Signs of the Future: Emerging Countries vs. Developed Countries

The world goes on.  Whereas the news has tended to be dominated by what is happening in Europe, with some attention going to the United States, things are still going on in other parts of the world. 

For example, “Standard & Poor’s has become the third rating agency this year to upgrade Brazil’s sovereign debt…” (http://www.ft.com/intl/cms/s/0/a1c1a890-116a-11e1-9d04-00144feabdc0.html#axzz1e48y8AYK)

“Brazil’s debt fundamentals are already seen by markets as superior to many European countries with spreads on the Latin American country’s debt trading tighter than those of many eurozone countries.”

“The move…emphasizes the growing divergence between the fast-growing large emerging markets, led by China, Brazil, and India, and the advanced economies.”

Meanwhile, the central banks in emerging markets are buying gold in the largest quantities for forty years.  The forty years is important for that refers back to 1971 when President Richard Nixon severed the tie between the United States dollar and gold. 

“The scale of the purchases was bigger than previously disclosed and puts central banks on track to buy more gold than at any time since the collapse of the Bretton Woods system 40 years ago, when the value of the dollar was last linked to gold.”  (http://www.ft.com/intl/cms/s/0/c0025500-10ef-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

Many emerging countries, especially the BRICs, now believe that they are over-exposed to the dollar in their central bank reserves and are trying to build up gold reserves at times when the price of gold dips.  Also, there is incentive to buy as concerns grow over the role of the United States dollar as a reserve currency.

“It is a mark of creeping distrust in the unofficial reserve currency, which nervous central bankers see being printed by trillions even as America’s political leadership shows no sign of dealing with its daunting fiscal challenges.  Fiscal worries are even more acute for the number two and three reserve currencies, the euro and the yen.” (http://www.ft.com/intl/cms/s/3/59f07c7e-113f-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

But, “Central bankers are late to the gold party.  Private buyers of ETFs alone have accumulated 15 times as much since their advent a decade ago as government bought last quarter.  But their shift should be of far more concern.” http://www.ft.com/intl/cms/s/3/59f07c7e-113f-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

Seemingly oblivious to these happenings, the United States continues to pursue policies that will devalue its currency.  Fed Chairman Ben Bernanke appears to be focused on keeping the world abundantly supplied with U. S. dollars while Treasury Secretary Timothy Geithner continues to swear that U. S. policy is to maintain a “strong” dollar while the Obama administration continues to issue more and more debt. 

Others within the Federal Reserve System continue to back up the Fed effort to continue to inflate the world.  The President of the Federal Reserve Bank of New York, William Dudley, says that “the central bank isn’t out of ammunition “ and that “monetary policy must do its part” to support economic growth. (http://professional.wsj.com/article/SB10001424052970204517204577044481934030256.html?KEYWORDS=michael+derby&mg=reno-secaucus-wsj)

And, the pressure in Europe is intense to get the European Central Bank to engage in much more aggressive actions to save the European Union and the euro.  Is quantitative easing in the future for Europe? (http://professional.wsj.com/article/SB10001424052970203611404577042302226590104.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

The emerging nations are seeing the “crack in the door” and are steadily moving to take advantage of the fact that the developed countries must currently keep their focus on current distractions.  By following such a policy they see “the door” opening wider and wider.

To me, the real report card is the value of the dollar.  The credit inflation of the last fifty years in the United States, first, forced the United States off the gold standard, and, second, resulted in a secular decline in the value of the dollar.  The U. S dollar still fluctuates near the lows reached over the past forty years since its value was floated.

 

Looking at the value of the dollar against twenty major currencies one can see that news lows were hit around August of this year.  One can note that the three periods of recovery from the lows reached in 2008 were periods when there was a “rush to quality”.  The first was during the “Great Recession” and the other two spikes came during the sovereign debt crises in Europe. 

The economic policies of the United States government aim at a devaluation of the United States dollar.  Still the United States dollar is the reserve currency of the world and is the currency of the country that remains the strongest country economically.  This is why the United States dollar is still the haven for others when there is a movement to “quality.” 

Since the second world war, the United States…with western Europe tagging along…has dominated the world, economically as well as militarily.  During this time, the United States has basically acted independently of all others.  It is still “Number One” in these areas but is finding that its voice is growing weaker and weaker.  Current examples of this are the position the U. S. had to take in the actions in Libya and the back seat it took in the G20 meetings in Cannes, France.  And, more and more it is finding that with its fiscal position that it just does not have the money to “throw at things” that it used to have in the past. 

One way or another, the separation between the developed countries and the emerging countries is going to be a major factor in the world going forward.  Most analysts have moved up the time they expect some of the larger emerging nations to catch up with America and western Europe.  Within this environment, the currency conflicts and the financial conflicts are just going to grow

Winning Strategies

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

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

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

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

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

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

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

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

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

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

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

Where should they start?   

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

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

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

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

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

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

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

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

Federal Reserve Continues to Underwrite Big Companies and Big Banks

Economic spokesperson for the Obama administration, Ben Bernanke, and the Federal Reserve System continue to underwrite “big”…Big Companies and Big Banks.

The Federal Reserve has just released its survey of senior credit officers. The headlines, “Large United States Banks are Starting to Ease Credit Terms.”

Terrific!

“Large companies may also be finding an appetite to borrow, especially for mergers and acquisitions…The start of January was marked by a record level of M&A and 77 per cent of banks that reported an increase in loan demand said deal financing was a somewhat to very important reason for it.” (See http://www.ft.com/cms/s/0/6dbf2546-2d71-11e0-8f53-00144feab49a.html#axzz1Chh2pOYC.)

But wait…”A flood of cash by investors seeking to profit from rising interest rates is having an unintended effect in the deal world, where this money is being recycled into corporate buyouts.

Investors have been selling bonds which typically lose money when interest rates rise and putting their cash in funds that invest in bank loans that finance corporate buyouts. The loans have floating rates, so the interest they pay investors rises as rates go up.” (http://professional.wsj.com/article/SB10001424052748704254304576116542382205656.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Wow! Have I got a deal here!

And, what about big banks? Well, Bloomberg has an answer for that: “Fed’s Easy Money Helps European Banks Refinance.” (See http://www.bloomberg.com/news/2011-02-01/fed-s-easy-money-helps-european-banks-refinance.html.)

Seems as if European banks are selling record amounts of dollar-denominated bonds to refinance almost $1 trillion of their debt maturing this year. “As a result of the extra dollars created (by the Fed’s quantitative easing), cross-currency basis swaps show that it’s cheaper for European banks to sell bonds in dollars and swap the proceeds back to euros than it was at the same time last year.”

European lenders “sold $43.8 billion in investment-grade bonds in the U. S. (this January), beating the previous record of $42.4 billion last January.”

So the Federal Reserve’s quantitative easing is doing good!

Yes, but what about economic recovery and the smaller banks and smaller businesses?

