Credit Downgrades and Europe

The problem is the free flow of capital throughout most of the world. 

When capital flows freely you cannot escape the consequences of your actions.

What is called the “trilemma” problem of international economics makes this very clear.  The “trilemma” problem states that a country can only choose two of the following three options.  The three options are to be a part of world capital markets where capital flows freely; have a fixed exchange rate; or, be free to run an independent economic policy.

If there is a free flow of capital internationally, then the choice is reduced to just one of the two remaining options.  But, there are consequences to either choice.

First, if a country choses to run its economic policy independently of all other nations, then it must let it currency float in the foreign exchange markets.  Generally, a nation that wants to run an independent economic policy has particular domestic economic goals it wants to achieve and so wants to be able to choose an independent economic policy that supports these goals.

The goals most often chosen in the latter part of the twentieth century have been full employment and social welfare programs like government jobs, early retirement, substantial amounts of vacation, and high pension levels.  The means of achieving these goals has often been a policy of public sector credit inflation. 

If a country chooses the path of credit inflation then the price of its currency in foreign exchange markets must be allowed to float.  And, if credit inflation becomes extreme, the value of the currency in the foreign exchange markets will decline.  And, this will bring on other problems. 

This is one reason John Maynard Keynes wanted restrictions on the international flow of capital in the 1920s and 1930s. (http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell)   A limited flow of capital internationally was a reality when Keynes helped to craft the Bretton Woods agreement that created the rules for the post-World War II international monetary system.  This agreement also included fixed exchange rates between the currencies of the participant nations. 

The purpose of this system was to allow member countries to follow their own economic policies aimed at achieving high levels of employment in their own country.  Therefore, a policy of credit inflation could be followed in each country without disrupting changes in foreign currency rates.

The Bretton Woods system fell apart as international capital markets opened up in the 1950s and 1960s and the credit inflation created in the United States in the 1960s resulted in a situation where the United States could not maintain its fixed exchange rate.  On August 15, 1971, President Nixon choose to float the value of the U. S. dollar.

A second choice, given the unrestricted flow of capital internationally, is to choose a fixed exchange rate.  But, if a nation chooses a fixed exchange rate then it must give up its sovereignty with respect to running an economic policy that is independent of other nations. 

This is what the European nations did when they choose to form a monetary union based on a single currency, the euro: in essence, they choose to have a fixed exchange rate between member nations.  But, the nations forming the union did not want to give up their sovereignty with regards to the formation of their government budgets. 

Oh, they allowed for budget deficits to be run, but they were to be limited in scope.  This, they felt, gave the included nations some flexibility in creating their budgets, but, they were not supposed to exceed the set limits.  The problem was that these limits were unenforceable. 

Which brings us to the current time.  Budget limits have been grossly exceeded and the nations forming the European currency union and these eurozone nations are unable…or unwilling…to give up the sovereignty of running their own economic policy or abiding by the rules of the union.

The “trilemma” analysis states very clearly that in circumstances like this the monetary union must be broken up and the countries must form a central budgetary unit or must once again establish their own currency units whose price will be floated against the other currencies of the former eurozone countries. 

The ultimate cost of running independent economic policies and trying to run a single currency monetary union will be the destruction of the sovereign political bodies as we know them in Europe or the euro, as we know it now, will have to become history.

Current events now relate to the break down of solvency talks, which had been taking place between the Greek government and private investors in Greek debt.  An “unrealistic” proposal has been rejected by the debt holders.     

Furthermore, the credit downgrades of France and other nations, which took place over the past week, were expected, yet no one really exhibited any sense of urgency.   Now that the downgrades have taken place a downward spiral seems to be starting.

“Both events are important because they show us the mechanism behind this year’s likely unfolding of events.  The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades.  A recession has started.  Greece is now likely to default on most of its debts and may even have to leave the eurozone.  When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.” (http://www.ft.com/intl/cms/s/0/987fd2fe-3ddc-11e1-91ba-00144feabdc0.html#axzz1jd5VycTs)

The European Financial Stability Facility has also been downgraded and this means that its effective lending capacity has been reduced.  The ability to “bailout” distressed countries has declined.  And, the European Central Bank cannot resolve the longer-term issues.  There is very little still available to the European officials to “kick the can down the road” any more.

