Long-term Bond Yields and QE2

One of the fundamental things I learned when working in the Federal Reserve System and in running financial institutions was that the Federal Reserve could only temporarily lower long term interest rates.

In attempting to achieve a goal of lowering these rates, the yield on long-term Treasury securities would initially dip below its previous level and then rise to a point where it was above the previous level. The moral of this market behavior was that attempts to keep long term interest rates lower than the market desired only ended up causing the rates to go up as the market adjusted to the efforts of the central bank.

In my professional career I have not observed anything that would lead me to change this viewpoint.

Yet, supposedly, the QE2 efforts of the Federal Reserve are aimed at reducing the yield on long-term Treasury securities so as to encourage a more robust recovery of the economy. The argument given is that there is little or no indication that inflation will pick up because, if anything, the probability that we might enter into a period of deflation is high enough to be of concern.

As recorded in my post yesterday, I believe that on the subject of inflation/deflation, Ben Bernanke is a lagging indicator. He always seems to be behind what is happening. (See “The Fed: Bubble, Bubble Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.)

Let me start from where I am. First, the United States economy IS recovering. However, this recovery is going to be a very slow one because of all the re-structuring that needs to be done within the economy of the United States. We have considerable under-employment with one out of every four individuals of working age being under-employed. We have a capital structure in which a lot of capital is not being used: current capacity utilization is around 75% and the previous peak “high” was only about 81%. We have built too many houses and there seems to have been too much development of commercial properties. There is still too much debt outstanding: more deleveraging needs to take place. And, this doesn’t even come close to touching the needs of our educational system. (See “Top Test Scores from Shangshai Stun Educators,” http://www.nytimes.com/2010/12/07/education/07education.html?ref=education.) And, so on.

I just do not believe that monetary stimulus, or, for that matter, further fiscal stimulus is going to achieve much faster economic growth.

The financial system is still fragile and this, I have argued is the real reason for the Fed’s attempt to flood the world with liquidity. Banks, other than the largest 25 banks, are still extremely distressed. State and local governments face huge fiscal problems. And, the federal government is going to post $15-$18 trillion in new debt over the next ten years given the current budgetary posture. Financial markets must be kept calm so that the FDIC and others can work off insolvent banks; where pension accounting in government can be brought into line; and assets values can be written down throughout the economy.

Let me reiterate: the economic recovery is progressing.

And, what about inflation?

According to the implicit price deflator of Gross Domestic Product, inflation was running at about a one percent year-over-year annual rate in the third quarter of this year. I prefer this measure of inflation as opposed to the Consumer Price Index (CPI) because of all the expert “fussing” with this latter measure over the past 15 years. Also, I do not really trust an indicator that has a large component relating to the rental price of owner-occupied housing that is estimated and has been shown to have substantial biases.

As can be seen from this chart, the year-over-year rate of change in prices did not turn negative during the Great Recession and seems to be on a relatively steady upward movement. It is my belief that the inflation shown in the GDP Implicit Price Deflator will continue to rise, but not explosively.

That is, the economy will continue to grow, but only modestly over the near term. And, I believe that the longer-term trend in prices in the United States economy is up. Furthermore, I believe that the longer-term trend in the value of the dollar is down.

In terms of the last forecast I believe that the value of the dollar will continue to decline in world markets over time in spite of the best efforts of Europe to “prop up” the dollar through the absence of leadership and guts that seems to prevail in the halls of the European Union.

Now, back to bond yields. Within the scenario I have described above, I really cannot see how the Federal Reserve, through its QE2 efforts, can keep long-term Treasury yields down. I guess my major question becomes, is this really the goal of the Federal Reserve? Or, are the statements coming out of the Federal Reserve a diversion to keep people from looking too deeply into the continuing problems of the banking system, and of the state and local governments, and asset values? Are the efforts of the Federal Reserve just a holding action while the value of assets, those of banks, those of state and local governments, those of home owners, and those of businesses, are written down?

