Saturday, February 27, 2010

The Ring of Fire

In his latest missive, Bill Gross, PIMCO’s Managing Director, aptly summarizes the major themes Carmen Reinhardt’s and Kenneth Rogoff’s study of over 8 centuries of financial crisis. Simply put, if you play with fire, you will get burn. Maybe not today or tomorrow, but at some point, when you least expected, you will. In any event, three points become evident from the study:

“1. The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.

2. The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years.

3. Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%.”

Based on these observations, he names the following countries likely to become culprits: Spain, Ireland, UK, USA, France, Greece, Italy, and Japan.

Mr. Gross makes the salient point that the aforementioned study, “if anything, points to the inescapable conclusion that human nature is the one defining constant in history and that cycles of greed, fear, and their economic consequences paint an indelible landscape for investors to observe.”

Against this background, quantitative measures—the order of the day in risk management and stock picking—are a ticking time bomb. Black swans, low probability but highly explosive events, are bound to come up when least expected. In this environment, investment returns are akin to picking up pennies in front of an oncoming train.

Monetary Base, Excess Reserves, Money Supply - My Analysis

The following chart represents the latest year-over-year change in the adjusted monetary base (AMB) [click here for larger picture]. As you may recall, the AMB is the amount of money printed by the Federal Reserve. After a sustained decline, it has sharply increased. This in part reflects the purchases of U.S. Treasuries and mortgage-backed securities by the Central Bank.

This next graph demonstrates the level of excess reserves in the banking system. It is the amount of money available for bank lending. Through the multiplicative process of fractional reserve banking, whereby only a portion of deposits are kept as a cushion for customer withdrawals, more money is created. For example, assuming a 10% reserve requirement, every $100 will create an additional $900. This extra money will invariably chase a fixed amount of goods, subsequently sparking price inflation.

As we suspect, M1 [see graph below], a measure of the level of money supply in the U.S. is increasing, despite the fact that the money multiplier has declined. This means that the percent change (i.e. decline) in excess reserves has been greater than the decline in the money multiplier ratio.

Friday, February 26, 2010

Government Debt: Adding Gasoline To The Fire...

David Oakley of the Financial Times reports the following:

"This year the Organisation for Economic Co-operation and Development forecasts $16,000bn will be raised in government bonds among its 30, mostly industrialised, member countries. This is a sharp increase of $4,000bn in the space of just two years as governments around the world have turned to the capital markets to pay for fiscal stimulus packages and bank bail-out initiatives."
There are a plethora of economists who live in la la land about the consequences of persistent deficits. Their rationale, in simple words, goes like this: deficits saved the world from economic depression, since we haven't had a problem in the recent past there is no need to worry now, but at some point maybe we will, and if this ever comes into fruition let future generations worry about it, in the meantime let's party. In economic jargon, as a Keynesian economist recently put it, this would be translated as "the benefits of the higher output today exceed the cost of debt service tomorrow."

Of course, modern economists don't speak in clear terms. The more esoteric and convoluted their speech, the more adulation they receive -- or so it seems. The same folks who never saw the current crisis coming are at the forefront of policymaking and forecasting greener pastures ahead. You would be wise avoiding their analysis.

My Economic Lesson to U.S. Senator Robert Menendez

Several weeks ago, I wrote to my State Senator, Robert Menendez, encouraging him not to vote for the confirmation of Dr. Ben Bernanke. He replied to me. Not being content with Senator Menendez answer, I responded with clarifications on my position. Here is what i wrote to him (please note that as of this writing I have yet to receive any response, albeit it's been a short period of time since i e-mailed my letter.)


Dear Mr. Menendez:

I sincerely appreciate your response to my inquiry regarding your vote on the nomination of Dr. Ben Bernanke. As your constituent, I am compelled to clarify some of your misunderstanding about the real issues pertaining to this matter. Let me preface by saying that I speak as someone who is well versed on this topic: by the mercy and grace of God I have not only a B.A. in Finance and Economics from Rutgers University and a Masters in Economic Policy from Columbia University but also over eight years of working experience on Wall Street.

In the post scriptum you will find your response letter in its entirety. In this section I want to address some of the points (which are in quotation marks) that you mentioned.

Indeed, while you write that, “[b]y law, the Chairman of the Federal Reserve reports twice a year to Congress on its monetary policy objectives,” Congress should require the transcripts of the Federal Open Market Committee within 24-hour after its meeting. Congress already adheres to this standard. Why not the Federal Reserve (FED)?

