Sandy Weill Says, "Break Up the Big Banks"!

Sanford (Sandy) Weill, former empire builder and former Chairman and Chief Executive Officer of Citigroup, has gotten religion. 

“Break up the big banks,” Sandy cries from the rooftops!

“The big banks do not make economic sense and are subject to systemic collapse.”

“Re-instate Glass-Steagall.”

My question is “What job is Sandy Weill shooting for now?  My goodness, the man is 79 years old.  Does he want to take over for Tim Geithner when Geithner ceases to be Treasury Secretary?  Or, maybe he wants to be the Chairman of the Board of Governors of the Federal Reserve System when Bernanke goes.”

There must be something behind this latest outburst for this man taught the world how to build a “big”…no, a huge…financial institution.  This man did all he could to remove Glass-Steagall and wrote the textbook on how to construct banks that were too big to fail. 

Has he seen the light?  What form did his revelation come in?  He must be trying to trick us to get something he wants.  Be careful…the man is a tiger!

Or, is he just too old?

The banking system is not what it was when Sandy Weill was running things.  Even as he remained Chairman of Citigroup into the 2000s, Citi grew out of his understanding and control.

Finance is different now.  Finance is just about information and how information is used.  Electronics is taking over. 

In one sense, who needs a bank?  I do not “bank” at a commercial bank.  I don’t need to.  My children don’t use a bank.  They don’t need to. 

Today, “banking” can be integrated with a person’s financial portfolio in a non-bank and that person can transfer funds from anything they own into cash, or, transaction accounts, or, money market accounts, or, stocks, or commodities, or, foreign exchange, or, whatever…in real time.     

All these things are just information and modern information technology allows people the opportunity to operate in this sophisticated world of modern finance if they so desire.  And, these systems will become ubiquitous in the near future, all available on a handheld device.

Obviously, if individuals have the ability to act in this way, the institutions that provide these services also have the ability to act in this way.  And, guess what?  These institutions are going to act at the edges of where the technology allows them to act.  And, guess what?  The regulators are going to have very little ultimate control over this. 

In fact, it is my belief that the regulators don’t really know exactly what the banks…excuse me…the big banks do.  As usual, the banking system is out in front of the regulators and, as usual, the regulators are scrambling as hard as they can to catch up with where the banks are.

But, what does the banking system in the United States look like? 

The FDIC tells us that as of March 31, 2012 there were 6263 commercial banks in the banking system, of which, 525 held assets in excess of $1 billion.  Please note that these 525 banks held 91 percent of the assets in the whole banking system. 

The Federal Reserve gives us a little finer breakout.  The largest twenty-five domestically chartered banks in the United States hold 57 percent of the total bank assets of the country, but they hold 66 percent of the assets held by all domestically chartered banks.

Thus, in terms of domestically chartered banks, one can argue that the largest 25 domestically chartered banks in the country hold 66 percent of the assets in domestically chartered banks; 500 domestically chartered banks in the country hold 25 percent of these assets, and 5,738 domestically chartered banks in the country hold 9 percent of the assets.    

Foreign-related financial institutions hold 14 percent of all the bank assets in the United States.  This means that the assets of the largest 25 domestically chartered banks in the United States plus the assets of foreign-related financial institutions total up to 71 percent of all the banking assets in the country!

Where do you draw the line in defining what banks are too big to fail?  And, where do you draw the line in defining what banks are too small to survive?  How can you make judgments like these is a fair and just manner?

And, information technology operates on scale and this means that the future is going to belong, even more, to the larger banks…not the smaller ones.

Right now, however, it is the 6,200 or so, smaller domestically chartered banks that I have the greatest concern for.  The United States still has more than 800 banks that reside on the FDIC’s list of problem banks.  And, this list does not include those banks that are in enough trouble that the FDIC and the OCC are looking for other organizations to acquire them. 

Furthermore, we still have 311 banks that the U. S. Treasury has an ownership position in.  This is down 32 banks from the total in April 2012. This ownership position was achieved during the Troubled Asset Relief Program (TARP) that was launched in 2009. 

