The Obama speech to the Congress on Tuesday night was “well given” and, basically, “well received”. It has been criticized for, among other things, not being specific enough. But, this was not the purpose of the speech. The speech was the first effort of the new President to lay out a vision for the near term and the future.
It was about the “vision” thing. A leader is, first and foremost, supposed to give us the “big picture” and not the details. The leader is supposed to provide us with something we can hold onto because we like the worldview it represents…or, provide us with something to disagree with because it does not conform to our worldview. I think that President Obama did that.
In terms of the crises in the economy and the financial markets, the thing that does not seem to come through in the “big picture”, however, is that there are two categories of problems we face. These two sets of problems can be put into boxes that are labeled…the problems of the past…and the problems of the future.
These are different issues and must receive different attention if they are to be resolved. Too often we lump them together for a bastard “Keynesian” solution.
The first set of problems has to do with debt…too much of it…and inappropriately assumed. This is the box of problems from the past…the box labeled “Insolvency Crisis”.
Too much debt, inappropriately assumed is a burden…it can cause finance and commerce to slow down or stop…and this can lead to a cumulative result in which the burden of the debt gets heavier and heavier. This burden is exacerbated as insolvencies grow and deflation becomes the problem (not inflation).
It has been argued that the only thing government can do to counter this problem is to reflate (Irving Fisher) or inflate (Keynes). That is, the only way government can lessen the burden of this excessive load of debt is to reduce the “real” value of the debt by causing prices to rise rapidly. But, this only recreates the environment in which the excessive debt was created! And, the consequence of this is just more and more leverage…which, in the longer run only makes the situation that much worse.
The excessive debt was created within the asset bubble world of the last decade or so. This world of asset price inflation resulted in a greater assumption of riskier assets and an overly aggressive assumption of leverage.
Financial and economic positions were taken than could only be justified within the rarefied world of the bubble!
The valuations from that time cannot stand up…outside the bubble!
In the case of the “Insolvency Crisis”, I believe that the only three choices are:
1. let the economy adjust to more realistic valuations by itself and just accept that we have to bear the burden of this adjustment;
2. help to smooth out the adjustment to more realistic valuations;
3. inflate our way out of the crisis…which, of course, would mean that we were just postponing the resolution of the foundation of the crisis.
The third of these choices is often attributed to Keynes and it is, I believe, an inappropriate application of Keynesian thinking…because it does not really resolve the situation.
President Obama is opting for choice number two…a choice I think most of us agree with. He is saying that choice number one is just too painful for the country and it’s people to go through. Hence, government must play a role in helping people and institutions work through the “debt problem” and that is going to cost…how much, we just don’t know.
That is the vision…the devil is in the details. And, that, I believe, is the problem right now. Most of us can agree with the vision…we just haven’t received sufficient information on how this is going to be done and how much it might cost. And, without greater certainty…markets will drop!
The second set of problems has to do with the future…and the box containing this set of problems is labeled “What We Want To Be.” President Obama stated in his speech Tuesday evening that in his vision of the future, he sees America as energy independent…he sees Americans protected with some form of universal healthcare…he sees Americans as among the best educated in the world. President Obama sees an America that is energetic and innovative…a continuation of what America has been in the past.
This, to me, is the stimulative part of the President’s program…the part of the program that is not focused on the consolidation of past ills, as is the part of the program discussed above. This part of the program is an effort to provide incentives to create the next era and not “bailout” the old.
That is the vision…the devil is in the details. A first look at some of the specifics came in the stimulus package recently passed. More will be coming in the near future. Again, more details will help us get over the grey areas of uncertainty that constrain our willingness to commit.
We need to keep these two sets of problems separate as we go forward. The first set of problems is going to take time…and not everything that is done to resolve these issues is going to be “fair”. As I have said before, once one has created this set of problems, one finds that all the choices available for solving the problems are not happy ones. But, “inflating” our way out of these problems is not the solution…it can only, ultimately, make more pain for the future.
The second set of problems must be looked upon in terms of the opportunities that are available to us. In my view, no serious economic crisis has ever been resolved without the creation of new innovations and new technological platforms. In the Great Depression, the innovations and the new technologies did really come about until the end of the 1930s and into the 1940s and were related to war. Earlier stimulus efforts in the 1930s tended to support what existed in the past.
We don’t want government providing stimulus to the economy that will just result in the old world being “re-created”…we do not want the “old” products or the “old” managements renewed and rewarded! We must move on to the future.
By providing his “vision” of this future, President Obama has changed the field of engagement. President Obama is not just talking “stimulus”…he is talking about the world we want to live in. We may not agree with him on everything. We may not agree with him on most things. But, we must accept the challenge, and…while we are attempting to resolve the debt problems from the past…we must enter the dialogue and debate about what the shape of the future will be.
In this sense, what President Obama has put forth is a stimulus plan…but with more than just one meaning of the word stimulus.
Wednesday, February 25, 2009
Monday, February 23, 2009
It's All A Matter Of Incentives
Cerberus Capital Management has asked for a bailout! Who would have thought that a private equity fund would be seeking the help of the Federal Government to provide it with bailout funds?
The United States government is the largest creator of incentives in the world. Whatever it does it sets up incentives that people respond to in order to gain whatever edge they can obtain. And, the competition can sometimes become extremely fierce.
Incentives can either be positive or negative. They can either encourage us to do something…like pursue an education…or they can discourage us from doing something…like quitting smoking. They can work to make the society better…like improving the environment…or they can cause criminal behavior…like prohibition resulted in an underground business boom.
Whatever it is that the government does…it sets up incentives that people respond to. And, making lots and lots of funds available to people creates a huge incentive for those individuals to line up…with their hands out.
We saw this earlier with TARP. I thought that this effort supposedly had something to do with the “toxic assets” that were on the balance sheets of banks. But, as soon as it was passed…all of a sudden mayors and governors had their hands out for some of the money. Somewhere I missed their inclusion in the bill passed by Congress.
The major criteria now for getting money from the Obama stimulus plan just passed by Congress is “shovel ready.” Wow…I didn’t know that so many governmental bodies in the United States had so many proposals ready to begin putting the shovel into the ground next Monday!