In light of your commitment to a “strong and fair regulations that spur economic recovery, promote sustainable growth, and protect the financial well-being of all Americans,” you voted in favor of Mr. Bernanke because you “believe that our economy could have sunk even further into a depression if [he] had not responded as forcefully as he did by providing funds at such a pivotal moment.” With all due respect Senator, “could have” does not equate to “would have.” The fact of the matter is that the FED’s intervention in the free-market is the progenitor of economic instability. It is disingenuous to tacitly endorse the commonly accepted idea—albeit erroneous—that a Committee of economists can know what the interest rate the market requires. The free-market allocates capital based on supply and demand. As you know, when the cost of capital declines investment increases. However, when the FED reduces such costs by way of manipulating the interest rate, too much investment takes place—most of it which is misallocated because it is not based on real demand. This explains the reason why private market participants, who maintain their “going concern” due to appropriate forecasting of consumer demand, suddenly miscalculate and must subsequently exit their businesses. In this scenario, bankruptcies and unemployment skyrocket. As you know, this is what exactly has happened. While the relaxation of loan underwriting standards and other imprudent banking practices augmented the crisis, the severity of it could not have happened without the leverage (i.e. excessive printing of money) employed by the FED. The massive and unprecedented intervention during the post-Lehman Brother’s collapse by the FED assures that the next economic crisis will be more severe than the one previously experienced. It is only a matter of time before this happens.

Having said that, I applaud your efforts of being “forceful with Dr. Bernanke, particularly concerning his oversight of the financial markets.” I hope you continue to do so.

Kind regards,

Cesar A. Garcia

P.S. Below is your response to me in its entirety.

Dear Mr. Garcia:

Thank you for contacting me to express your opinion on the nomination of Dr. Ben Bernanke for a second term as Chairman of the Federal Reserve. Your opinion is very important to me, and I appreciate the opportunity to respond to you on this critical issue.

As you are well aware, the Federal Reserve is the central banking system of the United States. Among other duties, the Federal Reserve supervises and regulates certain banks, conducts the nation's monetary policy, and provides "lender of last resort" financing to those banks. By law, the Chairman of the Federal Reserve reports twice a year to Congress on its monetary policy objectives.

In August 2009, President Obama nominated Dr. Bernanke for a second four-year term as Chair. As a member of the Senate Banking Committee, it is my responsibility to oversee our nation's financial institutions and vote on nominations. This is a responsibility I take very seriously, especially in light of the economic plight we currently face. I have long been committed to strong and fair regulations that spur economic recovery, promote sustainable growth, and protect the financial well-being of all Americans.

On this, as well as many other issues, there are different viewpoints. I voted for Dr. Bernanke's re-confirmation because I believe that our economy could have sunk even further into a depression if Dr. Bernanke had not responded as forcefully as he did by providing funds at such a pivotal moment. Furthermore, I believe that Dr. Bernanke is more likely to provide continuity and stability as our economy appears to be recovering. However, I also laid out substantial changes I expect to see implemented at the Federal Reserve. I believe the Federal Reserve should have acted earlier to prevent the housing bubble and to stop harmful mortgage practices. I have been, and will continue to be, forceful with Dr. Bernanke, particularly concerning his oversight of the financial markets. In addition, I have long championed greater transparency at the Federal Reserve.

Thank you for sharing your thoughts with me. Please do not hesitate to contact me in the future about this or any other matter of concern. I invite you to visit my website ( to learn more about how I am standing up for the citizens of New Jersey in the United States Senate.

Wednesday, February 24, 2010

Almost 10% of FDIC-insured banks "troubled"

Agency's Deposit Insurance Fund had a $20.9 billion loss as of Dec. 31

By Ronald D. Orol, MarketWatch

WASHINGTON (MarketWatch) -- Driven by expanding problems with commercial real estate loans, the number of distressed banks in the U.S. rose to 702 in the fourth quarter, marking the highest level in 16 years, according to a report released Tuesday by the Federal Deposit Insurance Corp.

That's up from 552 at the end of September and 416 at the end of June. This is the largest number of banks on the FDIC's "problem list" since June 30, 1993.

Based on the result, roughly one in 11 of the approximately 8,000 U.S. banks are on this list, with regulators expecting a significant expansion in the number of failures throughout 2010, boosted in large part by increased losses on commercial real estate sustained by mid-sized and smaller banks. See more on analyst expectations for 2010 bank failures.

"This year, the losses are going to be heavily driven by commercial real estate, we've known for some time and we have been projecting that," FDIC Chairwoman Sheila Bair told reporters. "The pace is probably going to pick up this year and for the total year it will exceed where we were last year. Overall, the banking system is challenged but stable, but is performing its credit extension role."

Bair said it takes longer for losses on commercial real estate to work through the system because frequently borrowers may have cash reserves and can continue to make good on payments for a while, even as a downturn expands.

"Tenants may be in longer-term leases, but those leases eventually come due and they don't renew or they renew at significantly reduced rental rates," she said.
Also Tuesday, the National Association of Realtors on Tuesday reported that it doesn't expect any meaningful recovery in commercial real estate before 2011.

