This question is the defining question in finance and economics today.
Yet, the predominant approach used in macroeconomic policymaking does not include debt and the possibility of defaults in its model. So, the policy answer is obvious. The policy makers must “bailout” individuals, banks and businesses, and governments.
Well, forget individuals, let them default!
But, we need to save banks and businesses…and governments. Provide them with cash grants. Provide them with excessive amounts of liquidity. Defaults of banks and businesses and governments are not a part of our theoretical picture of the world.
Look through the book “”Ben Bernanke’s Fed” written by Ethan Harris, a former research officer at the Federal Reserve Bank of New York and published by Harvard Business in 2008. Chapter 2 is called “How the World Works: a Brief Course in Macroeconomics.” Here we get a picture of the basic model the Federal Reserve uses in its analysis of the state of the world.
“Getting into the head of the Fed requires a basic primer on how the economy and monetary policy works, Harris writes, “Nonetheless, a relatively simple framework underlies much of the discussion at central banks today.”
The foundation of the Fed’s analysis, according to Harris is something called “the Phillips Curve” which supposedly captures the tradeoff between inflation and unemployment. This, of course, incorporates the two government policy objectives written into law in 1978 and affectionately referred to as the Humphrey-Hawkins Full Employment Act.
Harris continues that “Bernanke is a proponent of the ‘financial accelerator model,’” which brings the credit market into the picture. “The idea that strong financial and credit conditions and a strong economy can reinforce each other to create economic booms (and that weak conditions can interact to create busts). During booms, both firms and households have stronger incomes and their assets are worth more, encouraging relaxed lending rules. Easy lending makes the economy even stronger and that, in turn encourages even easier lending standards.”
In other words, Bernanke, and people within the Fed, believe that pumping credit into the economy produces “stronger incomes” and “assets are worth more.” Thus there is a wealth effect. But, as long as inflation is “in check” there will be no problems on the “real” side of the economy and unemployment will be reduced. BINGO!
However, within this view of the world, there are no problems with debt loads, foreclosures, and bankruptcies. Piece of cake…just throw more spaghetti against the wall! (See “Bernanke’s Next Round of Spaghetti Tossing”: http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing.)
Remember, Keynes won and Irving Fisher lost the battle for the hearts and minds of the economics profession. To resolve economic downturns just create more and more debt. Forget about the fact that debt has to be paid off. Just toss more liquidity into the markets.
Defaults are not considered in the model because the assumption is that the problem is one of liquidity, not solvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)
Therefore, individuals, banks and businesses, and governments can issue all the debt they want and the Federal Reserve, the European Central Bank, the United States government, or the European Union can step in and solve any discomforting situations that arise through bailouts and loose monetary policy.
However, debt does matter! And, defaults should not just fall on individuals and families. Foreclosures and bankruptcies are very common into the world today.
Yet, governments continue to try and sweep solvency issues “under-the-rug” when it comes to banks and businesses…and to governments.
The only time we really hear about problems of this sort within these institutions is the weekly list of bank closings overseen by the FDIC. But, this information tends to end up on the fifth or sixth page of the business section of the newspaper and rarely, if ever, gets into the radio or television news. Maybe this news, week-after-week, is too boring. However, the FDIC is closing three to four banks a week and they have been doing this for more than a year. Still there are nearly 900 banks on the FDICs list of problem banks, and this does not include a thousand or more banks that are sliding into this problem bank list but have not reached the “statistical” test of being on the list.
This has to be the case within the sector of non-financial businesses. How many small- to medium-sized firms are still on the brink of insolvency? My guess is…a lot. It seems like every week there are more and more empty spaces in the strip malls and other business buildings.
And, then there are the state and local governments. The municipal bond market is in a mess!
In the banking week ending November 19, 2010, the Federal Reserve reports that the average yield on State and Local bonds was 4.72 percent. In the same week 30-year U. S. Treasury bonds yielded 4.30 percent. And, State and Local bonds are not taxed.
WHEN HAVE YOU SEEN AN INTEREST RATE RELATIONSHIP LIKE THIS BEFORE?