Most incentives in an economy evolve out of the workings of the economic and social system that exists within a country. One could say these incentives are “endogenous” to the system…that is, they are created through the normal functioning of daily life. One could say that these incentives arise naturally.
Governments and some large organizations can create incentives “exogenously”…that is, they can impose incentives on a society from outside the system…say, because they think that certain incentives create “right” behavior. A church, for example, is one such system. A government can create incentives that will raise the nation to fight a war…and the incentives must be strong enough to get the nation to pay for that war by paying taxes to support the war.
One of the problems with these “exogenous” incentives is that they may ultimately be harmful to the people that they were trying to help. This problem is observed quite often in economics because most changes in incentives take a substantial time period to work themselves out. Consequently it is difficult to attach the “consequence” of a government policy with the underlying “cause” of the result. Especially since modern society and its sources of information…television, newspapers, and radio…tend to focus on the current and the dramatic “consequences” without any recognition of what might have started off the whole chain of events leading to this end.
This leaves us with an uncomfortable situation in which we must deal with the existing problem and with the emotions and psychology of current events isolated from what got us into the mess we are in.
Last Friday, we saw an announcer on public television ranting and raving about how the people that have followed the rules and responsibly sheparded their resources now have to dig into their pockets and cover those that have not behaved in such a sensible manner and now are experiencing financial and economic difficulties. And, this tirade has gained national attention by both sides of the argument.
The auto industry “big-guys” are down on their knees begging for some “bread and water” so as to keep their positions of power and control. Yet, these are the people that have been protected for years by the same state and national politicians they are now seeking mercy from.
And, the bankers…what a bad lot they are…those greedy “b……s”! Of course, bankers are always an easy bunch to pick on…and this picking goes back centuries. The auto-guys are just wimps in comparison to bankers when it comes to taking criticism.
The question that goes unanswered is “What was the environment created by government that set up the incentives that resulted in the results just described?” I have already answered this for the auto industry. But, who wouldn’t go to the government and get protection of their industry when it was so possible to do so?
Who wouldn’t support the Federal Reserve keeping interest rates so low for an extended period of time…of course, real interest costs were negative…so that business could be continued at a furious pace? Who wouldn’t be in favor of substantial tax cuts for the wealthy…especially if you happen to be wealthy? Who wouldn’t support going after that bad dictator who had those…what was it now? Oh, yes…weapons of mass destruction.
The obvious point to this discussion is that government got us into the mess we are in through the incentives it created eight or so years ago…and now we are faced with a situation in which it appears that government must set up a new set of incentives in order to make up for the mess that resulted from the incentives set up from an earlier time.
Yes, we have to take some money from those that did not over play their fiscal hand and transfer it to some that did. Yes, we have to help those financial institutions that responded in too extreme a form to the perceived opportunities that existed for them. Yes, we may need to do more for the auto industry…and for other industries.
But, where does it stop? Is everyone entitled to a bailout? (Well, as a matter of fact…I think I need a billion or two to get me through the next several years! I’m sure you are deserving of a bailout as well!) And, what are the consequences down-the-road a piece for the people and the society that are getting the bailouts?
Does Cerberus Capital Management really deserve a bailout? I thought private equity firms were risk takers and that is why they got the big bucks? Maybe Cerberus should face a "stress test" like the commercial banks.
What kind of a society are we creating through the incentives that are being developed today? What mess is the government going to have to bail us out of in two or three, or, five or six years from now…the mess that we are now creating…but we don’t know what mess that will be?
Of course, the final question is…how are you going to respond to the incentives now being created? Is it wise for certain Republican governors to turn down the bailout money because of…what was that…because of their principles?
The United States government is the largest creator of incentives in the world. Whatever it does it sets up incentives that people respond to in order to gain whatever edge they can obtain. And, the competition can sometimes become extremely fierce.
Incentives can either be positive or negative. They can either encourage us to do something…like pursue an education…or they can discourage us from doing something…like quitting smoking. They can work to make the society better…like improving the environment…or they can cause criminal behavior…like prohibition resulted in an underground business boom.
Whatever it is that the government does…it sets up incentives that people respond to. And, making lots and lots of funds available to people creates a huge incentive for those individuals to line up…with their hands out.
We saw this earlier with TARP. I thought that this effort supposedly had something to do with the “toxic assets” that were on the balance sheets of banks. But, as soon as it was passed…all of a sudden mayors and governors had their hands out for some of the money. Somewhere I missed their inclusion in the bill passed by Congress.
The major criteria now for getting money from the Obama stimulus plan just passed by Congress is “shovel ready.” Wow…I didn’t know that so many governmental bodies in the United States had so many proposals ready to begin putting the shovel into the ground next Monday!
Most incentives in an economy evolve out of the workings of the economic and social system that exists within a country. One could say these incentives are “endogenous” to the system…that is, they are created through the normal functioning of daily life. One could say that these incentives arise naturally.
Governments and some large organizations can create incentives “exogenously”…that is, they can impose incentives on a society from outside the system…say, because they think that certain incentives create “right” behavior. A church, for example, is one such system. A government can create incentives that will raise the nation to fight a war…and the incentives must be strong enough to get the nation to pay for that war by paying taxes to support the war.
One of the problems with these “exogenous” incentives is that they may ultimately be harmful to the people that they were trying to help. This problem is observed quite often in economics because most changes in incentives take a substantial time period to work themselves out. Consequently it is difficult to attach the “consequence” of a government policy with the underlying “cause” of the result. Especially since modern society and its sources of information…television, newspapers, and radio…tend to focus on the current and the dramatic “consequences” without any recognition of what might have started off the whole chain of events leading to this end.
This leaves us with an uncomfortable situation in which we must deal with the existing problem and with the emotions and psychology of current events isolated from what got us into the mess we are in.
Last Friday, we saw an announcer on public television ranting and raving about how the people that have followed the rules and responsibly sheparded their resources now have to dig into their pockets and cover those that have not behaved in such a sensible manner and now are experiencing financial and economic difficulties. And, this tirade has gained national attention by both sides of the argument.
