Italy is the Key in Europe

It seems to be boiling down to this.  Italy and its prime minister Silvio Berlusconi are the evolving focus of any acceptable solution to the European sovereign debt crisis. 

There are, I believe, two reasons for this focus.  First, Italy is the third largest economy in the European Union.  Thus, moving it into the spotlight leapfrogs the problems of Spain and Portugal and others in terms of impact.  If Italy can be “tamed” then Spain, Portugal, and others will have to fall in line.

Second, Italy, within the European Union, is most like Greece in terms of fiscal irresponsibility, governmental patronization, and lackluster economy.  If both Greece and Italy take steps to correct their situations, then other troubled countries can justify stronger efforts to straighten out their problems as well. 

Another factor is that Silvio Berlusconi has become a characterization of European leadership…or the lack thereof…given his personal as well as his public tribulations.  And, this does not include his recent disputes with others, like that with French president Nicolas Sarkozy, over the makeup of the board of the European Central Bank.  Berlusconi, it seems, must be brought into line...even though he is just barely hanging onto power now.  

By focusing on Italy, the European Union is, in a sense, attempting to “get its arms around” the problem.  The EU efforts of the past have started with the smaller countries with the idea of working up the ladder as the need arose to deal with larger and larger countries.

By bringing Italy in at this time, the EU seems to be admitting that the problem is more fundamental than it had assumed in the past and that the problem is one of solvency and not the liquidity of the sovereign debt.  

Furthermore, the EU seems to be saying that more fiscal coordination needs to be achieved within the European Union itself and to gain this coordination, even the larger countries, like Italy, must submit to greater oversight and community discipline than had originally been built into the organization.    

With the crisis, it has become more and more obvious that for the countries of the European Union to really benefit from the creation of a common currency, greater fiscal union must be achieved as well.  Painful as it may be to some to accept this reality, I don’t believe that there is really much support anywhere for the breaking up of the currency union.

The European Union may finally be getting someplace, although I don’t want to be too optimistic.  Up to this point, the EU has just been “kicking the can” down the road.  It has continually avoided the seriousness of the situation; it has not accepted the reality of the solvency issue; and it has attempted to deal with problems piecemeal. 

As a consequence, many analysts have claimed that it would be better for some nations to leave the currency union or for the Euro to be eliminated all together. 

The fact is, the benefits of the currency union have been sufficiently great that the members of the EU really don’t want to see it go away. 

The “big bump in the road”, however, has been the need for sovereign nations to give up some of their sovereignty on the fiscal front, something they have, understandably, been reluctant to give up.  As a consequence, the path to greater fiscal union has been winding and painful.  No one, willingly, wants to look like the pansy.

By putting the pressure on Italy, the European Union is accepting the seriousness of the situation; it is accepting that the primary issue is one of solvency and not liquidity; and it is finally trying to encircle the problems that exist, not deal with them one-by-one.

This does not mean that the crisis in Europe is over.  There are still many “bumps in the road” that must be smoothed over. 

However, to me, putting Italy into the spotlight raises some hope that the officials in Europe (I am not willing to call them “leaders” yet) may finally be moving in the right direction.

Europeans Facing More of a "Haircut" Than Preciously Thought

News is leaking out that the “haircuts” on European Sovereign debt are going to be greater than imagined just several weeks ago!  “EU looks at 60% haircuts for Greek debt.” (http://www.ft.com/intl/cms/s/0/66bdcbc0-fc11-11e0-b1d8-00144feab49a.html#axzz1bRwsVH3F)

Three months ago European officials agreed to a 21 percent haircut.  Then, in the last several weeks, the figure moved to around 50 percent.

And, still officials are dawdling.

European banks are troubled, and we hear about how the “French Banks Fought Oversight.“  Seems as if French banks and French regulators consistently ignored the reality of the situation within the banks claiming that no problems ever existed. 

Of course, bankers are notorious for claiming that problems do not exist on their balance sheets!  But, this is not new. (See my http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs.)  The bankers’ denial of any problems on their balance sheets is maintained right up to the time hey begin to argue that “It was not our fault!”