I just do not see the European countries at this time getting over their resistance to form “a strong central fiscal authority with power to tax and allocate resources across the eurozone.”  Hence, I don’t have much confidence for the continued existence of a common currency for Europe, except maybe, on a much more limited scale.  Right now, I don’t see alternatives to the downward spiral mentioned above.

The bottom line is that the conditions of the “trilemma” problem seem to hold.  Given that capital is flowing freely throughout the world nations cannot just totally ignore the consequences of their choice of economic policy.  And, if the consequences of that economic policy are not realized immediately, the evidence shows that they will be realized sooner or later.  This is a lesson in macroeconomic decision-making that all countries need to take into account when determining what economic policy they should be following.  Are you listening America?     

The Banks, They Are A Changin'

The banking system is going through massive changes.  The morning papers are filled with stories about what is happening in the banking area, although they cover only a minor portion of what is going on in the industry.

The Wall Street Journal trumpets, “Bank of America Ponders Retreat.” (http://professional.wsj.com/article/SB10001424052970204409004577156881098606546.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj) The current Bank of America represents, perhaps as well as any organization the excesses of the financial institutions over the past twenty years or so.  Currently selling at 33 percent of book value, the Bank of America can be potentially classified as one of the “Zombie” banks that now meander through the environment. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The Journal article does not give us much faith that management has a firm grasp on the situation…or, at least, is not revealing to us the reality that they face.  “Bank of America Corp. has told U. S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen…”

The crucial hedge word is “if”.

Commercial banks have to recover from the binge that has taken place in the banking industry over the past fifty years.  This binge has seen commercial banks grow to enormous size and many have become “too big to fail.”  It has resulted in a massive shift in employment in the United States as the proportion of people working in the manufacturing trades has declined substantially relative to those working in the financial industry.  It has resulted in a huge shift in risk-taking in the industry, a move to more and more financial innovation, and a substantial increase in the amount of financial leverage used in the industry. 

Several of the articles in the morning paper discuss the reductions that are taking place employment.  For example, yesterday the Royal Bank of Scotland Group PLC announced that it will be laying off 3,500 people.  Cutbacks have also been announced by UBS AG and UniCredit SpA and well as Credit Suisse Group AG and many other major players.  The reductions in staff of the smaller institutions do not get as much publicity and play in the press. 

Some have argued that the industry is going through a cyclical shift that generally happens after a downturn in the economy but more and more industry analysts are claiming that they see a more permanent shift taking place.  And this is true of other parts of the financial industry than just the commercial banks.  “It isn’t just the lackluster business environment that is prompting banks to rein in their lofty investment-banking ambitions.  A realization is sinking in among securities-industry executives that because of the huge potential losses they are exposed to in bear markets, the business just isn’t as attractive as it once seemed.” (http://professional.wsj.com/article/SB10001424052970204409004577156833880721736.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The fifty year period of credit inflation bought out over time many of the bad decisions and allowed the banks to go merrily on their way.  As “Chuck” Prince, former CEO of Citigroup expressed it…”As long as the music continued to play, people had to keep dancing.”

But, this continual pressure to grow and expand and take on more risk resulted in a massive change in the banking industry itself.  Going from around 14,000 commercial banks in the 1960s the commercial banking industry now contains less than 7,000 banks.  My forecast is for this number to drop below 4,000 in the next several years. 

And, the banking industry is bifurcating: almost two-thirds of the assets in the banking system are owned by the largest 25 banks in the country.  That leaves just one-third of the assets in the hands of about 6,300 banks.  More and more wealthier personal banking relationships are being handled by firms that cannot be considered to be community banks.  The products and services in these banks are many and the electronic interchange and access between financial assets and transactions are seamless and almost instantaneous.  

One could imagine a banking system in which the wealthier people worked with institutions like these and the less wealthy “banked” at non-profit credit unions, the non-profit institutions being the only ones that could provide the products and services needed without having to achieve a competitive return on shareholder’s equity.

The last factor producing major changes in the banking industry is the advances taking place in information technology.  Finance is nothing more than information.  That is, finance can ultimately be just a recording of 0s and 1s.  Thus, as information technology advances, so does the innovation in the financial industry. 