To me, long-term bond yields should rise over time. I just can’t see how the Fed can keep them down.

What is most disturbing in all of this to me is the fact that the Chairman of the Board of Governors of the Federal Reserve System has become the primary spokesperson of the Obama administration. Tim Gaithner has failed in that role; Christina Romer has failed in that role: and Larry Summers has failed in that role. Now, Ben Bernanke has become the voice of Obama on economic affairs. How sad!!!

Dodd-Frank Wall Street Reform and Consumer Protection Act

What do I think of the Dodd-Frank Financial Reform legislation?

I can't express it better than this:

The Dodd-Frank Financial Reform Act is already "legacy".

Bubble, Bubble, Everywhere!

The Federal Reserve just doesn’t seem to get it!

Monetary ease can cause bubbles and not just in the United States. Bubble Ben at the Fed still denies that the Federal Reserve had anything to do with the bubbles in asset prices in the early 2000s in housing and the stock market. Bubble Ben, in 2005, placed blame on the Chinese and other countries for the “Global Savings Glut” that helped to finance the budget deficits of the United States government thereby allowing the interest rates in the America and other countries to be excessively low, causing substantial concern about world inflation and international resource misallocation.

Bubble Ben continues to see price moderation as a problem, just as in 2006 and 2007 he saw inflation as a problem far beyond the period when inflation was a problem. When it comes to price movements and asset bubbles, Ben Bernanke is a lagging indicator!

What is happening in the real world, Ben?

We see the headlines, “Investors Pile into Commodities”, (http://professional.wsj.com/article/SB10001424052748703963704576005933072423242.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.) “Investors are holding their biggest positions on record in the commodities markets as prices surge…Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.”

We read in the Financial Times, “Crude Oil Tipped to Bubble over $100 a Barrel,” (http://www.ft.com/cms/s/0/cfb5cd58-022f-11e0-aa40-00144feabdc0.html#). “For the first time in two years, oil bulls are starting to outnumber bears.” Have you noticed that the price of gas has jumped $0.30 or so over the past month or two. And, the price of gasoline at the pump is going to continue to rise.

And the same picture arises for worldwide commodity prices, “Material Difference,” (http://www.ft.com/cms/s/0/d1e31d98-023d-11e0-aa40-00144feabdc0.html#axzz17WmrNvT3). “World prices for cotton have risen by 73 percent since the start of June.” This is just one item; one can go to other commodities and see substantial increases. This is sure going to help the economic recovery?

“In other words, a generation that has grown up with food and clothing deflation must now get used to paying more for the shirts on their backs and the bread on their table. The options: less breakfast cereal in the carton and hair-raisingly static-inducing nylon shirts, or pummeled profit margins for the global food and clothing industry.” That is, world commodity inflation is causing cost pressures that must surface somewhere. And, this is going to help the recovery?

And, we are seeing China, Brazil, and India, among other countries, raising interest rates and restricting bank lending so as to combat increasing levels of inflation. Governments are very concerned.

Last week, the Federal Reserve released information about the financial and non-financial institutions that it assisted throughout the world during the recent financial crisis.

Commentators responded by referring to the Federal Reserve System as the “world’s central banker.”

The Federal Reserve System has become the “world’s inflator”!

International financial markets have become so interlinked and flows of funds have become so fluid that pumping up the world’s reserve currency can affect almost every corner of that world. If the Federal Reserve creates an environment in which investors can borrow at 25 to 50 basis points and lend elsewhere at much higher rates, money is going to flow from the United States into these other opportunities.

And, bubbles result...worldwide!

What the Federal Reserve fails to understand is that industry and finance in the United States is in need of a massive re-structuring. Efforts to pump funds into the U. S. economy in a short-run attempt to put people back to work is just resulting in the money going “off-shore”. These efforts are not helping people and businesses de-leverage and modernize; it is not helping them re-structure.

And, these efforts are not helping America compete in the 21st century when its educational system is just producing students that are average or just above average in science, math, and reading when compared with other children throughout the world.