The auto industry “big-guys” are down on their knees begging for some “bread and water” so as to keep their positions of power and control. Yet, these are the people that have been protected for years by the same state and national politicians they are now seeking mercy from.
And, the bankers…what a bad lot they are…those greedy “b……s”! Of course, bankers are always an easy bunch to pick on…and this picking goes back centuries. The auto-guys are just wimps in comparison to bankers when it comes to taking criticism.
The question that goes unanswered is “What was the environment created by government that set up the incentives that resulted in the results just described?” I have already answered this for the auto industry. But, who wouldn’t go to the government and get protection of their industry when it was so possible to do so?
Who wouldn’t support the Federal Reserve keeping interest rates so low for an extended period of time…of course, real interest costs were negative…so that business could be continued at a furious pace? Who wouldn’t be in favor of substantial tax cuts for the wealthy…especially if you happen to be wealthy? Who wouldn’t support going after that bad dictator who had those…what was it now? Oh, yes…weapons of mass destruction.
The obvious point to this discussion is that government got us into the mess we are in through the incentives it created eight or so years ago…and now we are faced with a situation in which it appears that government must set up a new set of incentives in order to make up for the mess that resulted from the incentives set up from an earlier time.
Yes, we have to take some money from those that did not over play their fiscal hand and transfer it to some that did. Yes, we have to help those financial institutions that responded in too extreme a form to the perceived opportunities that existed for them. Yes, we may need to do more for the auto industry…and for other industries.
But, where does it stop? Is everyone entitled to a bailout? (Well, as a matter of fact…I think I need a billion or two to get me through the next several years! I’m sure you are deserving of a bailout as well!) And, what are the consequences down-the-road a piece for the people and the society that are getting the bailouts?
Does Cerberus Capital Management really deserve a bailout? I thought private equity firms were risk takers and that is why they got the big bucks? Maybe Cerberus should face a "stress test" like the commercial banks.
What kind of a society are we creating through the incentives that are being developed today? What mess is the government going to have to bail us out of in two or three, or, five or six years from now…the mess that we are now creating…but we don’t know what mess that will be?
Of course, the final question is…how are you going to respond to the incentives now being created? Is it wise for certain Republican governors to turn down the bailout money because of…what was that…because of their principles?
Wednesday, February 18, 2009
Bernanke: His Words of Encouragement?
Ben Bernanke spoke today at the Nation Press Club luncheon in Washington, D. C. (His speech is found at http://www.federalreserve.gov/newsevents/speech/bernanke20090218a.htm.) His pledge to us is that the Fed will do “everything possible within the limits of its authority” to restore stable markets and get the U. S. out of recession.
If the past six months is any indication, we can believe him when he says this. For one thing, we have seen the Federal Reserve increase the “Factors Supplying Reserve Funds” from about $939 billion on September 3, 2008 to a peak of around $2.347 trillion on December 17, 2008 before falling to about $1.879 trillion on February 11, 2009. So from September 3, 2008 to February 11, 2009, “Factors Supplying Reserve Funds” to the banking system doubled…that is in a period of 23 weeks or less than one-half of a year.
Yes, I think we can believe what the Chairman of the Fed has said.
The effort is to “restore stable markets and get the U. S. out of recession.”
One can argue that the financial markets have stabilized somewhat and there have not been the major financial bailouts or nationalizations (AIG) or failures (Lehman Brothers) that we saw in September 2008. If this is restoring stability to the markets then there has been some success. However, with the lending pipeline seemingly paralyzed and the stock market at near-term lows, there is still a long way to go before we can conclusively say that the markets have become stabilized.
Let’s look a little deeper at what has happened in the financial system over the past several months.
First, let’s look at the total reserves in the banking system. Here we see, first hand, the impact of Federal Reserve actions on the banking system. Total reserves at depository institutions (not seasonally adjusted) were around $44.1 billion in January 2008 and were still around $44.1 billion in August 2008. Since August, however, total reserves have increased by approximated $809 billion to $1.853 trillion. Year-over-year (January 2008 to January 2009) this represent an annual rate of increase of 1853%...not bad. (Don’t annualize the rate of increase from the August figure…the figure is kind of silly!)
The next thing we can look at is what Bernanke calls “the narrowest definition of the money supply, the monetary base”. The monetary base is defined as all items that are bank reserves or could become bank reserves (cash held outside of depository institutions). In January 2008, the monetary base (not seasonally adjusted) was at about $831 billion. In August 2008 it had only increased to around $847 billion. But, in January 2009, the monetary base totaled about $1.710 trillion. Obviously, the year-over-year rate of increase in the monetary base was slightly over 100%...a pretty sizeable annual rate of increase…again, most of the increase coming from September 2008 to the present.
This, we are told is where the problem with the financial system is…”banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed.” That’s what financial institutions do when they are scared silly…because they don’t know the value of their assets and might be insolvent…or because they don’t know how good the credit is of people who want to borrow…if there are any that do want to borrow. That is, there is constipation in the lending system.
The increases in total reserves and the monetary base is having an impact on the growth of the two broader measures of the money stock but this increase is coming primarily in cash held outside of banks. That is, people and businesses are holding onto cash rather than spending it. This is consistent with the effort of people to either save or to pay down debt…exactly what one would expect at a time like this. People have too much debt, are risk averse about the future, and so are holding onto things…if they can.
The money stock measures have increased through the end of the year showing some effect of the Federal Reserve action. The year-over-year rate of growth of the M1 measure of the money stock (not seasonally adjusted) is around 13%, up from about 2% in August and a negative number through the first half of 2008. The broader measure of the money stock, M2, is running at an 11% year-over-year rate of increase (on a not seasonally adjusted basis), which is up from about 5.5% in August and around 6.5%for the first half of 2008. Both of these measures are growing at rates that are historically very high, but, again, a lot of this increase is in the cash component of the money stock and is not being spent!
What about lending in the banking system? Loans and leases at commercial banks in the United States have increased since the last week in August 2008 from about $6.9 trillion to around $7.1 trillion in the first week of February 2009…an increase of about $200 billion. Commercial and industrial loans have risen by about $50 billion and real estate loans have risen by around $144 billion. Residential real estate loans have risen by about $32 billion and commercial real estate loans have increase by around $47 billion. Consumer credit has grown by $55 billion, primarily with an increase in credit card debt.