And, don’t think of how you use banking services right now…think about the electronic gadgets that your children or your grandchildren are using.  This is where you will see what financial institutions are going to need to provide for in the coming years.  What goes on in “electronic stuff” is real to these children and will become a part of the financial system as electronic finance becomes ubiquitous in the future. 

Furthermore, as advances in information technology has allowed “finance” to become more innovative, my guess is that for the future…we haven’t really seen what financial innovation can do.

This has tremendous implications for the regulatory efforts going on in the United States and the world.  I have argued for three years now that the efforts of the United States Congress and others throughout the world have been to create a regulatory system that will prevent a 2007-2008 financial collapse.  To me, the commercial banks in the United States are way beyond this system already.  Oh, the banks fight Congress and the regulators all along the way.  But, how much of this is real and how much of this is a smokescreen. 

Throughout my professional career…and I have run three banks…the banks have always been ahead of the legislators and the regulators in terms of what is going on in the banking system.  I am no less confident now that the banks are still far ahead of legislation and regulation and will continue to be so into the future. 

I can’t imagine what banking will be like in five years…but, it will be something substantially different than it is now.  It will be more electronic, it will be more innovative, and it will be harder to control.  The only way we can hope to keep up with what is going on is to increase the openness and transparency with which the banking system operates.   

There Still Are "Zombie" Banks Around

In Europe, “On average the 31 companies in the Euro Stoxx Banks Index (SX7E) trade for 39 percent of common equity, or book value, according to data compiled by Bloomberg.  France’s Credit Agricole SA (ACA) trades for 23 percent of book.  Yet somehow the European Banking Authority last month concluded it had no capital shortfall.

The situation in the U. S. is better, but not good.  Bank of America Corp. (BAC), for example, trades for 33 percent of book and insists it doesn’t need to sell new common shares, in spite of the markets’ contrary verdict.”  (See http://www.bloomberg.com/news/print/2012-01-12/financial-frankness-is-a-bad-dream-for-a-bank-commentary-by-jonathan-weil.html.)

“Zombie” banks are banks that have substantial amounts of worthless assets on their balance sheets but are afraid to write them down.  In essence, the financial markets are doing the “writing down” for them.

Bankers are reluctant to write down assets in the first place.  First of all it is an admission of a failure…of underwriting, of intuition, of forecasting, of lax behavior.  The bankers that are holding your deposits don’t like to admit that they have made a mistake.

I know this is true…I have completed three (successful) bank turnarounds in my career…so I have seen the other side of the asset acquisition process in commercial banks.

Furthermore, bankers don’t like to write down assets way after the time in which they should have written them down. 

Bad assets accumulate and the longer that bankers  “paper over” their bad asset problems the problems tend to grow and “the eventual clean up” becomes even worse.  Rather than admitting that a problem exists and allocating resources to “clean up” the problem at an early stage, the bankers postpone devoting enough effort to resolving these issues and, in consequence, they find that the difficulties of their job increases in a non-linear fashion as the number and complexity of bad assets grow and multiply.

The problem now is that most of these “zombie” banks want to raise more capital to satisfy the new, higher regulatory requirements for capital but find that their stock prices are so depressed that raising additional capital can be extraordinarily expensive. 

The author of the Bloomberg piece, Jonathan Weil, discusses this in the above quoted article.  He focuses on UniCredit, the Italian bank that took a large writedown in the third quarter of 2011, which resulted in a 10.6 billion euro loss.  On top of this the European Banking Authority determined, after the latest stress tests, that UniCredit had an 8 billion euro capital shortfall.

As of September 30, 2011, UniCredit had 950 billion euros in assets and only 52.3 billion in euros in common shareholder equity on its balance sheet.  The stock market value of the bank is 14.8 billion euros.  Something doesn’t add up here.

And, that is where the concern over the other European (and American) banks comes in. 

With bank valuations in the range of those mentioned in the first two paragraphs of this post, the financial markets seem to be indicating that many of these banks have substantial amounts of questionable assets on their books that they have failed to publically acknowledge.  And, this is one of the problems financial markets face…if the institutions they invest in are not brave enough…nor honest enough…to reveal this to the marketplace…then investors just have to guess at how serious the problems are. 

In times like these, the guesses will tend to be on the negative side.  And, this certainly doesn’t help the bankers to raise the capital they need to get back onto a solid capital footing. 