Most of these banks are smaller banks…the larger ones have paid back the fund in full.  The bank shares owned by the Treasury are now being auctioned off to investors who would like to own part of a bank.  In April, 20 banks were auctioned off and the Treasury received back 90 percent of what it was owed.  In the latest auction of 12 banks, the Treasury took a 14 percent haircut on 10 of the banks and could only partially sell shares in the two other banks.

The attractiveness of the remaining 311 banks is expected to be substantially less than those that were involved in the latest auction.  The Treasury has several ideas about how the shares of these banks might be made more attractive.

To me, the issue is not about breaking up the larger banks.  These banks are going to all be technologically advanced and very difficult to breakup, let alone regulate.  The issue is about the 6,200 banks that cannot compete electronically and the subsection of these banks that are still facing issues of solvency. 

I remain confident that the number of banks in the banking system will drop below 4,000 in the next couple of years and the trend will continue downwards.  I also remain confident that, in the near future, the largest 25 domestically chartered banks in the country plus foreign-related financial institutions will see their share of assets in the U. S. banking system rise from 71 percent to 80 percent and more.  So let’s see, that leaves the remaining 3,950 or so “smaller” banks less than 20 percent of bank assets in the U. S.  And, it is my belief that of this number, the ones with any chance of survival will not be less than $1 billion in asset size.  What do you think, Sandy?

United States Profits and the United States Dollar

I recently discussed the recession in Europe and the impact this recession is starting to have on the United States economy.

In addition to this impact, we are now observing how the decline in the value of the Euro is impacting the profits of United States companies.

The Euro took a nosedive against the United States dollar in May and has remained weak against the U.S. currency ever since.  This can be seen in the accompanying chart.

It is not so much that the United States economy is that strong.  It isn’t. 

But, foreign exchange rates are relative and the current story is that the United States economy may not be that strong…it is just that the economies of the eurozone are that weak…and the leadership in the eurozone is seemingly subject to a similar shortcoming.

 

For much of the first quarter of 2012, the value of the Euro averaged around $1.32 to $1.34. 

In late April, but especially in May, the value of one Euro against the dollar dropped quite dramatically.  On May 11 the value of the Euro was still above $1.30.  By May 25, the value of the Euro dropped below $1.25.

The “fun” thing about this drop was that I was in Italy during this time and experienced the fall, first hand.

The more important factor is that the decline in the dollar value of the Euro has hurt United States companies as they converted the profits they earned in the second quarter of this year in Europe back into U. S. dollars. 

Interestingly, United States companies did not seem to be hit too hard by the drop in the Euro’s value in the latter half of 2011, probably due to the fact that the Euro moved much more slowly at this time and, coupled with a rise in value during the first half of the year, things seemed to “even out” for all of the year.  Also, eurozone countries had not gone into a recession until the last quarter of the year so the sales of U. S. companies in Europe remained relatively strong.

But, in the second quarter of 2012, the profits U. S. companies earned in Europe were hit pretty hard by the changing value of the Euro. 

For example, Colgate-Palmolive Co, and Dow Chemical presented evidence that the rise in the value of the dollar hurt their second quarter profits.  Colgate, for example, claimed that its bottom line was down by 9 percent due to currency issues.  Dow’s profits also were substantially lower.

Thomas Freyman, chief financial officer of Abbott Laboratories indicated impacted sales figures of his company by about 5 percent.  Yum Brands, Inc. owner of KFC, Pizza Hut, and Taco Bell, claimed that the exchange rate situation lowered profits by about $13 million in the first two quarters of 2012.  And, Snap-on Inc., stated that currency movements in the second quarter reduced sales growth by more than three percentage points. 

Why didn’t these companies establish hedges against such movements?

“The reason why you can’t offset the kind of significant foreign-exchange swings that we had in the second quarter was the speed of the change,” states Ian Cook, chief executive officer of Colgate-Palmolive. 