Also, the Federal Reserve does not understand the role it has played in exacerbating the increasing gap in incomes between the highest earners and the rest of the income spectrum.

As a consequence, the Federal Reserve is just producing bubbles everywhere and it is hard to see how this is really going to help us.

America Continues to "Go Liquid"

The monetary story of the “Great Recession” is that the two most watched measures of the money stock, M1 and M2, have continued to grow, year-over-year, throughout the downturn and slow recovery. The problem with this is that the money stock measures have grown because Americans have almost continuously been moving their funds from less liquid assets into assets that can be used for transactions purposes.


In other words, Americans have wanted their assets where they can immediately spend them.


This is very obvious when we compare the year-over-year growth rates of the M1 and M2 money stock measures. For the last seven months, M1 growth has averaged around 6% (down from around a 13% average for the previous year). The M2 growth rate has been around 2.5% for the same time period (down from about 6% for the previous year).


The non-M1 component of M2 has grown at about 1.5% for the past seven months, much slower than the rate at which M1 grew over this same time period. The average growth of this measure for the previous twelve months was hardly different from zero.


This continued relative movement into “transaction accounts” is not a positive signal that the economic recovery will pick up soon. Americans still seem to be putting their funds into currency and checkable deposits because they need “ready” cash to spend on necessities. They are not saving for a rainy day for, to these people, the rainy days are here.


Another indication of the desire of Americans to have money available for spending is the continued high growth rates in the currency component of the money stock. Through much of the 2000s up until September 2008, the year-over-year rate of growth of the currency component of the money stock rose by less than 2.0%. For much of the time it was below 1.0%.


Beginning in September 2008, more and more Americans wanted cash on hand. At one point, the year-over-year rate of growth of currency rose to about 12.0%. Although the demand for currency has dropped off, the year-over-year rate of growth was in excess of 5.0% in October 2010 and around 6.0% in November 2010. This is another indication of the need for people to have money “ready-to-spend.”


This movement of funds is also reflected in the numbers for bank reserves. Total reserves in the banking system have actually declined, year-over-year, in the past two months. In November, total reserves were actually down by about 9.0%, year-over-year.(In the first quarter of 2010, total reserves were up 120.0%!)


Required reserves in the banking system, however, were actually up during this two month period. In November, required reserves showed a year-over-year increase of about 5.0%. This shows how the deposits at financial institutions have moved from time and savings accounts to checkable deposits that have higher reserve requirements.


As a consequence of this shift, excess reserves at commercial banks have declined slightly over the past several months. This decline has not been initiated by the Federal Reserve, but has resulted from the shift in deposits within the commercial banking system.

The Federal Reserve was highly criticized for the way it reacted to the period known as the Great Depression. As Milton Friedman showed, at one time, the Federal Reserve had allowed the M2 money stock to decline by about one-third. He attributed the Great Depression to the fact that the monetary authorities allowed the money stock to decline by such a massive amount.


The year-over-year growth rate of the M2 money stock measure has never dropped below zero over the past four years. This can be seen in the accompanying chart. In late 2008, this growth rate accelerated as people moved money into currency and checkable deposits. You can see the drop off as the most dramatic movements resided. The important thing, however, is that the growth rate of the M2 money stock measure never turned negative.


What are we currently watching for in these measures of money stock and reserve growth?


We are interested in an acceleration of economic growth. This acceleration will not take place until two things happen in the money stock measures. First, the movement of funds from assets that serve as a “temporary abode of purchasing power” (a term coined by Milton Friedman) to checkable deposits must be reversed. The movement from these interest bearing assets to checkable deposits indicates the weaknesses that exist on balance sheets and the need to keep funds available for current spending.


Second, commercial banks must begin making loans again. Banks, in the aggregate, still do not seem to be too willing to make loans and expand business and consumer credit. (See http://seekingalpha.com/article/235487-the-banking-system-seems-to-be-dividing-large-vs-small-commercial-banks.) Until this starts to happen we will not see the checkable deposits at commercial banks beginning to rise again for reasons other than that people want to hold more checkable balances.


