Debt Deflation: Is It a Possibility?

There is still too much debt around.  The fact that there is too much debt around is a result of fifty years of credit inflation and financial innovation that resulted from it. 

The concern now as financial deleveraging takes place is whether or not we will go into a spiral of debt deflation.

The headlines currently are coming out of Europe.  Austerity plans are forthcoming everywhere.  Sovereign debt is the crowning issue…but there is growing concerns over corporate debt. 

And, with the cutback in government spending, the cutback in business spending, and the cutback in personal spending people are getting gloomier and gloomier about a new, European recession.  The clouds seem to be on the horizon.

But, a spillover of a European recession would be another American recession.  The United States depends upon the exports that it sells to Europe.  If Europe goes into a recession then the probability of the United States going into another recession increases. 

The problem is that America still has lots of problems on its own.  Just note some of the issues that have recently been floating around.

For one, corporate bankruptcies still are taking place on a regular basis.  Just recently we have Solyndra going bankrupt which brought attention to the solar industry area as a source of more financial difficulties.  Then we had Syms and its Filene’s Basement go into bankruptcy.  And, then who could forget MF Global.  And, there are many more still on the edge of considering such action…one of them possibly being Kodak.

And, what about the financially tenuous position of state and local governments?  Just Wednesday, Jefferson County, Alabama filed for the largest municipal bankruptcy in United States history.  And, Harrisburg, Pennsylvania was just taken over by the state of Pennsylvania because of its financial problems.  Now we learn that Flint, Michigan is on the verge of insolvency where the state government will takeover there.  And, what about Detroit, Michigan?  Again, the state is about to take over this financially distressed city.  And, there are many more still cities and states still on the edge of financial ruin with underfunded pension funds and so on.

Then we hear that mortgage problem is still not over and that banks are facing further write-downs of the mortgages on their books.   The latest case is that of HSBC which has garnered all sorts of attention over the past few days.   HSBC is still paying for its move into subprime loans earlier.  But, it is also facing a relatively new thing…a customer taking a mortgage payment “holiday.”  Given the political climate financial institutions are finding that people feel that they have very little to lose if they just stop payments on their mortgages.  Banks are finding it very difficult to foreclose on delinquent properties these days and that people fear little retribution if they just quit on any kind of payment to the bank. 

“Customers realized that if they stop paying, there’s very little we (HSBC) oar other banks can do.  This is an emerging trend.” (http://dealbook.nytimes.com/2011/11/09/hsbc-warns-of-economic-challanges-even-as-profit-rises-66/?scp=3&sq=julia%20werdigier&st=Search)

The commercial real estate market is not in very good shape either.  Although commercial real estate is picking up in some areas of the country, a look at the commercial banking data indicates that loans on commercial real estate is the item that is declining the fastest on the balance sheets of commercial banks…especially those that are smaller than the largest 25 in the country. 

Of course, these problems come through when we consider the condition of the banking system.  The commercial banking industry is still not very healthy yet and the prospect of it getting much better through 2012 is not that great.  Many small- and medium-sized banks are still really suffering. (http://seekingalpha.com/article/303929-business-lending-is-increasing-especially-at-the-largest-u-s-banks)

The Federal Reserve can’t really afford to tighten up at all because of the weakness that still exists within much of the banking system.  (See my post, “Post QE2 Federal Reserve Watch: Part 3” of November 7: http://maseportfolio.blogspot.com/. ) And, the FDIC still continues to close two banks per week and this does not include any banks that have been acquired and absorbed into other banks within the system.

The general desire within the economies of both Europe and the United States is to continue to shed debt…to de-leverage.  But, if this de-leveraging takes place at the same time that the economies of Europe and the United States go into another recession, the situation can become a cumulative one.  That is, de-leveraging can contribute to slower economic growth or even declining growth, which leads to more de-leveraging, which leads to even slower economic growth and so on.

This is a debt deflation.

We are not there yet, but, it seems as if we are edging closer to the precipice. 

The problem seems to be that this situation cannot be undone by fiscal stimulus.  If people want to de-leverage they will de-leverage.  Adding more debt to the situation, even government debt created through more government spending, does not help the situation as the “fundamentalist” Keynesian would like to think.  More debt implies more taxes in the future, which just adds that much more of a burden to the person trying to de-leverage.  And, maybe, this just adds incentives to the equation leading the individual to take a debt payment “holiday”.

But, more debt write-downs can cause more debt write-downs.  And, this is the problem of a debt deflation.  It can become cumulative.  And, this is something the Keynesian models cannot pick up.

And, writing down debt for some people just means that someone else has to “eat” the loss elsewhere…and then someone else has to take a loss…and so on and so forth.  The consequences of debt do not just go away. 

The dilemma: if fiscal spending is not an option and monetary policy is basically “spent”, what is there left to do?  Not much?  Is the problem of creating a situation where there is too much debt outstanding that you just have to wait until people work off the excess debt?

This is a conclusion that most people don’t like.

Read My Lips! Too Much Debt!

People and businesses leverage when an economy expands over an extended period of time.  The last major period of leveraging in the United States occurred over the past fifty years beginning in the early 1960s.  This was a period of sustained credit inflation that resulted in an 85% decline in the purchasing power of the dollar. 

People and businesses de-leverage when the economy reaches an unsustainable level of debt and that de-leveraging can take a substantial period of time. 

Research by Carmen Reinhart of the Peterson Institute and her husband Vincent Reinhart of the American Enterprise Institute has suggested that “excessive debt could be corrected only by a long period of deleveraging.” (See the article “Running Out of Road” in the June 18, 2011 copy of The Economist, pages 77-78.)

De-leveraging also means, in aggregate, that increases in lending (debt creation) will not become too buoyant during the restructuring of balance sheets. 

Consequently, de-leveraging will tend to reduce the multiplier effect of any fiscal stimulus program and the creation of more debt through fiscal stimulus will only add an additional burden on the economy that is trying to get its balance sheet back under control.

The desperate hope to counter this de-leveraging is to flood the financial markets with liquidity and pray that the printing of money will somehow stop the de-leveraging and make debt acceptable once again. Hence, QE2!

A caveat here: there are a number of large companies that came out of the Great Recession with their balance sheets well in hand.  For example, Microsoft was one of these companies.  Many of these companies have issued debt over the past year or so to build up cash reserves to acquire other companies that have been overleveraged and are not in such good financial shape. This generally represents a separation in the market between large organizations and all others.