Now we get into sovereign debt. Let me just start listing the problems: Greece, Ireland, Portugal, Spain, Italy, France…
Need I say more?
And, what about the United States? On September 30, 2009, the Gross Federal debt outstanding was almost $12 trillion; the Federal debt held by the public was about $8 trillion on that date. And, what if the Gross Federal debt more than doubles over the next ten years as I have been predicting? How acceptable will the debt of the United States government be in the world?
DEBT MATTERS!
Why isn’t debt included in the models the policy makers use? We can’t continue to operate under the assumption that debt doesn’t matter and that all we need to do, policy wise, is throw more spaghetti against the wall.
People, other than individuals, families, small businesses, and small banks, must come to realize that there is a penalty for taking on too much debt. That penalty is default followed by bringing one’s books under control. People must learn that the solution to issuing debt is not issuing more debt!
Showing posts with label defaults. Show all posts
Showing posts with label defaults. Show all posts
Tuesday, November 23, 2010
Wednesday, June 16, 2010
Unfortunately, Debt Must Be Repaid
Fitch Ratings Ltd. is releasing a report today that points up the problems of having too much debt. Restructuring the debt of a person or a family (or a business), even when government programs help to formalize and regularize loan modifications, is not a “magic wand” that resolves the issue of debt overload.
Using data from the Obama administration’s Home Affordable Modification Program, Fitch reports that “the redefault rate within a year”, of the loans that are modified, “is likely to be 65% to 75%”. This information comes from the Wall Street Journal article, “High Default Rate Seen for Modified Mortgages,” http://online.wsj.com/article/SB10001424052748703280004575308992258809442.html?KEYWORDS=james+hagerty. “Almost all of those who got loan modifications have already defaulted once.”
The failure rate is likely to be high because “most of these borrowers were mired in credit-card debt, car loans and other obligations.” That is, when a person or family (or business) goes into debt they go into debt “across the board” and do not just limit themselves to one kind of debt or one type of lender.
And, the Treasury Department says, that those given loan modifications under this program have a “median ratio of total debt payments to pretax income” that is around 64%. “That often means little money is left over for food, clothing or such emergency expenses as medical care and car repairs.”
The good news is that the results of the program indicate that around one-third of the loan modifications make it through the first year. This is looked on as “good” by the Treasury Department and by a Fitch representative.
This is the reality of debt creation during a period that can be referred to as a period of credit inflation. At times like these, more and more people, families, businesses, and governments take on more and more debt until it gets to the point that the debt loads become unsustainable in some sectors of the economy.
Thus, to the first point, people and families take on mortgages, as well as “credit-card debt, car loans and other obligations” until, the second point, their “ratio of total debt payments to pretax income” becomes too large. Then, any increase in total debt payments, like a re-setting of the interest rate on a mortgage, or a reduction in pretax income, due to being laid off a job, puts the borrower into a situation in which debt payments cannot be made. Defaults occur, and a foreclosure…followed by a bankruptcy…may follow.
The “macro” government response is to provide fiscal and monetary stimulus to make sure people stay employed and to inflate incomes so that debt loads (debt payments relative to pretax income) decline. This is the Keynesian prescription!
The problem with this solution is that in a period of credit inflation, as incomes and prices continue to increase, debt loads continue to increase. If the government buys people out of their debt burdens by fiscal stimulus and monetary inflation, people (and families and businesses) don’t adjust their behavior to become more financially prudent. They just keep on, keeping on. This is another case of moral hazard.
Even worse, given the belief that government will continue to “bail out” those who have taken on too much debt, we find that those that have taken on too much debt generally go even further into debt. Take a look at what has happened over the last fifty years of credit inflation and this type of behavior is observed everywhere.
The Keynesian prescription of fiscal and monetary stimulus to keep unemployment low and debt burdens manageable only exacerbates the problem over time. That is, governmental efforts to sustain prosperity over time just postpone the consequences of dealing with the debt loads that are built up during these time periods.