And, if time and savings accounts do not stabilize and begin to increase and banks do not start increasing their lending, the year-over-year rate of growth in the M2 measure of the money stock will continue to remain lethargic. This will be one indicator that the economy is not picking up steam.


If consumers, businesses, and banks do not start to change their behavior I cannot be optimistic about the success of the Fed’s efforts at quantitative easing, i. e., QE2 (see post of December 6, “Federal Reserve QE2 Watch: Part 1”: http://seekingalpha.com/article/240224-qe2-shifted-mortgage-backed-securities-to-treasury-securities).

Federal Reserve QE2 Watch: Part 1

Quantitative Easing, Part 2 has begun. As I wrote on November 4, 2010, “The Fed is going to purchase an additional $600 billion in US Treasury securities over the next eight months, or $75 billion per month, in order to get the economy growing again…over the same time period, roughly $250 to $300 billion will run off of the Fed’s mortgage-backed securities portfolio. This $250 to $300 billion in mortgage-backed securities will be replaced by $250 to $300 billion in U. S. Treasury securities. (See "The Fed's $850 billion bet": http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications.)

The reason given for this policy is that the economy is not picking up fast enough and that unemployment is such a problem that the Fed must act in an extraordinary way in order to correct the situation. Nothing, however, is being said about the weaknesses in the commercial banking sector and the need to put a floor under asset prices so that the banking regulators can work out all the insolvent banks.

So, we are entering a new phase of monetary policy. It is very important to keep on top of what the Fed is doing so that we can try and understand how this quantitative easy is working and what impacts this policy is having on the banking system.

Remember, starting in July 2009, the Federal Reserve began to execute an “exit policy” to remove all of the excess reserves it had pumped into the banking system in the first round of quantitative easing. The Fed, in combating the “Great Recession” pushed the excess reserves in the banking system from about $2.0 billion to over $1.0 trillion. During this time, the balance sheet of the Fed grew from less than $900 billion to more than $2.0 trillion. The “exit policy” was an attempt to return the balance sheet to a size that was comparable to the earlier figure and substantially reduce the excess reserves in the banking system.

During the year or so that the Fed was engaged in its “exit strategy”, the Fed’s balance sheet actually increased and excess reserves in the banking system rose! (See http://seekingalpha.com/article/224085-federal-reserve-non-exit-watch-part-1.)

So much for an “exit strategy.”

Now for QE2! Given the directive mentioned above, there are three areas that we need to keep a close watch on. First, we need to watch what happens to the Federal Reserve balance sheet and what happens to the excess reserves in the banking system. This will tell us whether or not the Fed policy is expansive. Second, we need to watch the runoff in the portfolio of mortgage-backed securities (and Federal agency securities) to see whether or not the Fed is replacing the runoff with purchases of Treasury securities. Third, we need to see what “operational” factors are influencing the Fed’s balance sheet to determine whether or not the purchase of Treasury securities are going to support movements of funds connected with seasonal or other operation factors.

Over the last thirteen week period, Reserve Balances held by commercial banks at Federal Reserve banks actually declined by $2.0 billion.

In terms of the first point, it appears that the Fed did not act to aggressively expand bank reserves or the excess reserves held by the banking system.

In terms of the second point, during this thirteen week period, the Federal Reserve purchased roughly $131 billion in United States Treasury securities. However, the Fed’s portfolio of mortgage-backed securities and Federal agency securities declined by almost $90 billion. The net increase in Securities held outright by the Federal Reserve was more than $40 billion.

Two major “operational” events absorbed bank reserves during this period. These two events caused funds to flow out of the banking system and the Fed needed to inject reserves back into the banking system to replace them. This is what the above $40 billion in securities purchases went to do.