The problem I have with all this is that attention is being deflected from the real issues while blame is being diverted from the real culprit.

The real culprit, to me, is the post-World War II attitude in America, the UK, and Western Europe that the creation of debt, especially by governments, could keep unemployment at low levels and this would end the possibility of social unrest caused by masses of unemployed persons.  The result was that the latter half of the twentieth century became the “poster child” for the benefits of what can be called credit inflation. 

Creating debt, especially government debt, was not just a policy of the left, but it was also the policy of the right.  The creation of debt would resolve almost all social issues since it kept people at work.  This would also help politicians get re-elected.

In the 1960s we added to the goal of keeping people working the goal of seeing to it that every family owned their own home.  This was especially the case in the United States.  I was working for a cabinet secretary in the early 1970s in a “conservative” administration, and one of the major goals of this administration was the development of mortgage-backed securities.

The reason for the development of this instrument was certainly not an economic one.  The reason for the development of the mortgage-backed security was to get politicians re-elected.  The argument was that if more Americans owned their own home, the more willing they would be to re-elect those Senators, Representatives, and Presidents that supported this goal. 

The government’s development of the mortgage-backed security, of course, brought several new things to the financial markets, like ‘slicing and dicing’ cash flows, that paved the way for the financial innovation that was to take place later in the century.

Of course, the major driver behind all of this was the continual efforts of the national governments to create credit through deficit spending to hire large numbers of people themselves, to almost continuously stimulate the economy to keep unemployment low, and to continue to find ways to put more and more people into their own homes. 

This is the essence of credit inflation!  And, the central banks, fundamentally, helped the national governments to write the checks.

The undisciplined creation of debt, however, does not end well.  This is the story that Carmen Reinhart and Kenneth Rogoff tell in their book “This Time is Different.”  And, for the United States, the UK, and Western Europe, this time was not different and financial crisis arose.

The point I am getting at is that the resolution of a financial crisis is not a unique action.  However, many of those in authority are crying out “This time is different”!

One of the boldest “criers” is Fed Chairman Ben Bernanke.  I have written my opinion of him in an earlier post. (http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs)  But, Mr. Bernanke is not the only authority at the central bank that is searching for a new or better way to conduct monetary policy. (http://professional.wsj.com/article/SB10001424052970203752604576643510352250474.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

Gillian Tett also writes in the Financial Times that “Central Bankers must update outdated analytical toolkit.” (http://www.ft.com/intl/cms/s/0/877b7bfa-fb21-11e0-bebe-00144feab49a.html#axzz1bRwsVH3F)  

Let me just say in answer to this situation we are in: This time is not different!

The problem is too much debt!  The cause of the problem was 50 years of credit inflation in the United States, the UK, and Western Europe.  This debt must be worked off and it takes time to work off excessive amounts of debt.  Again, I recommend you check the Reinhart and Rogoff book.  I have also just written a post on this: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.

And, the lessons from this experience are not new.  Don’t issue too much debt!  Don’t just focus on short-run goals…like fiscally stimulated low unemployment, like everyone owning their own home, like governments hiring all their own supporters…and so on and so forth.

The problem is not financial innovation or greed or speculators.  These things will never go away. 

The problem has been that the credit inflation created in the last 50 years has created huge incentives to develop financial innovation, to exercise greed, and to benefit from speculation.  And, in the frenzy, things got out-of-control.

That is where we are today.  The haircuts that are now necessary are large and if something is not done about them soon, the haircuts will get even larger!  What if the write-down on Greek bonds were 90 percent?  What if the write-down on the bonds of Italy were 50 percent?  Portugal…60 percent? Spain…?  And, France…?

Over the last fifty years or so, people in the United States, the UK, and Western Europe have been living pretty well.  They can live well again.  But, we need to get away from Keynesian policies that promise something for nothing and return to some fundamentals that have played well over the years.