Some increase in credit is occurring…but not a whole bunch…and a lot of this is to help businesses and others keep things going as their cash flows have slowed down. Lending is NOT robust, by any measure.
So, we have words of encouragement being spoken…but we are a long way from getting through this thing. And, the Federal Reserve owns up to this in the projections it released after Bernanke spoke. These projections are a part of the information reviewed by the Federal Open Market Committee at its meeting on January 27-28 2009. The release of these projections is a part of the Fed’s attempt to be open to the world by supplying the forecasts it is basing its decisions upon.
And the forecasts…gross domestic product may contract by up to 1.3% in 2009, although it is expected to increase nicely in 2010 and 2011. Unemployment might rise to a high of 8.8% this year, although it is projected to drop substantially in 2010 and 2011. And, what about inflation, we are told that the Fed is projecting core inflation to be between 0.9% and 1.1% this year and only modestly higher in 2010/2011.
The basic interpretation is that the economy will continue to be in recession throughout 2009 but will be getting better by the end of the year. Then things will get continually better in the following two years.
Inflation…well don’t worry about inflation…even though the Fed has pumped all these reserves into the banking system and the Federal Government is looking at deficits in the trillions of dollars for several years down the road. The Fed’s balance sheet “can be unwound ‘relatively quickly’ given the short-term nature of the assets the Fed holds.” Bernanke assures us that “The principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.” Okay...
I think I am missing something, however. First, when is credit going to start to flow again, given all the bad assets that are being held by banks? Doesn’t this have to happen before we start to get a smooth acceleration in economic growth? Second, who is going to finance all of the government debt that is going to be issued? Is the Federal Reserve going to print money to take care of the deficits we are facing? Somehow, I am missing some in the encouragement I am being given!
If the past six months is any indication, we can believe him when he says this. For one thing, we have seen the Federal Reserve increase the “Factors Supplying Reserve Funds” from about $939 billion on September 3, 2008 to a peak of around $2.347 trillion on December 17, 2008 before falling to about $1.879 trillion on February 11, 2009. So from September 3, 2008 to February 11, 2009, “Factors Supplying Reserve Funds” to the banking system doubled…that is in a period of 23 weeks or less than one-half of a year.
Yes, I think we can believe what the Chairman of the Fed has said.
The effort is to “restore stable markets and get the U. S. out of recession.”
One can argue that the financial markets have stabilized somewhat and there have not been the major financial bailouts or nationalizations (AIG) or failures (Lehman Brothers) that we saw in September 2008. If this is restoring stability to the markets then there has been some success. However, with the lending pipeline seemingly paralyzed and the stock market at near-term lows, there is still a long way to go before we can conclusively say that the markets have become stabilized.
Let’s look a little deeper at what has happened in the financial system over the past several months.
First, let’s look at the total reserves in the banking system. Here we see, first hand, the impact of Federal Reserve actions on the banking system. Total reserves at depository institutions (not seasonally adjusted) were around $44.1 billion in January 2008 and were still around $44.1 billion in August 2008. Since August, however, total reserves have increased by approximated $809 billion to $1.853 trillion. Year-over-year (January 2008 to January 2009) this represent an annual rate of increase of 1853%...not bad. (Don’t annualize the rate of increase from the August figure…the figure is kind of silly!)
The next thing we can look at is what Bernanke calls “the narrowest definition of the money supply, the monetary base”. The monetary base is defined as all items that are bank reserves or could become bank reserves (cash held outside of depository institutions). In January 2008, the monetary base (not seasonally adjusted) was at about $831 billion. In August 2008 it had only increased to around $847 billion. But, in January 2009, the monetary base totaled about $1.710 trillion. Obviously, the year-over-year rate of increase in the monetary base was slightly over 100%...a pretty sizeable annual rate of increase…again, most of the increase coming from September 2008 to the present.
This, we are told is where the problem with the financial system is…”banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed.” That’s what financial institutions do when they are scared silly…because they don’t know the value of their assets and might be insolvent…or because they don’t know how good the credit is of people who want to borrow…if there are any that do want to borrow. That is, there is constipation in the lending system.
The increases in total reserves and the monetary base is having an impact on the growth of the two broader measures of the money stock but this increase is coming primarily in cash held outside of banks. That is, people and businesses are holding onto cash rather than spending it. This is consistent with the effort of people to either save or to pay down debt…exactly what one would expect at a time like this. People have too much debt, are risk averse about the future, and so are holding onto things…if they can.
The money stock measures have increased through the end of the year showing some effect of the Federal Reserve action. The year-over-year rate of growth of the M1 measure of the money stock (not seasonally adjusted) is around 13%, up from about 2% in August and a negative number through the first half of 2008. The broader measure of the money stock, M2, is running at an 11% year-over-year rate of increase (on a not seasonally adjusted basis), which is up from about 5.5% in August and around 6.5%for the first half of 2008. Both of these measures are growing at rates that are historically very high, but, again, a lot of this increase is in the cash component of the money stock and is not being spent!
What about lending in the banking system? Loans and leases at commercial banks in the United States have increased since the last week in August 2008 from about $6.9 trillion to around $7.1 trillion in the first week of February 2009…an increase of about $200 billion. Commercial and industrial loans have risen by about $50 billion and real estate loans have risen by around $144 billion. Residential real estate loans have risen by about $32 billion and commercial real estate loans have increase by around $47 billion. Consumer credit has grown by $55 billion, primarily with an increase in credit card debt.
Some increase in credit is occurring…but not a whole bunch…and a lot of this is to help businesses and others keep things going as their cash flows have slowed down. Lending is NOT robust, by any measure.
So, we have words of encouragement being spoken…but we are a long way from getting through this thing. And, the Federal Reserve owns up to this in the projections it released after Bernanke spoke. These projections are a part of the information reviewed by the Federal Open Market Committee at its meeting on January 27-28 2009. The release of these projections is a part of the Fed’s attempt to be open to the world by supplying the forecasts it is basing its decisions upon.