Are there still a lot of “zombie” banks “out there”?

I believe there are.  Although the FDIC only closed 92 banks in calendar year 2011, the number of banks in the United States shrunk by more than double this number.  In the third quarter alone, only 26 banks were closed yet a total of 61 banks left the banking system.  While the number of banks closed in the 12-month period ending September 30 was around 100 in number, the banking system had 271 fewer banks.  So for 2011 it seems as if the number of banks leaving the banking system were two- to three-times the number of banks that the FDIC actually closed.

There was cheering when the number of banks listed on the FDIC’s problem list fell in the third quarter to 844 banks, down from 865 banks the quarter before.  But, this means that although the problem list dropped by 21 banks, 61 banks, most of them troubled in one way or another, dropped out which means that maybe around 40 new problem banks got added to the FDIC’s list.

(For more on this see my post http://seekingalpha.com/article/310644-while-small-banks-disappear-big-banks-get-bigger.)

My point here is that I don’t believe that either Europe or the United States is finished with its banking problems.

I still contend that one of the major reasons that he Federal Reserve pumped so much money into the banking system was to keep banks liquid enough so that they didn’t have to write off bad assets at too fast a pace, so that the banks had more time to try and work out these bad assets, and so that the FDIC had sufficient time to either close these banks as smoothly as possible or arrange for acquisitions to eliminate a substantial number of the “bad” banks.

Sooner or later, however, the bad assets on the balance sheets of banks are going to have to be recognized. 

The problem is still sufficiently severe so that these “zombie” banks are unwilling to admit to the world that they remain troubled.  For a more realistic valuation of their assets we will just have to look at market values.

But, these banks are not out of the woods yes, for in Europe the “next” recession seems to be in progress.  How this recession will play in the United States is, of course, unknown. (See my post, http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe.)

How much better it would have been for these banks to “recognize” and “claim” these bad assets earlier and to have fully disclosed them and then set out to work to correct the situation than to postpone recognition and “paper over” the problems which, in the end, creates major difficulties.

Bankers vociferously fight mark-to-market accounting and the timely writing down of “worthless assets” after-the-fact, that is, after the damage has been done.  The problem is that mark-to-market accounting and the timely writing down of “worthless assets” are aimed at getting bankers to do their jobs before the financial crisis occurs.  The hope is that the early proper recognition of the problems will lead to earlier resolution of them thereby avoiding major cumulative collapses. 

Where Does Sovereign Credibility Come From? The European Sitaution

As usual, when Bob Barro of Harvard writes something it usually contains some provocative ideas.  In the Monday morning Wall Street Journal, Barro writes about how Europe might get out of the Euro. (http://professional.wsj.com/article/SB10001424052970203462304577134722056867022.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

What interested me most in Barro’s piece was the emphasis he placed on the credibility of the organizations that issue a currency. 

In essence, as I read the article, Barro argues that the credibility of the Euro comes from those within the eurozone that are fiscally sound and carry those that are not fiscally sound, the “free riders”, along with them. 

This credibility is maintained for as long as the “free riders” conduct their irresponsibility within limits.   In fact, this is what the original charter of the eurozone called for…limits to how irresponsible the “free riders” could be.

But, the limits must be enforced.

“Greece…has been increasingly out of control fiscally since the 1970s.  But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.” 

The bailouts have become serial, as bailouts have also been given to Portugal, Ireland, Italy, and Spain. 

Thus, the only way credibility can be maintained is for Germany to continue to be fiscally strong while the union continues to provide bailout packages that will carry the “free riders” along for as long as possible.

Meanwhile, the internal effort of the members of the eurozone has been to create a stronger “fiscal” bond within the zone itself…ultimately moving to a “centralized political entity” that will oversee the fiscal and currency policy of the whole eurozone. 

Europe, to achieve such a “centralized political entity”, would have to overcome many, many issues that have existed on the continent for a long time.  For one, the internal rivalries that have existed for centuries would have to be overcome.  Already the resentment against Germany has grown as Germany has become a more demanding partner within the union.  Even statements like “Germany is achieving through economics what it could not achieve militarily at an earlier date” demonstrate some of the underlying emotions that exist on the continent.  Then you have the cultures, languages, and other hurdles to overcome to achieve the needed unity.