Keynesian economic models, with the exception of the maverick Keynesians like Hy Minsky, don’t include the credit or debt aspects of economic activity. As a consequence, they ignore how people (and families and businesses) manage their balance sheets over time. In essence, these models ignore the very real fact that ultimately, debt must be repaid and cannot just increase without limit!
Over the past fifty years we have seen people and families and businesses and banks and governments take on more and more debt. Inflation has risen at an average compound rate of about 4% from 1961 through 2008 so that it has paid people to increase financial leverage, take on more risky assets, and finance long term assets with short term debt. And the federal government has underwritten this inflation by increasing its gross debt by around 7.7% per year for this period of time and the Federal Reserve has caused the base money in the economy to rise by 6.2% per year. The M2 money stock measure rose at a compound rate of 7.0% per year. All roughly in line with one another.
The Fitch report is presenting us with a picture of what happens when debt loads get “out-of-hand”…when there is just too much debt around.
The current response of the Federal government? Official federal government forecasts of the cumulative fiscal deficits for the next ten years runs around $9 to $10 trillion. Some of us believe that the deficits will run more in the neighborhood of $15 trillion. In terms of monetary policy, the Federal Reserve has placed $1.1 trillion in excess reserves in the commercial banking system. The leadership of the Federal Reserve expects us to believe that they will be able to reduce the amount of these excess reserves to more normal levels without the reserves being turned into loans that will expand the money stock measures by excessive amounts. (Just a reminder: excess reserves totaled less than $2 billion…note, billion and not trillion…in August 2008 before the big injection of reserves into the banking system took place.)
For one more time, the federal government is betting that by stimulating the economy and putting people back to work in the “legacy jobs” they were laid off from and by re-inflating prices and incomes that debt burdens will be reduced and we can get back to “spending as usual”. If the federal government is successful, the day in which debt loads are reduced will be postponed…once again!
However, the credit inflation causes other things to change. Over the last fifty years we have seen that in every employment cycle, fewer and fewer people are re-hired in the “legacy jobs” from which they were released. Under-employment, not just un-employment, rises and this puts more and more pressure on incomes. The ratio of debt payments to pretax incomes rise for these people. Right now, I estimate that roughly one out of every four or five potential works is under-employed, the highest level since the early 1950s.
Second, the steady inflation of the past fifty years has resulted in a larger proportion of the capital stock being un-productive. As a consequence, capacity utilization in industry has fallen to post-World War II lows. As we have seen in each business cycle during this last fifty years, less and less of this capacity is used in each recovery. This results in a drag on employment and income.
Eventually, debt must be repaid and debt loads must be reduced. The Fitch report highlights this problem. It is something that all of us should keep in mind in the upcoming months. If the situation with respect to under-employment and capacity utilization don’t change the debt loads will get even heavier.
Using data from the Obama administration’s Home Affordable Modification Program, Fitch reports that “the redefault rate within a year”, of the loans that are modified, “is likely to be 65% to 75%”. This information comes from the Wall Street Journal article, “High Default Rate Seen for Modified Mortgages,” http://online.wsj.com/article/SB10001424052748703280004575308992258809442.html?KEYWORDS=james+hagerty. “Almost all of those who got loan modifications have already defaulted once.”
The failure rate is likely to be high because “most of these borrowers were mired in credit-card debt, car loans and other obligations.” That is, when a person or family (or business) goes into debt they go into debt “across the board” and do not just limit themselves to one kind of debt or one type of lender.
And, the Treasury Department says, that those given loan modifications under this program have a “median ratio of total debt payments to pretax income” that is around 64%. “That often means little money is left over for food, clothing or such emergency expenses as medical care and car repairs.”
The good news is that the results of the program indicate that around one-third of the loan modifications make it through the first year. This is looked on as “good” by the Treasury Department and by a Fitch representative.
This is the reality of debt creation during a period that can be referred to as a period of credit inflation. At times like these, more and more people, families, businesses, and governments take on more and more debt until it gets to the point that the debt loads become unsustainable in some sectors of the economy.