The thing everyone seems to agree on, however, is that if the value of the Euro remains where it is now, there will be continued losses in the third quarter of this year and possibly the fourth.

Given the political situation that exists in Europe right now, I can’t see the European economy getting much better through the end of the year.  As a consequence, I can’t see the value of the Euro against the dollar appreciating at all through by the close of 2012.

Therefore, I can only suggest that the profits of United States companies will continue to be hurt through the rest of 2012 due to the strength of the U. S. dollar against the Euro. 

Hence, we add one more reason to the list of things impacting the American economy and one more reason why the economic growth in the United States will remain weak in 2012.

Recession in Europe and Beyond: the Impact on the United States

Early this year, January 4 to be exact, I posted a blog stating that the number 1 issue for 2012 would be recession in Europe.

Well, Europe has done its part…most of the eurozone is experiencing a recession. 

But, economic growth in other parts of the world…like China…is experiencing slower growth as well.

And, what about the United States?  Certainly the figures on real economic growth released last Friday do not provide any support that the United States is doing much better. 

Year-over-year, the United States grew at a 2.2 percent rate of growth, down from 2.4 percent in the first quarter of the year.

The most interesting part about the release of data, however, was the fact that real GDP growth for early on in the recovery was revised making the whole economic recovery weaker than previously thought. 

Here we see in the accompanying chart that the growth of real GDP never actually reached 3.0 percent at any time.  That is, once the recovery took place, economic growth stayed in the 1.6 percent to 2.8 percent band…highly unusual.

I have discussed how this pattern has also been followed closely by industrial production and that the weakness in the whole economy is reflecting major long run issues that must be dealt with if a more robust level of economic growth is to be attained.

But, the situation in Europe is worsening and economic growth in the rest of the world is facing major challenges. 

The concern here is how the economic malaise being felt in different parts of the world are beginning to play off one another.  This is, of course, the concern that I expressed in the January 4 blogpost.

I have just been talking with several friends, people who own their own businesses.  The general comment is that their businesses have either turned south or are moving even faster in a southern direction.  The common thread to their story: orders from Europe and from Asia are drying up!  The trend throughout the world seems to be downward.

Everyday we are hearing more and more stories about how the soft conditions in other parts of the world are being reflected more and more in current sales.  The impacts are becoming cumulative.

Thus, on top of the dislocations that now exist within each economy (topics I spend more time on in the post about the movement of industrial production) the interconnections of world trade are now experiencing evidence of reciprocal impacts.

I see eurozone forecasts that show economic growth becomes positive for countries in the eurozone in the fourth quarter of 2012, with slow growth expected for all of 2013. 

The question is, are these forecasts realistic?  Are they too optimistic?

The problem is that the situations these countries face are a result of longer-term factors, things that the European Central Bank and the individual countries, cannot just correct through short-term governmental stimulus. 

Youth unemployment of 24.6 percent in Spain!  This is not a cyclical problem!  It is not going to be overcome by short-term Keynesian efforts to “get the economy going again.”

And, the same is true of Italy…and Greece…and Portugal…and so on and so on.

The problems being experienced in these countries are structural and must be resolved through reform efforts that are going to seriously challenge each individual country as well as the whole.

Europe hasn’t owned up to this yet and there is no indication that it will anytime soon.

Herein lies the further problem.  Europe’s mess is now having a greater and greater impact on other countries in the world…like the United States.  The “mess” has spread beyond the bond markets where “cash” has flown to “safe havens” like the United States Treasury bond market.

I believe that we are now going to see more and more of this “spread” being reflected in the economic growth of the United States.  And, the monetary policy of the involved central banks is not going to be able to stop the spread. 

Earlier this year I reduced my forecast for the growth of real GDP into 2014 to the 2.0 to 2.5 percent year-over-year range.  I am beginning to think that this forecast may be a little high as the problems of Europe spread to the United States. 

