“The economic downturn exacerbated forces that have long been undermining men in the workplace,” and “the impact has been greatest on moderately skilled men, especially those without a college education,” and African-American men and Hispanic men. 

This is another re-structuring problem related to the changes in technology and the changes that have taken place in education: “college graduation rates essentially stopped growing for men in the late 1970s,” whereas “women continued to pursue college degrees in greater numbers and have been more responsive to the changing economy in other ways.”

Third, the last fifty years has also seen a tremendous shift in American employment from the manufacturing sector to the financial sector.  The credit inflation created by the United States government has underwritten the finance industry and resulted not only in growing institutions but also in more and more innovation leading to the greater horizontal diversification of financial institutions.

The example of this is four of our large commercial banks: GE Capital, Goldman Sachs, Morgan Stanley, and ALLY (formerly GMAC).    GE Capital has $606 billion in assets and is bigger than all but seven U. S. banks.  It now finds itself regulated by the Federal Reserve where the Office of Thrift Supervision formerly regulated it.  But more, important is that GE Capital recently provided 40 percent of the profits of its parent company General Electric.  (Before the financial collapse, the contribution of GE Capital reached 75 percent of GE earnings.)   This shows how manufacturing has given way to finance in the United States.

The re-structuring of the American economy is going to have to take place over the next ten years or so.  This “fix” cannot be achieved through short-run solutions. 

In fact, short-run solutions will only exacerbate the situation.  This, of course, is what most of the economic policy of the last fifty years has done for the United States economy.  The credit inflation of this period has built up the financial sector of the economy relative to the manufacturing sector.  The credit inflation has also supported the growth of the public sectors as the inflation in real estate prices supported the government tax base and open capital markets allowed even small governmental units to expand their expenditures.  Finally, much of the economic policy of the government during this fifty years was aimed at putting people back into the jobs they had lost during periods of slow economic growth.  This “Keynesian” approach to the government’s economic policy had an unfortunate impact on male employment, especially those with a lesser education, because the jobs these people were put back into were jobs that were becoming less and less important in the economy.

The times have changed.  Employment practices must change to meet the needs of the modern world. 

Re-structuring is never easy and we can expect a lot of pain in the process.     

The Economic Picture--No Steam Ahead!

The August unemployment rate was 9.1 percent.  Not much joy in Mudville.

About one in five Americans in the prime age for working range remain under-employed. 

We have the short-run problem related to economic growth and the fact that families, businesses, and governments need to get their balance sheets in order before they will really begin to spend again. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction) 

We have the long-run structural problems in the labor market related to the fact that the skills of many individuals of working age do not mesh with the jobs the economy is creating or is going to create.  For a dismal picture of this situation see the recent article in Bloomberg Businessweek (August 29—September 4, 2011) titled “The Slow Disappearance of the American Working Man.” 

And short-run growth seems to be going nowhere.  Just look at the year-over-year rate of change in industrial production.  Note that this series peaked in the second quarter of 2010.  The modest decline in this growth rate has now been going down-hill for more than 12 months.

Of course, the performance of industrial production is also captured in the year-over-year growth rate of real Gross Domestic Product.  Here the peak growth rate was achieved in the third quarter of 2010.  The growth rate has declined since.

If the economy fails to grow by 3.0 percent or more, jobs will not be added at a rate that will lower the unemployment rate.  And, growth at this rate will certainly not resolve the long run problem related to those that are holding part-time positions that would like to have full-time jobs and those people that have left the work force. 

Furthermore, this scenario is not one that is favorable to people making much headway in reducing the burden of their debts.  Thus, the “debt overhang” seems to be a part of the continuing saga of our economic malaise.  The environment for getting out of debt does not exist.

Given this picture, the questions that arise pertain to the concern that America may face a decade like Japan has faced or a decade like that in America in the 1930s.  Maybe this is the “payback” for the period of credit inflation we have experienced over the past fifty years.  Maybe the only way out of this situation, which is not a short-run solution, is to focus on the fundamentals, focus on the structural problems created over the past fifty years.

The Federal Reserve, so far, has acted so as to prevent another “shock” to the economy like the one they introduced in the 1937-38 period.  In this earlier period the Fed caused banks to become even more restrictive in their lending operations than they had been and this precipitated a second depression for the 1930s.  This time the Fed has flooded the banking system with liquidity and seems to be in no hurry to remove anything that appears excessive in terms of bank reserves even though bank lending remains modest, at best. (http://seekingalpha.com/article/290416-quantitative-easing-theory-need-not-apply)   

The short-run conflict that is going on right now is between the efforts of the Federal Reserve to stimulate bank lending and the financial system, and the efforts of families, businesses, and governments to reduce their debt loads.  At the present time, the latter interests seem to be winning.

The longer run question relates to whether or not the government stops focusing just on short-run solutions to the problems of the economy and begins to focus on the longer-term structural problems that exist.  The difficulty here is that it took a long time to get where we are now and it can be expected that it will take us a long time to get things back in order. 

