The United States Economy Will Continue to Grow

I believe, as I have written before, that the United States economy is recovering and will continue to recover. 

However, I also believe that “financial crises are protracted affairs.” (Reinhart and Rogoff, “This Time is Different”, page 224.)

Why don’t I believe that there will be a “double dip” recession, a 1937-38 depression like the one following the 1929-33 Great Depression?

In the case of the 1930s, there were policy errors committed that resulted in the 1937-38 depression: the most prominent one being the effort of the Federal Reserve to eliminate all the excess reserves being held by the commercial banks at that time so that the Fed would have more “control” over the money markets.

Unfortunately, the banks wanted those excess reserves around even though they were not in the mood to expand their lending activities.  As a consequence, when the Fed attempted to remove those excess reserves by raising reserve requirements, the banks cut back even more on their lending activities in an effort to achieve the financial protection they believed those excess reserves brought them.    

This has not happened in the current situation because Fed Chairman Ben Bernanke (a student of the Great Depression era) and the Fed have done just about everything possible to make sure that the banking system is flooded with excess reserves so that a similar contraction of the banking system does not occur.  There are questions about what this means for the future, but we are not at that future yet.

So, I believe that the economic recovery will continue.

The economic recovery, however, will not be robust.  One reason for this is the debt overhang that exists in the private sector.  David Brooks speaks to this point in his Tuesday morning column in the New York Times. (http://www.nytimes.com/2011/10/18/opinion/the-great-restoration.html?_r=1&hp) 

“Quietly but decisively, Americans are trying to restore the moral norms that undergird our economic system.

The first norm is that you shouldn’t spend more than you take in. After an explosion of debt over the past few decades, Americans are now reacting strongly against the debt culture. According to the latest Allstate/National Journal Heartland Monitor poll, three-quarters of Americans said they’d be better off if they carried no debt whatsoever. Not long ago, most people saw debt as a useful tool for consumption and enjoyment. Now they see it as a seduction and an obstacle.
 
By choice or necessity, eight million Americans have stopped using bank-issued credit cards, according to The National Journal. The average credit card balance has fallen 10 percent this year from 2010. Banks, households and businesses are all reducing their debt levels.”

This same phenomenon is occurring in the world of state and local governments, and the non-profit world.

How is spending going to expand within the context of this kind of behavior?

The general fundamentalist Keynesian response to this is that the federal government needs to do more to stimulate the economy.  The argument is that government spending actually needs to be much greater than is being proposed at the present time.  The people that are making this argument also state that the economic recovery in the 1930s was as slow as it was because the government did not spend as much as it should have back then.  Government expenditures will never be large enough for these people. 

But, how is more government debt going to change the picture?  As Reinhart and Rogoff state in their book, “the value of government debt tends to explode” (page 224) in the aftermath of any severe financial crisis anyway.   

The reason is that as incomes drop, tax revenues decline and the government deficit increases. 
But, greater deficits mean greater interest and principal payments in the future, and someone like Robert Barro argues that this will mean more taxes for the private sector in the future so that current savings will increase even further to offset this future obligation.     

Even if the private sector does not fully discount future taxes into their current spending plans, people may just accelerate their efforts to save to provide themselves with more flexibility to manage their financial affairs in an uncertain future world dominated by huge government debts. 

The problem that results from this scenario, in my mind, is that given the behavior of the Federal Reserve System there is lots and lots of cash floating around in the economy, but this cash is not in the hands of those people and businesses that are trying to restructure their balance sheets.  Because, this cash is not in the hands of those people and those businesses that are trying to restructure their balance sheets, the fundamental economic recovery will continue to be modest. 

Thus, you have lots and lost of cash looking for places to invest where there are very few “productive” places for the money to go.  So, money seems to be chasing assets.  However, the uncertainty seems to be causing other problems and this is resulting in increased market volatility. (http://professional.wsj.com/article/SB10001424052970203658804576637544100530196.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

“The problem is a lack of liquidity—a term that refers to the ease of getting a trade done at an acceptable price.

Markets depend on there being many offers to buy and sell a particular stock, across a range of prices. But as investors have gotten nervous, many of those offers have dried up. That is causing wider-than-normal gaps between prices showing where stocks can be bought and where they can be sold—the difference between the "bid" price and the "ask" price.