This time is not different!  Discipline and integrity are winners and have always been winners.  But, in a state of chaos, returning to discipline and integrity is difficult and painful.  The historical lesson, however, is that if people do not return to a condition of discipline and integrity the pain and suffering does not end…and in many cases it will only get worse!   

Oh, My Gosh! We Now Need "Forward Guidance"!

Poor Ben Bernanke. 

To me, the kindest thing that can be said about him is that he is suffering the fate of those who are in charge of large institutions with little or no practical experience in administering any other organization of consequence.  He just does not seem to understand how to lead such an organization and he does not seem to have the capacity to adapt how he does things so as to achieve a better performance. 

Where one can criticize Mr. Bernanke and the Fed, as I have done in the past, for claiming that solvency problems are just liquidity problems, one can also criticize Mr. Bernanke and the Fed for claiming that their problems with the market are ones of the appropriate information flow and not one of credibility.

Now we are presented with the specter of something called “Forward Guidance.”  To quote Mr. Bernanke, “forward guidance and other forms of communication about policy can be valuable even when the zero lower bound is not relevant (short-term rates are not around zero).  I expect to see increasing use of such tools in the future.” (http://www.federalreserve.gov/newsevents/speech/bernanke20111018a.htm)

Mr. Bernanke came into the position of Chairman of the Board of Governors of the Federal Reserve System promising to provide greater openness and transparency to what the Federal Reserve is doing.  He has been consistently more available to the press and others than any previous Fed Chairman.  His latest effort has been to talk directly with the press after four regularly held meetings of the Federal Reserve Open Market Committee to explain what the Fed is doing.  The first such meeting was less than rousing. 

Yet, apparently, Mr. Bernanke is unsatisfied with the results of this accessibility.  Why else would we need to have something dangled in front of us like this so-called “Forward Guidance.”

Roughly, “Forward Guidance” provides banks and financial markets with an explicit idea of what the Federal Reserve is attempting to achieve in the future in much the way that the August 2011 statement that the Fed would keep short-term interest rates low until mid-2013.

And, there are other forms the “Guidance” could take.  For example, Mr. Bernanke has been an advocate of “inflation targeting” something other central banks in the world have adopted.  For example, the Fed, during the regime of Mr. Bernanke, has had an informal target for inflation of 2 percent.  Under the new effort to keep the public better informed, this policy effort, tying interest rate levels to an inflation target, would be made more formal and explicit.

One could also do the same thing with respect to an unemployment goal. 

When this effort of communication does not work, I wonder what Mr. Bernanke will try next.  His increasing attempts to inform the public about how the Fed will operate given the policy parameters it is watching seems to be constantly falling short of what Mr. Bernanke and the Fed have expected.  Hence, the need to try different things.

In my mind, Mr. Bernanke and the Federal Reserve have followed one basic policy since late 2007.  This policy can be described as throwing as much “stuff” as possible against the wall to see how much of the “stuff” can stick to the wall.

The term “stuff” can apply to many things.  An early example of “stuff” was the Term Auction Credit (TAC), which first showed up on the Fed’s balance sheet on December 26, 2007.  During 2008, the Fed became the banker to the world lending to the European Central Bank and the Swiss National Bank, among others, through swap lines of credit.  The Fed’s line item, Other Federal Reserve Assets, which includes these central bank transactions, rose from about $56 billion on December 26, 2007 to $105 billion on August 27, 2008.  Added to this was the Fed’s assumption of assets from the Bear Stearns transaction, which first showed up on July 2, 2008.  Then in the fall of 2008, the door swung wide open. 

Whereas the earlier efforts did not expand Federal Reserve credit appreciably during most of 2008 (this measure rose from about $874 billion on December 26, 2007 to $884 billion on August 27, 2008 as the Fed reduced other categories of assets to expand credit where it seemed to be needed) by December 31, 2008, Federal Reserve credit reached $2.250 trillion!

On October 12, 2011, Federal Reserve credit stands at almost $2.845 trillion!

We have had QE1, and QE2, and now we have “Operation Twist.”  Excess reserves in the commercial banking system have risen from less than $2.0 billion in December 2007 to about $770 billion in December 2008 to over $1.550 trillion in September 2011.