The Financial Times article continues: “If most of the increased loan demand is for M&A, it may be slow to feed through into higher investment in the economy.

The scope of easier credit also remains limited: Large banks say they are lending more to large companies, but life has become no easier for small companies and small banks.

There was also little sign of any improvement in lending for either commercial or residential real estate.”

It is in the smaller banks and the smaller businesses that solvency concerns still reign. It is in
commercial and residential real estate that economic conditions remain depressed and credit woes abound.

Big banks and big corporations have lots and lots of cash. The reason for this build up in my mind has been for the “Great Acquisition Binge” of the 2010s. (See my post “Where the Real Deals will be in 2011: http://seekingalpha.com/article/244709-where-the-real-deals-will-be-in-2011.) And the bank lending reported above is just adding to the acquisition cycle. The big banks are now increasing lending and, it looks as if the increased lending is going for more and more buyouts. The hedge funds and private equity funds are now stepping up their involvement in this exercise as is evidenced by the interest in floating rate loans.

And, how is this banking activity helping to get the economy growing more rapidly and reduce unemployment?

If anything, the increased merger and acquisition activity will result in a “rationalization” of business which will mean that the acquiring firms will engage in more downsizing of the acquired firms and this will mean that more workers will be laid off.

Companies will become bigger…there will just be fewer companies around.

If this is the case, why does the Federal Reserve continue to underwrite the big banks and the big corporations?

I continue to argue that the Federal Reserve is pursuing quantitative easing as aggressively as it is doing in order to keep the smaller banks going as long as possible so that the FDIC can close as many as they need to in an orderly fashion. Eleven banks have already been closed this year.

Last year the FDIC formally closed a little more than 3 banks per week throughout the year. However, the number of banks in the banking system dropped by two to three hundred (we don’t have the final numbers on this yet) when you count the mergers and acquisitions that took place in the banking industry.

My guess is that we will experience the same amount of contraction of the banking system in 2011. The monetary stance of the Federal Reserve is crucial for the banking system to continue to contract in an orderly fashion. But, this is not necessarily spurring on economic growth.

Until this contraction is over, the feast will continue for the biggest banks and the biggest corporations.

Long-term Treasury Yields in 2011

Yesterday, I attempted to lay out how I thought 2011 would play out in terms of the value of the United States dollar. In “The U. S. Dollar in 2001” (http://seekingalpha.com/article/242766-the-u-s-dollar-in-2011) I argued that the general outlook for United States monetary and fiscal policy was more of the same policy stance that the United States government had taken for the last 50 years: credit inflation. (For more on this see the Financial Times/ Goldman Sachs business book of the year, “Fault Lines” by Raghu Rajan: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.)

The year 2011 will follow the pattern of large fiscal deficits and monetary ease and this will carry into the foreseeable future. As a consequence, the long term direction of the value of the United States dollar will be downward. I focus on this initially because this sets the stage for how financial market participants view the actions of the United States.

This downward movement, however, will be interrupted in the short run by the continued problems relating to the sovereign debt of various countries within the European Union. The United States, in 2011, will still be seen as a refuge from risk which will result in the dollar being supported by a “risk averse” investment community through much of 2011.

The turmoil in Europe is taking the pressure off of the policy makers in Washington, since they will be free of any criticism that might come their way because of a declining value of the dollar. As a consequence, the Obama administration will not need strong leadership to execute an “unpopular” monetary or fiscal policy: this was the case in the late 1970s and early 1980s as Paul Volcker, leading the Federal Reserve, put the brakes on the economy and the value of the dollar rose significantly; and Robert Rubin, leading the Treasury Department in the 1990s, helped to bring the federal budget from a deficit to a surplus, which produced another significant rise in the value of the dollar.

So, my basic expectation for the economy for the next year (and for the near future) is similar to that being called “the new normal”. The new normal incorporates sluggish economic growth, high unemployment, and weak inflation. (See “Champions of the ‘new normal’ stick to their guns,” http://www.ft.com/cms/s/0/b9c8a49e-0c5b-11e0-8408-00144feabdc0.html#axzz18l9xj6XV.)

The sluggish economic growth of the United States will remain around 3.0 percent to 3.5 percent, year-over-year, something way below what ordinarily has occurred in economic recoveries in the past. This modest growth rate under-scores the structural problems exhibited in the economy, the unusually low level of capacity utilization on the part of industry, the fact that the under-employment rate will remain in the 20 percent to 25 percent range as employers remain reluctant to bring back workers on a full time basis, and the fact that the year-over-year rate of growth of industrial production has been dropping off every month since June 2010.

I do see three ominous clouds on the horizon present in the financial sector. First, the solvency problems in the smaller commercial banks will continue to linger. As readers of this column know, I believe that the Quantitative Easing on the part of the Federal Reserve is more to keep the banking system afloat as the FDIC closes a sizeable number of banks over the next year or so. This will keep a lid on bank lending.

Second, there are the financial problems being experienced by state and local governments and these problems spill over into the financial markets for the bonds of these entities. The implications of this situation for the reduction in budges are huge.

Finally, large corporations have accumulated a huge chest of cash (both in the United States and Europe). It is my belief that this accumulation of cash is for “buying” purposes and we will see a sizeable pickup in mergers and acquisitions as the economic recovery continues. But, this restructuring of the economy will not create more jobs and increase production. In fact, it will do just the opposite. Large banks will also participate in this expansion of mergers and acquisitions. And, the big will get bigger.

Overall inflation will remain moderate. The year-over-year rate of increase in the implicit price deflator of gross domestic product remains around 1.0 percent and this probably will not go much above 1.5 percent this year, if it goes that high. Thus, general inflation does not seem to be a near-term problem.

However, given the current stance of monetary policy we see the possibilities of bubbles forming all over the place. (See “The Fed: Bubble, Bubble, Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.) As we saw over the past 25 years or so, general inflation was low and policy makers felt under control of things. Yet we saw bubbles here and bubbles there. Now, the actions of the Federal Reserve are being picked up in a rise in commodity prices, rising stock markets of emerging nations, and the buildup of inflationary pressures in export driven countries like China and Germany.

Putting this all together, my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5% to 5% in the upcoming year, a rise from around 3.3% to 3.5% now. The 30-year Treasury security will rise to the 5.5% to 6.0% range, up from around 4.4% to 4.5% now. The spread between the yields of these two maturities will be about 100 basis points, slightly lower than it is at the present time.

Bernanke will not be able to keep long-term interest rates down!

This just puts long term Treasury yields back at the levels they were for much of the 2000s.

From this, I argue that the long run expectation for inflation built into these securities would be in the 2.0 percent to 3.0 percent range. For myself, I find that this level of inflationary expectations over the next ten to thirty years is low. But, that is another story.

The major uncertainties in this picture? The first uncertainty pertains to the stability of the banking system. I believe, however, that the Federal Reserve will continue to flood the financial market with liquidity in order to allow the failing banks to be worked off in an orderly fashion. If this occurs, the recovery will continue but at a slow pace.