Many big investors, such as hedge funds and mutual funds, which at times can act as shock absorbers for trading because they tend to trade large chunks of stocks, have been on the sidelines. Some hedge funds, for example, say they're not trading as much until they know how much money their clients will withdraw at the end of October, a deadline some clients have to inform funds of intentions to redeem money at year-end. “

In my mind, the economic recovery is going to continue on its slow path.  But, given all the money around and given the general impatience that is attached to this money, wide swings in asset prices are going to continue well into the future, especially if the Federal Reserve really keeps interest rates as low as they are into the middle of 2013.

Patience is not an attribute of traders…and of politicians…but that is another story.

The Current State of Monetary Policy

At the top of my Financial Times this morning reads the blurb: “Did Ben Bernanke Drop the Ball Over QE3?”  This is reference to an editorial by Clive Cook. (http://www.ft.com/intl/cms/s/0/7f55246e-cf2d-11e0-b6d4-00144feabdc0.html#axzz1WPnzI9CU)

In examining the speech given by Fed Chairman Bernanke, Cook takes on the Financial Times essays published last week by Michael Woodford (http://www.ft.com/intl/cms/s/0/aa41c0f2-ce78-11e0-b755-00144feabdc0.html#axzz1WPnzI9CU) and Mohamed El-Erian (http://www.ft.com/intl/cms/s/0/0472f1ea-cd89-11e0-b267-00144feabdc0.html#axzz1WPnzI9CU) that argued against the Fed implementing a QE3.  Cook contends that Bernanke missed a chance…a “chance to jolt ailing America.”

I don’t believe that Bernanke dropped the ball.  I don’t believe that a declared QE3 is necessary.  Whereas Cook believes that a QE3 would “shock” America, I believe that a QE3 would be taken as ho-hum, more of the same. 

In this, I don’t believe that QE1 and QE2 were understood. 

Michael Woodford, the “good” academic states in his essay: “The economic theory behind QE has always been flimsy.”

Get real…this is the “real world”!

QE1 and QE2 were not a result of economic theory.  QE1 and QE2, in my mind, were a response of real people to a desperate real world situation.  In the first case, the financial markets were falling apart.  In the second case, the economy was not growing. 

In both cases, the response of Mr. Bernanke and the Fed’s policy makers were to throw whatever they had against the wall to see what would stick.  There is little in the way of theory behind this.   Some of us believe that in the first case this was not one of Mr. Bernanke’s finest hours. (See my post, “The Bailout Plan: Did Bernanke Panic,” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

In my mind, what was behind these actions was not theory…but history. And, Mr. Bernanke is one of the premier students of the history of the Great Depression and the 1930. 

So, what was behind QE1 and QE2?

In the case of QE1, Mr. Bernanke was aware of the massive monetary history written by Milton Freidman and Anna Schwartz.  The famous conclusion drawn from the Friedman/Schwartz history is that the Federal Reserve allowed the money stock of the United States to decline by one third over the 1929-1933 period. 

Mr. Bernanke and the modern Fed was not going to allow this to take place.  As a consequence, they, Bernanke and the Fed, threw everything they had at the wall.  There was no theory in this.  They were just human beings re-acting in a situation in which there was extreme uncertainty and in which things seemed to be falling apart around them. 

In terms of QE2 we can also go back into the history of the 1930s to get some instruction that might help us understand what the Federal Reserve has been attempting to do over the past year.  The specific case here comes from the period 1937-1938.  The United States economy had been modestly recovering since 1933 but bank lending had not really picked up.  Excess reserves at commercial banks became, for the time under review, excessive.  Since the Federal Reserve’s policy makers did not want to have all these excess reserves around because they felt this reduced their control over the banking system they raised reserve requirements so as to get rid of these “superfluous” reserves.

The consequence? 

There was another collapse of the money stock because the commercial banks “wanted” those excess reserves due to the uncertain times and the slow pickup in business activity.  So, when the Fed took away the excess reserves, the banks reduced their lending activity even more to recover their “excess” reserves and the financial system declined once again.  There was another depression following up on the “Great” one!