The real dilemma is that we don’t create more problems for the future by implementing short-run solutions to our problems that will just exacerbate our longer-run problems.  In the long run we may all be dead, but we now seem to be dealing with the long-run problems left to us by earlier generations of policy makers that just focused on short-run solutions without any regard for the long run!

Just How Bad Off Are the Banks?

Here we are, how many years after the start of the financial crisis, and we still have questions about the status of individual banks and the banking system…in both the United States and Europe.

European banks have gone through two “stress” tests.  The United States banks have gone through their own “stress” tests.  And, still, there are questions about the solvency of individual banks and the banking system. 

Christine Lagarde, Managing Director of the International Monetary Fund, received all sorts of criticism from the remarks she made last Saturday concerning the status of the European banks and the fact that they “need urgent recapitalization.” 

Early this week we read about how various European banks are writing down the values of the distressed Greek government debt they hold.  Some banks are taking have taken a 50 percent write down while others have taken haircuts of slightly more than 20 percent.  There are no standards for taking such write downs leaving each bank to follow its own path. (http://professional.wsj.com/article/SB10001424053111904199404576540291609289616.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

American banks are not coming off much better.  One looks at the discounts being assessed against US banks in the stock market and the legal efforts that they face and one wonders what is real.   Are these banks really solvent?

Bank of America has become the poster-child of the mismanaged large banks in the United States.  Warren Buffett brought it some relief with his “pussy-cat” deal.  Yes, Mr. Buffett can say that he (and other wealthy people) should pay more taxes as he cuts such sweet deals with such nice tax benefits for himself.  Yet, some are taking the Buffet bailout of Bank of America as a signal that maybe a closer look needs to be given the position of Bank of America. (http://dealbook.nytimes.com/2011/08/31/buffett-investment-could-erode-confidence-in-wall-st/)

Just look at some of the numbers.  Bank of America has  stated that slightly less than 20 percent of its residential mortgage loans as either delinquent or nonperforming, a rate that is similar to that of Wells Fargo.  JPMorgan Chase has about 24 percent falling in this class while the fourth of the big four, Citigroup, has less than 14 percent. 

And, “Not only does the bank still face billions in legal settlement costs from Countrywide Financial deals, but it also has to buy back billions in faulty mortgages.  Bank of America’s questionable foreclosure practices continue to drag it down, and, in addition, it faces Securities and Exchange Commission investigations into the actions of its subsidiary, Merrill Lynch, in the lead-up to the financial crisis.”

In addition, bank profits are falling (http://www.nytimes.com/2011/08/29/business/top-banks-confront-leaner-future-by-cutting-jobs.html?_r=1&scp=1&sq=profits%20falling,%20banks%20confront%20a%20leaner%20future&st=cse) and with the Fed promise that it will keep interest rates low for the next two years, bank interest rate margins and, hence, bank profits can be expected to remain squeezed for the near term. 

And, why is the Federal Reserve keeping interest rates so low for the next twenty-four months?

One reason for keeping interest rates so low is that the Fed will continue to provide the banking system with substantial liquidity so that banks can work themselves out of their bad loan situation and that failing banks can be removed from the banking system with the least disruption possible.

Furthermore, commercial banks in both Europe and the United States are cutting back on their employment by not just thousands of people, but tens of thousands of people when all the layoffs are added together.   

We look at all this information and we wonder, “Just how bad off are the banks?”  The regulators have been working on this situation for at least three years.  And, we still have all these questions?

The only conclusion one can draw from this is that the regulators and the people “in the know” did not want us to know how bad things were.  And, they still are reluctant to let any of this information out.  Notice how upset people got when Ms. Lagarde let the “cat-out-of-the-bag” on Saturday.

So much of this dilemma goes back to the discussion about the need for financial institutions to mark their assets to market.

I know how hard this is to do in the case of some assets without active markets.  And, I know how painful this is to do “after-the-fact”, that is, after the asset values drop underwater.

But, this is a lame excuse that has been allowed to go on for too long!

If banks take risky bets on interest rate movements, they should only do so with the knowledge that if the markets move against them they will have to pay a price by marking the assets to market.  I also don’t buy the argument that they will hold the assets to maturity.  If the banks “place the bet” they must pay the consequences.

Same thing with risky assets: as banks take on more and more risky loans in an effort to “beef-up” their return on capital they are overtly exposing the bank.  Again, when the assets go south the banks need to own up to the bets they placed. 

And, if these mark-to-market efforts are done on a more timely basis then the banks will have to move to correct their asset problems earlier and they will not get into the deep “doo-doo” they now find themselves in.

Sooner or later these bank problems are going to have to be taken care of.  Stringing things out as the regulators and politicians have done only postpones the day we can move off into the future.  It is a prerequisite for finally achieving more robust economic growth. 

The fact that the problems we continue to read about still exist three years after the financial collapse took place only raises further questions and continues to add uncertainty to the economic climate.  No wonder that people are so risk averse today and only want to buy US Treasury securities or gold. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)