And, of course, this will have implications for the labor market.  If my friends are seeing orders from Europe and Asia dropping, what incentive do they have to add anyone else to their current payrolls?  What incentive do they have to purchase capital equipment?  And, what incentive do they and their employees have to spend all of their income? 

I believe that the United States economy will continue to expand in the next year or so, but nowhere near the pace needed to reduce unemployment, let alone under-employment. 

In my view, the third quarter of 2012 is not going to be a very good one for a sitting president to get re-elected on.  And, at this time, there is really next to nothing of substance that the president can do in order to get better economic statistics before November 6.    

Europe on the Edge Again

The yield on the Spanish 10-year government bond was trading around 7.50 percent on Monday.  (A rate of 7.00 percent has been declared “unsustainable.”)  The Italian bond was getting into the neighborhood of 6.50 percent, trading close to 540 basis points over the similar 10-year German bond, not too far from its euro-ear spread high.  Greek bonds were over 27.0 percent, more than 2,600 basis points over the yield on the German bond. 

Investors were moving toward 10-year German bonds, with a yield of about 1.10 percent, and, US Treasury bonds and UK bonds, both saw yields of around 1.40 percent.  The “flight to quality” continues.

Are we moving toward the “endgame”?

I don’t think we can afford to be too optimistic because we have taken the path of optimism too many times in the past only to be disappointed again…and, again…and, again.

But, the endgame we might be facing now is not the nice diplomatically negotiated fiscal union that has been talked about…or the banking union that has gained more and more attention in recent days.

No the endgame I am talking about here is the endgame that Germany is playing for.  My June 26 post contained the following analysis:

“Some believe that…Germany and its Chancellor Angela Merkel have not fully let on what path they ultimately want to follow. Germany, the creditor nation, ‘is acting as creditors always do. It wants to be paid back or put debtors through default proceeding to extract maximum benefits.’

Germany, it is argued, can ultimately achieve its goals by one of three paths: deflation, inflation, and writing checks.

‘Deflation in the periphery would eventually make it competitive, and is Germany’s favored option. But, as we are seeing, it naturally leads to default by weaker banks and governments.’

With inflation, Germany loses because it gets paid back in cheaper euros. By writing checks, Germany would pay off the periphery for leading an undisciplined life.  Another case of moral hazard.

To others, Germany has made a decision. They have opted for the first of the three: European deflation. The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation.

But, as the quote above mentions, this would lead these nations to recognize their insolvency and the insolvency of their banking systems in any solution they arrive at.”

The difficulty in forming a fiscal union…or in forming a banking union…is that the 17 countries must agree on the terms and conditions of the union, whichever one, and in doing so the individual countries would have to give up substantial authority which they now possess.

This is a Herculean task given the 17 proud, independent countries that now make up the eurozone, 17 proud countries that have a long history of battles and conflicts and disagreements. 

In this scenario, forming a fiscal union…or a banking union…is not going to happen unless things get pretty ugly. 

The German path…if it is the path that Germany is truly following…will be ugly.  It is not a pretty thing to see sovereign nations declare themselves and many of their institutions insolvent. 

Yet, as events progress, this looks to be the path that Germany has taken.  And, one must be careful in assuming any victories over this German focus:  “It is always dangerous to claim a victory against Angela Merkel.  After the last eurozone summit, Mario Monti and Mariano Rajoy emerged triumphalist.”  This from Ferdinando Giugliano the Financial Times.

In the longer run…both Mr. Monti of Italy and Mr. Rajoy of Spain have had to retreat.  And, Ms. Merkel continues to plug along.

Germany has the chips.  In my mind, Germany is not going to retreat from the path they have chosen because they perceive that this is the only way to save the euro…create a European banking union…and, at the same time, create a European fiscal union.

I truly believe that the Germans want to see the euro continue. 

It is risky…but, 17 proud, independent countries need to be brought together and the times are not such that the eurozone can wait for 10 years…or 15 years…to achieve such a union.  The world is moving too fast, and several of the emerging nations…China, Brazil, and India, for example…are beefing up to directly challenge the nations of the eurozone. 