The first “event” that drained reserves out of the banking system was a flow of currency “out of” the banking system. This always happens as people prepare for the Thanksgiving and Christmas holiday seasons: people increase their holdings of cash for current spending purposes. Over the past thirteen week period, Currency in Circulation rose by almost $27 billion and had to be replaced.

The second “event “related to the recapitalization plans of American International Group (AIG). Pending the closing of the recapitalization plan, the cash proceeds from certain asset dispositions will be held by the Federal Reserve Bank of New York as agent. This account appears as a deposit (liability) on the Fed’s balance sheet and results from a flow of funds out of the banking system. Like currency flowing out of the banking system, this movement also has been replaced in the banking system through the Fed’s purchases of U. S. Treasury securities. This account rose by almost $27 billion over the past thirteen weeks.

These were the major changes in accounts over the past thirteen weeks. Other smaller movements of funds provided the balance of getting to the $2.0 billion decline in the Reserve Balances account.

Over all, excess reserves in the commercial banking system declined by about $2.2 billion from the first week in September to the first week in December. Thus, the initial move toward quantitative easing has not resulted in any major change in the banking system, although the Fed’s balance sheet rose by about $45 billion, to almost $2.4 trillion. This rise has occurred due to “operating transactions” relating to the seasonal rise in currency outside of commercial banks and due to the recapitalization of AIG.

So far, the major impact of the QE2 formula is the shift in the overall portfolio of securities held outright by the Federal Reserve. Here we got a major shift from mortgage-backed securities and Federal agency securities to securities issued by the United States Treasury.

We will keep watching.

One final point: I have never seen the Federal Reserve so blatantly political. Fed Chairman Ben Bernanke is now the “point person” for the Obama administration’s economic policy. Never, has a Fed chairman had to go out and sell the government’s monetary and fiscal policy like Bubble Ben has. To me, it’s embarrassing. As reported by Mike Allen in Politico Playbook, the FEDWATCH On 60 MINUTES - CBS News release: “In a rare and frank interview, Federal Reserve Chairman Ben Bernanke talks to Scott Pelley about the troubled economy and the measures the central bank has taken to improve it. Bernanke's interview took place in Columbus, Ohio, last Tuesday (30) and addresses several pressing economic matters..He also talks about the federal deficit and reforming the tax code. He explains why the Fed announced its intention to buy $600 billion in Treasury securities, defending against charges the move will lead to inflation and not ruling out the purchase of more. The Fed chair also addressed the federal deficit.”

Step on the Gas; Hit the Brakes; and at the same time!

There has been lots of words and press spilled on the recent revelations about who the Federal Reserve “bailed out” during the recent financial crisis. Let me just use one such article to capture some of the attitudes being expressed about this information.

Sebastian Mallaby, a senior fellow at the Council on Foreign Relations and the author of the book “More Money than God”, writes in the Financial Times” (http://www.ft.com/cms/s/0/9f5584f2-fe1d-11df-853b-00144feab49a.html#axzz173T61Eok):

“The point is that the Fed bail-outs were hair-raisingly enormous, and that neither the regulators nor the regulated should be allowed to forget that. Wall Street institutions that now walk tall again survived only because the taxpayers saved them. Goldman Sachs turned to the Fed for funding on 84 occasions, and Morgan Stanley did so 212 times; Blackrock, Fidelity, Dreyfus, GE Capital – all of these depended on taxpayer backstops. The message from this data dump is that, two years ago, these too-big-to-fail behemoths drove the world to the brink of a 1930s-style disaster – and that, if regulators don’t break them up or otherwise restrain them, they may do worse next time.”

There doesn’t seem to be much movement afoot to “break them up” at this time, but there has been, and will continue to be, great efforts to “restrain them”. I don’t see the will or the leadership to “break them up”. I have my own views about the ability of the government to “restrain them” but I treat that question elsewhere.

I would like to raise another issue at this time which I believe to be integral to the situation mentioned above.

Discussions about the actions of the Federal Reserve during the financial crisis tend to be completely void of any discussion about the actions of the federal government or the Federal Reserve in creating the environment that resulted in the financial collapse.