Mr. Bernanke, the historian, and the Fed did not and does not want a repeat of the 1937-38 depression.  As a consequence, QE2 was created.  The thought behind QE2 was to throw enough against the wall so that something would stick!  Economic growth was sluggish at best; bank lending was still declining in the summer of 2010; debt loads of businesses, and families, and governments were huge; foreclosures and bankruptcies were at record levels; and under-employment were at levels reached only in the 1930s.  Banks had excess reserves, yet, nothing much seemed to be moving.

Mr. Bernanke and the Fed wanted to escape a replay of 1937-38!

There was little or no theory behind QE1 and QE2.  These two programs were put into place by real people facing extreme situations who did not want to err on the side of not doing enough.  They were people that would let history decide whether or not they acted correctly…and let the theorists debate all they wanted to in their own little worlds. 

And, what are we left with right now?

A commercial banking system that has around $1.6 trillion in excess reserves and about $2.0 trillion in cash assets on its balance sheets.  And, we are told that the central bank is poised to act in the future in anyway needed to shore up the banking system and the economy.  Furthermore, we are told that short-term interest rates are to stay around where they are for two more years. 

Mr. Bernanke, who has overseen both QE1 and QE2, is not afraid to throw more “stuff” against the wall if needed.  This, to me, is current state of monetary policy at the present time.        

The World Economy: A Time of Transition

It seems as if “Macro” forces are dominating movements in the financial markets these days. The latest call to attention of this fact is the article by Tom Lauricella and Gregory Zuckerman on the front page of the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704190704575489743387052652.html?mod=wsjproe_hps_TopLeftWhatsNews). The “big” picture appears to be driving things and not the performance of individual investment opportunities.

Specific attention is given to a statistic called “correlation” which measures “the tendency of investments to move together in a consistent way.”

The article reports that in the 2000-2006 period the correlation of stocks in the Standard & Poor’s 500 Index was 27%, on average. However, during the events that led up to the Iraq war, correlations were near 60%. At the height of the financial crisis, October 2008 to February 2009, correlations were around 80%. They were around 80% during the sovereign debt dislocations in Europe earlier this year. In mid-August correlations dropped to 74% and now reside in the 65%-70% range.

When the prices of many or most stocks move together, individual stock picking is not the optimal investment strategy. This is why many investors have been moving to mutual funds that focus more on “macro” issues rather than on individual companies.

One of the most interesting statements in the article was this: “Prior to the financial crisis, such high correlation levels were seen previously only during the Great Depression, according to data compiled by market-strategy firm Empirical Research Partners.”

I pick up on this statement because of my belief that we are going through a tremendous period of transition. The world is changing. And, it is changing in ways that we don’t fully comprehend. As a consequence, individual “bets” are extremely risky, much more risky than “bets” that tend to aggregate outcomes.

The period of the Great Depression represented another period of major transition. During the Great Recession of the 2000s people were constantly referring back to the 1930s for “lessons learned” with respect to monetary and fiscal policies that could be applied to the current situation so as to avoid falling into as deep a hole as occurred at the earlier time.

However, the major lesson we may have to learn from the era of the Great Depression is that economies have to go through transition periods as they move from one kind of societal structure to another. In many ways, the American economy, and much of the rest of the developed world, still operated on an agricultural foundation in the 1920s. Yes, the industrial base was developing, labor unions were coming into existence, and cities were coming to dominate the rural areas but, in many ways, agriculture still dominated economic policy making.

The government in the United States supported and subsidized the agriculture sector in a way that was unsustainable relative to the emerging industrial cities. When this unsustainable effort collapsed, the economy fell apart and the 1930s through the 1940s saw America restructure from a rural society to one where prosperity resided in the cities and suburbs.

During this transition, it was not easy to pick out winning investments because no one really knew what the future was going to look like. Thus, the correlations of stock prices were high because success depended more upon how the whole economy re-structured and, consequently, how the whole economy recovered.

I believe that there are strong parallels in this respect between the current situation and that which existed in the 1930s.

Whereas America supported the farms and farmers in an earlier age because farming was “the American Way,” in the post-World War II period America supported owning a home in or near cities because it was believed that owning a home was, more or less, the right of all Americans.