The second uncertainty pertains to state and local finance. My feeling is that the federal government will not allow this situation to get out of hand. Welcome to the bailouts of 2011.

The third uncertainty pertains to the bubbles that have been created or are being created. As we have learned, bubbles can last only so long. The question will remain about how long the bubbles created will last. Given that the Fed will continue to flood the market with liquidity, it is unlikely that the world will be bubble-free.

One thing mentioned above I believe will be an uncertainty only in timing. That is the increase in the amount of mergers and acquisitions taking place. I believe that 2011 will see a continuation in the acquisition splurge that has already started and will continue beyond this coming year. The only uncertainty related to this is the reaction of the federal government to the bigger companies. My guess is that the new Congress won’t challenge this and the Obama administration will not have the will to challenge it.

The United States Dollar in 2011

I still believe that the long term trend for the United States dollar is downward. For the near term, for 2011, I believe that the United States dollar will remain relatively strong, at least against the other major currencies in the world.

My reasoning for the belief that the long term trend for the United States dollar is downward is based on the fact that the fundamental economic policy of the United States has been and will continue to be one of credit inflation. I explain this stance using the following chart.

The general trend in the value of the United States dollar reflected in this chart is downward. If one begins in March 1973 when the value of the index was set at 100, in November 2010, the value of the dollar declined by 27 percent.

The decline in the value of the dollar since the United States floated the price of the dollar internationally in August 1971 is even greater. Rough estimates place the decline in the value of the dollar from the time it began to float against major currencies until March 1973 between 15 percent and 20 percent. This would place the decline in the value of the dollar since it was floated through November 2010 roughly at 35 percent to 40 percent.

The underlying cause of this decline in the value of the dollar began in the early 1960s as the fundamental philosophy of economic policy in the government shifted to one in which a low level of unemployment became the over-riding goal of the fiscal and monetary policies of Washington, D. C.

The immediate results of this shift in economic philosophy was the destruction of the existing “fixed-rate” international foreign exchange system as capital flows opened up throughout the world and it became impossible to maintain fixed exchange rates in the face of independent national economic policies. A world of credit inflation became the norm.

There were two interludes, that of the Volcker monetary tightening in the early 1980s and the Clinton efforts to balance the government budget in the late 1990s. These periods, however, were just temporary diversions from the basic economic thrust of the policies of both Republicans and Democrats over the full 1961 to 2010 period.

I believe that the longer term trend in the value of the United States is still downward because the fundamental economic philosophy of the United States government has not changed. Credit inflation is still the basis of any policy being proposed by the government and this has been re-iterated over and over again by the economic policy spokesman of the Obama administration, Fed chairman Ben Bernanke.

I expect that federal budget deficits over the next ten years will total more than $15 trillion and the monetary policy of the government will just support the placement of that debt over time.

I don’t see any leader in Washington with the foresight or the strength to build a more sensible economic policy. That is, I don’t see anyone “in place” or on the horizon to pull off efforts at constraint like we saw in the early 1980s or the latter part of the 1990s. Thus, the basic fundamental economic strategy of credit inflation will continue to rule Washington, D. C. for the indefinite future.

The thing that will arrest this decline in the value of the dollar in the short-run is the situation in Europe. In a real sense the United States dollar is being protected in the short-run by the fact that the lack of leadership in Europe exceeds the lack of leadership being exhibited in the United States. One does not see this situation reversing itself in 2011. The value of the United States dollar will not deteriorate further against the Euro (and some of the currencies of other major developed nations) in the coming year.

Here the scale is reversed from the above chart. The Euro weakens against the United States dollar in the early part of 2010 as the sovereign debt crisis worsened in Europe. Around June in the year some confidence picked up as the European “bailout plan” for some of the perimeter European nations seemed to be coming together. As the summer wore on, doubts arose about the potential success of the effort. This backing off continued until the speech administration spokesperson Bernanke gave at Jackson Hole, Wyoming putting forth the idea of what is now referred to as QE2, Quantitative Easing 2.

The European financial situation once again came to dominate this foreign exchange market as the problems in Greece, the accelerating political and economic problems in Ireland, were coupled with downgrades to Portuguese debt and this has now expanded to potential downgrades to Spanish debt and other “non-perimeter” countries like France and Belgium. Confidence in the leadership within the European Union continues to fall: this chaos is seen as the dominating drama still to be played out.

So to summarize: in the longer-run, the value of the dollar can be expected to decline. The reason is that the political and economic leadership of the United States does not seem to have learned much over the past 50 years. However, this decline will be further interrupted for a while as European leadership continues to exhibit its greater incompetency.

There is one other development that I think it will be important to keep one’s eye on and that is the growing movement to conduct world trade in currencies other than the United States dollar. We see that Russia and China have moved in this direction. Brazil is also interested in moving in this direction as are several other countries that have not made a “big deal” out of it yet. The important point is that the “rest of the world” seems to be moving without the United States. This is just another example of the receding influence of the United States in world economic affairs.

America Must Start Again On Financial Regulation

Henry Kaufman, the Wall Street economist who formerly worked and gained his reputation as “Dr. Doom” at Salomon Brothers, Inc., has an op-ed piece in the Financial Times that raises a point that should be considered. The title of the article: “America Must Start Again On Financial Regulation.” (http://www.ft.com/cms/s/0/0d05c9c0-0955-11e0-ada6-00144feabdc0.html#axzz18NUIeP7n)

Kaufmann’s basic point is that the Dodd-Frank Act “enshrined” the domination of big institutions in our financial system.

That is, the Dodd-Frank Act achieved just about everything it didn’t want to happen.

But, to be fair, the Obama administration efforts, not just in regulation, but also in its conduct of monetary and fiscal policy, has done about everything it can to achieve just the opposite of what it wanted to do.

And, as Ben Bernanke, the chief economic spokesman for the Obama administration has pointed out, the focus is still on unemployment and the means to bring unemployment down. The beat goes on, or the image Charles “Chuck” Prince, the former CEO and chairman of Citigroup, gave us was that “the music must keep on playing.”

For almost 65 years, the United States government has attempted to achieve something that it cannot achieve, “full employment.” This objective of the United States government was written into law, first in the full employment act of 1946 and then in the Humphrey-Hawkins full employment act of 1978.

In 1968, the economist Milton Friedman showed us that the government’s fiscal and monetary policy cannot achieve full employment. Friedman’s work, along with that of Edmund Phelps, another Nobel-prize winning economist from Columbia University, highlighted the insight that a government that brings about greater inflation cannot permanently reduce unemployment below a “natural rate of unemployment” by doing so. Unemployment may be temporarily lower than this “natural rate”, if the inflation is a surprise, but in the long run unemployment will be determined by the frictions and imperfections of the labor market.