Of course, having the chips and taking such a strong stand can create some bad blood and resentments within other nations. 

So be it.  Let the games continue.

My bet is on the Germans, on the creation of a banking union…and a fiscal union…and on the future existence of the euro.

Exactly how we get there is still a mystery.    

The Banking System Through the First Half of 2012

Total reserves in the banking system have actually dropped from June 2011 to June 2012 by about 6.6 percent or about $110 billion.  These are according to the latest figures released by the Federal Reserve.

Yet, required reserves in the banking system have increased by a little over $21 billion during this time period representing a rise of almost 28 percent.

The reason why these numbers are moving in opposite direction is that individuals and businesses are continuing to move their assets from short-term interest bearing instruments into currency or into transaction accounts at financial institutions.

Coin and currency in the hands of the public rose by 8.5 percent, from June 2011 to June 2012.  Cash holdings are continuing to run at relatively high annual rates because a lot of people are keeping their funds in currency these days because of the bad economic times.  This high of a rate of increase in currency holdings is a sign of weakness in the economy and the bad financial condition so many people find themselves in.  It is not a sign of economic health.

The M1 money stock measure increased by 16.0 percent over the past 12 month period.  One can note right off that this figure is down from the March 2011 to March 2012 period which was 17.4 percent and also down from the December 2010 to December 2011 period which was 18.4 percent. 

Since the rate of increase in currency outstanding has not changed much from the end of the year, this means that the other components of the M1 measure of the money stock have declined.  And, this is true.  The June-over-June rate of growth for the non-currency component of the M1 measure of the money stock now rests at 16.0 percent. 

The M2 measure of the money stock was growing by a little more than 9.0 percent in June, down since the end of last year, but this decline has not been caused by a drop in the non-M1 component of M2 which has remained relatively constant through the first half of 2012. 

The movements of funds are very clear:  small-denomination time accounts at financial institutions are down by 17.0 percent, June-over-June; retail money funds are down by almost 3.0 percent; and institutional money market funds are down by almost 8.0 percent. 

Individuals are moving funds from short-term interest bearing assets to currency holdings and transaction accounts either because of their economic situation or because of the low interest rates.

As a consequence, the required reserves at commercial banks have grown quite rapidly.  Since, there are so many excess reserves in the banking system, the total reserves in the banking system can decline while the required reserves in the banking system can increase.  This is not the case in more "normal" times. 

And, the transaction accounts at financial institutions can also increase at historically high rates, at almost 28.0 percent, year-over-year, and yet this rise is not looked on as inflationary because of the massive movement of funds around the financial system.

It can be seen, however, that loans and leases within the banking system are now increasing at a faster pace.  Total loans and leases increased at a 5.3 percent year-over-year rate in June, the highest rate of increase in a long time. 

More specifically, commercial and industrial loans (business loans) expanded at a 14.0 percent annual rate in June, with C&I loans at the largest 25 domestically chartered banks in the United States rising by almost 17.0 percent.  This is the strongest showing since the economic recovery began.

The questions one must ask here are about the type of business loan the banks are making and what kind of impact are these loans having on the various measures of the money stock? 

At the present there is no indication that these business loans are going for productive uses, for purchasing physical capital goods…investment goods.  They may be going into the financing of inventories…physical goods that are not getting sold…or information technology.

Furthermore, if these loans are having any impact on the money stock measures it is small relative to the huge flows of funds coming into the transaction-type accounts from short-term interest bearing assets.  Hence, they cannot be seen as “inflationary” at the present time.     

Commercial real estate loans continue to decline, both at the largest banks and in the rest of the banking system.  As I have discussed many times, this decline will continue well into next year because of the condition of the commercial real estate market.

Interestingly, consumer-type loans at the largest banks, consumer credit and home equity loans, declined over the past year while these types of loans did increase modestly at the smaller banks.

I still have a great deal of concern for the health of the “smaller” banks in the banking system.   Five more depository institutions were closed this past week bringing the total number of banks closed this year to 38. 