Now, something else is happening. The industrial base in the United States is deteriorating, capacity utilization is around 75%, underemployment of individuals of working age is around 25%, and income inequality has become quite large. Labor unions are becoming like the dinosaurs, their species is dying. Center cities do not seem to be the wave of the future as they once were seen. And, home ownership for everyone may not fit into the future of society.

The United States government supported and subsidized the housing industry for fifty years, putting GIs into homes after World War II, financing the suburbs, rehabbing the cities, and so forth. Well, the bubble burst, just like it did for the agricultural sector.

What’s next?

That’s the interesting thing about transitions…you never know exactly where they are going to end up.

There are lots of changes taking place. Before the 1930s, the Industrial Age began: the late 19th century was just the spectacular beginning although agricultural still dominated the scene. The late 20th century saw the beginnings of an Information Age even as the cities and industrial concerns remained in the headlines.

What will an Information Age look like? That is still up to the science fiction writers.

What I am sure of is that information will continue to spread and cause changes worldwide that we cannot even imagine at this point in time. Information markets are going to become ubiquitous and innovation with respect to “Information Goods” is going to extend far beyond the field of finance.

But, there are other changes taking place that are going to “rock” the world. One of these is the political makeup of the world. There is the rise of China and the other BRIC nations. Power collected in the G-7 has been transferred to the G-20. The IMF is changing and will have to change a lot more, moving from European and American dominance to include greater roles for South America and Africa. These changes are going to have massive impacts on the way things are going to get done.

Furthermore, the emerging markets seem to be the place to invest these days. The economies of the United States and western Europe are the sluggards as they go through their needed transitions. These emerging nations are now dealing with one another because the allocation of commodities in the world is crucial for the continued progress of these areas. All these movements are “macro” in nature.

As the transition takes place, the “old” is not going to work in the way it used to. Stock investing will be different, at least for a while. The “old” political philosophies are not going to be very effective as we are finding out in the United States and in western Europe. But, this is a part of the whole process. We must adjust and find out what works and what doesn’t work.

Those that try to force things back into the “old” boxes are not going to survive!

Federal Reserve Exit Watch: Part 12

This is the twelfth edition of the Federal Reserve Exit Watch. The first edition was posted in August 2009. The Great Recession, many contend, ended in July 2009 and, at that time, the major task of the Federal Reserve System appeared to be the task of reducing, as judiciously as possible, the massive amount of reserves that the central bank had put into the banking system to combat the threat that the Great Recession might turn into a second Great Depression.

On July 8, 2009 on the Fed’s balance sheet, total factors supplying reserve funds to the banking system totaled over $2.0 trillion, up from around $0.9 trillion one year earlier. It was September of 2008 when the liquidity crisis hit the financial system in the United States which resulted in the rapid injection of funds into the banking system to protect the system from a series of systemic failures. In July 2009, excess reserves in the banking system average around $750 billion.

The concern at that time was that all of these excess reserves in the banking system would eventually end up in the money stock and this would result in inflationary pressures threatening significant increases in consumer and asset prices.

One year later on July 7, 2010, total factors supplying funds to the banking system amounted to about $2.4 trillion. Excess reserves in the banking system totaled more the $1.0 trillion. Obviously, the Federal Reserve System did not remove reserves from the banking system during the past twelve months.

The reason given for not removing reserves from the banking system is that the economy has remained excessively weak: and the Federal Reserve will not start removing reserves from the banking system until the economy seems to be picking up momentum.

My belief has been that the health of the smaller banks in the banking system, those 8,000 or so banks that are smaller than the 25 largest banks, is still not good and the Fed will not begin to remove reserves from the banking system until these non-big banks get in much better shape. With about one in eight banks in the United States on the problem bank list of the FDIC, the banking system is a long ways from being healthy.

And, the Fed has promised that it will continue to keep its target interest rate close to zero “for an extended period” of time. That is, banks should not be afraid of rising short term interest rates any time soon. Many market analysts don’t expect short term interest rates to begin rising until after the start of 2011.