Still, the Federal Reserve and other governmental agencies seem to act as if there is a trade-off between inflation and unemployment, a trade-off commonly called the “Phillips Curve.” Former Federal Reserve economist Ethan Harris confirms the use of the Phillips Curve in current analysis within the Fed in his book “Ben Bernanke’s Fed: The Federal Reserve after Greenspan.”

As a consequence, the United States government has followed an explicit policy of credit inflation since the early 1960s. The gross debt of the United States government has increased by more than a 7 percent compound rate of growth since 1960. This, and the accompanying monetary policy, has resulted in a massive increase of debt in the private sector accompanied by a substantial increase in risk taking. The environment has been optimal for the production of financial innovation and the massive growth of the financial industry and financial institutions.

And, everything that the federal government seems to do just further contributes to the growth of financial institutions and the growth of federal debt.

The question needs to be asked, “Why do the financial giants on Wall Street need to lobby the federal government?” One could make the argument that the federal government has basically been under-writing the growth of the financial industry and the proliferation of financial innovation for much of the last fifty years.

Maybe the efforts of the financial giants on Wall Street to “cry wolf” every time the federal government talks about regulating or re-regulating the finance industry and further lobby the federal government is just a cover.

The biggest financial institutions are doing just fine, thank you. But, they don’t want you to know it.

Many of my posts over the last year and one half have discussed the fact that the “movers and shakers” in the financial industry have come out just fine. As Kaufman asks in the above mentioned article, what happens when a large financial institution gets into trouble? The answer he gives: the only institutions that can absorb a large, troubled financial institution is another large financial institution. If Bear Stearns goes down, JPMorgan Chase picks it up. If Merrill Lynch goes down, Bank of America picks it up. The large financial institutions just get larger.

Regulation is not useless, but the misled efforts of the Congress to regulate the financial industry often overshadow the good that regulation can do. Unfortunately, Congress, in attempting to re-regulate the finance is primarily fighting the “last war”. This is always the “wrong war”.

The new regulatory environment is basically “out-of-date” on arrival. I have argued in post-after-post that the Dodd-Frank Act is a bill that is, by-in-large, irrelevant because the largest commercial banks had moved well beyond the legislation by the time that the legislation passed.

To me, the federal government needs to focus on three things going forward with respect to economic policy and financial regulation. First, the federal government needs to get its focus off of short run efforts to achieve full employment in the economy. It cannot be done and the credit inflation that follows only creates problems that must be dealt with later, as we have been dealing with the aftermath of fifty years or so of credit inflation. To reduce un-employment and under-employment, policies must be put in place that take a longer time to achieve desired results, but the results are longer lasting and more consistent with current market needs. However, this is hard for politicians to do.

Second, the government must work to obtain greater openness and transparency in the financial markets. In this information age, more and more information is readily available and should be available on a timely basis. If the Wikileaks episode shows us anything it is that in most cases it is very difficult to keep information. One would think that organizations, including financial institutions, would want to get out “ahead of the curve” with respect to providing information to the world by advocating more and more openness and transparency of their own data. If they don’t, the message is that someone else will provide the openness and transparency. Let’s “open up” in a voluntary and well-thought out way.

Third, create regulatory efforts that use market based early warning systems, like the one proposed by Oliver Hart and Luigi Zingales. (See my post http://seekingalpha.com/article/239531-are-more-stress-tests-for-the-banks-of-europe-useful.) In this information age, old-style regulation is ineffective if it is of much use at all. A lot of people are really going to have to re-think the whole regulatory environment.

The bottom line is that it appears as if we are getting “more of the same.” The only thing Bernanke knows is how to throw spaghetti against the wall. (See http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.) But, more of the same is more and more emphasis on unemployment and the provision of liquidity to the banking system. This is the short-sightedness that Milton Friedman warned us all about. I guess fifty years of economic policy failure is not enough of a lesson.

Whither Economic Policy? Whither Investments?

President Obama has returned to Washington, D. C. We are told that he plans upon his return to focus on domestic economic issues.

The president has had two weeks that have not necessarily been the best of his administration. The mid-term election did not go the way he wanted and his sojourn into the international waters of the East did not go swimmingly.

Now, where is he going to go on the economic front?

His economic team is crumbling before his eyes and Ben and Tim are not getting the best critical reviews.

The economic news is not exactly what he would like to hear. It seems as if the results the economy is posting are exactly the opposite of what he has tried to do.

The front page of the Wall Street Journal trumpets: “Paychecks for CEOs Climb”. Here are the opening words:

“The chief executives of the largest U.S. public companies enjoyed bigger paydays in their latest fiscal year, as share prices recovered and profits soared amid the country's slow emergence from recession.

At these 456 companies, the median pretax value of CEO salaries, bonuses and long-term incentives, such as grants of stock and stock options, rose by 3% to $7.23 million, according to an analysis of their latest proxy filings for The Wall Street Journal by consulting firm Hay Group.

The Journal usually tracks executive compensation each spring. To provide a fuller post-recession picture, it followed up this year by analyzing pretax CEO pay at every U.S. public company with at least $4 billion in annual revenue that filed proxy statements between Oct. 1, 2009, and Sept. 30, 2010.

The results differ markedly from the April analysis, which covered 200 such companies and found median total direct compensation had dropped 0.9%.” (http://professional.wsj.com/article/SB10001424052748704756804575608434290068118.html?mod=wsjproe_hps_MIDDLESecondNews.)

The largest companies in the United States and their chief executives seem to be doing just fine, thank you. Plus, these companies are able to raise debt at record low interest rates and they seem to be piling up cash as fast as they can.

Recent headlines also reported that the income distribution in the United States again has moved more and more toward the wealthier end of the spectrum.

And, what do the policymakers and economists supporting the administration recommend? More spending because the administration has been too timid. More liquidity for the financial markets because we are in a liquidity trap.

Will this continue to be the economic policy of the Obama administration going forward?

I see no indication that it’s economic policy will change. And, if this is the case then this environment should drive investment decisions going forward.

The foundation of these investment decisions, I believe, is that the “largest U. S. public companies” will continue to prosper. The economic policies being proposed have little or nothing to do with resolving the underlying economic imbalances that exist in the United States and that is why the recovery, as it continues, will be skewed toward the larger companies.

Of course, not all of the largest U. S. public companies are going to thrive, but I believe that this is where a lot of the action will be. The action will be in the following companies: companies that will be bought by the large companies building up the large piles of cash; the companies that are engaged in “bubble” assets like commodities, emerging market financial instruments, and bond markets; and a select few companies that are doing the buying of the smaller companies.

I don’t immediately like companies that are doing the acquiring because mergers and acquisitions don’t always work out. In fact, my research indicates that at least two-thirds of the corporate combinations don’t work out. First off, those that move earlier tend to fare better because the acquisition prices don’t get inflated until the merger frenzy progresses: followers get killed. Second, I don’t trust a lot of executives in making mergers work. So many get caught up in “ego” problems that they either overpay for the target or move to make mergers without the culture or the expertise to pull off the acquisitions.