But, this is not the only number we should be looking at.  From March 31, 2011 to March 31, 2012 82 banks were closed in the United States.  But, over the same time period, the number of banks in the banking system dropped by 190.  Obviously, quite a number of banks left the banking system during this time period through merger or acquisition.  It is my view that the banking system will continue to lose individual institutions from its numbers, maybe not at the almost 4 per week rate of the period ending March 31, 2012, but at a similarly rapid rate for the next twelve months are so.  This is what the Federal Reserve and the FDIC are attempting to achieve as smoothly as possible. 

The pressure may be lessening in this area.  Over the past three months, the cash assets at both the largest 25 domestically chartered banks in the United States have declined, as have the cash assets at the rest of the domestically chartered banks.  And, excess reserves in the banking system have also declined modestly.

My interpretation of the stance of the Federal Reserve right now is to accept the high rates of growth of the M1 and M2 measures of the money stock as these rates are due to individuals and businesses re-arranging their assets and not due to the Fed’s monetary stimulus.

Business lending may be getting stronger, but, as of this point in time, there is little or no indication that this lending is going into constructive physical assets.  This area, however, needs to be watched.  On the other side, one also needs to continue to watch what happens to the commercial real estate area.  As discussed before, many of these loans are loans that are paid off at maturity and these maturity dates are coming due over the next 12-to-36 months.  Many of these loans may not get refinanced.  This could be very difficult on the banks…especially the “smaller” ones.

Finally, the Federal Reserve…and the FDIC…are still keeping a close eye on the health of the banking system.  Especially the Fed does not want to do anything silly at this time…like it did in 1937…and prematurely remove excess reserves from the banking system before the system is ready to “let them go.”  I still believe that there are a lot of banks in the system that are technically insolvent and that the Fed and the FDIC are being extra careful to “not rock the boat” while these institutions need to be closed or merged out of business.  This remains a major concern at the Fed.   

Little M&A Activity: Another Sign of a Weak Economy

“The stock market is weak, IPOs are hard, there’s no M&A market to speak of.”  This quotation from Blackstone President Hamilton “Tony” James on a call to discuss the firm’s second-quarter earnings.

This weakness is another sign that the economic recovery is not moving along very well.

Earlier this year, many of us believed that 2012 was going to be a “gang buster” year for the merger and acquisition business. 

One reason for this was the huge buildup on cash on the balance sheets of many potential buyers who were progressing well through the economic morass.  Another reason for thinking this would be a big year in M&A was the exceedingly low interest rates.  Some corporations, over the past year, like Microsoft, for example, went to the capital markets and borrowed money where they had never even thought about issuing debt before.

Furthermore, many corporate valuations seemed depressed, making these organizations very attractive targets for those looking to expand their horizon. 

As a consequence, things looked good on the “deal” front.  I tried to capture this in a January post.

However, things have not worked out that way. 

For one, the economic recovery has been anemic.  Although we were not expecting United States economic growth to achieve the average level of economic growth over the last forty years of the last century—around 3.0 to 3.2 percent—we still expected it…as did almost everyone…to average more than the 2.0 percent or so actually posted.

Thus, potential acquirers did not experience an ebullient environment in which to obtain additional assets.

Second, the regulatory situation has not been the most favorable.  The year began with the reality of the AT&T/T-Mobile breakup.  I believe that this set a cloud over the whole M&A scene and created the specter of an administration in Washington, D. C. that looked on this form of activity with great suspicion.  Thus, the potential cost of merger transactions rose substantially…the implicit costs as well as the expected explicit costs.

Third, the newly passed regulatory laws were not understood and not completely written.  The role of financial institutions was cloaked in mounds of uncertainty.  People just did not know where they stood.

Finally, there is the general uncertainty as to what is the economic policy of the administration.  As of this time, the Obama administration seems to have no economic policy and this is adding even more uncertainty to what potential acquirers might expect in the future. 

Blackstone’s results for the first half of the year were not that good, they posted a $75 million loss, although this beat analysts expectations. 