Thus, the only way this de-leveraging will be overcome is by reducing the real value of the debt through a period of credit inflation like the one experienced over the past fifty years.  Otherwise, the debt levels are not sustainable.  Efforts to bail out the people, businesses, and governments that have issued too much debt will only postpone the problem.  The debt levels will have to be reduced sometime…now or in the future. 

The debt loads that people, businesses, and governments are carrying seem to be un-sustainable, even with the very, very loose monetary policy.  For example, household liabilities have declined by a little more than $600 billion since the recession began in December 2007, but the total amount of household debt still totals a little more than appeared on the household balance sheets in the second quarter of 2007. 

Household debt at the start of 2011 is almost double the amount of household debt that existed at the start of the year 2000.  This represents a compound rate of increase of more than 8 percent per year.  One could argue that this rate of increase is not sustainable given that over the long haul the real economy grows only slightly more than 3 percent per year.

Total business debt shows roughly the same pattern.  This debt has declined by a little more than $160 billion from the start of the recession to the first quarter of 2011.  However, the current total is around the same level it was in the third quarter of 2008 indicating that in total, businesses have not accomplished a great deal of de-leveraging to this point. 

And, the debt problem is also entangled with the ability of people and businesses to unravel their situations through foreclosure and bankruptcy proceedings.  Foreclosures take time.  If people or businesses are in foreclosure but these foreclosure proceedings take longer and longer to work out, the economic units involved in the proceedings will be more or less relegated to the sidelines in terms of any additional borrowing or spending. 

An instructive article appeared on the front page of the New York Times yesterday. (“Backlog of Cases Gives a Reprieve on Foreclosures,” http://www.nytimes.com/2011/06/19/business/19foreclosure.html?_r=1&scp=2&sq=foreclosure&st=cse.) “In New York State, it would take lenders 62 years at their current pace, the longest time frame in the nation, to repossess the 213,000 houses now in severe default or foreclosure, according to calculations by LPS Applied Analytics, a prominent real estate data firm.
Clearing the pipeline in New Jersey, which like New York handles foreclosures through the courts, would take 49 years. In Florida, Massachusetts and Illinois, it would take a decade.“
And, this problem is not easing.  In May 2011, total foreclosures in the United States totaled 1,736,724.  Six months earlier the total was 1,682,499.  And the number of sales has declined reflecting the back up in the whole foreclosure process. 
Personal bankruptcies are down but are still running near record rates of 1,450,000 to 1,500,000 per year.  In 2010 there were only 56,425 business bankruptcies, down from 60,851 in 2009.  For the first three months of 2011, business bankruptcies are running around a 50,000 annual rate, far above the figures for the rest of the 2000s.
And, this doesn’t even get into the problems connected with the debt of state and local governments. 
Debt loads must be reduced sometime…in one way or another.  People, businesses, and governments are still carrying too much debt.  And, more and more federal government debt does not really help the situation.  A good portion of the debt must be repaid.
This is the drag on the economy.  And, until a lot of this load is worked off…in one way or another…economic growth will remain weak. 
Why hasn’t this gotten the notice it should in all the discussions going on? 
Because almost all of the economic models used to predict economic activity do not contain information on debt levels and leverage.  The reason is that debt levels and leverage levels are quite subjective over time and depend upon what governments are doing and what people believe to be acceptable.  These decisions vary from cycle to cycle and are extremely hard to model.  Furthermore, as the Reinhart’s have argued, there has not been a sufficient amount of data available to adequately study the influence of debt on economic activity.
My conclusion from this information is that the major problem facing the western countries now is that there is too much debt outstanding.
And, when I look at how the system is working off this debt I can only conclude that there is still a long way to go before people, businesses, and government get to levels of debt that are sustainable.  Even QE2 does not seem to be shaking these economic units from their desire to rebalance their balance sheets.  There is just too much debt still in the system and it doesn’t need more.

The Consequences of Debt Are All Around Us

Why isn’t the economy expanding at a faster pace?  Why aren’t consumers spending as robustly as they have in the past?  Why aren’t banks lending?

The answer has to do with either the debt still on the balance sheets of businesses, banks, and households, or the remains left by the debt that was created over the past fifty years.

We see the consequences of the half-century debt binge posted all over…on the Internet, in newspapers, and on radio and television.  Lots and lots of debt or the results of debt everywhere. 

Of course, the Greek debt situation is all over the papers this morning  In addition, the Socialists lost control of many local governmental bodies in Spain on Sunday, giving rise to fears that large amounts of unrecorded debt in many of these units will be discovered as a result of the change in government. (http://seekingalpha.com/article/271083-the-global-economy-debt-and-accounting-gimmicks)   

State and local governments in the United States are offering thanks that the media attention has shifted from them to the European entities.  But, the debt problems of state and local governments will not go away…so just wait!

The most important news this morning, to me, is the attention given to the banking systems of both Europe and the United States.

The headline in the Wall Street Journal proclaims, “Buyers Battle for Europe’s Bad Loans,” (http://professional.wsj.com/article/SB10001424052748704083904576335510788215984.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) “The push by banks across Europe to clean up their balance sheets is causing a feeding frenzy among hedge funds and private-equity firms hungry for their troubled assets.”

“Banks from the U.K., Ireland, Germany, Austria, Greece, Italy, Portugal and Spain have been unloading tens of billions of dollars worth of assets…”

Marathon Asset Management LP, for example, is reported to have purchased bank assets “usually in batches of $25 million to $100 million, at discounts of as much as 50% of their face value.” 

“European banks are sitting on more than €1.3 trillion ($1.9 trillion) of loans that are considered ‘non-core’ to their businesses and are likely to be put up for sale over the next decade.”

“In the U.S., a similar process has been going on for years…Until recently, European regulators generally were content to let their banks work through their problems over time.” 

Europe’s sovereign-debt crisis put an end to that!

The point is that there is still a “ton” of debt “out there” that is being written down or is going to be written down and still has to be “worked out.” 

In other words, the economies of Europe and the United States are not fully out-of-the-woods.

The “working out” part of this statement is captured in the New York Times headline, “Banks Amass Glut of Homes, Chilling Sales” (http://www.nytimes.com/2011/05/23/business/economy/23glut.html?_r=1&hp). “The nation’s biggest banks and mortgage lenders have steadily amassed real estate empires, acquiring a glut of foreclosed homes that threatens to deepen the housing slump and create a further drag on the economic recovery.”

“All told, they own more than 872,000 homes as a result of the groundswell in foreclosures, almost twice as many as when the financial crisis began in 2007.” 