And the forecasts…gross domestic product may contract by up to 1.3% in 2009, although it is expected to increase nicely in 2010 and 2011. Unemployment might rise to a high of 8.8% this year, although it is projected to drop substantially in 2010 and 2011. And, what about inflation, we are told that the Fed is projecting core inflation to be between 0.9% and 1.1% this year and only modestly higher in 2010/2011.
The basic interpretation is that the economy will continue to be in recession throughout 2009 but will be getting better by the end of the year. Then things will get continually better in the following two years.
Inflation…well don’t worry about inflation…even though the Fed has pumped all these reserves into the banking system and the Federal Government is looking at deficits in the trillions of dollars for several years down the road. The Fed’s balance sheet “can be unwound ‘relatively quickly’ given the short-term nature of the assets the Fed holds.” Bernanke assures us that “The principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.” Okay...
I think I am missing something, however. First, when is credit going to start to flow again, given all the bad assets that are being held by banks? Doesn’t this have to happen before we start to get a smooth acceleration in economic growth? Second, who is going to finance all of the government debt that is going to be issued? Is the Federal Reserve going to print money to take care of the deficits we are facing? Somehow, I am missing some in the encouragement I am being given!
Sunday, February 15, 2009
Stree Testing the Banks, Bank Regulation, and Bank Failures
It is obvious from my recent posts that the amount of debt in the economy is my biggest concern right now. Of course, the focus of current concern is the banking industry. Bankers got caught up in the euphoria of the stock market bubble of the 1990s and the credit market (housing) bubble of the 2000s and showed the way to others about how to take on riskier and riskier assets and finance these assets with more and more debt. Off-balance sheet financing and virtual deals added to the fragile structure of the banking system as innovation built upon innovation.
I will not place all the responsibility for not catching everything that was going on, on the shoulders of the regulators because one of the things that a market system is very good at is finding ways to get around regulations and regulators. This is one of the reasons why regulation will always fail in the end…it just cannot keep up with what private institutions can find to do…and so regulation is always lagging behind in its ability to know what is going on in financial institutions and financial markets.
Let me just say that I have served in the Federal Reserve System and I have been the CEO of two publically traded financial institutions and CFO of a third, and, although the banks I worked with did not have the resources to be innovative in this way…my knowledge of the banking industry leads me to applaud the ingenuity and creativity of bankers to come up with new instruments, new markets, and new ways to do things. Innovative behavior is the pride of a market economy.
The law of economics in irrefutable…if incentives exist within a given market situation…economic units will make an effort to take advantage of them. Thus, if rules and regulations are placed on a market or on institutions and incentives exist to get around these rules and regulations…people will get around them!
The effort is not to break laws…but rules and regulations are never complete in and of themselves…hence there will always be wiggle room for an organization to maneuver and take advantage of the incentives available to them. This is why regulation will never…read me again…never…be able to gain complete control. The only way to gain complete control over institutions and markets is…to totally take over and own the institutions and markets, themselves.
We must remember this as people in Washington, D. C. attempt to build up the new regulatory system.
That said…I think a lot of responsibility does fall on the shoulders of the regulators for falling so far behind the banking system in their examination and oversight of individual banks. There is a need for rules and regulations to be imposed on the banking system because of the problem…not of one or two banks failing…but the fear that there could be a contagion within the banking system that could severely damage the financial and economic system…either in terms of a liquidity crisis…which took place in December 2007…or a solvency crisis which we are going through right now.
A liquidity crisis and a solvency crisis are not the same and should not be compared with one another. A liquidity crisis the Federal Reserve System can do something about. A solvency crisis is beyond the ability of the Fed to resolve. However, the Federal Reserve and other regulatory bodies, through their responsibility for the examination and oversight of the banking system, can help to prevent a liquidity crisis by doing a deep and thorough review of the books of financial institutions and hold these financial institutions to the standards of “good” banking practice. This effort is a first line defense against a failure of banks that could lead to a contagion amongst financial institutions.
Now, Tim Geithner, Secretary of the Treasury, has informed us that a “stress test” will be performed upon banks to determine whether or not specific banks will be eligible for financial aid from the United States government. The “stress test” is to be broad enough and deep enough to discern if a bank is still breathing or not…and if it is breathing…it can be eligible to receive capital from the government in order to help it work out its asset problems.
My question is…shouldn’t the government already know this? Wasn’t this their job!
If we have to go through an additional examination process on a large number of banks to find out whether or not they are solvent…what have we been paying for over the past 20 years or so?
And, I hear the cry for “regulatory forbearance”…that the regulators should ease up on the bad assets of the banks…and give the banks a chance to “work things out over time.” I think this is crap!
I like “mark to market”! If banks know that they are going to be responsible for marking their assets to market then one should not feel sorry for them when they have underwater assets…and want “regulatory forbearance”. To me this situation has arisen because bankers never felt that regulators were going to hold them responsible for this procedure and so they went along believing full well that they would never have to mark their assts to market. Now, they are ticked off! Now, they believe that the regulators have double-crossed them! I say…too bad!
Finally, let me say that I believe that banks that are insolvent should be allowed to fail. The stock holders have lost everything. Others may have lost large chunks of wealth…but, the banks have been badly mismanaged. The banks took on too much risk and they assumed too much leverage. The executive at the larger ones took it for granted that they would be considered to be too big to fail…and their jobs would be safe.
I know that I have not run a bank with a trillion dollars or more in assets…or even hundreds of billions. Yet, in those I did run, I never wanted to have the regulators or central bankers or Treasury officials tell me what to do. My rule of thumb was to always maintain operating procedures that were more conservative than those that the regulators required. I wanted to be in control of the bank…I did not want someone else imposing their standards on me!
When you push yourself right up to the edge…and even over the edge…with financial innovations and creative accounting…you run the risk of losing control of your organization. If this is the way you want to lead and manage your organization…then you are exposing yourself to the possibility that you will lose control of the future of your organization. Don’t cry when the government comes and takes away your goodies. It was a choice that you made.
There are going to be more bank failures. We have only had 13 failures so far this year…possibility 18 or so by the end of this month. At this rate we would have about 110 failures during the year. Most of these will be small ones, although the probability of two or three or more large failures taking place is increasing every day. However, this is far below the 200 or so bank failures that took place during the S & L crises.