Bank lending remains anemic, at best, and economic growth stays modest. 

What is the Fed’s monetary policy?  The Fed’s monetary policy is to flood the banking system with “cash”.  What else needs to be explained? 

“Operation Twist” and “Forward Guidance” and “QE2” and whatever do not change the general thrust of the Fed’s monetary policy.  The Fed is throwing as much “stuff” against the wall as it possibly can.  And, it will continue to do so for as long as Mr. Bernanke and the Fed feel that it is necessary.

But, Mr. Bernanke does not feel that this is enough.  And, so he tries this and tries that to increase the “openness and transparency” of the Fed to the rest of the world.  I believe that he is concerned about this more to calm his own mind than to calm the mind of the banking system and the financial markets.

The problem is that people are attempting to reduce their debt loads.  The fifty years or so of credit inflation released on American families and businesses by the United States government since the early 1960s has resulted in a situation where these same families and businesses feel that they are burdened by too much debt.  Consequently, they are attempting to reduce their debt loads. (See my post, “The US economy will continue to grow”: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.)

However, de-leveraging takes time.  Unfortunately, given the current circumstances, the only thing that would stop the de-leveraging is a rapid build-up of inflation making debt “economically valuable” again.  In one sense, this is what it looks as if Mr. Bernanke and the Fed are trying to do.

But, with modest economic growth and tepid inflation, families and small- and medium-sized businesses will continue to reduce the amount of debt on their balance sheets.  These people will not come back into the debt market for some time.  This is  consistent with the research published by Reinhart and Rogoff in their book, “This Time is Different.” 

Even if this is true, Mr. Bernanke and the Fed, for the history books, do not want to look as if they did not do everything in their power to combat a second Great Recession…a double dip, if you will.  Consequently, they will stand ready to throw as much “stuff” as they feel they need to against the wall and will continue, in an open and transparent way, to tell the world that they are doing everything within their power to get the economy moving again.  To me, this is a lack of confidence that does not enhance their credibility.

The United States Economy Will Continue to Grow

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

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

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

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

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

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

So, I believe that the economic recovery will continue.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

European Bankers Balk at Big Write Downs

In my experience there are three ways for bankers with “bad” assets to move on.  First, the bank can “work out” the bad assets, but this takes time and in some cases a lot of luck.  The “lot of luck” component of this solution often refers to a recovery of the economy, local or national, that lifts up all asset values and brings the value of the “bad” assets more in line with the accounting values that exist on a banks’ balance sheet.

The second way is to get someone else to take over the “bad” assets.  Can the bankers find a “sucker” to acquire the “bad assets” at a price near book value and relieve the bank of the need to write down the value of the asset?  There are “suckers” out there, but the “suckers” then have the problem of having an overvalued asset on their balance sheet.  Of course, in some cases, the “sucker” turns out to be the government…or, should we say the “sucker” turns out to be the taxpayer. 

Third, the bank can write down the assets to a realistic value and get on with business. 

The first way is what bankers generally try to do.  Bankers are notorious for their optimism concerning the value of the assets on their balance sheets.  “We just need a little more time and everything will be fine.”  “The borrower just had some bad luck, but is getting things back in order.”  “The economy is improving and we just have to hold on until things get better.”  Of course, in the case of bonds on the balance sheet: “We plan to hold on to them until maturity.” 

In many cases, the old line applies: “People told to smile because things could be worse, so I smiled and sure enough things got worse.”

When the hole gets deeper the problem becomes more severe. 

I have successfully completed three bank turnarounds in my professional career and my general impression is that bankers tend to “look the other way” and postpone dealing with their problems, particularly when the problems pile up.  In many cases, the time runs out and the bank either has to be sold or taken over or has to be closed.