“The pileup could lead to $40 billion in additional losses for banks and other lenders as they sell houses at steep discounts over the next two years…”

And, this problem is extended to other areas of the real estate market like the commercial real estate sector. 

The good news…”the number of new foreclosures and recent borrowers falling behind on their payments by three months or longer is shrinking.”

Where is the focus of the banks?

The focus is more on attempting to minimize the amount of write down the banks must take and is not on generating new loans to build up revenue streams.  Right now, the balance of effort in banks seems to be on the side of keeping down charge-offs because of the larger impact on solvency, rather than just on earnings.  In fact, the recent increase in bank earnings has been largely due to a reduction in loan charges rather than an increase in revenues. 

If we are to get the focus of banks back on lending and on supporting economic growth we must get through this period of restructuring the balance sheets of commercial banks to remove the bad assets.

But, this presents a problem to the policy makers in Washington, D. C.  If commercial banks, and other economic bodies, must work through their debt problems before they can focus on increasing loans and increasing spending, efforts to stimulate the economy through further governmental credit inflation will have little impact on picking up economic growth.

This factor is not considered in most macro-economic models because the importance of debt on business decision-making will vary from time-to-time.  At lower levels of indebtedness, economic units may not feel that they have to restructure their balance sheets to reduce debt loads and further fiscal stimulus, more credit inflation, will bring about more rapid economic growth.

However, in periods when the burden of the debt loads become too heavy, people will need to re-adjust their behavior and reduce levels of financial leverage to more reasonable amounts.  At these times, further fiscal stimulus, more credit inflation, may have only a modest impact on economic growth.  In situations like these, fundamentalist preachers like Paul Krugman may cry all they like about the need for more and more governmental spending, but even that will not bring on “the Rapture.”

We are in a period when the excesses of the credit inflation of the past must be worked off before people can begin to fully focus again on the future.  The economy is highly bi-furcated, both in Europe and in the United States.  Those people and institutions that are not highly leveraged and have cash-on-hand, will prosper relative to those that are highly leveraged and are short on cash.  The last fifty years has seen a tremendous skewing of the income and wealth distribution in the United States toward the richer end of the spectrum.  My guess is that, given the current situation and the current economic policies, this trend will continue.  Maybe debt is not such a “good thing” after all.      

Bank Re-regulation Forgot to Consider Google and Twitter

One of the clearest comments I have heard recently about the financial reform actions of Congress and the regulators is that those passing the new laws and establishing the new regulations completely ignored the fact that something like Google and Twitter had been created.

In other words, times have changed and those in Congress and in the regulatory bodies have kept their focus just on the past.

Financial regulation, however, is not the only thing that is falling victim to a backward looking focus.

We are seeing a concentration on the past in dealing with state and local government problems, problems with pensions, bargaining power, and employment. The law just passed in Michigan giving the state government broader powers to intervene in the finances and governance of struggling municipalities and school districts…” has been fought by those that argue that the law “undermines collective bargaining and threatens to subvert elected local governments.” (http://professional.wsj.com/article/SB10001424052748704360404576206603444375580.html?mod=ITP_pageone_1&mg=reno-wsj.)

Times have changed.

The years of inflation which began in the early 1960s has reached a tipping point in many areas. The days of inflated state and local government budgets, of passing on the fiscal impacts of lucrative union bargaining agreements in the form of higher property taxes, and of using the accounting gimmicks that postponed dealing with pension obligations is over. Adjustments must be made

But, that is not how people deal with the unpleasantness of current dislocations.

The inflation benefit for labor unions in manufacturing industries gave out years ago.
Manufacturers of cars and steel and so forth could neither pass on lush labor agreements to the public nor hide the increasing labor costs is limited technological advancements in their products or the production of their products.

And, the labor unions that still exist in these areas of manufacturing have shrunk, both in numbers and in terms of bargaining power.

State and local governments are now having to deal with this phenomenon.

And, what about debt?

The taking on of debt thrives in periods of credit inflation and Americans have had at least fifty years to get on this bandwagon.

And, now people have not really been borrowing. The real question is, should they start borrowing again? I have addressed this in my post “Does Getting Out of Debt Mean that People Should Start Spending More?” (See http://seekingalpha.com/article/257772-does-getting-out-of-debt-mean-people-should-start-spending-more.)

What has this debt done for people? If the number of foreclosures and bankruptcies over the last few years and the number of foreclosures and bankruptcies pending or near the edge are any indication, many people may not want to jump right into the “debt circus” again any time soon.

What accounts for the popularity of the finance guru Dave Ramsey? Take a peek at his new book, “The Total Money Makeover: A Proven Plan for Financial Fitness.” And, what is his recipe for financial fitness and greater happiness?

GET OUT OF DEBT! ALL OF IT!

This advice doesn’t apply to just families. It applies to small businesses, and medium-sized businesses, and others.

GET OUT OF DEBT!

Pass that message on to Chairman Bernanke.

And, what is the solution of Chairman Bernanke and other leaders in Washington, D. C.?

Let the presses role! Start the credit inflation once again!

The question is, will this new round of credit inflation succeed. It seems as if over the past fifty years that every time we entered a new round of credit inflation, some things got worse.

For example, capacity utilization in manufacturing continued to drop since the 1960s. That is, every subsequent peak in capacity utilization during this time period was lower than the previous peak. Furthermore, after almost two years of economic recovery, capacity utilization still remains just a little over 75%.

Underemployment has continually risen over the last fifty years and now about one out of every five individuals of working age in the United States is underemployed.

In addition, the inflationary environment of the last fifty years has benefitted the wealthy who can either take advantage of the inflation or protect themselves against it and has been exceedingly costly for the less wealthy, who cannot protect themselves. As a consequence, we have the worst skewing of the income distribution toward the wealthy in United States history.

And, there is more!

But, this is not the point.

The point is: the times have changed!

If we do not accept this fact in financial regulation, in the management of state and local governments, in our own finances, and in the federal governments budgetary policy, we will all be the sorrier for it.

Who has the credit inflation of the last fifty years really helped? The financial industry. And, I have asked the question, who is the “Bernanke Credit Inflation” going to help? This time, will the financial industry just dance alone? (See http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone.)

Does Getting Out of Debt Mean that People Should Start Spending More?

From the Wall Street Journal this morning:

“U.S. families—by defaulting on their loans and scrimping on expenses—shouldered a smaller debt burden in 2010 than at any point in the previous six years, putting them in position to start spending more.