Thus, to the first point, people and families take on mortgages, as well as “credit-card debt, car loans and other obligations” until, the second point, their “ratio of total debt payments to pretax income” becomes too large. Then, any increase in total debt payments, like a re-setting of the interest rate on a mortgage, or a reduction in pretax income, due to being laid off a job, puts the borrower into a situation in which debt payments cannot be made. Defaults occur, and a foreclosure…followed by a bankruptcy…may follow.
The “macro” government response is to provide fiscal and monetary stimulus to make sure people stay employed and to inflate incomes so that debt loads (debt payments relative to pretax income) decline. This is the Keynesian prescription!
The problem with this solution is that in a period of credit inflation, as incomes and prices continue to increase, debt loads continue to increase. If the government buys people out of their debt burdens by fiscal stimulus and monetary inflation, people (and families and businesses) don’t adjust their behavior to become more financially prudent. They just keep on, keeping on. This is another case of moral hazard.
Even worse, given the belief that government will continue to “bail out” those who have taken on too much debt, we find that those that have taken on too much debt generally go even further into debt. Take a look at what has happened over the last fifty years of credit inflation and this type of behavior is observed everywhere.
The Keynesian prescription of fiscal and monetary stimulus to keep unemployment low and debt burdens manageable only exacerbates the problem over time. That is, governmental efforts to sustain prosperity over time just postpone the consequences of dealing with the debt loads that are built up during these time periods.
Keynesian economic models, with the exception of the maverick Keynesians like Hy Minsky, don’t include the credit or debt aspects of economic activity. As a consequence, they ignore how people (and families and businesses) manage their balance sheets over time. In essence, these models ignore the very real fact that ultimately, debt must be repaid and cannot just increase without limit!
Over the past fifty years we have seen people and families and businesses and banks and governments take on more and more debt. Inflation has risen at an average compound rate of about 4% from 1961 through 2008 so that it has paid people to increase financial leverage, take on more risky assets, and finance long term assets with short term debt. And the federal government has underwritten this inflation by increasing its gross debt by around 7.7% per year for this period of time and the Federal Reserve has caused the base money in the economy to rise by 6.2% per year. The M2 money stock measure rose at a compound rate of 7.0% per year. All roughly in line with one another.
The Fitch report is presenting us with a picture of what happens when debt loads get “out-of-hand”…when there is just too much debt around.
The current response of the Federal government? Official federal government forecasts of the cumulative fiscal deficits for the next ten years runs around $9 to $10 trillion. Some of us believe that the deficits will run more in the neighborhood of $15 trillion. In terms of monetary policy, the Federal Reserve has placed $1.1 trillion in excess reserves in the commercial banking system. The leadership of the Federal Reserve expects us to believe that they will be able to reduce the amount of these excess reserves to more normal levels without the reserves being turned into loans that will expand the money stock measures by excessive amounts. (Just a reminder: excess reserves totaled less than $2 billion…note, billion and not trillion…in August 2008 before the big injection of reserves into the banking system took place.)
For one more time, the federal government is betting that by stimulating the economy and putting people back to work in the “legacy jobs” they were laid off from and by re-inflating prices and incomes that debt burdens will be reduced and we can get back to “spending as usual”. If the federal government is successful, the day in which debt loads are reduced will be postponed…once again!
However, the credit inflation causes other things to change. Over the last fifty years we have seen that in every employment cycle, fewer and fewer people are re-hired in the “legacy jobs” from which they were released. Under-employment, not just un-employment, rises and this puts more and more pressure on incomes. The ratio of debt payments to pretax incomes rise for these people. Right now, I estimate that roughly one out of every four or five potential works is under-employed, the highest level since the early 1950s.
Second, the steady inflation of the past fifty years has resulted in a larger proportion of the capital stock being un-productive. As a consequence, capacity utilization in industry has fallen to post-World War II lows. As we have seen in each business cycle during this last fifty years, less and less of this capacity is used in each recovery. This results in a drag on employment and income.