In terms of the second avenue, “suckers” are all around.  However, in the case of one bank “selling” a “bad asset” to another investor, the bank escapes the problem of dealing with an overvalued asset, but the “system” does not get rid of the overvalued asset.  It still has to be dealt with.  In the case of the government (Fannie Mae or Freddie Mac) buying the asset, or, as in the case of the FDIC closing a bank, or, in the case where the government “bails out” a company or an industry and sets up a company with the “bad assets, the government must absorb the difference between the accounting value of the asset and the market value of the asset.  The losses incurred in this way must be paid by the taxpayer over time. 

Admitting one made a mistake and writing down the value of assets is the only way for a bank to really get on with business.  This is a hard thing to do, but to recognize the problem early on and deal with the problem as soon as possible is the only way to allow the bank to get back to the business as usual.  If bankers take the first or second route mentioned above, they lose focus and their performance suffers. 

This is why I am such an advocate of banks marking their assets to market on a regular basis.  It forces them to address their problems as early as possible and after facing their problems head on, they can then turn their focus back to what they should be doing, making loans and building their customer base. 

Even in the case of the bankers buying long-term securities with short-term funds: bankers are doing this to increase the interest rate spread they earn.  They are intentionally taking on interest rate risk in order to improve their performance.  To me it is disingenuous for these bankers to act surprised and perplexed when interest rates rise and the market value of their long-term securities drop relative to their accounting value.

The problems bankers face related to overvalued assets can never really go away until the bankers fully embrace the situation and write down the value of their assets to realistic values.  The asset values must be written down to a level that, at least, eliminates the uncertainty about whether or not the bankers are fully recognizing the problem.

This is one of the freedoms of coming into a troubled situation to “turnaround” a bank.  The “turnaround” specialist can assume a “worst case” scenario and write down assets sufficiently to eliminate the uncertainty surrounding the value of the assets.  If the “turnaround” specialist does not do this, he or she is only creating further problems for themselves sometime down the road.  It is the only way to move on!

European banks still appear to be somewhere in the middle of these three paths to the future.  See, for example, the piece “Bankers Balk at EU push for Bigger Greek Losses” in Bloomberg this morning. (http://www.bloomberg.com/news/2011-10-16/bankers-balk-at-eu-push-for-bigger-greek-losses-higher-capital.html)

The problems faced by the European banks are huge.  The problems faced by European governments are huge.  The lack of fiscal discipline on the part of European governments for the past fifty years or so has caught up with both the governments and the banks that supported this deficiency.  Now, the governments and the banks find that they cannot continue to ignore the problem and hope for things to get better.  Furthermore, the governments and the banks cannot just push the problems off on the taxpayers.

Still they continue to hold out!

The only way the Europeans can resolve their current difficulties is to “bite the bullet” and accept the fact that several of the governments in Europe are insolvent and that the value of the sovereign debt issued by these governments must be written down to values that will eliminate the uncertainty pertaining to whether or not the governments are really accepting the severity of the problem. 

A difficulty inherent in this solution, however, is that the European Union may have to become more politically unified.  Letting the EU dissolve at this time is almost unthinkable and would end up, I believe, in an unconscionable banking catastrophe for the continent.  This may be the “unforeseen consequence” of the formation of the EU…that the crisis resulting from the way the union was initially set up may result in the nations of the EU forming a more unified political structure.  Imagine…

But, the financial problems will not go away as long as those running the governments of Europe continue to face up to the real issues and then deal with them.  The real issues relate to the fiscal irresponsibility of several of the European nations and the consequent insolvency that has resulted.  This insolvency is threatening the insolvency of the European banking system.

Unless this reality is accepted and acted upon, the crisis will just continue to play itself out. 

The Solution to the European Problem?

“The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bonds markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately.”

‘

This is the prognosis of Mr. Martin Wolf, the economics editor of the Financial Times, in today’s edition of the paper. (http://www.ft.com/intl/cms/s/0/3ba2f7c4-ee76-11e0-a2ed-00144feab49a.html#axzz1ZuI4wzxo)

“Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health.”

The word is getting out…the European banks are going to have to take bigger write downs of their holdings of sovereign debt than ever imagined. 

Can the eurozone governments cover the hole in the balance sheets of these banks?