Total U.S. household debt, including mortgages and credit cards, fell for the second straight year in 2010 to $13.4 trillion, the Federal Reserve reported Thursday. That came to 116% of disposable income, down from a peak debt burden of 130% in 2007, and the lowest level since the fourth quarter of 2004.” (See “Families Slice Debt to Lowest in 6 Years,” http://professional.wsj.com/article/SB10001424052748704823004576192602754071800.html?mod=WSJPRO_hps_LEFTWhatsNews.)

The logic in this is that people reduce debt so that they can spend more. I think that is called a “non sequitur”.

If people (and businesses) get more and more in debt over a fifty year period (as they have since 1960) and this contributes to the worst recession since the Great Depression the objective of these people (and businesses) getting out of debt is so that they can get more in debt once again?

I thought that if people (and businesses) got themselves so leveraged up and so “over-extended” that they found themselves in serious financial trouble and were faced with foreclosure on their real estate and personal (or business) bankruptcy that what they would try and do is bring their debt more in line with their incomes so that they could manage their debt.

I thought that maybe people (and businesses) would become more prudent and try and manage their debt in a way that would allow them more “peace of mind” not having to scramble to make principal or interest payments every month.

And we read that there are 11 million people who find themselves owing more on their mortgages than their home is worth on the market.

And we read that about one out of every four individuals of working age is under-employed.

And, we read that the income distribution is skewed toward the high income end worse than it has ever been in the history of the United States.

And, we read that America is bifurcating more and more based on education and race.

And, we read that many state and local governments can’t meet their pension commitments and can’t balance their budgets so that they are cutting jobs, cutting pensions, and cutting education.

Some people are spending. Some people are using credit again. Some people are buying very nice homes. Some people are paying for very expensive educations.

But, this spending and credit extension is not across the board.

The inflation over the past fifty years created the ideal environment for debt creation. The inflation was not large enough to create a panic. From time-to-time, the inflation was not enough to really see.

Yet, from 1960 to the present time, the purchasing power of the dollar has fallen by 85%. The dollar that could buy a dollar’s worth of goods in 1960 can only buy about fifteen cents worth of goods now.

This was the perfect scenario for the creation of credit, for financial innovation, and for the growth of the finance industry.

This could not have been a better environment for the consumer culture to thrive where people could feed their insatiable appetites for goods and think that things were great.

And, now a substantial part of our economy is mired in this debt and struggling hard to get their heads above water. They don’t need to pile on more debt…they need some stability and consistency to their lives.

Yet, many are pushing to get the “credit machine” going again. The federal government is setting the standard (as it has over the past fifty years) by living way beyond its means and threatening to increase its debt by $15 trillion or more over the next ten years.

The Federal Reserve has pumped almost $1.4 trillion in excess reserves into the banking system in order to get the banks’ lending again.

We want families to be “in position to start spending more” as the Wall Street Journal article stated.

A credit inflation is just what is needed.

Each time we restart the “credit inflation” button again, more and more people seem to be in a position in which they are excluded from its benefits. They are under-employed, substantially in debt, and excluded from benefitting from further increases in prices.

This means each time the “credit inflation” button is pushed again, only a smaller proportion of the population can participate in subsequent expansion.

Maybe this is why it is taking us so long to get the economy “moving again.”

History has shown that this “show” cannot go on forever. The difficulty is in knowing just when the “show” is over.

The government is trying to start the music playing again. And, those that can are supposed to begin dancing. But, maybe this time only the financial industry will be dancing (http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone).

Why Debt Is Going To Continue To Be A Problem In The United States

Officials at the Federal Reserve and in many other leadership positions around the world believe that liquidity is the solution to our current woes. And, if the amount of liquidity that is in the anking and financial markets is not enough to resolve our problems then more liquidity is certainly the answer.

This is behind QE2, and this is behind most of the effort to resolve the sovereign debt crisis in Europe.

What does liquidity allow you to do? It allows you to sell assets into the marketplace.

However, selling assets into the marketplace does not solve your problems if the price at which you sell the assets is substantially below the accounting value of the assets on your balance sheet. In such cases, having liquid markets in which to sell assets may allow you to more than wipe out your equity and leave you unable to pay off your debts.

There are two ways to counter this problem. The first is to inflate prices so that the real value of the debt declines which reduces the amount of leverage you have on your books. The second is to create income and wealth so that equity increases relative to the debt outstanding thereby reducing leverage.

The people advocating the injection of more liquidity into the financial system hope to spur bank lending and thereby stimulate economic growth. Those that are concerned with the creation of more and more liquidity argue that this first group of people really just want to create inflation and reduce the real value of the debt.

The problem I see unfolding is that the economy is expanding and will continue to expand in 2011, but it will not expand in such a way as to stimulate sufficient income growth and wealth creation so as to lower the debt loan many people are bearing. As a consequence, the further liquefying of the banking and financial markets will just benefit those who are not too highly leveraged…generally the financially better off in society…and continue to depress those who are highly leveraged.

In terms of economic growth, the economy is expanding. However, by historical standards, the year-over-year rate of growth of real Gross Domestic Product is substantially below the general recovery pattern. In the year-over-year rates of growth in 2010 were 2.4%, 3.0%, and 3.4% in the first, second and third quarters, respectively. Historically, at this stage of the recovery, the growth rates are usually much greater.

The problems come when we observe some very basic facts with respect to economic performance. First, although Industrial Production has recovered from the lows reached during the recession it has not come close to reaching the peak it attained before the recession set in. Second, the capacity utilization of our manufacturing has recovered, yet it still lies well below its previous peak (which is the lowest peak achieved since the statistical series was begun in the 1960s). Finally, even though unemployment dropped last month, under-employment continues to be extremely high as I estimate that one out of every four or one out of every five individuals of employment age are either unemployed, working part time but would like to work full time, or have dropped out of the work force. This phenomena is captured in the data on the Civilian Participation rate. Note, that this rate is substantially below the level it was before the Great Recession began in December 2007 and is also even further below the level reached before the 2001 recession. Under-employment in the United States has been growing, almost steadily, since the latter part of the 1960s.

Even though corporate profits are rising dramatically, even though many large corporations are acquiring other corporations at a very rapid pace, even though commodity prices are going through the ceiling, even though the big banks are doing very well, thank you, there seems to be a real structural problem in the United States. Liquidity is helping a lot of people but it is not the people we are talking about in this

"Sharing the Pain: Dealing with Fiscal Deficits"

Over the past week or so, I have spent a lot of time on sovereign debt and the problems being faced by various nations across this planet with respect to their budget deficits. I suggest the article “Sharing the Pain” in the March 4, 2010 edition of The Economist as a good compilation of issues relating to the situation many countries are now facing. This piece is contained in the briefing, “Dealing with Fiscal Deficits,” http://www.economist.com/business-finance/PrinterFriendly.cfm?story_id=15604130.