Leading up to the financial crisis of 2008-2009 was approximated fifty years of governmental actions that created the largest credit inflation in the history of the United States. The gross federal debt of the United States government increased at a compound rate of approximately 9 percent per year from 1961 to the start of the crisis. Monetary policy, throughout this time period, accommodated this growth in debt. And, this period saw the greatest burst of financial innovation and credit creation in world history.

Why did this happen?

Two major reasons: first, the short-run emphasis of the government to sustain high, perhaps unsustainable, levels of employment; second, the goal of the government to put as many Americans in their own home and provide them with a financial “piggybank” to secure their future.

The first reason meant that the government had to keep stimulating the economy to keep people employed in the jobs they had. As a consequence, many American workers did not have the incentive to grow and prepare themselves for the “jobs of the future.” As a consequence, about one out of every four Americans of employment age is “under-employed”! Furthermore, the length of being unemployed has trended upwards from the 1950s and in October 2010 the average duration of unemployment is just about 34 weeks, almost three years. (See “Unemployed and Likely to Stay That Way,” http://www.nytimes.com/2010/12/03/business/economy/03unemployed.html?ref=todayspaper.)

The second reason meant that the government had to build programs and provide financial innovation and finance so that more people could own their own homes. The inflation that took place in the real estate sector resulted in home ownership becoming the real “piggybank” of the middle class, producing for them the “best” investment they could experience over this time until, of course, the bubble burst.

The federal government set up the environment and the incentives that everyone else had to live within.

Chuck Prince, the former Chairman and CEO of Citigroup, made the now famous statement that “while the music keeps playing, you must keep dancing.”

The environment created by a government that set the example of “living beyond one’s means” created an almost perfect environment for taking financial risk, mismatching maturities, leveraging up debt, and financial innovation. The “Greenspan Put” during the 1990s and early 2000s sustained this environment by providing downside protection thereby creating greater “moral hazard.” In essence, the federal government “kept the music playing” and businesses, both financial and non-financial, had to “keep dancing” in order to remain competitive.

The question was constantly asked by executives, “How can I get a few more basis points return to be competitive with others in the industry?” The answer within such an environment was more leverage, more risk, and new financial innovations. At least, until the load became too heavy to bear.

But, in the rush to “break” companies up or to regulate and “restrain” them from such activity, most people have forgotten that the whole environment and the incentives set up were created by the same people now interested in breaking up these companies or restraining them.

So, within this call for breaking up these companies and regulating them more closely we hear
the same people calling for more government spending, more tax cuts, more quantitative easy on the part of the central bank, and greater welfare benefits to those that are hurting.

This is why the whole scenario seems to be one of trying to drive your car as fast as you can while at the same time trying to drive your car as safely as possible.

You are stepping on the gas and stepping on the car brakes at the same time!

So, where does this discussion take us? Really nowhere.

In my view, the people calling for the federal government to constantly provide fiscal and monetary stimulus to the economy are still in control and I don’t see their demise anytime soon.
People will try to regulate and restrain the financial sector, but, as I have written many times before, they will not be able to be successful. Given the global nature of finance today and the tools brought to the finance industry by information technology, these attempts to regulate and restrain will not succeed.

And, there will be renewed calls for providing social services and payments for those being hurt by the actions mentioned in the preceding two paragraphs. What is really needed to resolve the problems of the modern economy is of a long term nature and our short-sighted politicians will never implement these solutions, at least, anytime soon.

So, we must continue to face a bumpy ride. Stepping on the gas and the brake pedal at the same time produces such a ride.

More Stress Tests Coming for the Banks of Europe

We have been given Quantitative Easing 2 (QE2) by the Federal Reserve System in the United States and now we are facing Stress Tests II (ST2) to be imposed on banking institutions in the European Union. (http://professional.wsj.com/article/SB10001424052748703994904575646903413631856.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Will we eventually be facing Financial Reform Act II (FR2) that will incorporate the next round of regulatory reforms of the financial system of the United States?