Even so, Barro continues, in the shorter run, the credibility of the nations is vitally important because of the sovereign debt that has already been issued by the governments of Europe and that rest on the balance sheets of the banks within the eurozone.  This is the reason there is rush to achieve the near term austerity in the budgets of Italy, Spain,…and France…among others. 

Greek debt is now yielding more than 34 percent on its ten-year bonds.   Portuguese bonds are yielding more than 13 percent.  The debt of Italy is yielding more than 7 percent.  And Spanish bonds are above 5.5 percent.  These rates are unsustainable!

French debt is yielding around 3.5 percent and the rating agencies are soon expected to remove their AAA rating.

The status of this debt is important because, “the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on.  Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany, and elsewhere.”

Credibility is lacking because “it is unclear whether Italy and other weak members will be able and willing to meet their long-term euro obligations.” 

Not only is the banking system threatened by this lack of confidence, the uncertainty that exists surrounding the future structure and performance of this area does not contribute to the achievement of stronger economic growth.  If anything, this uncertainty works to reduce growth.

Only as independent nations with their own currencies would these countries be able to meet their own obligations and achieve the credibility a nation needs to function within the global economy.  “This credibility underlay the pre-1999 system in which the bonds of Italy and other eurozone countries were denominated in their own currencies.  The old system was imperfect, but it’s become clear that it was better than the current setup.”

The issue is one of credibility. 

Right now, Germany seems to possess credibility.  But this credibility is based on its maintaining the position of fiscal responsibility it has already achieved.  And, this is just what the Germans seem to be doing. (“Germany Resists Europe’s Plea to Spend More,” http://www.nytimes.com/2012/01/09/business/global/germany-resists-europes-pleas-to-spend-more.html?_r=1&ref=business)  

As long as the current economic structure exists for the eurozone, the credibility of the eurozone will depend upon it’s ability to provide sufficient “band aides” to piggy-back on the credibility of Germany.   My guess is that it will become harder and harder for financial markets to buy-into this piggy-back arrangement. 

Credibility requires the provision of actions that backup promises.  Barro is suggesting that the only way that the fiscally irresponsible will become credible is for them to be “out-on-their-own” again where they will have to be totally responsible for their own actions.  Unless this happens, there is too much historical baggage carried by the eurozone that will not be overcome.      

Monetaray Policy in 2011: Looking Back

Total reserves in the banking system rose by almost 50 percent in 2011 to average around $1.6 trillion.  The increase during the year was slightly more than $511 billion. (Remember in August 2008 when total reserves in the banking system averaged less than $45 billion?)

Excess reserves in the banking system rose by about $490 billion from December 2010 to December 2011 to a total of about $1.5 trillion. (Remember in August 2008 when excess reserves in the banking system averaged less than $2 billion?)

The Federal Reserve continued to pump reserves into the banking system in 2011 and about 95% of the reserves going into the banking system went into excess reserves. 

Bank loans fell during the year by approximately $50 billion.  There was a pickup in business loans (commercial and industrial loans) of about $122 billion, but real estate loans (primarily commercial real estate loans) fell by $150 billion and consumer loans dropped by $22 billion. 

Note that the pickup in business loans was predominately located in the largest 25 domestically chartered banks in the United States.  The increase here was approximately $95 billion. 

One can conclude from this that the reserves that the Fed pumped into the banking system did not, on balance, go to support an increase in lending.

Yet, the growth rate in both measures of the money stock rose during the year.  For the M1 measure of the money stock, the year-over-year rate of increase rose from 7.5 percent in December 2010 to 19.1 percent in December 2011. (This is using the 13-week average of the measure.)  The year-over-year rate of growth of the M2 measure of the money stock rose from 3.3 percent in December 2010 to 9.8 percent in December 2011. (Again using the 13-week average.)

The increase was highlighted by a whopping 45% rise in demand deposits!

But, this increase in demand deposits did not come from an increase in bank lending because the bank lending that might have resulted in an increase in demand deposits and hence the M1 money stock actually declined!

The reason for the huge increase in demand deposits seems to be that people are moving assets from short-term investment vehicles to demand deposit accounts. 