A congressional watchdog group reported on Feb. 11 that it over the next few years, a wave of commercial real estate loan failures could threaten the U.S. financial system, and in the worst-case scenario, hundreds of additional community and mid-sized banks could face insolvency. Read about the report.

Banks insured by the FDIC dropped to a total quarterly profit of $914 million in the fourth quarter ended Dec. 31, compared with $2.8 billion in the third quarter. The result, however, was significantly better than the $37.8 billion loss for insured institutions seen during the fourth quarter of 2008, but well below historical norms.

Insured deposits reported full-year net income of $12.5 billion.

"Consistent with a recovering economy, we saw signs of improvement in industry performance," said Bair. "But as we have said before, recovery in the banking industry tends to lag behind the economy, as the industry works through its problem assets."

Further into negative territory

According to the FDIC, the value of what are deemed problem assets at institutions stood at $402.8 billion at the end of 2009, compared with $345.9 billion at the end of the third quarter.

The FDIC also reported that its Deposit Insurance Fund, used to protect depositors, dropped further into negative territory, reporting a $20.9 billion loss for its fund balance in the fourth quarter, worse than the $8.2 billion loss in the third quarter -- and its lowest number on record.

The agency also collected three years of assessments on banks in advance at the end of 2009, along with banks' fourth-quarter assessments, a total of 13 quarters of assessments, which brought in roughly $46 billion of capital to help dismantle failed institutions.

With those funds, the Deposit Insurance Fund's cash resources stood at $66 billion as of Dec. 31. The agency's fund reserves are a positive $23.1 billion, including its contingent loss reserve of $44 billion at the end of December.

As institutions take a charge, quarterly on their books, for their pre-payments for the deposit insurance fund, the deposit insurance will recognize corresponding revenue.

Bair said she believes the fund's cash balance should be enough to weather the rest of the economic downturn, adding that the FDIC estimates that much of the losses anticipated by the contingent loss reserve can be attributed to losses expected in commercial real estate.

She also pointed out that 95% of the 8,000-plus U.S. banks exceed regulatory standards for being well capitalized.

"We don't anticipate needing more special funds for the fund," Bair said. "We'll be in good shape this year."

The FDIC hasn't accessed a temporary $500 billion fund of capital, available to it from the Treasury Department, for the insurance fund.

The FDIC estimates that bank failures will cost the agency as much as $100 billion over the five years running through 2013, with the majority of the losses likely to take place in 2009 and 2010. The agency made that estimate in September and as of February it still stands, agency staffers said.

Big banks urged to lend more

The agency may require payment of additional assessments to cover losses to the fund if bank failures expand in greater numbers than the FDIC's currently anticipating.

Bair also took issue with larger banks, saying they need to be out lending more.

"We'd like to see more of credit extensions, within the framework of prudent risk management, particularly with the larger institutions," she said. "Their declines on loan balances, their cutbacks on credit lines have been significant, and hopefully we'll see some churning of that this year."

Friday, February 19, 2010

U.S. Capital Productivity Declines

Byron Wien, senior Managing Director at Blackstone Advisory Partners, brings to the forefront a very important fundament to economic growth: the productivity of capital. Now for those who may not familiar with economic jargon, capital is defined as factors of production. Capital in economic terms is not money or things related to such; but rather those things that are used to produce other things, such as land and labor.

Economists have a term that measure how productive capital is in an economy. It is call the marginal product of capital (MPK). MPK is the additional output that is produce for each additional use of capital. In other words, for each investment made how much gross domestic product increases. This is in essence what MPK measures. The higher the (relative) measure, the more productive is capital, and therefore the richer society gets. For example, a society that uses $1 of capital to product $1 of additional GDP is more productive in relation to a society that uses $2 of capital to produce $1 of additional GDP.

Having said that, this is what Mr. Wein writes in the Financial Times:

"The biggest problem the US is facing is the productivity of capital. After the end of the second world war it took less than $2 of investment by government, corporations and individuals to produce $1 of GDP growth. The productivity of capital continued to be impressive until 1980 when Europe had recovered and Japan was producing cars and consumer electronics products that found wide acceptance in world markets."

"In the single decade of the 1980s, the productivity of capital declined from a level where it took less than $2 of investment to produce $1 of growth to one where about $3 was needed. If you assign a 30 per cent gross margin to that revenue growth, the return on investment declined from 15 per cent to 10 per cent."

"That level of return proved to be satisfactory, but in the first decade of the current century capital productivity declined seriously in the US. Because of profligate spending on over-priced housing and other assets that declined seriously, as well as deficit spending by the government, by the end of the decade it took $6 of capital to produce $1 of growth. The return on that would only be 5 per cent and few would put money at risk for that reward."