We can separate the discussion into three categories: the problem, the pain, and the pragmatic response.

First, the problem. History shows us that when economies slow down, budget deficits appear or widen. Revenue growth declines as the needs to increase outlays rises. Put this general movement on top of decades of undisciplined management of government budgets and you can get “one hell of a problem”

The Economist article states that “deficits in several countries have increased so much and so fast during the economic crisis of the past 18 months or so that it is generally agreed that remedial action will be needed in the medium term. Deficits of 10% or more of GDP cannot be sustained for long, especially when nervous markets drive up the cost of servicing the growing debt.” It continues, “when markets do lose confidence in a government’s fiscal rectitude, a crisis can arise quite quickly, forcing countries into painful political decisions.”

Second, the pain. History shows, according to Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, that it is highly unlikely that the “rich countries” of the world will experience a burst of rapid and prolonged growth. “Sluggish growth is more likely” and “the evidence offers little support for the view that countries simply grow out of their debts.”

“So, short of debt default or implicit default via inflation, that leaves just two other ways of closing the deficit. Spending must be cut or taxpayers must pay more.” Hence the pain!

Here we can point to the situation in Greece where much of the effort to return some fiscal discipline to the country is falling on cuts in government wages and in social benefits. This has resulted in substantial personal retrenchment and civil unrest. Today we read of a second general strike in the nation that closed all public services. See, “New Strike Paralyzes Greece,” http://www.nytimes.com/2010/03/12/world/europe/12greece.html?ref=business.

The deficits are so large in most of the affected countries that minor adjustments to spending or taxes will have little or no impact. The budget adjustments that must be made are quite substantial: hence the depth and breadth of the pain.

In recessions that are relatively minor, government monetary and fiscal stimulus seems to restore economic growth, thereby rectifying the situation and minimizing the pain. But, in a recession of the magnitude of the Great Recession the government does not seem to be able to “buy” itself out of the trouble. Hence, the spread of the pain.

Furthermore, there is an added difficulty that enters the picture in the more extreme cases. Those that are more affected by the recession and by the adjustments that need to be made in government budgets may come to see the changes as a break in the “social contract” of the country. This government that saw to their welfare, put them to work, and sustained them through the minor crises of the past, now seems to be abandoning them. And, for whom? The international financial community!

Obviously, if we get into this state of affairs, the emotions can become quite high, as in Greece.

This leads us into the third category which has to do with what government can do in such situations. The problem with the situation brought on by large budget deficits and a growing national debt is that there are no good solutions. Anything the government does in an attempt to get the budget under control while encouraging the economy to recover hurts someone.

This is why governments must be very pragmatic in what they propose. Doctrinaire approaches just do not seem to work. There are only two suggestions from the historical perspective that seem to have borne some fruit in the past. The first is that there needs to be some “social cohesion” in the country to achieve some success in the effort to get the country’s budget under control. The second is that governments “should focus on spending cuts rather than tax increases.”

The article in The Economist points to two instances where successful government tightening has taken place in recent memory: Sweden and Canada. In both cases the crisis in the country became acute enough and the ruling governments acted in a sufficiently pragmatic way so that voters finally got behind the efforts. However, this social cohesion was not always achieved on the first attempt.

Some of the social cohesion can be gained by raising some taxes, especially on the “better off”. This may be the “quid pro quo” for the less well off to accept the other things that need to be done. The downside to this is always that the “better off” have more escape hatches that will allow them to avoid any imposition of taxes they feel are excessive. And, many countries in the past twenty years or so have built up reputations as “low tax havens” to attract business. Ireland, for example, lowered its corporate tax rate to just 12.5% and is very reluctant to increase this and harm the climate they benefitted so much from. If taxes go up on these people and businesses, they can be very mobile and move to less oppression environments. Also, tax evasion can be a huge problem especially against sales or value-added taxes.

So, the burden of fiscal tightening falls on the spending side but this is not an easy road either. And, when one looks at the “big” targets for cuts, good arguments for not making cuts abound. Military spending is not a major item in many countries needing budget cuts, but it is in the United States. Here, there are two wars being fought and the need to maintain the world’s “top” military machine and keep it current through research and development makes the budget almost non-touchable.

The next major item that comes up on the list to consider is government employment. Over the last 50-60 years, governments throughout the world have exploded in terms of providing employment. Over the last several years the rate of government hiring has gone up, especially in the United States, in an effort to deal with the financial crisis and the Great Recession. Is it realistic to think that governments will shrink in size or in terms of payroll expenses? This is where Greece and Ireland and Portugal and Spain have promised to do something. And, of course, this is where much of the civil unrest has come from.

Next, social programs, a huge item in many government budgets and the primary cause of the expansion of government budgets in the post World War II period. (For more on this see Niall Ferguson’s book “The Ascent of Money: A Financial History of the World.) The Economist suggests that one area that can be rationalized here is the pension system in these countries.
And, there are other ideas available.

The thing the article (implicitly) points out is that the way out of the fiscal dilemma is not easy. But, I suggest three further things that need to be considered. First, leadership. The countries facing the problems discussed here need to have someone out in front that is understood and trusted. The only way out of this situation is pragmatic: not progressive, not conservative, not liberal, not socialist, or any other dogmatic approach. But, to achieve the “social cohesion” necessary for success, there must be leaders that draw people together.

Second, the proposed solutions cannot just force people back into the way things were. One reason for the depth and breadth of the Great Recession is the changing structure of the society and culture. (For more on this see my post, http://seekingalpha.com/article/192713-the-trouble-with-recovery.) If this is true, then the leadership must be forward-looking rather than serving just entrenched interests.

Finally, this will not be easy. As The Economist article closes: “There are many battles over deficits to come. Well chosen policies that foster growth may make them less fierce. They may be bloody even so.” Amen.

Who is going to be the next Greece?

This seems to be the major question asked by most commentators in most media outlets. Is it going to be Spain? Japan? The U. K.? Italy? Portugal? Just who might it be?

Might it be California? Or New York? Or some major city?

Who are the hedge funds attacking this week? Where is the bailout going to come from? What about the IMF, what role is it going to play? And so on and so forth?

As far as the United States is concerned, thank goodness for all the attention being paid to the problems being experienced by these other countries, and states, and cities. At least others governmental units are getting the headlines about the debt problems going on in the world, and not the U. S. government.