For the past two years or so I have been arguing that this movement into demand deposits is coming for two reasons.  The first reason is that interest rates on short term investments are so low that people do not believe that it is worthwhile to keep their money in interest bearing assets rather than demand deposits. (For example, Federal Reserve data record a drop of almost $90 billion in Institutional Money Funds over the past year.)

The second reason is that many people are still is difficult financial condition.  Hence, they are keeping what funds they have in transaction-type accounts so as to pay for necessary living expenses.  Additional information that supports this argument is that the currency component of the money stock rose by more than 9 percent this last year.  This is, historically, an extremely high number.  People in tough economic situations also hold more cash.

The evidence from the banking system is not very encouraging with regards to a pickup in economic activity.

How did the Federal Reserve inject more than $500 billion reserves into the banking system this last year?

First, the Federal Reserve increased its holdings of securities by roughly $442 billion.  Actual acquisitions of Treasury securities amounted to about $640 billion but these purchases were offset by a $43 billion decrease in the Fed’s holdings of Federal Agency issues and a $154 decline in the Fed’s holdings of mortgage backed securities. 

One should also note that there was a net decrease in funds associated with the bailout actions of 2007 and 2008 of approximately $140 billion. Also, primary borrowings from the Fed’s discount window declined by $36 billion.  One generally assumes that these “operating” factors are offset by the Fed’s purchase of securities.  Thus the “net” addition of funds from the increase in the Fed’s outright holdings of securities totaled about $266 billion. 

Second, the United States Treasury also played a role in the increase in bank reserves.  At the end of 2010, the Treasury held almost $200 billion in something called the U. S. Treasury Supplementary Financing Account. (I have mentioned the use of this account many times in 2010…here is one post: http://seekingalpha.com/article/256497-qe2-watch-version-4-0-fed-is-tone-deaf-and-spaghetti-tossing.) These funds were injected into the banking system this past year…the full $200 billion of them.  This can be added to the $376 billion mentioned in the previous paragraph to account for $466 billion of reserves going into the banking system. 

Third, the currency being demanded by the public mentioned above is supplied to the public by the Federal Reserve “on demand”.  That is, the Federal Reserve generally replaces the currency flowing out of the banking system into general circulation, dollar for dollar.  This past year, currency in circulation rose by about $93 billion.  Thus the $466 billion of the previous paragraph drops to $373 billion.

Fourth, the Federal Reserve has “pumped” dollars into the European banking system due to the sovereign debt crisis in Europe.  For example, Central bank liquidity swaps have increased by about $100 over the past year, most of the increase coming in the past six months.  This is not the only way the Fed influences what is going on internationally as the Fed holds other assets denominated in foreign currencies and also engages in reverse repurchase agreements with “foreign official and international accounts”.  If one roughly nets out the accounts associated with all of these type of transactions, we can say that the Fed roughly added another $104 billion to bank reserves which brings the total injection to $477 billion 

One final operating factor influences this total figure, payments into and out to the general account of the United States Treasury.  This fluctuates with tax payments and actual government expenditures.  The year-over-year drop in this account is about $28 billion and this brings the total increase in “reserve balances at Federal Reserve banks to $505 billion, which matches very closely with the $490 increase in excess reserves mentioned in the second paragraph of this post. (The difference is due to minor operating factors that we do not need to discuss.)

In summary, the Federal Reserve (and the U. S. Treasury) put a lot of reserves into the banking system this past year.  As usual, the Fed needs to take care of other operating factors that constantly impact the banking system, but in general, the injection of reserves came from the securities the Fed purchased as a part of the QE2, the dollars being advanced to European central banks to help relieve the pressures of the sovereign debt crisis, and the injection of funds into the banking system from the fiscal activities of the United States Treasury.

As of this time, the reserves going into the banking system have not been lent out…they are just sitting on the balance sheets of the commercial banks.  The extraordinary increase in the money stock measures are the result of the low interest rates that people can earn on their money balances and the need of people who are economically distressed to hole transaction accounts.

The efforts of the monetary authorities are not being felt, yet, by an increase in economic activity.

What the Federal Reserve is Risking

There are two articles in the Wall Street Journal today that I believe are very important responses to the announcement of the Federal Reserve that it will release interest rate projections for several years out.