Eventually, debt must be repaid and debt loads must be reduced. The Fitch report highlights this problem. It is something that all of us should keep in mind in the upcoming months. If the situation with respect to under-employment and capacity utilization don’t change the debt loads will get even heavier.
Monday, February 22, 2010
Inflation is in the News
There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” http://seekingalpha.com/article/188351-doesn-t-anyone-understand-inflation. The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.
This morning we see an opinion piece by Wolfgang Münchau in the Financial Times, http://www.ft.com/cms/s/0/9776aeb0-1ef2-11df-9584-00144feab49a.html; an article by Sewell Chan in The New York Times, http://www.nytimes.com/2010/02/22/business/22imf.html?ref=business; and another article by Jon Hilsenrath in the Wall Street Journal, http://online.wsj.com/article/SB20001424052748704511304575075902205876696.html#mod=todays_us_page_one. All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.
The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”
In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.
The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!
It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.
The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.
Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.
The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”
The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.
The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.
Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.
Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.
The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.
I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.
The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.
This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.
This morning we see an opinion piece by Wolfgang Münchau in the Financial Times, http://www.ft.com/cms/s/0/9776aeb0-1ef2-11df-9584-00144feab49a.html; an article by Sewell Chan in The New York Times, http://www.nytimes.com/2010/02/22/business/22imf.html?ref=business; and another article by Jon Hilsenrath in the Wall Street Journal, http://online.wsj.com/article/SB20001424052748704511304575075902205876696.html#mod=todays_us_page_one. All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.
The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”
In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.
The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!
It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.
The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.
Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.
The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”
The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.
The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.
Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.
Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.
The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.
I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.
The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.
This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.
Friday, November 6, 2009
Has the Fed (and other central banks) Made a Mistake?
The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.
I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.
I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.
If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.
But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.
Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.
The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.
A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.
First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.
And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.
The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.
To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.
Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.
Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?
And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.
To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.
One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!
I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.
I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.
If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.
But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.
Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.
The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.
A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.
First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.
And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.
The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.
To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.
Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.
Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?
And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.
To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.
One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!
Thursday, February 12, 2009
The Three Problems We Face: Debt, Debt, and Debt!
The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
Thursday, December 11, 2008
Should Banks Start Lending Again?
Banks aren’t doing a lot of lending these days.
Why not?
The Federal Reserve System has bent over backwards dumping liquidity into the financial system. The United States Treasury Department has provided the banking industry with a lot of new ‘capital’. Why aren’t the banks’ lending? Why aren’t the banks even lending to themselves…
My question: Why should the banks be lending?
My answer: they shouldn’t…not right now!
A good reason for this is that United States financial institutions still do not have a firm grasp on the value of a large portion of their assets. “The biggest US financial institutions reported a sharp increase to $610 billion in so-called hard-to-value assets during the third quarter…” (“Financial groups’ problem assets hit $610 bn”, http://www.ft.com/cms/s/0/ea576c7c-c729-11dd-97a5-000077b07658.html.) These assets, primarily mortgage-backed securities and collateralized debt obligations, don’t have active markets at the present time and they are difficult to value. I should be noted that the assets so identified “are many times bigger than the market cap of the banks.”
If you were a banker right now, where would you be focusing your resources at the present time? Would you be attempting to put new loans on the books that would pay off over several years’ time…or…would you be trying to get your arms around the value of these ‘level-three’ assets and see how you can minimize the damage they might cause…in the immediate future?
As long as these assets are on-the-books bank managements are going to muddle around, attempting to minimize the information that is released, and ask for the government to protect them from the downside through asset purchase programs that shore up asset price and the like.
This only distracts efforts and prolongs things! Until the banks are forced to write down their assets to realistic (some form of market) values and take their hits…they will be unable to focus on business and get on with their lives.
But there are other things looming on the horizon. Why would you want to put on new loans when you have people talking about the rising level of foreclosures? Elizabeth Warren of Harvard who is leading the oversight of TARP stated on television last night that in the next two years 8 million houses will be in foreclosure, an amount that is about 16% of the housing stock. That is one out of every six houses in the United States will be in foreclosure within the next two years!