S&P 500 4th Quarter 2009 Earnings

Thanks to Chart of the Day (

With fourth-quarter earnings largely in the books (over 79% of S&P 500 companies have reported for Q4 2009), today's chart provides some long-term perspective to the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. Today's chart illustrates how earnings declined over 92% from its Q3 2007 peak to Q1 2009 low -- the largest decline on record (the data goes back to 1936). Since its Q1 2009 low, S&P 500 earnings have surged (up over 600%) and currently come in at a level that has only been exceeded during the latter years of the dot-com and credit bubbles.

Blogger note: Warning sings are plentiful. Few heed the lights of the oncoming train. But in every bubble and market mania, these signs are ignored and many follow their own fancy and conjecture. It will not be until the implosion occurs that folks will wake up from their fantasy sleep. This is the way it always has been--unfortunately.

Wednesday, February 17, 2010

Foreign demand falls for Treasuries

Like a deer in front of an oncoming automobile, the masses of investors, politicians, economists, et. al. rarely see a catastrophe coming their way. Try to voice a concern or sound an alarm of warning, you will simply be either passed off as a charlatan or not taken serious altogether—despite the fact that you have been right in the past. Granted, the past is no indication of the future. Nevertheless, heeding the warning (or at least considering it) is always a wise. But the masses being what they are, this is highly unlike of ever occurring.

Today’s article in the Financial Times regarding the fall in foreign demand for treasury securities is an example of a frozen deer. What the article mentions is merely a symptom of a larger problem, which is the root of all evil: fiscal deficits ‘til the eye can see and no credible options of retiring the public debt. Since the U.S. Dollar is still perceived as a the “flight to quality” currency, buyers of such assets are simply setting themselves up for a cataclysmic result. There is no question that the “flight to quality” idea of the U.S. dollar will someday disappear. What is difficult to gauge is when exactly that will happen. But that it is coming, of this there is no doubt. But still, few consider this prognostication as accurate or probable. Nevertheless, it pays to consider the evidence and make a decision for yourself whether this is just a fancy or a possible scenario.

Here is the article:

By Alan Rappeport in Washington
Published: February 16 2010 (Financial Times)

Foreign demand for US Treasury securities fell by a record amount in December as China purged some of its holdings of government debt, the US Treasury department said on Tuesday.

China sold $34.2bn in US Treasury securities during the month, the US Treasury said on Tuesday, leaving Japan as the biggest holder of US government debt with $768.8bn. China overtook Japan as the largest holder in September 2008.

The shift in demand comes as countries retreat from the “flight to safety” strategy they embarked on upon during the worst of the global economic crisis and could mean the US will have to pay more to service its debt interest.

For China, the shedding of US debt marks a reversal that it signalled last year when it said it would begin to reduce some of its holdings. Any changes in its behaviour are politically sensitive because it is the biggest US trade partner and has helped to finance US deficits.

Alan Ruskin, a strategist at RBS Securities, said that China’s behaviour showed that it felt “saturated” with Treasury paper and that this is the sign of a trend. The change of sentiment could come at the detriment of the US dollar and the Treasury market as the US has to look to other countries for financing. Japan and the UK could pick up some of that slack and last month both added to their Treasury holdings. However, the overall monthly sell-off of $53bn was the biggest on record.

The figures come as the White House grapples with how to cut the US deficit, which is projected to be $1,560bn in 2010, or 10.6 per cent of gross domestic product. However, the move away from the safety of US debt is a sign of growing confidence in the global economy.Net purchases of long-term US securities declined to $63.3bn from $126.4bn in November, according to Treasury figures. Foreigners increased their purchases of US equities, buying $20.1bn in December after buying $9.7bn the previous month.

However, Gregory Daco, economist at IHS Global Insight, said that global appetite for US assets remained relatively solid , and that the recent turmoil in European bond markets caused by the Greek debt crisis meant the US would remain attractive even as the dollar strengthened.

“A stronger US dollar should not deter foreign investments as long as real GDP [gross domestic product] and productivity growth remain strong,” he said.

Monday, February 15, 2010

The Left, The Right, & The State

By Lew Rockwell, Jr.

[Note: This is the introduction to the book, which has the same title as this post, written by the same author.]

In American political culture, and world political culture too,the divide concerns in what way the state’s power should beexpanded. The left has a laundry list and the right does too.Both represent a grave threat to the only political position thatis truly beneficial to the world and its inhabitants: liberty.

What is the state? It is the group within society that claimsfor itself the exclusive right to rule everyone under a special setof laws that permit it to do to others what everyone else isrightly prohibited from doing, namely aggressing against personand property.