And, the nice thing about the problems going on in the rest of the world is that investors still consider the dollar and dollar-denominated securities to be the least-risky of the lot. Flee to the dollar! Flee to U. S. Treasury securities!

Sometimes it is good to rank things on a relative basis. The person who receives a grade of D can save his own self-respect and place in the world when compared with the rest of the class who received a grade of D-. Doesn’t say much, however, about the whole class.

The United States dollar, a currency under attack until the financial crisis of 2008-2009, once again finds itself gaining strength as the financial condition of other countries come under attack and their currencies come under selling pressure.

The value of the United States dollar, which was once again under attack in the late summer and fall of 2009, has risen by more than 6% against major trading partners since the beginning of December as investors “flew to quality.” The United States dollar has done even better against the Euro as it has risen by about 18% versus the Euro over this same time period.

And, what are central banks doing under these circumstances?

They are still primarily operating under the umbrella of “quantitative easing.” That is, the central banks cannot drive interest rates any lower so they continue to provide reserves to their own banking systems in order to keep those banking systems afloat.

For the vultures circling over the scene it seems to be banquet time. The big banks, the big hedge funds, and others seem to be prospering in this environment of close to zero borrowing costs. These organizations are earning record profits! Not so, of course, for the small- to medium-sized financial institutions that are hanging on for their lives.

There are no good solutions! Every path out of this situation is full of difficulty and pain. And the strong get stronger and the weak, weaker.


The problem faced by politicians is that they must appear as if they are being active in the attempt to resolve the problems that their countries are now facing. Yet, to increase stimulus packages only exacerbates already stretched budget deficits. But, to cut spending, because revenues are down due to the weak economic conditions, only causes greater misery and social unrest. The fiscal conservatives attack those that push for more economic stimulus; the social liberals attack those that push for more budget restraint.

The central bankers worry about what will happen when interest rates begin to rise and asset values and business expectations start to fall again.

The world is in a tough spot when the basic question being asked becomes “who is going to fail next?”

It seems as if all these countries (states and cities) can do is attempt to reach a balance between improving the fiscal discipline being demanded by investors and voters and between the safety-nets that need to be created to cushion the difficulties being faced by many of the people within their domains.

With no “good” solutions available, governments must “muddle through” as best they can. There is no panacea.

The thing that should be avoided, but, in the distress of the moment, will, in all likelihood, not be avoided, is to create programs or solutions that will not be helpful once the crisis period is over. Politicians and others tend to “rush in” during “crisis” times and create programs, rules, regulations, or laws. (As Rahm Emanuel has stated, ““You don’t ever want a crisis to go to waste; it’s an opportunity to do important things that you would otherwise avoid.”) Once on the books, however, these programs, rules, regulations, and laws remain in practice for a lengthy period of time, and, over the longer-run, many fail to achieve the positive effects that was desired when implemented.

It is important for leaders, in my mind, to appear as if they are in control during times like these. In essence, all of these leaders are heading “turnaround” situations. These leaders must be pragmatic in practice. They must re-establish discipline in all that is done under their watch. They must not be the slaves of some ideology.

What these leaders do will not be pretty, but they need to be strong in order to bring people behind them. These leaders need to build support and trust. The worst thing that they can do is to look as if they are not in control for the vultures will jump on this appearance and dominate events.

What do the markets seem to be saying in response to the efforts of current leaders?

The headlines we are now reading in the newspapers and hearing on newscasts indicate that governmental leaders are not in control. It appears as if the future is being driven by hedge funds and others who are taking advantage of the feeble conditions in the various political units around the world. No one seems to be in charge and no one seems to be rising to the task!

Two Ponts about Debt and the Economic Recovery

The Internet, print journalism, and the broadcast media contain story after story about the debt problems in the world. A wider audience just learned this week a new acronym: PIGS, or PIIGS if you will. This, we all know now, stands for Portugal, Ireland, Greece, and Spain, or, some include Italy.

The problem is debt!

The solution? Well, we don’t quite know that yet.

How did the problem arise? In my mind, the problem has arisen because of the attitude that has prevailed in the world over the last fifty years or so relative to how governments should conduct their fiscal affairs.

Beginning in the 1960s we saw more and more governments turn to budget policies that could stimulate employment and economic activity through the creation of spending that would add to the aggregate demand in their countries. These policies began with the argument that budget deficits should be produced only when the economy was below full employment. But, governments found these policies so attractive in terms of attempting to get re-elected that budget deficits were produced whether or not the economies of their countries were running below full employment.

This attitude created an environment of credit inflation, as well as price inflation, that did three things. First, it caused economic units to focus on finance and financial engineering. Second, it resulted in structural unemployment as many, many people were hired or re-hired back into “legacy” jobs and not the jobs of the future. This hurt lower income and less educated people the most. (See Bob Herbert’s column in the New York Times: http://www.nytimes.com/2010/02/09/opinion/09herbert.html.) Third, it ended up transferring a lot of the wealth of the country offshore to China, the Middle East, and other places.

There are two points I would like to make about all this credit creation and the piling up of debt.
The first point is that, ultimately, those people, companies, and nations that have little or no debt WIN over those that issue lots and lots of debt.

The situation is similar to that historically called “the Phillips Curve.” The Phillips Curve captured the tradeoff between unemployment and inflation and the economists that developed this tool used it to show how, for a little bit of inflation, a government could buy a lower amount of unemployment.

Milton Friedman destroyed their case by arguing that the Phillips Curve was dependent upon a given assumption about inflationary expectations. He showed that the tradeoff between inflation and unemployment remained stable only if inflationary expectations remained the same.

However, even if people are fooled in the short run, the presence of higher inflation than they expected would eventually lead to an increase in inflationary expectations. Thus, to get the same decline in unemployment the government would have to create a higher level of inflation. The tradeoff resulting in constantly rising inflation, which is what the United States observed through the 1960s and 1970s.

The same type of situation exists for the creation of debt. A company or a nation can benefit from the creation of “more leverage” or more deficit spending. However, as more and more credit is created, people, companies, or nations must issue more and more debt to keep retain or even increase the benefits of their debt creation relative to others. Credit inflation, once started, is self-feeding!

Of course, when the credit bubble bursts, as it did for the world in 2007 and 2008, all the debt built up becomes a huge burden, especially if economies dip into a period of price deflation. The solution to a situation like this? Well, one solution is inflation: make the real value of the debt burden less and less.