This makes the potential targets for takeover extremely attractive. Why? Because the targets in this instance will be those companies that are not performing well due to the recession and the tepid recovery and the price of their stocks will be relatively low with few prospects, except for being acquired, for they are still basically struggling companies.

To me the pieces are in place for a substantial consolidation of companies in the United States. The largest companies have cash and will have the ability to garner much more as they need it. Note: this just came across the net: Caterpillar Strikes $7.6 Billion Deal for Bucyrus. Caterpillar is offering $92 a share in cash for Bucyrus, a 32 percent premium, as the heavy equipment colossus makes a big push into mining equipment.

Alright!

The executives of these companies stand to make lots and lots of money by making their companies bigger, whether or not they make them bigger successfully. Given the information presented above, this seems to have already started. Continuing the government’s existing
economic policy will see this environment lasting for quite some time.

Companies dealing in “bubble” assets can obviously benefit from “going to the dance.” The downside is “staying too long at the dance.” But, the Treasury and the Fed have signaled that their current policies will continue for “an extended time.” Let the music play on.

The results of this? The income distribution will continue to skew toward the wealthy end. Big businesses will get bigger. Small businesses will do alright, but they will be on the periphery not at the center and will be devoted more to upper income tastes. Employment will continue to be weak because mergers and acquisitions tend to result in layoffs and a shrinking workforce rather than an increasing one. Capital investment will not be too lively because mergers and acquisitions, at first, result in the scrapping of old physical plant and equipment and not the expansion of it.

Basically, the scenario I have described translates in the following way: the stimulus is going to be paper, and, therefore, the profits and wealth that are going to be created are going to be primarily paper.

Money will be made in this environment…lots of it! Just don’t remain too long at the dance!

China Buys the World

I missed the news.

And, I presume a lot of others also missed the news.

“In the weeks ahead, a 104-year-old unit of General Motors will be sold to new owners from China. The unit made steering equipment for decades under the name Saginaw Steering Gear. Now known as Nexteer, it employs 8,300 people around the world. It new Beijing owners call themselves Pacific Century Motors.” (http://professional.wsj.com/article/SB10001424052748703957804575602943255219552.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

China is, and has been, buying companies throughout the world.

“But,” the above article goes on, “it is one of the landmark deals of the era, the first time Chinese investors have bought a U. S. industrial operation of such scale and history: Twenty-two factories around the globe, six engineering centers, 14 customer-support centers.”

The only direct way to stop this activity is through capital controls and other forms of protectionism.

The United States Congress did balk at some earlier attempts by China to purchase U. S. companies that were considered to be threatening to American security interests. Still, China continues to seek out and acquire United States companies.

I have mentioned this behavior on the part of the Chinese before. But, the Chinese are not alone…other emerging countries are engaging in the purchase of American companies as well.

And, the United States government continues to feed China and these other countries with the means to buy American countries.

“Ironically, at the G-20 conference in Seoul this week, U. S. leaders are trying to cajole China to buy more from the U. S., to help right a trade deficit that hit $28 billion in August alone. Such imbalances, they say, helped feed the credit craze that culminated in the 2008 financial crisis.”

In my mind, the “U. S. leaders” don’t get it!

The United States government continues to inflate the world with dollars and dollar-denominated U. S. Treasury securities and then encourages these foreign governments to buy American companies to combat the trade deficits that they have been instrumental in creating.

What am I missing here?

The United States government is inflating the world with dollars because the unemployment rate is too high and then encouraging foreign governments to buy American companies to put these people back to work again.

Again, what am I missing here?

And, why should the Chinese government want the situation to change. The Chinese government is in the driver’s seat and the United States is just feeding it with the means to buy companies both in the United States and in the rest of the world.

The Chinese have no reason to change the existing situation.

And, as long as the leaders in the United States government keep pointing their fingers at the Chinese and saying that the problem is out there…the problem will be that of the United States continuing to feed the rest of the world the means to acquire America.

But, this will not continue forever. The United States Congress will not allow it.

The threat, then, is as described by the German chancellor Angela Merkel stated in an interview with the Financial Times, is the imposition of controls and protectionism. (http://www.ft.com/cms/s/0/3cb912ca-eb6f-11df-b482-00144feab49a.html#axzz14tWucN4h)

This will not be good for either world trade or for international cooperation and peace.

But, the United States government shows no inclination to change its behavior. The leaders in the government are still working off of an outdated and inappropriate economic model. They are also working with an outdated ego that claims that America can still “go-it-alone” in the world.

Unfortunately, these outdated ideas are working entirely against what the United States would like to achieve. It is hard when you are your own worst enemy!

And, the United States continues to shoot itself in the foot. There is an excellent op-ed piece in the Wall Street Journal this morning by Alan Reynolds. (See Ben Bernanke’s Impossible Dream”: http://professional.wsj.com/article/SB10001424052702303467004575574610003111250.html?mod=ITP_opinion_0&mg=reno-wsj)

Although though Reynolds concentrates the focus of the article on the Bubble Ben’s quantitative easing plan, I could not help but think about who would benefit from the consequences of the “easing” that is presented. All the consequences described by Reynolds will benefit the wealthy because they are the only ones that are in a position to take advantage of the incentives that will be created by the quantitative easing.

This policy, then, will have three ultimate effects. First, income (wealth) inequality will continue to increase in the United States. The economic policies followed by the United States over the past fifty years which are just variations on the quantitative easing policy, have created a massive shift toward a more unequal distribution of income (wealth) in America. But, in an attempt to help the less-well-off, the government will continue to follow its existing policy-prescriptions.

Second, the United States will continue to become less and less productive. This is one of the criticisms leveled by Wolfgang Schäuble, the German Finance Minister. Schäuble stated that the reason for the strength of German exports was the fact that German industry was so effectively productive. He implied that other countries, like the United States, were not as competitive. The United States will be even less so if the results Reynolds foresees are achieved.

Third, given the current economic philosophy of the United States government, the leaders of the government will continue to combat this loss of competitiveness by “more-of-the-same” in terms of economic policies. This will just continue to hand the Chinese, and others, the means to acquire American companies.

Following such a path will result in the Obama administration achieving exactly what it does not want to happen. But, this is precisely what the Obama administration has achieved in the less than two years it has been in charge of the United States government.

And, why should China want anything different?

"Remember Bush Appointed Bernanke"--President Obama

In this mid-term election season in the United States, President Obama has blamed everything else related to the state of the economy on Bush 43. It makes sense to also blame the appointment of Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve System on Bush 43 as well.