One crucial thing to understand about the operations of the Federal Reserve over the past 12 months is that the injection of funds into the banking system through the fall of 2008 and into the summer of 2009 consisted primarily of “innovative” efforts by the central bank to provide liquidity to specific parts of the money and capital markets. The reserves injected into the financial system were not anything like the classical operations of a central bank which mainly came from the sale or purchase of U. S. Treasury securities in the open market and discount window borrowings from the district Federal Reserve banks.

A major part of the exit strategy of the Fed related to the reduction in these “special” sources of funds and moving back into more traditional forms of central bank operations. Therefore, in the initial stages of the Fed’s exit strategy, efforts were directed at seeing the “special” sources of reserves decline as their needs receded and replacing the reduction in reserves with the purchase of securities from the open market.

The twist in this effort was that the Fed focused, not on the purchase of traditional source of open market securities, U. S. Treasury issues, but on acquiring a lot of mortgage-backed securities, up to $1.250 trillion worth, in order to provide support for the mortgage and housing markets, and on acquiring Federal Agency issues. On July 8, 2009, mortgage-backed securities on the books of the Federal Reserve System totaled about $462 billion. On July 9, 2010, this total reached $1.1 trillion. Federal Agency issues rose from around $98 billion on the earlier date to $165 billion on the latter date. U. S. Treasury securities rose as well, but only by about $104 billion.

Thus, in this 12-month period, total factors supplying reserve balances rose by $341 billion, and the amount of securities the Federal Reserve bought outright rose by $826 billion. The portfolio purchases replaced a lot of the “special” sources of funds supplied to the banking system by the Fed over the past ten months. This was an important part of the Fed’s exit strategy.

So, in the past 12-month period, the Fed actually increased the amount of excess reserves in the banking system. However, in the last 13-week period, excess reserves have actually fallen slightly. One could strongly argue that the decline in excess reserves has come more from operating factors rather than from any overt efforts to reduce bank reserves.

One cause for the reduction in excess reserves was the increase in U. S. Treasury deposits at the Federal Reserve in the Supplementary Financing Account. This is an account set up by the Treasury Department to specifically help the Fed drain reserves from the banking system. (See my post of April 19, 2010, “The Fed’s New Exit Strategy”, http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy.) During the past 13-week period this account rose by $50 billion, helping to bring down bank reserves. Other operating factors that drained reserves from the banking system was a $12 billion increase in currency in circulation. Also, reducing reserves was a decline in central bank liquidity swaps that fell by about $8 billion during this time period.

Over the past thirteen weeks, these factors draining reserves from the banking system was offset by about $50 billion in Fed acquisitions of mortgage-backed securities.

The net effect of all factors affecting reserve balances: a $50 billion decline in excess reserves.

Over the past four weeks Federal Reserve actions have remained relatively minor. Excess reserves in the banking system fell by about $19 billion, but this primarily resulted from operating transactions like the increase in currency in circulation and a rise in U. S. Treasury balances in the Treasury’s general account which is usually connected with tax receipts. So the last 4-week period can be considered to be uneventful.

One other thing we need to check in this analysis is the behavior of the M1 and M2 measures of the money stock. All that can be said here is that the growth rate of these two measures continues to be modest and actual growth rates have been achieved by people and businesses re-arranging assets rather than from commercial banks making loans. The year-over-year rate of growth of the M1 measure in June was about 6% while the M2 measure rose by only 1.6%.

Note that the non-M1 component of M2 grew by only 0.6% during this time period. This was because, small denomination time deposits at financial institutions have fallen by more than 22% over this time period and Retail Money Funds have dropped by more than 25%. All of these funds seem to have gone into demand deposits, other checkable deposits, and money market deposits, part of M1. This, as I have written before, is not a sign of health in the economy because people continue to transfer funds out of interest-bearing accounts and into forms of money that can be used for spending. This is a sign of desperation not of an improving economy.

A consequence of this has been that the required reserves at commercial banks have continued to rise so that the Federal Reserve must increase the total reserves in the banking system so as to keep excess reserves constant.

One other measure reflecting this shift in assets: monies in Institutional Money Funds have also fallen by 25% year-over-year.

The conclusion to this Exit Watch report is that the Federal Reserve HAS NOT YET started taking reserves from the banking system. That is, over the past year the Fed has not, if fact, exited. And, people and businesses in the aggregate still need to reduce their portfolios of invested funds in order to have money available for spending on their daily needs.