The United States stock market seems to think that they can.  This is the reason given for the rapid recovery of stock prices in the market yesterday. 

But, let’s look more closely at what Mr. Wolf is saying.  In the first condition, he writes about how the amount of the write down will be determined along with how the write down will be administered.  This is a daunting task in, and of, itself. 

Note further, however, that he is including ‘private’ debt along with the debt of sovereign borrowers.  The need to write down the ‘private’ debt is something new, something that has not gotten a lot of attention in the press in all the noise relating to the sovereign debt issue.  

The second point Mr. Wolf makes is about contagion.  How is any write down of the debt of the peripheral nations going to be kept to just the peripheral nations bonds, themselves?  The concern is that once write downs take place in bonds of the fiscally weaker nations that some spread is bound to occur to the nations that are in a stronger position, fiscally.

Then, Mr. Wolf addresses the issue of credibility.  Given all the “messing around” for the better part of almost three years, how can financial markets come to believe that solvency has been restored to the impacted nations?  If anything has increased over the past three years or so, it is the lack of trust in the eurozone governments when it comes to how the politicians carry out their responsibilities.  There is little or no trust in the people heading up most of the governments in Europe.  Can this “trust” be regained…and in time?

The add-on to this analysis is that the eurozone countries also need an immediate return to a robust economic recovery.

The happy conclusion to the analysis: “If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.”

Two comments on this analysis: first, I am glad to see that some people are finally seeing the problem as one of solvency and not one of liquidity.  It has taken a long time for the analysis to get to this point.  Now, it is time for the policy makers to accept this fact.

Second, Mr. Wolf pretty well lays out the dislocation that is going to have to take place in order to restructure and restore the eurozone to some sense of order and balance. 

“How, then, did the eurozone fall into its plight? The easy credit conditions and low interest rates of the first decade (of the European Union) delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain.”

The European condition is the result of credit inflation!  Quite an admission for a dyed-in-the-wool Keynesian!

The point is, however, that a long period of excesses must be matched by a painful and uncomfortable period of restructuring. 

In conclusion, however, one cannot ignore the social situation in Europe.  The “social contract” of the post-World War II era appears, to many, to be broken, and there is protesting and rioting in the streets.  Strong economic growth and low levels of unemployment, something that seems more and more unlikely to happen in the near future, of course, can resolve this situation.  Writing a new “social contract”, as history shows us, is not an easy thing to do.

Are there any lessons here for others?

The Banking Mess: It's Not Over Until It's Over

Credit inflation impacts asset values.  In a credit inflation, the expansion of credit takes place at a faster rate of growth than does the rate of increase in the production of the underlying assets.  Credit inflation can create bubbles. This occurred, as we know, in the dot.com bubble of the 1990s and the housing bubble of the 2000s.

The Federal Reserve is desperate to get credit inflation going again. This was the whole point behind the Fed’s QE2 operations.  Now, we have a version of “Operation Twist” an effort to lower longer-term interest rates relative to shorter-term interest rates.   

At present, the only bubbles the Federal Reserve has created have been in foreign assets like commodities and the stocks in emerging markets.

So far, the policy of the Federal Reserve has not been very successful in the way of domestic assets.  Credit expansion in the United States remains moribund.  And, as a consequence, asset prices seem to be remaining level.

Housing prices continue to fall, or, at best, stay relatively constant.  The stock market has gone nowhere.  Year-over-year, the Dow-Jones Average is up just 0.8 percent.  Since the same time in 2007, around the start of the recent recession, the Dow-Jones Average is still down 21.6 percent.

The only major borrowers of any consequence seem to be the largest companies and they seem to be either holding onto the cash or using the cash to repurchase their own stock.  Where once it was felt that these funds would be used for the acquisition of other companies, so far the number of acquisitions taking place have fallen below expectations as the future remains listless and uncertain.

We still have to look at the banking system for any sign of a recovery in credit and the credit inflation cycle.  And, in looking at the banking system, the signs of expansion still are absent.

A start up of bank lending is going to depend upon the status of the banks themselves…and this picture is mixed, at best.