In the present case, there is a good chance that several banks will be “nationalized” in some form or another. In my mind, the worst thing that Secretary Geithner can do is to try and soften the situation. Debt is our problem right now…see my blog “The Three Problems We Face: Debt, Debt, and Debt” posted on February 11, 2009, http://maseportfolio.blogspot.com/ …and debt is going to be our problem for some time into the future. We need to be honest about the problem, transparent about what is being done about the problem, and we must be courageous in addressing the problem. To me this is the only hope we have in shortening the present downturn.
I will not place all the responsibility for not catching everything that was going on, on the shoulders of the regulators because one of the things that a market system is very good at is finding ways to get around regulations and regulators. This is one of the reasons why regulation will always fail in the end…it just cannot keep up with what private institutions can find to do…and so regulation is always lagging behind in its ability to know what is going on in financial institutions and financial markets.
Let me just say that I have served in the Federal Reserve System and I have been the CEO of two publically traded financial institutions and CFO of a third, and, although the banks I worked with did not have the resources to be innovative in this way…my knowledge of the banking industry leads me to applaud the ingenuity and creativity of bankers to come up with new instruments, new markets, and new ways to do things. Innovative behavior is the pride of a market economy.
The law of economics in irrefutable…if incentives exist within a given market situation…economic units will make an effort to take advantage of them. Thus, if rules and regulations are placed on a market or on institutions and incentives exist to get around these rules and regulations…people will get around them!
The effort is not to break laws…but rules and regulations are never complete in and of themselves…hence there will always be wiggle room for an organization to maneuver and take advantage of the incentives available to them. This is why regulation will never…read me again…never…be able to gain complete control. The only way to gain complete control over institutions and markets is…to totally take over and own the institutions and markets, themselves.
We must remember this as people in Washington, D. C. attempt to build up the new regulatory system.
That said…I think a lot of responsibility does fall on the shoulders of the regulators for falling so far behind the banking system in their examination and oversight of individual banks. There is a need for rules and regulations to be imposed on the banking system because of the problem…not of one or two banks failing…but the fear that there could be a contagion within the banking system that could severely damage the financial and economic system…either in terms of a liquidity crisis…which took place in December 2007…or a solvency crisis which we are going through right now.
A liquidity crisis and a solvency crisis are not the same and should not be compared with one another. A liquidity crisis the Federal Reserve System can do something about. A solvency crisis is beyond the ability of the Fed to resolve. However, the Federal Reserve and other regulatory bodies, through their responsibility for the examination and oversight of the banking system, can help to prevent a liquidity crisis by doing a deep and thorough review of the books of financial institutions and hold these financial institutions to the standards of “good” banking practice. This effort is a first line defense against a failure of banks that could lead to a contagion amongst financial institutions.
Now, Tim Geithner, Secretary of the Treasury, has informed us that a “stress test” will be performed upon banks to determine whether or not specific banks will be eligible for financial aid from the United States government. The “stress test” is to be broad enough and deep enough to discern if a bank is still breathing or not…and if it is breathing…it can be eligible to receive capital from the government in order to help it work out its asset problems.
My question is…shouldn’t the government already know this? Wasn’t this their job!
If we have to go through an additional examination process on a large number of banks to find out whether or not they are solvent…what have we been paying for over the past 20 years or so?
And, I hear the cry for “regulatory forbearance”…that the regulators should ease up on the bad assets of the banks…and give the banks a chance to “work things out over time.” I think this is crap!
I like “mark to market”! If banks know that they are going to be responsible for marking their assets to market then one should not feel sorry for them when they have underwater assets…and want “regulatory forbearance”. To me this situation has arisen because bankers never felt that regulators were going to hold them responsible for this procedure and so they went along believing full well that they would never have to mark their assts to market. Now, they are ticked off! Now, they believe that the regulators have double-crossed them! I say…too bad!
Finally, let me say that I believe that banks that are insolvent should be allowed to fail. The stock holders have lost everything. Others may have lost large chunks of wealth…but, the banks have been badly mismanaged. The banks took on too much risk and they assumed too much leverage. The executive at the larger ones took it for granted that they would be considered to be too big to fail…and their jobs would be safe.
I know that I have not run a bank with a trillion dollars or more in assets…or even hundreds of billions. Yet, in those I did run, I never wanted to have the regulators or central bankers or Treasury officials tell me what to do. My rule of thumb was to always maintain operating procedures that were more conservative than those that the regulators required. I wanted to be in control of the bank…I did not want someone else imposing their standards on me!
When you push yourself right up to the edge…and even over the edge…with financial innovations and creative accounting…you run the risk of losing control of your organization. If this is the way you want to lead and manage your organization…then you are exposing yourself to the possibility that you will lose control of the future of your organization. Don’t cry when the government comes and takes away your goodies. It was a choice that you made.
There are going to be more bank failures. We have only had 13 failures so far this year…possibility 18 or so by the end of this month. At this rate we would have about 110 failures during the year. Most of these will be small ones, although the probability of two or three or more large failures taking place is increasing every day. However, this is far below the 200 or so bank failures that took place during the S & L crises.
In the present case, there is a good chance that several banks will be “nationalized” in some form or another. In my mind, the worst thing that Secretary Geithner can do is to try and soften the situation. Debt is our problem right now…see my blog “The Three Problems We Face: Debt, Debt, and Debt” posted on February 11, 2009, http://maseportfolio.blogspot.com/ …and debt is going to be our problem for some time into the future. We need to be honest about the problem, transparent about what is being done about the problem, and we must be courageous in addressing the problem. To me this is the only hope we have in shortening the present downturn.
Thursday, February 12, 2009
The Three Problems We Face: Debt, Debt, and Debt!
The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
Wednesday, February 11, 2009
The Three Problems We Face: Debt, Debt, and Debt!
The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
Sunday, February 8, 2009
Bail Out or Wimp Out?
The Obama administration is going to have to make a decision soon…is it going to try and commit to a program that will actually do something for banking and other financial institutions or is it going to extend the waffling on this issue that began last fall?