The Problems of Recovery

Comparisons abound between the Great Depression of the 1930s and the Great Recession of the 2000s. So far, we seem to have avoided the depths that were reached in the earlier experience, but we still have to consider whether or not the breadth of the two might be similar. That is, almost everyone one forecasting the recovery of the United States economy in the 2010s seems to be expecting that it will be a long, slow process.

The comparison I would like to consider in this post is the possibility that both of these periods represent a time in which the United States economy was going through a substantial structural change. Many people that have studied the 1930s period argue that the economy that existed in the United States in the 1950s was substantially different from the one that existed in the 1920s. Huge shifts took place in both manufacturing and agriculture throughout the 1930s and these shifts were just accelerated in the 1940s, a period of world war. The underlying cause of this change: technology had changed and the American economy had to adjust to become a modern nation. However, the mismanagement of the financial crisis in the 1930s just exacerbated the depth of the decline.

The argument can be made that major structural changes had to take place in the United States economy as it entered the 21st century. Changes of the magnitude of the present adjustment did not take place during the shorter, less severe recessions of the post-World War II period because the buildup of technological change takes time in order to build up a sufficient backlog of the new technology to really be disruptive. By the end of the 1990s, the structural change connected with the move from a society based upon manufacturing to an information society was ready to occur.

This buildup was not really a sudden one. It has been occurring throughout the last fifty years or so. I believe that the decline in the figures on capacity utilization for the United States captures this change very well.

Note in the accompanying chart that capacity utilization continues to decline throughout the whole period since the late 1960s. Obviously, cycles in this measure took place that were related to the various recessions occurring during the time span, but each new peak in capacity utilization never exceeds the peak it had reached in the previous cycle.

This, I believe, captures the changing nature of the United States economy and the movement from the foundational base of the Manufacturing Age to the growing impact of information technology and the Information Age. The conclusion that can be drawn from this is that the United States economy is not going back to where it was. But, this will take time.

Let me just point out three important factors that are playing a huge role in this change: evolving technologies, changing structure of the labor market, and the rise of the emerging nations.

First, the core of American commerce is not going to be manufacturing as we have known it. The future belongs to information technology, biotechnology, and knowledge. For the government to attempt to “force” workers back into jobs they held in the manufacturing world is just going to postpone the changes that WILL take place and threatens the stability of the society by re-establishing the inflationary environment of the last fifty years.

Second, the age of the labor union is past: non-public sector labor unions are legacy. There was a time when labor unions were needed to temper the pressures and demands of the industrial age of the large corporation who needed large numbers of physical laborers. These unions now compose less than half the union population in America yet have an over-sized impact on the politics of the country. In the next fifty years, the importance of the labor union is going to decline, economically and politically, as the United States moves from the manufacturing base that has dominated the last fifty years into the Information Age described in the previous paragraph.

Third, the United States, although it will remain the number one economic and military power in the world, is going to see its relative position in the world decline. The reason is that major emerging nations are beginning to feel their power and exert it. The immediate group of nations that come to mind are the BRICs. But, there are others. China, as we well know, is starting to exert its influence throughout the world. We see Brazil directly challenge America in the World Trade Organization concerning tariffs and subsidies. (See “Tax Move by Brazil Risks US Trade War”: http://www.ft.com/cms/s/0/dbf4284c-2afa-11df-886b-00144feabdc0.html.) And, more of this is to come! This is going to provide its own pressure for the economic structure of the United States to change.

These adjustments are going to take time. There will be substantial pain for those of working age who are not trained or educated for the new era. I believe that even the number of underemployed, 16%-17% of the work force, under-estimates the structural problem that exists. Thus, the estimate of 11 million new jobs that are now needed in the economy to get us back to where we were before the Great Recession began also under-states the problem.

Investment-wise, just as in the 1950s, the whole structure of opportunities available is changing from the earlier age. But, one needs to consider the new format of the economy that is evolving out of the manufacturing age in developing ones portfolio strategy. Similar to the 1930s, the 2000s are producing a modernization of the United States that will alter the world as it has been known and will produce a world that we can’t even hardly imagine yet.