The first of these by Kelly Evans says a mouthful: “Boosting Transparency, Fed Puts Its Reputation on the Line.” (http://professional.wsj.com/article/SB10001424052970204331304577141034029100316.html?mod=ITP_moneyandinvesting_5&mg=reno-secaucus-wsj) 

I love the quote that Evans leads the article with…it is from Abraham Lincoln: “it is better to remain silent and be thought a fool than to open one’s mouth and remove all doubt.”

First of all, to produce projections of interest rates three years into the future?  Come on…

And, to release the forecasts from all 17 members of the Federal Reserve’s open-market committee…

This is to produce credibility?

Come on…

Furthermore, the projections are to “make monetary policy more effective by lowering volatility and uncertainty in the market around the path of future rates.” 

Formerly, those in the Federal Reserve believed that some uncertainty should surround its goals because this allowed markets to move incrementally due to the fact that market participants had to search for where the Fed was moving.  At least this was the way it was when I worked at the Fed.

Knowing what the target will be results in markets that take discrete leaps…up or down…as market participants jump to the place where the wizards at the Fed now presume interest rates should be.

But, two points on this.  The first one is that making everything depend on the Fed’s prognostications and the persistence with which the Fed holds onto the projections, can lead to “sure-thing” bets on the part of market participants.  There are plenty of examples around in which “the market” bets against the ability of a government or a central bank to hold onto a desired “goal”.  As the pressure builds up, the probability that the government or central bank will have to adjust to the reality of the situation can approach 100 percent. 

The second point is that the Federal Reserve may actually be the cause of the volatility and uncertainty it is attempting to reduce.  As the very actions of the Fed become less recognizable and as, as Evans states, the forecasts “differ significantly from reality” the authority of the Fed decreases and this, in itself, creates “volatility and uncertainty.”

I would argue very strongly that the actions of the Federal Reserve over the past four years…if not longer…have been a large part of the uncertainty it abhors and this has resulted in the increase in market volatility that it would like to reduce.  But, this increase has not been due to a lack of “transparency” on the part of the Fed but has been due to a lack of understanding on the part of the Fed.   And, this lack of understanding has been transmitted from the Fed to the financial markets.     

This is where the other article in the Journal comes in: “Fed Rate Outlook to Bite Traders.” (http://professional.wsj.com/article/SB10001424052970203471004577141182345031606.html?mod=ITP_moneyandinvesting_3&mg=reno-secaucus-wsj) In this piece, Cynthia Lin argues that “With its push to provide a clearer policy road map, the Federal Reserve is about to give bond traders one less reason to like medium-term bonds as it pins down yields that already are at historic lows.”

Ms. Lin quotes Kent Engelke, chief economic strategist at Capitol Securities Management as saying, “The short end of the (yield) curve is dead.” 

Ms. Lin goes on, “Some investors even are suggesting that the new policy may give little reason to trade bonds maturing as late as 2019.”

Doesn’t someone at the Fed understand this possibility?

I have always assumed that volatility was a function of the depth and breadth of the market.  If the policy of the Fed has the result that it will tend to reduce the number of traders in the market, then it would seem to me that this is a movement will have the wrong consequences for the market.

As I stated yesterday, I believe that the move made by Mr. Bernanke and the Fed to achieve greater “transparency” of Federal Reserve operations is more an effort to justify what Mr. Bernanke and the Fed have done over the past four years or so. (See “Bernanke “Transparent about his lack of self-confidence,” http://seekingalpha.com/article/317453-bernanke-transparent-about-his-lack-of-self-confidence.) 

Furthermore, I believe that what has been done to the Fed over the past decade has changed central banking in the United States more that we can possibly imagine at this time.  And, as most of you know that have read my blog over the past, almost four years, I am not convinced that the movement has been in the right direction.  Unfortunately, I believe that we will be paying for this movement, in one way or another, over the next four or five years.       

Bernanke "Transparent" About His Lack of Self-Confidence

This post is about the Fed’s latest effort to build confidence in the financial system by “providing the predictions of its senior officials about their own decision, hoping to increase its influence over economic activity by guiding investor expectations.” (http://www.nytimes.com/2012/01/04/business/economy/fed-to-start-publicly-forecasting-its-rate-actions.html?_r=1&ref=business)

“The inaugural forecast will show the range of predictions made by Fed officials about the level of short-term interest rates in the fourth quarter of 2012, 2013, and 2014….  It will also summarize when they expect to start raising short-term rates….”