Again, the problem is that each cycle of re-flation tends to be greater than those of the past. But, this is the easy way out. Re-flation was the intellectual model that came out of the 1930s and, in its various forms, was incorporated by government’s worldwide beginning in the 1960s.

The problem is that re-flations ultimately never work, because the deeper and deeper people, companies, and nations get into debt, the more and more of them attempt to deleverage. If governments’ don’t want deleveraging to happen then they continue to re-flate. The cumulative effect of this is hyperinflation, and those countries that hyper inflate don’t win. The 20th century has many examples of the consequences of hyper inflation, the German case in the 1920s being the most pronounced.

But, before fully finishing this strand of thought, let me introduce my second point and it has to do with the effects of deleveraging. If the private sector realizes that it is over extended, debt-wise, then it will attempt to pay off debt or at least reduce its debt burden sufficiently so that it can operate once again. But, if economic units in the private sector begin to save more or sell assets in order to pay off debt, aggregate spending declines and this slows down or prevents an economy recovery from taking place.

John Maynard Keynes identified this “fallacy of composition” in the 1930s and labeled it “the Paradox of Thrift.” That is, while it is all well and good for individuals to increase their savings and pay off their debts, the very act of withdrawing spending from the economy reduces aggregate demand and the output of goods and services. So, even though it is good for people to save and pay off debt, individually, it is bad for the economy and everyone becomes worse off because of this prudent behavior.

The thing is, when they get badly burned, lose their homes, lose their jobs, and lose their wealth, people and businesses do “pull back”. And, their standards change. This, to me, is one reason why the stimulus policies of the 1930s were not very effective. They could not overcome the desire of people and businesses to restructure their balance sheets. People had to re-group. One sees the consequences of this in the 1950s: people and businesses were very, very conservative then in the way that they spent and managed their money. The near-term experience that dominated their thinking was the depression years of the 1930s. And, in many ways, this continued into the 1960s for the older generations.

So who benefits during the time that follows the bursting of the credit bubble? Those without a lot of debt!

To me, the creation of debt eventually impacted the world in two ways. First, during the last 50 years or so, many resources were diverted into financial engineering. Even companies that were primarily in manufacturing gave more and more attention to financial engineering. This distracted these companies from what should have been their main focus: manufacturing goods and industrial innovation. The emphasis on financial engineering changed the whole society and many of the best and brightest young people opted out of careers in engineering and applied science and went into the finance industry. Employment in financial firms grew dramatically relative to employment in manufacturing and production.

The second way the world was impacted is through the redistribution of wealth in the world. Massive amounts of wealth have been transferred over the past 20 to 30 years out of the West and into the Far East, the Middle East and Brazil. Who did American companies turn to in the financial crisis for capital? Who is Europe and America now turning for help? Where are we learning about this transfer? See the morning papers for starters: “China Lists $9.6 Billion in Shares of U. S. Companies”: http://www.nytimes.com/2010/02/09/business/global/09invest.html?ref=business.

This is not a winning strategy for those countries, businesses, and people who took on a lot of debt!

The Problem with Debt

The economy is recovering. The areas that seem to show the most life are those sectors that have had sufficient debt relief so as to be able to move forward. The big banks are moving out in a very robust fashion, just how robust we will begin to hear this week. The auto industry seems to be moving ahead, albeit a little more slowly than the big banks. And, there are other areas that show signs of moving forward, the health industry and firms in the information technology industry.

The big cloud hanging over all of this is the debt that still is outstanding in many sectors of the economy. The problem with debt is that it just won’t go away. Regardless of any adjustments made to who owes what to whom, if there is debt outstanding, someone has to pay for it in some fashion.

The big banks were saved, but who picked up the tab for the bailout? The taxpayer did, or, at least the taxpayer has footed the bill pending a potential Obama tax on the banks to “recover” some of the bailout monies.

Who saved the auto industry and subsequently holds the IOU for the rescue? A large part of the financial restructuring came at the expense of those that had provided credit or equity funds to the car companies. And, the federal government also paid a share.

If homeowners got relief from their mortgage and consumer debt, who would pay the bill? Shareholders of the bank, holders of mortgage-backed securities, and the federal government. (You might check out this little piece by Peter Eavis in today’s Wall Street Journal: http://online.wsj.com/article/SB20001424052748704081704574652660161217386.html#mod=todays_us_money_and_investing.)

And, what about the debt that is related to commercial real estate lending? Shareholders of banks, holders of commercial mortgage vehicles, and the federal government.

Then we move to the financial problems of the states. Recent information points to the fact that 36 states in the United States are having financial problems and these could lead to deficits in the state budgets of around $350 billion this year and next. Where is the money going to come to pay for these shortfalls? States have already attempted to sell off properties, outsource functions to the private sector, and even turn some things over to the federal government.

Part of the problem here is that the tax base in most states has collapsed as unemployment and under-employment have risen, as property values have fallen, and as business earnings have collapsed. Rating agencies have begun to lower credit ratings on some states. The best guess is that ratings will drop on many other states before the year is over.

And, what about local and municipal governments? Same problems.

And, then, what about the federal government? Without totaling up the bill for the problems mentioned above, let alone the escalation of wars here and there all over the world, health care reform, and some kind of energy bill, many expect federal deficits over the next ten years to total $15 to $18 trillion!

Who is going to purchase all or almost all of this debt? China?

What I find scary is that our “friends” are voicing concern in different ways. For example, the Financial Times this morning carries the opinion piece of Gideon Rachman titled “Bankruptcy Could Be Good for America”: http://www.ft.com/cms/s/0/a8486284-fee9-11de-a677-00144feab49a.html. The point Rachman makes is that the Brics, Brazil, Russia, India, and China all went through economic reform before they “broke out” into their current ascendency. Brazil’s reform came in the 1990s, Russia defaulted in the late 1990s, India embraced economic reform in 1991, and China moved to a new mindset in the early 1990s. “Those much discussed emerging powers, the Brics, all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis.”

Even if we print money to pay for the federal debt, as the Federal Reserve has done over the last year or so, (the monetary base rose 23% from December 2008 to December 2009, and rose by 101% over the previous 12 months) someone, somewhere will pay this debt in terms of a reduction in purchasing power.

Need I mention that since January 1961 the purchasing power of one dollar has dropped to roughly $0.15. Inflating the United States government out of its debts has a long, post-World War II history.

Might this process of “printing money” continue?