And, why would you want to put on new loans when you have people talking about the rising level of charge-offs related to credit cards? (See “Charge-offs Start to Shred Card Issuers”, http://online.wsj.com/article/SB122895752803296651.html?mod=todays_us_money_and_investing.) All the statistics in this area point to a surge in charge-offs that will be faced by credit card issuers in the future.
Furthermore, there is still the unknown number and size of business defaults that are coming down the road. Of course, there are the auto companies…but, the condition of the credit wings of the auto companies reinforce the concern. Ford Motor Credit Co. is teetering on the brink of bankruptcy…as is GMAC. (“GMAC Bondholders Balk at Debt Swap”, http://online.wsj.com/article/SB122891574162094585.html?mod=todays_us_money_and_investing. Also see “Doubts on GMAC bank holding plan”, http://www.ft.com/cms/s/0/3ccf9eb4-c727-11dd-97a5-000077b07658.html.)
Financial institutions cannot make loans when they are so uncertain about the loans that they have already made. Financial institutions cannot make loans when there is so much uncertainty about the length and depth of the recession, the rise in layoffs and the falloff in employment. (Just released: Jobless Claims hit a 26-year high!) Those individuals and businesses that are seeking loans want to refinance or restructure…to gain control over cash flows so that they don’t run out of cash. Borrowing related to expanding business or creating jobs is almost non-existent. (“Executives Are Grim on Economy”, http://online.wsj.com/article/SB122896532391397279.html?mod=todays_us_marketplace.)
Should banks be lending now?
The answer to this is no…they are not social institutions.
Yes, it would be helpful to the economy if all banks opened their doors and started flooding the market with loans. Everyone would benefit…right?
OK, then…who wants to be first?
Why not?
The Federal Reserve System has bent over backwards dumping liquidity into the financial system. The United States Treasury Department has provided the banking industry with a lot of new ‘capital’. Why aren’t the banks’ lending? Why aren’t the banks even lending to themselves…
My question: Why should the banks be lending?
My answer: they shouldn’t…not right now!
A good reason for this is that United States financial institutions still do not have a firm grasp on the value of a large portion of their assets. “The biggest US financial institutions reported a sharp increase to $610 billion in so-called hard-to-value assets during the third quarter…” (“Financial groups’ problem assets hit $610 bn”, http://www.ft.com/cms/s/0/ea576c7c-c729-11dd-97a5-000077b07658.html.) These assets, primarily mortgage-backed securities and collateralized debt obligations, don’t have active markets at the present time and they are difficult to value. I should be noted that the assets so identified “are many times bigger than the market cap of the banks.”
If you were a banker right now, where would you be focusing your resources at the present time? Would you be attempting to put new loans on the books that would pay off over several years’ time…or…would you be trying to get your arms around the value of these ‘level-three’ assets and see how you can minimize the damage they might cause…in the immediate future?
As long as these assets are on-the-books bank managements are going to muddle around, attempting to minimize the information that is released, and ask for the government to protect them from the downside through asset purchase programs that shore up asset price and the like.
This only distracts efforts and prolongs things! Until the banks are forced to write down their assets to realistic (some form of market) values and take their hits…they will be unable to focus on business and get on with their lives.
But there are other things looming on the horizon. Why would you want to put on new loans when you have people talking about the rising level of foreclosures? Elizabeth Warren of Harvard who is leading the oversight of TARP stated on television last night that in the next two years 8 million houses will be in foreclosure, an amount that is about 16% of the housing stock. That is one out of every six houses in the United States will be in foreclosure within the next two years!
And, why would you want to put on new loans when you have people talking about the rising level of charge-offs related to credit cards? (See “Charge-offs Start to Shred Card Issuers”, http://online.wsj.com/article/SB122895752803296651.html?mod=todays_us_money_and_investing.) All the statistics in this area point to a surge in charge-offs that will be faced by credit card issuers in the future.