I put this new round of stress tests for banks in the same place I put QE2 and the initial Financial Reform Act of 2010 and Basel III (B3)…in the dust bin. For my comments on QE2 see http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications; for my comments on the Financial Reform Act see http://seekingalpha.com/article/206341-the-sound-and-fury-of-banking-reform; and for my comments on B3 see http://seekingalpha.com/article/225116-basel-iii-chuckle.

Regulators and reformers (R&R) just never seem to get it right!

One reason is that they are always fighting the last war. The current popular belief amongst the R&R is that the initial stress tests in Europe did not include tests on liquidity and this element of the banking structure needs to be examined to get a real view of how much “stress” the banks can take. The R&R intend to correct this omission in the next round of stress tests.

Just two points on this. First, liquidity is a market condition and not something that exists on balance sheets. One cannot look at a balance sheet and determine how liquid markets will be. Duh!

Second, if a bank cannot raise funds in financial markets because they have bad assets, this is a solvency problem and not a liquidity problem. In addition they cannot retain funds from market savvy customers

Hugo Dixon wrote in the New York Times yesterday that the Irish banks, Allied Irish Banks and the Bank of Ireland, were “excessively dependent on wholesale money from other banks and big investors.” These monies are very interest rate sensitive and very sensitive to credit risk. Even though these banks passed the earlier stress tests, when the smell of problems arose, the wholesale money “started to flee.”

However, the problem faced by these banks was not a liquidity problem. The problem arose because the wholesale depositors were concerned over the health of the banks and this is a solvency problem.

The situation here is that the R&R can only work with historical data and, consequently, are always behind the times. Their analysis is always static. The movement of the “wholesale money” is current market information and provides a forward looking assessment of the condition of a bank or banks .

What would be desirable would be current information that was “forward looking” and more accessible to the investing public. What would be desirable would be some kind of “forward looking” market information that reflected the viewpoint of market participants that were “betting” their own money.

In a recent post I included a chart that presented market information and was very current. (See http://seekingalpha.com/article/239296-market-behavior-at-odds-with-european-bailouts-liquidity-vs-solvency.) This chart shows information on Credit Default Swap (CDS) spreads on European banks as well as on Spanish banks. One can see that the price of these CDSs began rising in late 2009 in anticipation of the sovereign debt crisis of 2010 and began rising even more dramatically before the current crisis that Europe is now facing. It seems as if some market indicator like these CDS’s could be used as an early warning signal that trouble was brewing in the financial sector of an economy or in specific banks.

Note, that the information provided by the Credit Default Swaps could be used as an early warning signal that something was wrong and this “signal” could then set off further analysis of the institution, or institutions, involved that would be conducted by the regulatory agencies.

Just such a suggestion has been made by Oliver Hart is the Andrew E. Furer Professor of Economics at Harvard University. Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago, Booth School of Business. Two references to their work are “Curbing Risk on Wall Street,” http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street, and “To Regulate the Finance, Try the Market,” http://experts.foreignpolicy.com/blog/5478.

To quote from the latter article: “In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI (large financial institution) to issue equity until the CDS price and risk of failure came back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.”

In the former article the authors argue that “The financial crisis of 2008 resulted from a series of misguided policies, failures of regulation, and missed signals. Unfortunately, much of the conversation about regulatory reform since has revolved around ideas that would only extend and exacerbate all three.”

The problem with implementing a plan like this is it that it causes the R&R to feel like they are losing some of their control…their power. Furthermore, many people within the R&R have little confidence in financial markets…it does not fit within their worldview. This is why I ended up a recent post with this comment: “many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry”

In conclusion, I have very little confidence in a new round of stress tests and believe that ST2 will lead to ST3…and then ST4…and eventually ST(n) where n is any number you want to give it. To me the sign that an approach is not appropriate and will not be successful over time is that people continue to use the same system and attempt to make the system tougher and tougher. Their system never works because their worldview needs to be changed.