Seems like a lot of people believe that it will. For one there is the problem of rising long term interest rates. More and more worry is being expressed about the expected increases. Why? Well most analysts believe that the Federal Reserve has helped to keep long term interest rates lower than they would have been in order to provide liquidity to the financial markets and to support the mortgage market. On January 6, 2010, the Fed held on their balance sheet $777 billion in U. S. Treasury securities, $160 billion in Federal Agency debt securities, and $909 billion in Mortgage-backed securities.

This totals $1.846 trillion in securities held by the central bank! The concern is that in the last week of August, 2008, the Fed had provided only $741 billion in funds to the banking system through some kind of market or auction based transaction.

How much affect these purchases have had on keeping long term interest rates lower than they would have been is currently being debated. What is not in question is that, sooner or later, interest rates are going to begin to rise, first because the Fed’s artificial support will be removed, but rates will rise as the economy begins to improve, further pressure will be put on rates as issuers of bonds race to place debt before the rise takes place (See “Rate Rise Fears Spark Rush to Issue Bonds: http://www.ft.com/cms/s/0/6f46f226-fef2-11de-a677-00144feab49a.html), and as inflationary expectations are incorporated into bond yields.

How fast will the Fed allow interest rates to rise because rising interest rates will slow down economic recovery. Also, the Fed has created another problem by keeping short term interest rates so low. Not only have these low rates created arbitrage possibilities for domestic investment, borrow short term money in the 35 to 65 basis point range and invest in 10-year government bonds at 3.50% to 3.80% but also for the international carry trade. It is argued that the Fed cannot allow rates to go up too fast or big financial institutions and other investors will get trapped in losses that will not help the economic recovery.

The point of all this discussion is that any “exit” strategy that the Fed is planning to reduce the securities held on its balance sheet from current levels to even a level of $1.0 trillion, let alone the $741 billion mentioned above, is already in jeopardy. And, many are arguing that in the face of such overwhelming future deficits, the Fed will be forced to print even more money than it has over the last 17 months.

The problem with debt is that debt, once issued, really does not go away. Someone has to pay for it!

The Deleveraging Continues

There are three major factors that will contribute to the timing and the strength of the economic recovery. First, there is the ability and speed at which individuals and businesses are able to get their balance sheets in order by reducing the amount of debt they have on them. Second, there are supply side questions about the restructuring of the economy. This has to do with the large number of people that have left the labor force and may not return in the near term and the secular decline in the capacity utilization of industry. (See my post of June 22, 2009, “Structural Shift in the U. S. Economy is Really in Supply”: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply.) Third, there is the tremendous amount of debt the federal government is issuing and the fear that this re-leveraging will create a credit inflation that may go right into prices rather than output and employment.

In this post, I am primarily focusing on the first of these factors. I will discuss the progress of the second two issues in future posts. There is more immediate information on the first and it is vitally important that this deleveraging takes place in an orderly fashion or the near term concern over the latter two will be misplaced.

Perhaps the two most highly publicized methods of deleveraging continue to speed along at a rapid pace. The American Bankruptcy Institute has reported that the total number of bankruptcies in the United States filed during the first six months of 2009 increased by 36 percent over the same period of time in 2008. The only time bankruptcies have been so large is right before the bankruptcy law change earlier in this decade. Business filings during the first six months were up 64 percent over the first six months in 2008 and individual or household filings were up 35 percent.

Bank closings reached 81 for the year with four new banks added to the list on Friday, one of them being the 10th largest bank failure in United States history. Talk now is that there will be 300 or more bank closures in the near future. The FDIC is scrambling to find ways to increase its financial resources to handle the upcoming deluge of failures and is also easing restrictions on those that can bring private equity into the mix to carry some of the financial burden in taking over these failed institutions.

Getting less publicity is the effort that individuals and businesses are making to bring their own financial situation under control. Cutting expenses is, of course, one of the immediate ways that people can work toward their own best interest. Another way of saying this is that people and businesses are increasing their savings. Every week, more and more articles are appearing informing people how this saving might be accomplished and presenting stories of how households and companies are successfully meeting this challenge.

Furthermore, there are a growing number of stories of people and businesses getting in touch with those they owe money to and working with the lenders to set up terms and conditions that will increase the probability that debt will be repaid in a timely manner. My experience in banking supports the contention that financial institutions and other lenders really would prefer to work something out with those they have lent money to, but depend on those borrowers that perceive that they are going to face some difficulties in the future to get with them and initiate discussions about how things might be worked out. Postponing discussions only puts more pressure on both parties and tends to make things harder to resolve.

Refinancing is another problem looming on the horizon. There seems to be dark clouds hovering over the commercial real estate industry and less credit worthy corporate debt issuers. A lot of debt is going to come due over the next 18 months or so. The big concern is whether or not this debt will be able to be re-financed since very little of it will be able to be re-paid. The bits and pieces of news coming out of this area is that discussions are being held and although there may be failures coming out of these situations that the problems are recognized and will be absorbed in a relatively smooth fashion as time passes.

The areas of the bond market that contain firms with higher credit ratings are performing remarkably well. Volumes of new issues are up and the financial markets have absorbed these rather smoothly. If anything, corporations have turned to the bond market for funding since the commercial banking system is actually shrinking its base of commercial and industrial loans. This is an interesting thing happening to substitute bond credit for the credit extended by the banking sector at this point, but, as they say, whatever works.

Another method for de-leveraging that seems to be picking up steam is that corporations are buying back their own debt off the open market. In some cases it is reported that these companies can buy back their existing debt at 50 cents on the dollar which is a pretty good exchange for the company going forward. Look to see this pick up this fall.

Finally, the Federal Reserve does not look like it is going to pull the rug out from the banking system and the financial markets going forward. Yes, there is a lot of concern about all the reserves the Fed has put into the banking system and whether or not it is going to be able to “exit” the banking system in an orderly fashion. However, the Fed does not want a replay of the 1937-38 experience when it caused a collapse in the banking system by trying to withdraw excess reserves from the banks by raising reserve requirements. (See my post of August 21, “Federal Reserve: Exit Watch”: http://seekingalpha.com/article/157620-federal-reserve-exit-watch.) The best guess here is that the Fed will continue to keep the banking system very liquid in order to help underwrite the de-leveraging now underway.

The important thing to remember at this time is that “quiet is good”! The de-leveraging is taking place. However, the de-leveraging will take time. We just can’t become too impatient for we must let the system do its work and restructure its balance sheets. We just don’t want any more shocks! There still is a long way to go toward a full economic recovery and the other two issues I mentioned in the first paragraph are of great concern. But, we move forward by just putting one foot in front of the other.