Why would any society permit such a gang to enjoy anunchallenged legal privilege? Here is where ideology comesinto play. The reality of the state is that it is a looting and killingmachine. So why do so many people cheer for its expansion? Indeed, why do we tolerate its existence at all?

The very idea of the state is so implausible on its face that thestate must wear an ideological garb as means of compelling popularsupport. Ancient states had one or two: they would protectyou from enemies and/or they were ordained by the gods.

To greater and lesser extents, all modern states still employthese rationales, but the democratic state in the developed worldis more complex. It uses a huge range of ideological rationales—parsed out between left and right—that reflect social and culturalpriorities of niche groups, even when many of these rationalesare contradictory.

The left wants the state to distribute wealth, to bring aboutequality, to rein in businesses, to give workers a boost, to provide for the poor, to protect the environment. I address many ofthese rationales in this book, with an eye toward particular topicsin the news.

The right, on the other hand, wants the state to punish evildoers,to boost the family, to subsidize upright ways of living,to create security against foreign enemies, to make the culturecohere, and to go to war to give ourselves a sense of nationalidentity. I also address these rationales.

So how are these competing interests resolved? They logrolland call it democracy. The left and right agree to let each otherhave their way, provided nothing is done to injure the interestsof one or the other. The trick is to keep the balance. Who is inpower is really about which way the log is rolling. And thereyou have the modern state in a nutshell.

Although it has ancestors in such regimes as Lincoln’s andWilson’s, the genesis of the modern state is in the interwarperiod, when the idea of the laissez-faire society fell into disrepute—the result of the mistaken view that the free marketbrought us economic depression. So we had the New Deal,which was a democratic hybrid of socialism and fascism. Theold liberals were nearly extinct.

The US then fought a war against the totalitarian state, alliedto a totalitarian state, and the winner was leviathan itself. Ourleviathan doesn’t always have a chief executive who strutsaround in a military costume, but he enjoys powers that Caesarsof old would have envied. The total state today is moresoothing and slick than it was in its interwar infancy, but it is noless opposed to the ideals advanced in these pages.

How much further would the state have advanced hadMises and Rothbard and many others not dedicated their livesto freedom? We must become the intellectual dissidents of ourtime, rejecting the demands for statism that come from the leftand right. And we must advance a positive program of liberty,which is radical, fresh, and true as it ever was.

Wednesday, February 10, 2010

The Via Dollorosa

by "The Lex Column" (02/09/2010 Financial Times)

Timothy Geithner has surely been told that one should “never say never”. The US Treasury secretary’s assertion that the US will forever retain its triple A credit rating is still far from the shibboleth that statements about a strong dollar have become when uttered by former Treasury secretaries, but that day may not be far off.

Reacting to projections of a record $1,600bn budget deficit, Moody’s said last week that, unless further deficit reduction action was taken or the economy grew more quickly than expected, that rating would eventually be in jeopardy. Credit default swaps traders were last week willing to give 5 per cent odds not just of a downgrade but of a US default within five years.

Even given America’s rapidly deteriorating fiscal outlook – gross government debt to output has risen from 62 per cent in 2007 to 85 per cent in just two years and will probably reach one-to-one by 2012 – such a rapid collapse is far-fetched. But longer-run budget figures are more daunting. Without entitlement reform, the scope for Mr Geithner’s pledge of future fiscal restraint will be meaningless unless he acts soon and forcefully. By 2020, less than a third of the budget may be discretionary and it may be too late then to stop the red ink without breaking social contracts.

The only really strong argument for why the US may never default is one Mr Geithner could never make in public. Having the luxury of issuing debt in its own currency, it can always create more to satisfy claims. Of course, to use the printing presses for this purpose would be the economic equivalent of cutting off your nose to spite your face. Yet even dollar debasement is a receding option as the average maturity of US government debt has fallen to below 50 months and the portion of debt that is inflation-indexed is rising, partially at the request of anxious creditors such as China.

In order for Mr Geithner’s words to have meaning, painful cuts must be made soon or the market will eventually call his bluff.

Monday, February 8, 2010

The Fed's Anti-Inflation Exit Strategy Will Fail


[**Mr. Meltzer is a professor at the Tepper School of Business, Carnegie Mellon University, and the author of "A History of the Federal Reserve" (Chicago, 2003 and 2010).]

Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.

I don't believe this will work, and no one else should.

The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they're legally required to hold. That's the critical question.

The efforts to reduce inflation during the 1970s failed because they ended prematurely. And they ended prematurely when business, unions, Congress and the administration objected loudly to the rising unemployment accompanying higher interest rates. Today's high current and prospective unemployment rates pose a similar dilemma.

No economist doubts that the Fed can induce banks to hold some more reserves by paying interest. But how much?

Normally, banks' principal business is lending, and the interest rate they can get on their loans is more important than the interest they might get on their reserves. Once borrowing resumes, banks will increase loans and expand deposits. The current massive volume of excess reserves will melt into a greater money supply, and later higher inflation.