Furthermore, there is still the unknown number and size of business defaults that are coming down the road. Of course, there are the auto companies…but, the condition of the credit wings of the auto companies reinforce the concern. Ford Motor Credit Co. is teetering on the brink of bankruptcy…as is GMAC. (“GMAC Bondholders Balk at Debt Swap”, http://online.wsj.com/article/SB122891574162094585.html?mod=todays_us_money_and_investing. Also see “Doubts on GMAC bank holding plan”, http://www.ft.com/cms/s/0/3ccf9eb4-c727-11dd-97a5-000077b07658.html.)
Financial institutions cannot make loans when they are so uncertain about the loans that they have already made. Financial institutions cannot make loans when there is so much uncertainty about the length and depth of the recession, the rise in layoffs and the falloff in employment. (Just released: Jobless Claims hit a 26-year high!) Those individuals and businesses that are seeking loans want to refinance or restructure…to gain control over cash flows so that they don’t run out of cash. Borrowing related to expanding business or creating jobs is almost non-existent. (“Executives Are Grim on Economy”, http://online.wsj.com/article/SB122896532391397279.html?mod=todays_us_marketplace.)
Should banks be lending now?
The answer to this is no…they are not social institutions.
Yes, it would be helpful to the economy if all banks opened their doors and started flooding the market with loans. Everyone would benefit…right?
OK, then…who wants to be first?
Thursday, December 4, 2008
Financial Indicators of the Deteriorating Real Economy
More and more we see concern being expressed about the deteriorating real economy and less emphasis being placed on the crises within the financial sector. The concern about the growing weakness in the real economy points to a longer and deeper recession than had been anticipated.
The current recession, as defined by the NBER, is in its 12th month and trails two other recessions which lasted 16 months as the longest post-World War II downturns on record. As economists revise their forecasts, most seem to believe that the 16 month period will be exceeded and many are saying that the current recession will reach the 20-24 month time span.
Economists only have to point to the daily release of employee layoff announcements to support their increasing pessimism. Companies are restructuring and these efforts are accompanied by reductions in workforce by 5,000 and 10,000 and more, per firm. AT&T announced today that they are going to lay off 12,000 employees and are taking a $600 million charge in the fourth quarter to cover severance payments. And, given recent experience, there will be two or three other companies announcing layoffs today. There will be more tomorrow…and Monday…and…
Then these layoffs must work their way through the rest of the economy. Lower spending…credit card defaults…additional decline in sales…more layoffs…and so on and so on. The effects are cumulative.
The policy problem is how to stop the cumulative contraction so that the downward spiral is broken.
The potential effects of this downward spiral in the real economy are being translated into the financial markets and the warnings are rather severe. For example, take the article in the Financial Times, titled “Record number of companies at risk of default”: http://www.ft.com/cms/s/0/490a8668-c154-11dd-831e-000077b07658.html. This article focuses on the Markit iTraxx Crossover index which measures the cost of protecting junk-grade companies against default. This index rose above 1,000 basis points for the first time ever indicating that “a record number of companies are on the verge of default because of deepening financial problems.”
The authors also write that “Some of the world’s leading investment-grade companies look in danger of default, according to CDS prices.” The point being that the future shows nothing but dark clouds now. As these firms continue to restructure to avoid default on their debt the situation, at least in the short run, can only worsen because the layoffs lead to lower incomes which results in lower spending which results more restructuring and so on.
This deterioration in the real economy is also being transmitted to the government sector. There are two concerns being expressed in terms of the government securities. First, at local and regional levels…state and local governments…there is a restructuring gong on as government revenues drop and attempts are made to bring government budgets into balance…or at least into manageable level of deficit.
Second, governments at the national level are attempting to protect financial markets and combat the deterioration in their real economies. As a consequence, national deficits are ballooning and concern is being raised over the possibility of default on the part of sovereign nations. Another article in the Financial Times speaks to this concern: “Sovereign CDS prices soar as debt mounts”: http://www.ft.com/cms/s/0/c441907a-c1a3-11dd-831e-000077b07658.html. “Credit default swaps, which insure against bond defaults, rose to all-time highs on the US, UK, France, Spain, Italy and Germany yesterday…The dramatic rise is due to investor concerns over the amount of bonds the government will have to issue to bail out the banks and stimulate the economy.” The concern relates not only to the current economic and financial difficulties but also to the possibility that these governments will not be able to stem the downswing and will have to issue more and more bonds in the future.