Almost everything that Bernanke has done has been wrong. The only thing people can really give him credit for is for throwing enough spaghetti against the wall in late 2008 so that some of it would stick to the wall. But, even this action may have resulted in action from an emotional scare that was something less than rational. See “The Bailout Plan: Did Bernanke Panic?” (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

Now we stand on the verge of another round of spaghetti tossing. The Fed, and many other central banks around the world, are meeting this week. “This week’s meetings are the greatest concentration of monetary-policy action by leading central banks since the first week of October 2008, when they met in emergency sessions to fight the global financial crisis.” (http://www.bloomberg.com/news/2010-11-01/thirty-three-hour-marathon-may-induce-ecb-surrender-as-fed-weakens-dollar.html)

The Washington Post puts it very bluntly: “Federal Reserve’s Bernanke on Line with New Move to Boost Economy” (http://www.washingtonpost.com/wp-dyn/content/article/2010/10/31/AR2010103103818.html?hpid=topnews). “The Federal Reserve is preparing to put its credibility on the line as it rarely has before by taking dramatic new action this week to try jolting the economy out of its slumber.”

This action just re-enforces the desperation of current policy makers. Their model is wrong, yet they persist in trying to make it work. (http://seekingalpha.com/article/232971-international-capital-mobility-the-united-states-dilemma) People are always their most desperate when they are losing control. In an effort to re-gain control they try more and more of the same old medicine.

How do you like this quote? “We’re very concerned about what to do. One thing we know is that when the bond rally ends, it will not end well.” This quote is attributed to Bob Michele, the chief investment officer at JPMorgan Asset Management. (http://www.ft.com/cms/s/0/d7abb7c2-e51d-11df-8e0d-00144feabdc0.html)

In addition, this behavior on the part of the Federal Reserve System and of the Obama administration is undermining confidence in political relationships around the world. “Traders are losing confidence in Group of 20 finance officials’ pledge to avoid foreign-exchange manipulation, less than a week after the leaders vowed to stop devaluing currencies to prop up their economies.” (See “Currency Swings Show G-20 Faith Fading as Korea Eyes Controls,” (http://www.bloomberg.com/news/2010-11-01/currency-swings-show-traders-losing-faith-in-g-20-as-korea-eyes-controls.html).

This comes after the feeble attempts of Treasury Secretary Geitner to get China to act in the interests of the United States. Again, this can be seen as a seemingly desperate try to put the blame on someone else.

The G-20, under these circumstances, is incapable of making an enforceable pledge. (See “The Do-Nothing G-20”: http://seekingalpha.com/article/232007-the-do-nothing-g20.)

As long as the United States continues to persist in its current policy stance things will not change. The Obama administration, plus the Federal Reserve, has made it very clear what their policy is going to be. And, since the rest of the world knows what the Federal Reserve policy will be, the rest of the world will act accordingly,

Consequently, this just makes the United States a sitting duck!

But, Bush 43 appointed Bernanke. Oh, yes, President Obama re-appointed him, but like TARP and some other things, a president cannot just eliminate the past. A president has live with some of the decisions of his predecessor. Right?

The world is waiting for the results of the meeting of the Board of Governors of the Federal Reserve System on November 2 and 3. The European Central Bank, the Bank of England, the Bank of Japan and the Reserve Bank of Australia also have meetings scheduled for this week. We may look back on this week as another significant date in the history of the Great Recession of 2008-2009 and its aftermath.

Unfortunately for President Obama, the legacy appointment of Ben Bernanke may play a large role in the definition of his place in history.

The Basics of Turnarounds: the United States Situation

A part of my life has been connected with company turnarounds, bank turnarounds to be more precise. I would suggest that the United States is in a turnaround situation right now but its leaders claim that the economic model it is using is still relevant and that all that is needed is a little more time and a little more co-operation from others and everything will turn out alright.

My experience has led me to some conclusions about what is needed in a turnaround situation. (By-the-way, all my turnarounds were successful and I can say that now because I am not doing turnarounds any more.) We don’t have much space to discuss these things so let me just summarize what I believe to be the four most important factors in achieving a turnaround: the business model; information coming from the market place; the need for transparency and openness; and the existing business culture.

Although these factors relate to a business situation, I believe that they can be applied to any “turnaround” situation, including the “turnaround” of a government.

First, and foremost, an organization gets into trouble because its business model, or economic model, is not working. But, because a leader or a management team believes that the organization has gotten where it is because of that business model, they tend to stick with the model and apply the model even more forcefully.

In some cases, the success of the model has come because of the timing of the model’s use and not because of any inherent characteristics of the model are correct. To justify this statement I refer the reader to the book “Fooled By Randomness,” by Nassim Nicholas Taleb.

In terms of the economic model that the United States government is applying, and has been applying for a very long time, there is no real evidence that it works. I am, of course, speaking of the Keynesian macro-economic model.

Ever since the 1930s when the model was first presented, all I have ever heard in times of difficulty is that the reason the Keynesian model falls short is that not enough stimulus has been forthcoming. Keynesian economists contend that the Great Depression continued on for as long as it did because governments did not create sufficient budget deficits. Only the war effort, World War II, got the US out.

This criticism has been applied over and over again during the last fifty years. All we have been hearing from the fundamentalist preacher Paul Krugman is that the Obama stimulus package must be greater. He has been consistent in applying this remedy since early on in the Great Recession. More spending, more, more!

Maybe the economic model the government is using is wrong!
The application of this model over the past fifty years has produced falling capacity utilization, rising under-employment, and greater income inequality.

Maybe the economic model has not been applied correctly!

Defensive comments like these are heard over and over again within a company that is in decline.

Second, it seems that others recognize the decline in the company even though the leaders and management of the organization do not. That is, the market recognizes that the model of the organization is not working and that the organization is in decline.

And, what is the response of the leaders or managements of the targeted organization. The response is “The market doesn’t understand us!” I don’t know how many CEOs I have heard express this sentiment in the face of a falling stock price.

The thing is, the market does understand the company and the fact that the company is applying an inappropriate business model.

The market response to the economic policy of the United States? Well, the behavior of the United States government in the 1960s resulted in the need for the United States to go off the gold standard. Since the United States has been off the gold standard, the value of the United States dollar has declined almost constantly (with the two exceptions, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve system and during the 1990s when Robert Rubin was the Secretary of the Treasury).

Obviously, for the value of the United States dollar to substantially fall, almost continuously, over a fifty year period, indicates that something must be wrong with the economic model the government is using. During the past fifty years, the government has relied on a credit inflation whose foundation is a federal deficit that has resulted in the federal debt increasing at an annual compound rate of growth of more than 9% over this time period. The government has created other avenues of credit inflation through programs like those built for housing and home ownership. The whole economic model was based upon inflating the economy causing people to constantly “leverage up” and take on more and more risk.

Third, transparency and openness goes by the wayside as organizations experience decline. Cover ups abound! President Obama came into office declaring that he was going to change the way things are done in Washington. Yet, his administration is now charged with opaqueness and obfuscation like every other presidential administration. Even little bits of information, like the recent report by the special inspector of the TARP program, only adds to the accusation that this administration is hiding things. This was in all the papers this morning. (See “Treasury Hid A. I. G. Loss, Report Says,” http://www.nytimes.com/2010/10/26/business/26tarp.html?ref=business.) This does not help!