When will inflation start? The date is uncertain. But the triggering event will be either a sustained increase in bank lending or a large increase in Fed purchases of government debt. Perhaps both. Either one would trigger a sustained increase in money growth.

With the exception of the early years after Paul Volcker became Fed chairman in 1979, the Fed has paid no attention to money growth. There have always been some Fed bank presidents concerned about too much or too little money growth, but they have not affected decisions. That problem remains.

The Federal Reserve has a well-known dual mandate to prevent both inflation and unemployment. It chooses to act on only one part of its mandate at a time. That cannot be the best way to achieve both targets, and it has failed repeatedly to bring low inflation and low unemployment. For example, the policy implied by the famous Phillips Curve—which says you can trade off higher inflation for lower unemployment—failed in the 1970s. We got rising inflation and higher unemployment.

Mr. Volcker publicly and privately discarded the Phillips Curve in favor of bringing inflation down by high interest rates and better control of the money supply. The result: about 15 years of low inflation and low unemployment. But the Fed abandoned its success by keeping interest rates too low after 2003. And now the Phillips Curve is back in fashion, with strong support from the Fed Board of Governors.

Christina Romer, chairman of the Council of Economic Advisers, reminds us regularly about the Fed and the Treasury's tig ht-money mistakes in 1937 which aborted the recovery, and she warns against repeating these mistakes. The principle drivers behind the recovery in 1934-36 were the veterans' bonus in 1936 and a gold inflow following the 1934 devaluation of the dollar—accomplished by unilaterally raising the gold price. The bonus ended, and the Treasury began to sterilize gold inflows in 1937 by selling securities, while the Fed doubled reserve requirements. Monetary policy shifted from excessive ease to excessive restraint.

Nothing of the kind is called for today. Instead, the Fed should announce a policy for preventing inflation that reduces the enormous stock of excess reserves, such as by selling securities. And the Treasury or the Office of Management and Budget should announce a credible policy for reducing deficits. That would help to reduce the uncertainty about future taxes, spending and inflation.

Policies without prices hide the serious problem posed by excessive debt and reserves, and are not credible. Policy makers should develop and announce credible plans now.

Saturday, February 6, 2010

Loan Demand Falls

A report in the Financial Times (FT) this past week tells us that a Federal Reserve’s survey of financial activity stated the following: “banks reported that loan demand from both businesses and households weakened further…”

Let’s see if this is accurate based on the latest data available. This is a graph that demonstrates the YOY change in weekly commercial and industrial loans at large banks.

For a larger graph see here.

As you can see, the fall since its peak has been precipitous. The trend has stabilized recently but growth is still exceedingly negative. This implies that loan demand from businesses continues to be weak, as the survey suggested.

Looking at the household sector, we simply have to look at the level of financial debt exposure and burden. With regards to total consumer credit, it decreased at a rate of 4.7% during the fourth Quarter of 2009. In fact, the quarterly trend was down for the entire 2009 period. See here.

Moreover, to estimate the financial burden we look at the household debt service ratio, which considers how much of what it is earned gets spend to cover debt payments. See here. There are no data for the fourth quarter 2009, but if the trend is any indicator, it should be down. This, along with the previous household statistic, gives us confidence that the second part of the survey—namely weak consumer credit—is probably accurate.

In addition, the FT article mentions that the economists’ consensus is that a “lackluster loan demand would hamper the economic recover.” Indeed, our fractional reserve banking system, whereby a portion of all bank deposits are held on a vault and the rest lent out, ensures that money is multiplied many times over. Assuming a reserve requirement—that is, the percentage required to be held by the bank to meet expected customer demand for cash—is 10%, for every $100 dollars that is injected into the banking system an additional $900 dollar gets created out of thin air. This extra digital “liquidity” can cause a false boom, which can be mistaken as a genuine economic recovery.

It is obvious banks are not lending. The trouble is that currently they are storing most of the excess digital “liquidity” at the FED. See here. Should this money ever make it into the economy, mass price inflation is inevitable. Policymakers are clearly stuck between a rock and a hard place. The best of both worlds is one where we find ourselves now. Push too tight, we get an economic depression. Push too loose, we get mass (and potentially hyper) inflation, ultimately killing the dollar and impoverishing everyone. Maintain the status quo, we get a stagnant economy.