People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.
All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.
Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.
In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.
And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.
The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.
My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.
The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.
There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.
Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?
Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.
Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.
My question to this is…aren’t they bankrupt…kaput…out-of-business…already?
The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?
This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”
In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!
Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?
A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.
Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.
The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.
So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!
People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.
All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.
Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.
In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.
And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.
The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.
My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.
The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.
There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.
Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?
Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.
Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.
My question to this is…aren’t they bankrupt…kaput…out-of-business…already?
The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?
This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”
In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!
Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?
A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.
Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.
The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.
So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!
Wednesday, February 4, 2009
This Issue Is Debt! Too Much of It!
Going forward…the primary issue the world is going to have to face is debt…lots and lots of debt. Debt is clogging the blood vessels of the world financial system!
And the proposal to get us out of this dilemma?
Create even more debt!
If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.
This is what the people and the government want to avoid…if possible.
The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.
Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.
Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.
This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.
However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”
Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.
These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.
In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.
I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.
People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.
I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.
And the proposal to get us out of this dilemma?
Create even more debt!
If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.
This is what the people and the government want to avoid…if possible.
The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.
Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.
Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.
This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.
However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”
Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.
These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.
In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.
I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.
People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.
I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.
Sunday, February 1, 2009
Concerns about the Obama Stimulus Plan
As the Obama Stimulus Plan becomes more and more of a reality, many different people are asking many different questions about it. To me, there are four basic issues that need to be debated very seriously before any such plan is passed by Congress. The first question is…how fast do we really need to move in passing such a plan? Second…how big does the stimulus package really need to be? Third…how is all the debt created by such a plan going to be financed? And fourth, can the stimulus really be withdrawn once the crisis is over?
In terms of speed of enactment we hear over and over again that speed is of the essence. Things are really bad…and things are going to get a lot worse. We need to get into the game and do something as quickly as possible!
We heard this argument before, not too long ago. It was reported in the Wall Street Journal, that “Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17.” Bernanke was reacting to things falling apart in the financial industry. He called Treasury Secretary Hank Paulson and said that the administration had to move. Thursday September 18. Paulson responded that he was “on board”. Bernanke insisted that Congressional leaders had to be assembled…which Paulson set up for that Friday evening. Bernanke read them the riot act at that meeting and insisted that a bill…what became TARP…be enacted no later than Monday or everything would fall apart. (For more on this see my post on Seeking Alpha of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?”) The bill was not enacted that Monday and the last half of the TARP money was not released until just recently.
Now we are hearing the call again. We must hurry. The Obama Stimulus Plan has been put on the fast track…and the pressure is on to get the plan enacted by Congress by President’s Day, February 16. But, does this plan really need to be enacted that quickly? Is it better to have any plan by President’s Day or is it better to have a plan that works?
It seems to me that the pressure to get something done quickly has important implications for the second question asked above. Since so little is known about how effective the plan will be…the issue becomes…MORE IS BETTER! Given the uncertainty of how the plan will work, it is important to throw as much as possible against the wall in the hopes that some of it will stick.
Wow! What a way to run a government! But that is what Bernanke/Paulson did.
And, this approach gives rise to the new justification for the program…confidence. The argument goes that “If the government shows that it is serious in ending the recession and this seriousness is reflected in the size of the stimulus package…this will spur on an increase in confidence…which is just what the economy needs right now!”
Let me get this straight. It doesn’t really matter whether or not the stimulus plan works…what is important is that the stimulus plan be very large…so that people will regain confidence.
And, if this is the underlying theory behind the stimulus plan…how is this going to raise the confidence of the world wide investment community…which relates to the third question presented above…to invest in the debt of the United States government?
Oh, well…the United States dollar is the world’s reserve currency and the United States debt is the place for world investors to go when there is a “flight to quality” in world financial markets. Given this fact, people will continue to flock to United States Treasury issues. No doubt about it!
As Alice Rivlin, economist of the Brookings Institution, former member of the Board of Governors of the Federal Reserve System, First Director of the Congressional Budget Office, and Director of the Office of Management and Budget (a cabinet position and appointed by President Bill Clinton a Democrat) recently testified before Congress…”We seem to be counting on the Chinese to keep investing to pay for this (the U. S. deficits) and we’re assuming that the rest of the world isn’t going to lose confidence once we use this moment to spend on a whole range of programs. And, I’m not sure that’s the right assumption.”
Rivlin also has something to say about the fourth question…the question about what happens in the long run. She states that “Because we’re doing this outside the budget process, it means that no one has to talk about what the long-term effects of any of this might be.” That is, what is going to happen beyond the short run if much of this expenditure is still going into the economy as the economy begins to grow again. No one is anticipating how this situation might be dealt with.
As Niall Ferguson, who shares his time between Harvard University and Oxford University, stated recently at Davos…and I am paraphrasing…the new administration seems to believe that by creating an impressive amount of new leverage that it can resolve a financial crisis created by an excessive amount of leverage.
So, I go back to the first question…do we really need to rush so quickly? Yes, I agree with President Obama…he won…he gets to set the table. But, does he want to do it right…or does he just want to do it?
The Congress is supposed to be a deliberative body…it is supposed to mull things over…kick them around…debate and dialogue with one another. Isn’t it better to get something right…than to not do something well…or to do something that may not work?
Projects should not just be put into a stimulus plan…just because they are a “good idea” or because “they are something we want to do and they are available.” Projects, to be included, need to have some real justification for their inclusion in such a plan…the benefit of the project (the whole flow of benefits accruing from the project) should exceed the social cost of the project. Questions should be asked about the timing of the project and when the expected benefits are expected to be received. The Congress should be very intentional about what it is going to do…how much it is going to spend. Success of execution should be the key criteria as to whether a project gets included in the plan…not just the speed of passing the bill.
If Congress were to judge the plan…the whole plan as well as the components of the plan…in this fashion, then something more specific could be said about the size of the plan. Given that every element of the plan could stand up to some form of cost-benefit analysis then the size of the plan would be less of an issue. We would have some rationale for the size of the plan…it would not be a question of hoping some of the material thrown against the wall would stick! The parts of the plan would be chosen because they work…not because they make the plan “large”.