Blackstone joins other financial firms, like Goldman Sachs Group, Inc. and Morgan Stanley, in reporting lower results for the first half of the year.

And, analysts are not expecting a significant improvement in the M&A business in the second half of the year.  Not only is there the continued weakness in the United States economy but the spread or recession in Europe and weakness in many of the world’s large emerging economies. 

So looking at what is taking place in the area of mergers and acquisitions, we add one more sector to those that are exhibiting problems and are confirming the basic weakness in the economy.  I have discussed several of these other areas of weakness in blogposts over the past week or so.  Some of these problems directly flow from the difficulties of the recent recession.  However, quite a few of them are structural in nature and will require quite a bit of reform before they regain their strength and contribute to a more robust expansion of the economy. 

Taken together, these problems help explain why the economic recovery is so anemic but also they help to explain why the recovery is taking such a long time to get things back to something more normal.      

Structural Economic Problems Connected with State and Local Governments

Many things are contributing to the slow economic recovery taking place and fiscal or monetary stimulus is not going to overcome them.  One reason for this is that some of the things that must be overcome are structural and will require time and patience to correct.

More specifically, one of the economic sectors in need of a major restructuring is the state and local government sector.  The need for such restructuring has been written up in the New York Times, which had a front page article on the subject Wednesday morning, while the Financial Times also contained a similar report. 

The Financial Times summed up the news: “US state governments are in desperate need of reform to solve structural challenges that extend well beyond the cyclical woes of the financial crisis and the recession, including $4 trillion in unfunded pension and healthcare liabilities.”

The difficulties of state governments have grown as the economy slowed and failed to strongly rebound although some states have recently experienced rising revenues.  However, people are being cautioned about becoming too optimistic that the worst is over.

In addition, local governments, as we know given the recent municipal bankruptcies, are also facing continued dark times.  Local governments depend upon property taxes for about 74 percent of their revenue.  These governments have been starving over the past couple of years as the “middle class piggybank”…home prices…have fallen.  And, although there appears to be some leveling out of housing prices, any major recovery of property prices seems somewhere out in the future. 

Furthermore, Washington, D. C. is also contributing to the concern over the state and local government budget situation.  Given the fiscal problems in Washington, D. C., there has been talk of removing the tax exemption of municipal bonds.  This possibility of this occurring could certainly cause uncertainty to rise about what yields investors might receive on their investments in “munis”. 

The basic problem has been that the residents of these areas have demanded more and more services, like education, health, prisons, courts, and other agencies, and the governments have been able to supply these wishes by tapping more and more into the middle class “piggy bank”…home prices…and have been able to underwrite the increases. 

But, another factor has been at work as well, helping state and local government to swell their budgets.  Public unions have grown from a relatively insignificant part of the labor movement to the point where, at present, more than 50 percent of all unionized workers are employed by the government.  State and local governments have been able to pad their payrolls, increase salaries and wages, raise health and pension benefits, and create better and better working conditions during the past fifty years as credit inflation and housing price bubbles have inflated the revenues of these governments.

However, most state and local governments have some kind of “balanced budget” constraint placed upon them.  Yet, in truth, many of these organizations have run "deficits" for years and years. The revenue increases have not kept up with all of these expenses.  As a consequence, state and local governments went to the well…they found out how to use “create accounting” techniques.  This is why these state governments find themselves with $3 trillion of unfunded pension plans and $1 trillion of unfunded health care plans.

And these states must take care of building the new infrastructure of America, of providing a new health care program for America, and of dealing with cries for better schools, a better social net, and a fully staffed organization.   

In addition, this whole state and local government mess is going to get caught up in the next “big” fight about the existence of labor unions!

The health of the labor unions in the Unites States is tenuous, at best.  “The number of workers who belong to a union has plummeted about 20 percent over the last decade.  Only 8 percent of all workers are unionized.”  This from a recent New York Times article, which discusses the future of unions. 