Modern Financial/Economic/Social Policy: The Art of Theft

“Remember, the enemy has only images and illusions, behind which he hides his true motives. Destroy the image and you will break the enemy.” – Enter the Dragon (Bruce Lee movie)

Behind fancy mathematical equations and theories promoting how to get things done, the truth is ultimately the victim in these endeavors. You can’t get something for nothing, but at the same time you can’t beat something with nothing. It is my objective to at least give you the “something” that will make you think of exactly where you stand. The “something for nothing” thinking is the essence of what is taught in many universities (including the so-called prestigious ones), in particular when it comes to developing financial, economic, or social policy. Of course, this shouldn’t be surprising since “do-gooders,” “world improvers,” and other former central planners (a.k.a. technocrats) are exceedingly busy “teaching” the new generation how to run other people’s lives. In this post, however, I simply want to devote a little bit of space to a rudiment that undergirds modern social science—specifically the disciplines of finance, economics, and social policy. This rudiment is the act of theft.

Of course, they won’t call it theft. In the name of saving the planet, taking care of the elderly, or providing “free” healthcare central planners stake a claim on property that does not belong to them. In other words, they believe the story of Robin Hood is good, despite the fact that they would not agree to this behavior if done to them.

Let me give you an illustration of what I am talking about. Say, for example, you have some money in a bank. If someone were to force you by putting a gun to your head to hand over the money, clearly this would be called theft. It wouldn’t matter if the money were used for a charity or any other thing. In fact, the thief (of the Keynesian variety) could reason that since you are not spending the money, you are hurting the economy. He is going to spend it for you. I hope we are in agreement in this crucial observation: taking something from someone by force is stealing.

I am not adding to the analysis beyond what I’ve just said. I am simply pointing out the fundamental principle that it is wrong to take something for your own use that you have not worked for.

Now, let’s extend the analysis. Say, for example, a politician comes along and claims he/she wants to achieve some goal (fill in the blank). The politician needs funds, of course, to execute the goal. Where is this money coming from? “From us, the taxpayers,” you may answer. But, what about the person who does not want to hand over the money? “It doesn’t matter,” you may say, “it is for the social good.” It goes without saying, but if you don’t pay your taxes, you go to jail. And there you have the gun. In the name of your favorite charity, an individual has been forcefully required to hand over his property. Logically, this example is no different than the previous one I illustrated.

Suddenly what the person agreed what was an act of theft at the individual level, when performed by an elected politician (in the name of doing good), that wrong becomes a right. This is fundamentally why we should never be captivated by anyone doing good deeds; they can certainly be deceiving when it is done out of order.

Make no mistake, I am not advocating that good deeds are bad; rather, doing them by way of stealing, is wrong. Or like the popular saying goes, two wrongs don't make a right!

Modern financial/economic/social policy propagates this thinking and behavior. Teachers of these disciplines promote the idea that redistributing resources by way of a central committee is always and everywhere efficient. They completely eradicate the notion of property rights within the framework of equality before the law. These promoters hide behind elaborate econometric analysis and theorems, which on the surface appear sound and legitimate, but ultimately cause more damage. In other words, the “cure” of the “problems” (created by previous policies) they seek to solve is actually “poison.”

Friday, February 5, 2010

The Short View

By John Authers
Published: February 5 2010 (Financial Times)

It is almost like old times. Yesterday's global sell-off was as ugly as anything since the worst fears of the crisis began to abate last spring. The rebound that started this week has been swiftly forgotten. What happened?

There were probably two catalysts, one generated by markets, and another by data from the real world.

First, confidence in European governments' ability to repay their debts reached something of a tipping point, ushered there by a combination of the fears over Greece, a troubled auction of Portugal's debt, and mounting fears that Spain's much bigger economy appears to be in deeper trouble than either Greece's or Portugal's.

The credit default swap market suggests that such a tipping point has come.

Merrill Lynch points out that the implied default risk on Markit's index of five-year sovereign debt is now slightly higher than for comparable corporate debt - a remarkable finding.

Then came the latest news on employment in the US. Initial claims for unemployment insurance went up, against expectations. The data are noisy, and may be affected by the bad winter that much of the north-eastern US has endured.

But there were 6 per cent more new claims last month than in December. This is a great leading indicator and it is rising again. This was not in the script.

If the labour market is viewed in the old-fashioned way as a zero-sum game between labour and capital, this might be good news for share prices. But persistent high US unemployment would not be taken that way. Rather it would suggest that last year's bounce back in asset prices has not been enough to stir a lasting recovery in the world's biggest consumer.

Today's US payroll report, expected to show a small fall in joblessness, might change momentum again. But in this environment, a bad number could lead to grievous falls.

Wednesday, February 3, 2010

The Decade in the Markets

Several months ago, the Financial Times published an excellent graphic demonstrating the behavior of several important worldwide markets--namely global stock market indices, ten-year bond yields, central bank policy interest rates, and commodities--during the first decade of the 21st century. Far from the cry of stability that central planners aim to achieve, it is anything but that.

You will find the information in the link below.