To me, this is Ben Bernanke’s latest effort to justify himself and what he has done.  It is Mr. Bernanke’s cry to financial markets: “please understand me.”

But, the more Mr. Bernanke cries for understanding, the more he digs a hole for himself with respect to the future.  For one, who can believe that anyone can forecast short-term interest rates for a three-month period let alone for a three-year time frame?  The record of the people at the Fed is no better than that any other group of forecasters. 

Second, by telegraphing the Fed’s intention, the Fed will be setting itself up for financial markets to “bet” against it.  This is always a possibility when central banks or governments explicitly state their policy goals.  And, the “bet” many times can become a “sure thing.”  Perhaps the best, most recent example of this is the Soros “bet” against the British government in the 1990s about the value of the pound. 

Ultimately, to me, this effort at “transparency” is a sign of Mr. Bernanke’s real lack of self-confidence in his ability to lead the Federal Reserve through this difficult time.  He can’t understand why people don’t understand what he is doing and so he tries, harder and harder, to create this understanding.  His steps to gain greater “transparency” over the past six months is just evidence of his struggle.        

I will admit that I am not, nor have I ever been, a fan of Ben Bernanke as the Chairman of the Board of Governors of the Federal Reserve System.  I was in favor of him being the Chair of the Economics Department at Princeton University…but not Chair of he Fed. 

I was against Bernanke’s re-appointment as the Chairman (http://seekingalpha.com/article/151474-exit-strategy-an-argument-against-bernanke-s-reappointment) and disappointed in President Obama for actually re-appointing him (http://seekingalpha.com/article/158762-bernanke-s-disappointing-reappointment).

In reviewing Bernanke’s record since being a member of the Board of Governors, I see nothing but a competent academic, out of his element and over-his-head in the deep water of a twenty-first century whirlpool. 

In more peaceful times when he was just a member of the Board of Governors (August 5, 2002 – June 21, 2005) he was a lackey of the then Fed Chairman Alan Greenspan, developing the argument for Greenspan’s defense of recent monetary policy that used the savings of China and the Middle East to finance U. S. Treasury debt. 

He was a strong supporter of Greenspan’s effort to keep the Federal Funds rate at one percent in the 2003-2004 period to combat the possibility of the economy going into a deep recession.  This effort helped to underwrite the “bubble” that took place at this time in the U. S. housing market. 

Then, once he was became Chairman of the Federal Reserve on February 1, 2006, he was a firm advocate of pushing the target rate for the Federal Funds rate to 5.25 percent and keeping it there into August of 2007 so as to combat the possibility that inflation might get out-of-hand.  

The Fed move was in response to the financial market meltdown of “Quant” financial firms that took place in August 2007. (See book review on “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)

The recession in the United States began in December 2007.

The next episode of Bernanke’s “steady hand on the tiller” came in the fall of 2008.  I have characterized Bernanke’s reaction to the Lehman Brothers failure as one of panic.  (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

But, what Bernanke and the Fed did next has been the basis for the claim that Mr. Bernanke saved the United States from a second Great Depression.  The Federal Reserve acted to increase its balance sheet from slightly less than $900 billion is assets to more that $2.0 trillion in assets by the beginning of 2009.  Through various stages of Quantitative Easing (QE), the Fed’s total assets now amount to more than $2.8 trillion.

This injection of funds into the banking system has resulted in around $1.6 trillion in excess reserves on the balance sheets of U. S. banks.  It has created little in the way of bank lending or economic growth.    

However, many people have given credit to Mr. Bernanke for saving the country and this may be an appropriate gesture on the part of a grateful country.  My concern has been that this policy is nothing more than a policy of throwing sufficient “stuff” against the wall to see what would stick.  As a consequence, monetary policy in the United States has become a tool of ignorance, not of professional competence. 

And, that is exactly where we are today.  That is why there is so little confidence in the Chairman of the Federal Reserve System in world financial markets.

Thus, that is why the Chairman of the Federal Reserve System is struggling to reach out to the financial markets to justify what he has done…and is doing.

This effort, in my mind, will achieve little or nothing…and could do much harm.