Retail sales figures for November have just been release and the story reads that November retail sales are amongst the weakest in many years.
The difficulty that any government faces in attempting to compose a monetary or fiscal policy that can turn this situation around is that it is in the best interests of most economic units in the economy, individual, family, business, or non-profit, to get back to basics, to restructure what they do, to cut back their living standard, and to reduce debt. Consequently, government efforts are like “pushing on a string”…there is nothing to push against.
The current recession, as defined by the NBER, is in its 12th month and trails two other recessions which lasted 16 months as the longest post-World War II downturns on record. As economists revise their forecasts, most seem to believe that the 16 month period will be exceeded and many are saying that the current recession will reach the 20-24 month time span.
Economists only have to point to the daily release of employee layoff announcements to support their increasing pessimism. Companies are restructuring and these efforts are accompanied by reductions in workforce by 5,000 and 10,000 and more, per firm. AT&T announced today that they are going to lay off 12,000 employees and are taking a $600 million charge in the fourth quarter to cover severance payments. And, given recent experience, there will be two or three other companies announcing layoffs today. There will be more tomorrow…and Monday…and…
Then these layoffs must work their way through the rest of the economy. Lower spending…credit card defaults…additional decline in sales…more layoffs…and so on and so on. The effects are cumulative.
The policy problem is how to stop the cumulative contraction so that the downward spiral is broken.
The potential effects of this downward spiral in the real economy are being translated into the financial markets and the warnings are rather severe. For example, take the article in the Financial Times, titled “Record number of companies at risk of default”: http://www.ft.com/cms/s/0/490a8668-c154-11dd-831e-000077b07658.html. This article focuses on the Markit iTraxx Crossover index which measures the cost of protecting junk-grade companies against default. This index rose above 1,000 basis points for the first time ever indicating that “a record number of companies are on the verge of default because of deepening financial problems.”
The authors also write that “Some of the world’s leading investment-grade companies look in danger of default, according to CDS prices.” The point being that the future shows nothing but dark clouds now. As these firms continue to restructure to avoid default on their debt the situation, at least in the short run, can only worsen because the layoffs lead to lower incomes which results in lower spending which results more restructuring and so on.
This deterioration in the real economy is also being transmitted to the government sector. There are two concerns being expressed in terms of the government securities. First, at local and regional levels…state and local governments…there is a restructuring gong on as government revenues drop and attempts are made to bring government budgets into balance…or at least into manageable level of deficit.
Second, governments at the national level are attempting to protect financial markets and combat the deterioration in their real economies. As a consequence, national deficits are ballooning and concern is being raised over the possibility of default on the part of sovereign nations. Another article in the Financial Times speaks to this concern: “Sovereign CDS prices soar as debt mounts”: http://www.ft.com/cms/s/0/c441907a-c1a3-11dd-831e-000077b07658.html. “Credit default swaps, which insure against bond defaults, rose to all-time highs on the US, UK, France, Spain, Italy and Germany yesterday…The dramatic rise is due to investor concerns over the amount of bonds the government will have to issue to bail out the banks and stimulate the economy.” The concern relates not only to the current economic and financial difficulties but also to the possibility that these governments will not be able to stem the downswing and will have to issue more and more bonds in the future.
Retail sales figures for November have just been release and the story reads that November retail sales are amongst the weakest in many years.
The difficulty that any government faces in attempting to compose a monetary or fiscal policy that can turn this situation around is that it is in the best interests of most economic units in the economy, individual, family, business, or non-profit, to get back to basics, to restructure what they do, to cut back their living standard, and to reduce debt. Consequently, government efforts are like “pushing on a string”…there is nothing to push against.
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