Fourth, the culture of an organization begins at the top. In a turnaround situation, a new culture
must be implemented and that culture must begin with Number One. The new leader that takes on a turnaround situation must change the way things are done and introduce a new business or economic model into the organization.

However, this new business model cannot be introduced or implemented if the (new) leader assumes that little or nothing needs to be changed. And, this implementation cannot be carried off unless the members of his or her team are all on board.

In my view, things need to be changed in Washington, D. C. The evidence in the market place is hard to ignore, although Washington has done its best to shift attention to others. But, the weakness of the United States position has been observed and others (China, Brazil, and India, and others) have moved into the void to take advantage of it. (See my post http://seekingalpha.com/article/229112-the-imf-bowl-u-s-vs-china.)

Even if the philosophy of economic policy used by the United States government was appropriate forty or fifty years ago, things have changed since then. (See my post http://seekingalpha.com/article/232044-maybe-things-have-changed.) The United States needs to be “turned around”. But, to do a turnaround, those that are in leadership positions must accept the fact that a turnaround is necessary. I don’t see this happening any time soon.

"Astonishing" Pricing Anomalies

I believe the article “Hedge Funds Reap Rewards from Treasuries” in the Financial Times is a good read for people interested in the financial markets. (See http://www.ft.com/cms/s/0/a5aa3c38-c111-11df-afe0-00144feab49a.html.)

The authors, Sam Jones and Izabella Kaminska, start right out talking about “Classic relative value arbitrage” the investment strategy which “involves betting that price discrepancies between securities that normally trade at similar values should correct over time.” The implosion of Long-Term Capital Management brought this strategy to public notice.

Hedge funds have been making a “pretty penny” recently by taking positions based upon this strategy. The reason why a strategy like this has been working is that there are “astonishing” pricing anomalies being observed in the financial markets ever since the collapse of Lehman Brothers in September 2008.

Why have these anomalies occurred?

Thank you Mr. Bernanke and the Federal Reserve System!

“Instruments that should normally track each other almost perfectly saw their prices diverge sharply as investors panicked and central banks, including the US Federal Reserve distorted bond demand by buying up huge amounts of debt as part of the emergency efforts to pump more money into the economy.”

“Thanks to continued distortions in bond supply and demand, as well as jittery investors and political intervention, funds…have been able to exploit a rich seam of arbitrage opportunities.”

These opportunities have been “less risky” than might have been expected because the promise Mr. Bernanke and the Federal Reserve have made that their interest rate policy will continue for “an extended period.” So far, that period has lasted for twenty-one months and most expect it to remain in place into next spring…at least.

I have been arguing for months now that the interest rate policy of the Federal Reserve has been accounting for the profit recovery of the biggest banks in the United States. This interest rate policy has been subsidizing the big banks and has been producing a counterpoint within the government to the attack on those banks that are considered “too big to fail.” The Fed’s policy has been underwriting the process in which the big banks will get bigger and control more and more of the assets in the banking system as a whole.

The material being reported by Jones and Kaminska is the first piece of information outside of the commercial banking industry of how the Federal Reserve (and other central banks) have been underwriting the success of participants in other areas of the capital market.

“If 2009 was an excellent year, then 2010 is still a very good year. The opportunities are huge in some cases,” says Bob Treue, founder of the hedge fund Barnegat.

My best guess is that we will be seeing more evidence pointing to exceptional returns being made on the financial market distortions created by the Federal Reserve. One can also surmise that many, many other representatives of the wealthy are making huge gains on these market situations and we will never know about them because they will not have to be reported.

I am not against people making money. Actually, I am very much in favor of this result.

What I am concerned about is that the money that is being made on these arbitrage transactions is a part of explicit government policy and that the consequences of this explicit government policy contradicts almost all of what the Obama administration is saying it is trying to achieve!

The only justification that I can give for why the government is engaged in this contradictory behavior is that it knows something we don’t and that something it knows would be tremendously scary to us if we knew it.

Real World Lessons of the Obama Administration

There are two things that some of President Obama’s base is finding out. First, you just cannot walk away from war. Before you are “in the office” you can say all you want about ending wars or not getting into wars, but once “you get the seat” just being against war is not a sufficient policy. There are dumb wars and there are smart wars; there are well run wars and there are stupidly run wars; but wars are always present in one way or another. To many of President Obama’s supporters, President Obama is not walking away from war, and they don’t like it!

The second thing is that powerful nations need a healthy business sector. Regardless of how important you feel the role of government is in a society, without a strong economic system that is performing well your government will always be weak relative to other countries that have strong economic systems that are performing well.

I addressed this point from a different perspective in a recent post: see “Emerging Markets and the Future”, http://seekingalpha.com/article/214661-emerging-markets-and-the-future. One can deduce a similar point from Floyd Norris in today’s New York Times, “How to Tell A Nation Is at Risk,” http://www.nytimes.com/2010/07/16/business/economy/16norris.html?_r=1&hp.

Norris writes: “Which governments will not be able to pay their bills?

The ones with private sectors that are not doing well enough to bail out the government.

That should be one lesson of the near default this year of the Greek government. Government finances are important, but in the end it is the private sector that matters most.

If so, those who focus on fiscal policy may be missing important things. Spain appeared to be in fine shape, with government surpluses, before the recession hit. Now Spain is being downgraded and has soaring deficits.”

The take away from these two pieces: You need to have a strong, vibrant capitalistic system in place, even if it is a state driven capitalism like that of China. The exception is those despotic nations that have a monopoly on a natural resource like Venezuela or many of the middle eastern fiefdoms, but these situations have their own problems. Economic weakness and slow growth lead to waning economic power. Check out much of Europe.

Today’s New York Times was filled with signs that the Obama administration was cognizant of the role the business sector must play in the economy in order to ensure its success and continuation. On the front page of the Times we read of the “Obama Victory” with respect to the financial reform package. This is the coin thrown to some of his supporters.

The real news, to me, is on the front page of the business sector in bold headlines: “Cut Back, Banks See a Chance to Grow: Its fight ended, Wall St. Is Already Working Around New Regulations.” (See http://www.nytimes.com/2010/07/16/business/16wall.html?ref=business.)

Funny, but some of this article seems especially like my recent post “Financial Reform: Ho, Hum”, http://seekingalpha.com/article/213263-financial-reform-ho-hum. The authors of the Times article write:

“The ink is not even dry on the new rules for Wall Street, and already, the bankers are a step ahead of everyone else…

So after spending many millions of dollars to lobby against the legislation, bankers are now turning to Plan B: Adapting to the rules and turning them to their advantage."

The Obama administration and those in Congress that wrote the bill had to have enough in the bill to “declare a win” but many are looking at the legislation as just a cost and an inconvenience. Main street must be given something to justify the possibility of re-electing those currently in office. But, Wall Street must be healthy so that the Administration can stand up to China!