Bank Failures Are Up: Way Up!

On Friday, bank failures for the year reached 77. In January or March of this year people started projecting that we may make 100 by the end of the year. I think that is as sure a bet as you can get these days. Now, we are seeing forecasts of over 200 more bank failures in the next 18 months.

The headlines over the past several days have been eye-catching. On Bloomberg.com, we saw “Toxic Loans Topping 5% May Push 150 Banks to Point of No Return.” On Reuters Blogs, we saw ”Citi’s Dirty Pool of Assets,” which reported that Citigroup had identified $39.5 billion that represented deep problems on its pool of subprime mortgages, of which it has only incurred $5.3 in looses leaving another $34 billion to go. Citi also faces problems in it CDO portfolio some of which it has hedged its exposure with credit default swaps. And, Jonathan Weil, in an article titled “Next Bubble to Burst Is Banks’ Big Loan Values” on Bloomberg.com, argues that the change in mark to market accounting early this year has covered up huge losses on the books of the biggest banks that were reported in the fourth quarter of 2008 but have since disappeared.

The good news in all this is that most of the troubled assets in banks have been identified and the regulatory bodies, particularly the FDIC, are fully aware of the most troubled banks. These individual insolvency cases are being worked out on a case-by-case basis. We got headlines in the newspapers this week because of the sell-off of Colonial BancGroup Inc. which was the largest bank to fail in 2009 and one of the most costly bank failures ever. But, this bank had been identified a long time ago and it has been systematically handled. The other four that failed this week did not claim headlines. This is good because the banking sector is staying relatively quiet. (See my post of August 10 on this http://seekingalpha.com/article/154998-banking-sector-stays-quiet.) Most bank failures over the next year or so will not get major headlines. (Our most optimistic wish is that none of the bank failures coming in the next year or so will warrant headlines.)

We are in the part of the credit or debt cycle where things are relatively calm: we are way past the phase of the cycle where liquidity was the primary issue. The problem now is not that financial institutions need to and want to get rid of assets as quickly as they can. We are in the “work out” phase of the cycle. Historically, the time it takes to “work things out” depends upon the depth of the collapse in asset values. The betting now seems to be that this time around, the “work out” phase of the cycle will be a relatively long one.

If we still have to go through 125 to 150 more bank failures in the next 18 months or so, the banking system as a whole is not going to be too aggressive in putting new loans on its books. And this will not result in a strong economic rebound going forward.

In addition, the amount of debt that is still outstanding in the economic system will remain a major drag on the banking system. The uncertainty pertaining to the future repayment of loans to the banking system, in the areas of commercial real estate loans, of credit cards, and because of another wave of residential loans that will be repricing over the next 12 months or so, is still a concern. This uncertainty will further restrain banks from being too aggressive in making new loans. (See my post of August 12, “The Debt Problem Poses a Two-Sided Threat to the Fed,” at http://maseportfolio.blogspot.com/.)

And, those who have borrowed will be reluctant to spend giving the uncertainties about the state of the economy, unemployment, foreclosures, and other economic dislocations. Even Paul Krugman has recognized the role that debt plays in spending. In a recent lecture Krugman discussed why the Great Depression did not re-start after World War II when almost all economists expected it to do so. He argued in this talk that by the end of World War II the private sector of the economy, households and businesses, had worked off most of the debt that it had taken on in the 1920s, but had not been able to eliminate in the 1930s. The private sector had deleveraged by the 1950s and was now ready to spend. Krugman contends that the private sector will not begin to spend again coming out of the current recession until it has deleveraged itself from the current buildup of debt.

The financial system and the economic system are working themselves out of their recent problems. Let us hope that things stay quiet. That means, we need to avoid any more surprises. If we don’t have surprises, there is a good chance that the recovery will start and will continue. This doesn’t mean that it won’t take a long time for the banks, households, and businesses to work through their current problems. It will. And, it doesn’t mean that other problems with respect to long term interest rates and the value of the United States dollar may not worsen because of the huge and increasing load of federal debt.

This “quiet” does give us some hope that we are moving in the right direction. There will continue to be bank failures, and foreclosures, and bankruptcies, and more. But, they can be worked through if we don’t get too impatient.