There still will remain questions about financing a stimulus plan. A plan constructed as suggested above would still result in the creation of a lot of new debt the United States government would have to issue. But, the investment community would have more justification to “trust” the plan because the Congress has done its homework…and, if the Congress had done its homework there would be something to say about how the debt will be financed and paid down in the future. That is, the United States government would be acting like a responsible steward of its fiscal responsibilities, something world financial markets have not seen for eight years or so.
To me, this is a crucial issue the Obama administration and the United States government has to deal with…restoring confidence in the fiscal credibility of the United States…something that Bush43 fell far short of doing. Rushing into the fray with a hastily constructed, ill-conceived stimulus plan, one that relies on the Chinese and the rest-of-the-world to finance with no thought for the future is not going to resolve the financial and economic mess we are now experiencing.
In terms of speed of enactment we hear over and over again that speed is of the essence. Things are really bad…and things are going to get a lot worse. We need to get into the game and do something as quickly as possible!
We heard this argument before, not too long ago. It was reported in the Wall Street Journal, that “Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17.” Bernanke was reacting to things falling apart in the financial industry. He called Treasury Secretary Hank Paulson and said that the administration had to move. Thursday September 18. Paulson responded that he was “on board”. Bernanke insisted that Congressional leaders had to be assembled…which Paulson set up for that Friday evening. Bernanke read them the riot act at that meeting and insisted that a bill…what became TARP…be enacted no later than Monday or everything would fall apart. (For more on this see my post on Seeking Alpha of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?”) The bill was not enacted that Monday and the last half of the TARP money was not released until just recently.
Now we are hearing the call again. We must hurry. The Obama Stimulus Plan has been put on the fast track…and the pressure is on to get the plan enacted by Congress by President’s Day, February 16. But, does this plan really need to be enacted that quickly? Is it better to have any plan by President’s Day or is it better to have a plan that works?
It seems to me that the pressure to get something done quickly has important implications for the second question asked above. Since so little is known about how effective the plan will be…the issue becomes…MORE IS BETTER! Given the uncertainty of how the plan will work, it is important to throw as much as possible against the wall in the hopes that some of it will stick.
Wow! What a way to run a government! But that is what Bernanke/Paulson did.
And, this approach gives rise to the new justification for the program…confidence. The argument goes that “If the government shows that it is serious in ending the recession and this seriousness is reflected in the size of the stimulus package…this will spur on an increase in confidence…which is just what the economy needs right now!”
Let me get this straight. It doesn’t really matter whether or not the stimulus plan works…what is important is that the stimulus plan be very large…so that people will regain confidence.
And, if this is the underlying theory behind the stimulus plan…how is this going to raise the confidence of the world wide investment community…which relates to the third question presented above…to invest in the debt of the United States government?
Oh, well…the United States dollar is the world’s reserve currency and the United States debt is the place for world investors to go when there is a “flight to quality” in world financial markets. Given this fact, people will continue to flock to United States Treasury issues. No doubt about it!
As Alice Rivlin, economist of the Brookings Institution, former member of the Board of Governors of the Federal Reserve System, First Director of the Congressional Budget Office, and Director of the Office of Management and Budget (a cabinet position and appointed by President Bill Clinton a Democrat) recently testified before Congress…”We seem to be counting on the Chinese to keep investing to pay for this (the U. S. deficits) and we’re assuming that the rest of the world isn’t going to lose confidence once we use this moment to spend on a whole range of programs. And, I’m not sure that’s the right assumption.”
Rivlin also has something to say about the fourth question…the question about what happens in the long run. She states that “Because we’re doing this outside the budget process, it means that no one has to talk about what the long-term effects of any of this might be.” That is, what is going to happen beyond the short run if much of this expenditure is still going into the economy as the economy begins to grow again. No one is anticipating how this situation might be dealt with.
As Niall Ferguson, who shares his time between Harvard University and Oxford University, stated recently at Davos…and I am paraphrasing…the new administration seems to believe that by creating an impressive amount of new leverage that it can resolve a financial crisis created by an excessive amount of leverage.
So, I go back to the first question…do we really need to rush so quickly? Yes, I agree with President Obama…he won…he gets to set the table. But, does he want to do it right…or does he just want to do it?
The Congress is supposed to be a deliberative body…it is supposed to mull things over…kick them around…debate and dialogue with one another. Isn’t it better to get something right…than to not do something well…or to do something that may not work?
Projects should not just be put into a stimulus plan…just because they are a “good idea” or because “they are something we want to do and they are available.” Projects, to be included, need to have some real justification for their inclusion in such a plan…the benefit of the project (the whole flow of benefits accruing from the project) should exceed the social cost of the project. Questions should be asked about the timing of the project and when the expected benefits are expected to be received. The Congress should be very intentional about what it is going to do…how much it is going to spend. Success of execution should be the key criteria as to whether a project gets included in the plan…not just the speed of passing the bill.
If Congress were to judge the plan…the whole plan as well as the components of the plan…in this fashion, then something more specific could be said about the size of the plan. Given that every element of the plan could stand up to some form of cost-benefit analysis then the size of the plan would be less of an issue. We would have some rationale for the size of the plan…it would not be a question of hoping some of the material thrown against the wall would stick! The parts of the plan would be chosen because they work…not because they make the plan “large”.
There still will remain questions about financing a stimulus plan. A plan constructed as suggested above would still result in the creation of a lot of new debt the United States government would have to issue. But, the investment community would have more justification to “trust” the plan because the Congress has done its homework…and, if the Congress had done its homework there would be something to say about how the debt will be financed and paid down in the future. That is, the United States government would be acting like a responsible steward of its fiscal responsibilities, something world financial markets have not seen for eight years or so.
To me, this is a crucial issue the Obama administration and the United States government has to deal with…restoring confidence in the fiscal credibility of the United States…something that Bush43 fell far short of doing. Rushing into the fray with a hastily constructed, ill-conceived stimulus plan, one that relies on the Chinese and the rest-of-the-world to finance with no thought for the future is not going to resolve the financial and economic mess we are now experiencing.
Subscribe to:
Posts (Atom)