Financial institutions spent a lot to keep a lid on Congress and its “spewing into the gulp” and in this respect have been more successful than BP with its oil spill. But, now that the cap is on in terms of the financial reform bill going to the President, it is time to get back to business. And, really, that is what the administration wants as well.

The third important headline on the front page of the business section (the other two articles were there too) is “With Token Settlement, Blankfein Unscathed”, http://www.nytimes.com/2010/07/16/business/16deal.html?ref=business. The New York Times claims that the deal Goldman Sachs reached with the Securities and Exchange Commission was a “Token”…mere pocket change. The people from the S. E. C. declared this to be a victory. What a joke! Well, now we can get back to business!

Just one more piece of information being shared this morning: Treasury Secretary Tim Geithner seems to be very opposed to Elizabeth Warren becoming the head of the new consumer protection agency created by the financial reform package. She is apparently too strong, too emotional of an advocate for the consumer. It seems as if such a person would rock the boat.

The reality of the situation seems to be that the Obama administration needs a strong, rebounding economy. It needs a strong, rebounding economy to not lose much ground in the elections this November. And, it needs a strong, rebounding economy to give the United States more bargaining power in the world.

The United States is still the number one economic and military power in the world. It is just that at this time, with a somewhat weakened economy, room is given to those large emerging nations to be more assertive in world affairs and to gain confidence in their ability to present their positions in world forums. Again, see my post on “Emerging Markets and the Future.”

The Obama administration is walking a narrow line. It cannot afford to lose the support it has been given in the past by the Independent voter and the middle of the political spectrum. And, it cannot afford to be captive of the sovereign wealth funds of the world that control large amounts of financial capital.

In order to achieve these goals, the Obama administration cannot stifle the United States business engine. The issue it now faces is how to support Wall Street and business without appearing to be abandoning Main Street. The danger the administration runs is that in attempting to walk this narrow line, it might not please anybody.

Hotshot Traders Leave Street

Jenny Strasburg captures the mood on Wall Street in her article in the Wall Street Journal this morning: http://online.wsj.com/article/SB20001424052748704515704575282982462922628.html#mod=todays_us_money_and_investing.
“The competition is on to scoop up Wall Street traders and portfolio managers increasingly unnerved by the likelihood of sweeping new financial regulation.

Since political momentum began building earlier this year to limit trading for profit at Wall Street firms, traders have been exploring their options, and some have already left. Outside the banks, private investment funds looking for traders have been gearing up for a hot talent market.”

Economics works!

You change the incentives and people change…people move.

With the situation being more mobile than ever, with the technology more available and adaptable than ever, with the future more uncertain than ever…people…and the system…can change more rapidly and in more different directions than ever before.

And, that is what is happening!

This is one thing that Congress (and others) can’t seem to understand. Even after observing fifty years of the most dramatic financial innovation that has ever taken place in the world, the members of Congress seem to believe that they can “freeze” things, return to the past, and prevent the recent financial crisis from ever occurring again.

They also seem to think that the government is blameless from creating any incentives that might have a derogatory impact on the future that they want to create.

People in the Obama administration, as well as members of Congress, seem oblivious to the fact that over the last fifty years the United States government, Republicans and Democrats alike, produced a fiscal environment that created the incentives that led to a burst of innovative activity in the financial sector that produced massive changes in the way people did business and in the composition of the American economy. A brief picture of the environment.

From January 1961 through January 2009, the Gross Federal Debt of the United States rose at a compound annual rate of 7.7%. The monetized portion of the federal debt, the monetary base, rose at a compound rate of about 6.5% from January 1961 through August 2008, just before the Federal Reserve’s balance sheet exploded in response to the financial crisis that took place in the fall of 2008. The M2 money stock grew by more than a compound rate of 7.0% during the time period under review.

Thus, money and credit variables grew relatively in line with one another. Real GDP growth during this time was about a 3.4% compound rate of increase every year.

Prices, as measured by the Consumer Price Index and the GDP implicit price deflator, increased at a compound rate of about 4% during this time period resulting in a decline in the purchasing power of the dollar by around 85%. A 1961 dollar bill could only buy 15 cents worth of goods in 2008!

Inflation breeds financial innovation and the late 20th century with its relatively moderate, yet steady increase in prices, was a perfect environment for financial innovation!

The leader in financial innovation was the federal government itself, confirming what Niall Ferguson argues in his wonderful book, “The Ascent of Money: A Financial History of the World.” Ferguson claims that governments, historically, have been the primary financial innovator because of the need to fight wars. This, he continues, spilled over into the 20th century as governments needed to expand deficit financing to incorporate spending on social programs.

My guess is that in the next five to ten years we will see the biggest change in finance that we have ever seen and this change will be worldwide. I have written a little on this in a recent blog: “Changes Continue to Shakeup the Banking System”. See http://seekingalpha.com/article/200475-changes-continue-to-shake-up-the-banking-system.

The largest twenty-five banks in the United States, who control about two-thirds of U. S. banking assets in the country, are already changing their business. Again, they have already moved beyond what Congress and the administration are doing to regulate the banking system.

More important, foreign banks are changing the banking picture in the United States. Currently, foreign branches control about 11% of the total banking assets in the country. I have already stated that this will increase to 15% to 20% over the next five years or so. We see this expansion taking place before our eyes. Yesterday “China Finds a New Market for Loans: U. S.” (See http://online.wsj.com/article/SB10001424052748703957604575273011917977450.html#mod=todays_us_money_and_investing.) Today, “China Bank IPO, Possibly Biggest Ever, Set for July.” (See http://online.wsj.com/article/SB20001424052748704875604575281690877047522.html#mod=todays_us_money_and_investing.) And, don’t forget the sovereign wealth funds, huge accumulators of money.

The world of finance is changing because the incentives affecting finance are changing all over the world. I can’t even imagine what this world will look like with instantaneous trading, further ‘slicing and dicing’ of cash flows and other financial information, greater use of information theory to detect trading patterns (see my book review of “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson), and more and more information markets popping up around the world (see Robert Shiller’s book “The New Financial Order: Risk in the 21st Century”)!

In the field of Complexity Theory, researchers speak of times like this when systems go through the process they call “Emergence” and “Self-Organization.” It is during times like these that one structural system is transitioning into another structural system. The problem is that no one, before-the-fact, can predict how existing information systems combine with other information to produce the resulting system. Systems just “self-organize” and a new system “emerges” from what was formerly un-organized.

This appears to be what is happening now. The movement of “hotshot” traders is one piece of evidence of this. The restructuring of the big banks is another piece of evidence. The response of hedge funds to the Congressional threat to change how partners are paid is evidence of this. The changes in financial regulations around the world is evidence of this. The growth and increased aggressiveness of Chinese banks is evidence of this. And, so on and so forth.

Congress is just speeding this change along. However, they better be careful about what they wish for because my best guess is that what they get will be nothing like what they are planning for.