Monday, February 1, 2010

Zero Unemployment Is Possible

Contrary to the folklore articulated in many economic textbooks these days, it is possible to have zero unemployment in any economy. Without resorting to fancy mathematical equations or economic axioms, simply look at the world around us: how many things that need to get done. I don't have to go into details what they are, simply having an observant eye will do. In fact, as Lew Rockwell says, "read any account of economic history from the late Middle Ages through to the 19th century and try to find any evidence of the existence of unemployment. You won't find it. Why is that? Because long-term unemployment is a fixture of the modern world, created by the interventionist state. "We" try to cure it and "we" ended up doing the opposite."

Moreover, it was this unemployment anomaly which became visible during the 19th century that caused Karl Marx to write its vitriolic missive against capitalism, believing--like many do today--that it is the root of all evil. Far be that from the truth, that view is a complete misrepresentation and misunderstanding of how the free-market economy works.

Having said that, i present you an excellent article written by Mr. Lew Rockwell, who wonderfully explains the plausibility for employment to persist in any economic system.

How to Fix the Jobs Problem
by Llewellyn H. Rockwell Jr. (January 29, 2010)

All this talk of unemployment is preposterous. Think of it. We live in a world with lots of imperfections, things that need to be done. It has always been so and always will be so. That means that there is always work to be done, and therefore, always jobs. The problem of unemployment is a problem of disconnect between those who would work and those who would hire.

What is the disconnect? It comes down to affordability. Businesses right now can't afford to hire new workers. They keep letting them go. Therefore, unemployment is high, in the double digits, approaching 17% or more. Among black men, it is 25%. Among youth, it is 30% or higher. And the problem will continue to spread so long as there are barriers to deal making between hirers and workers.

Again, it is not a lack of work to be done. It is too expensive to pay for the work to be done. So ask yourself, what are those things that prevent deals from being made?

Let me list a few barriers:

1. The high minimum wage that knocks out the first several rungs from the bottom of the ladder.
2. The high payroll tax that robs employees and employers of resources.
3. The laws that threaten firms with lawsuits should the employee be fired.
4. The laws that established myriad conditions for hiring beyond the market-based condition that matters: can he or she get the job done?
5. The unemployment subsidy in the form of phony insurance that pays people not to work .
6. The high cost of business start-ups in the form of taxes and mandates.
7. The mandated benefits that employers are forced to cough up for every new employee under certain conditions.
8. The withholding tax that prevents employers and employees from making their own deals.
9. The age restrictions that treat everyone under the age of 16 as useless.
10. The social-security and income taxes that together devour nearly half of contract income.
11. The labor-union laws that permit thugs to loot a firm and keep out workers who would love a chance to offer their wares for less.

Now, that's just a few of the interventions. But if they were eliminated today, and it would only take one act of Congress to do so, the unemployment rate would collapse very quickly. Everyone who wanted a job would get one.

Depending on the credibility of the new approach, businesses would begin hiring immediately. It would be a spectacular thing to behold. However, the new approach would have to be certain and not something to be reversed in a couple of months. No one wants to invest in employees only to have them taken away. So there could be no expiration date on the new laissez-faire approach.

What is the objection to this approach? I seriously doubt that many people would dispute that it would work to end unemployment. But many people say, oh, this won't do at all. It is not just jobs we want. It is good-paying jobs!

If that's the case, you have to understand what is being claimed here. People are saying that it is better that people be unemployed rather than exploited at low wages. If so, it all comes down to your definition of exploitation. If $10 per hour is exploitation, we should be creating even more unemployment by raising the minimum wage. We could dis-employ all but a few by raising the minimum wage to $1,000 per hour.

In a market-based labor contract, there is no exploitation. People come to agree based on their own perceptions of mutual benefit. A person who believes it is better to work for $1 an hour rather than sit at home doing nothing is free to make that contract. In fact, a person who works for a negative wage — who pays for an internship, for example — is free to make that deal too.

I propose to you, then, a definition of exploitation that comes from the writings of William H. Hutt: violence or threat of violence implied in the negotiation of anything affecting the life of a worker or employer. In that sense, the present system is exploitation. Workers are robbed of wages. Employers are robbed of profits. Poor people and young people especially are robbed of opportunity.

Read any account of economic history from the late Middle Ages through to the 19th century and try to find any evidence of the existence of unemployment. You won't find it. Why is that? Because long-term unemployment is a fixture of the modern world, created by the interventionist state. "We" try to cure it and "we" ended up doing the opposite.

So it is hard for me to take seriously all the political plans for ramping up intervention in the name of curing unemployment. There is no voluntary unemployment in a free market, because there is always work to be done in this world. It is all a matter of making the deal.

All that stands between the present awful reality and 0% unemployment is a class of social managers unwilling to admit error. How much higher does the rate need to get before we admit the error of our ways?