The good news is that the FDIC is closing two of its three temporary offices.  Due to a decline in the amount of bank problems and the severity of those problems, the FDIC has decided that it can handle problem banks primarily out of its permanent offices.  The period of the ramping up of staff and the sending of staff all over the country, seven days of week, seems to be over.

Also, only 74 commercial banks have been closed this year through Friday, September 30.  In 2010 the total number of banks that failed were 157 with 30 closings coming in the fourth quarter of the year.  In 2009 a total of 140 banks failed.   Bank failures are on the wane.

Note that the number of bank failures does not include the decline in the number of banks in business.  For example, since December 31, 2007, 396 commercial banks have failed.  Yet, the number of banks in the banking system declined by 871.  This left the commercial banking system with 6,41 banks in existence. 

Likewise, about 1,000 banks and savings institutions have disappeared since the end of 2007, leaving only 7,513 FDIC insured institutions in existence on June 30, 2011.

And, still there are 865 banks on the FDIC’s list of problem banks at the end of June, down only slightly from a total of 884 at the end of March 2011.

“Camden Fine, president of the Independent Community Bankers of America, a trade group, predicted another 1,000 to 1,500 banks will vanish between now and the end of 2015.” (http://professional.wsj.com/article/SB10001424052970204138204576603130578559172.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

My prediction has been more in the range of a further decline of 2,000 to 2,500 banks.  This will put the total number of commercial banks in the United States below 4,000.  And, I believe that the total number of FDIC insured institutions will drop below 5,000. 

The way that credit inflation works is through the rate of increase in asset prices.  In essence, if asset prices are increasing rapidly, the “real” value of the credit goes down making it much easier for the debtor to handle the increased leverage on his/her balance sheet.  This is, of course, what happened over the last fifty-year period of credit inflation. 

But, credit inflation is a cumulative process.  As people begin to borrow more, asset prices begin to rise.  And, as asset prices rise, borrowing, in real terms, becomes cheaper and so more borrowing takes place.  But, this causes asset prices to rise further, and so on and so forth.

Right now, people and businesses are not borrowing.  They are trying to reduce their debt loads because asset prices are remaining relatively constant or are declining.  The Fed is trying to get to the first stage of the cumulative process…to get people to begin borrowing again.  The commercial banks, especially the small- to medium-sized ones are not contributing to this cycle, either because the people aren’t borrowing or because the banks, because they are in trouble, are not lending. 

And, on top of this the commercial banks face two other problems.

First, the banks are facing a tougher regulatory environment that is resulting in increased costs of doing business.  Either they have to absorb the increased costs…or they have to pass them along to customers.  The debit card fees announced by Bank of America and others are just one result of this.  There is more, a lot more, coming.

Second, the banks are facing further interest margin squeezes due to the Fed’s “Operation Twist.”  Balance sheet arbitrage is dependent upon the ability of the banks to “borrow short” and “lend long.”  If these margins are narrowed because of what the Fed is doing, more pressure will be put on the banks to raise fees in order to survive.  The small- and medium-sized banks will suffer more because of this.

I believe that we need to keep a close eye on the banking system to determine whether or not the economy is going to pick up.  The banking system is still in a troubled state.  If either Camden Fine, of the Independent Community Bankers of America, or myself is correct about the continued decline in the number of banks in the United States, the commercial banking sector has a lot of adjustment to go through over the next four years or so and the focus of the industry will not be on lending. 

On the other side, the Federal Reserve is acting relentless in its efforts to start up credit inflation once again.  And, given the political climate in Washington, D. C. I don’t see any change in this attitude.

The question then becomes, when do we reach the tipping point?  When does the unwillingness of the banks to lend and the unwillingness of families and businesses to borrow lose out to the efforts of the Fed to create the credit inflation it so badly wants?  The problem is that once a tipping point is reached, the cumulative credit cycle buildup begins and I don’t really see how the Fed can prevent this from happening. However, there is no indication that another bout of credit inflation will produce more robust economic growth and job creation.   Still, keep your eye on the banks.