Unions in the private sector have declined dramatically over the past forty years, and, the only real source of strength in the union movement has been in the public sector.  But, now with the sour economy and with a depressed housing market, state and local government budgets are being stretched to the limit and the “creative accounting” is coming back to haunt them.  The resolution of these budget difficulties is not going to take place in the near term and this will lead to more and more fights between governments and public labor unions.

Evidence of this was seen in the tussle that recently went on in Wisconsin between pro-union supporters and Wisconsin Governor Scott Walker. Furthermore, as the New York Times article states “nonunion workers tend to resent rather than applaud the better pay and benefits of their unionized brethren,” adding to the pressure against unions trying to achieve their goals.

But, there will be a fight in the public sector because public sector unions grew up on little resistance from public sector officials.  This was because the public sector officials could always tap into, without much complaint, the rising value of property values and pass-off these rising costs.  If not that, then there was always the deep pockets found in Washington, D. C.  Now, however, the “free lunch” is over.

So, expect a lot of turmoil in state and local government sector over the next five years or so.  Budget realities are setting in at all levels. Pensions cannot go unfunded indefinitely.  Health care costs cannot go unfunded indefinitely.  And, public sector jobs need to be filed in order to cover ordinary, day-by-day operation.

Moreover, the federal government is looking for ways to tap into more revenues, like the taxe on municipal bonds interest mentioned above, or more cuts in expenses, like less funding of state prisons along with their call for more state and local participation in health care and law enforcement.   

 

There are massive structural problems that must be dealt with in the United States before economic growth can really pick up more speed.  Correcting these structural problems is a part of what must be done to help get the US economy growing again at a more rapid pace. However, structural change takes time and patience.   

Problems to Economic Recovery: State and Local Governments

In my post yesterday, I wrote about the slow economic recovery taking place and the need for the economy to achieve some structural reforms for economic growth to return to a level more consistent with that achieved over the past fifty years or so: a 3.2 percent year-over-year rate of growth.

I argued that one of the economic sectors in need of a major restructuring was the state and local government sector.  Well, this post has been followed by several reports in major newspapers concerning the problems that specifically plague the states.  For example, the New York Times had a front page article on Wednesday morning while the Financial Times contained a similar report. 

The Financial Times summed up the news: “US state governments are in desperate need of reform to solve structural challenges that extend well beyond the cyclical woes of the financial crisis and the recession, including $4 trillion in unfunded pension and healthcare liabilities.”

The difficulties of state governments have grown as the economy slowed and failed to strongly rebound although some states have recently experienced rising revenues.  However, people are being cautioned about becoming too optimistic that the worst is over.

In addition, local governments, as we know given the recent municipal bankruptcies, are also facing continued dark times.  Local governments depend upon property taxes for about 74 percent of their revenue.  These governments have been starving over the past couple of years as the “middle class piggybank”…home prices…have fallen.  And, although there appears to be some leveling out of housing prices, any major recovery of property prices seems somewhere out in the future. 

Furthermore, given the fiscal problems in Washington, D. C., there has been talk of removing the tax exemption of municipal bonds.  This possibility of this occurring could certainly cause uncertainty to rise about what yields investors might receive on their investments in “munis”. 

States and local governments, although most of them have some kind of “balanced budget” constraint placed upon them, have run deficits for years and years.  Residents of these areas have constantly demanded more and more services, education, health, prisons, courts, and other agencies as the middle class has grown and as the middle class “piggy bank”…home prices…have been able to underwrite the increases. 

Furthermore, there has been another factor at work as well, swelling state and local government budgets.  Public unions have grown from a relatively insignificant part of the labor movement to the point where, at present, more than 50 percent of all unionized workers are employed by the government.  State and local governments have been able to pad their payrolls, increase salaries and wages, raise health and pension benefits, and create better and better working conditions during the past fifty years as credit inflation and housing price bubbles have inflated the revenues of these governments.

Still, the revenue increases have not kept up with all of these expenses.  As a consequence, state and local governments went to the well…they found out how to use “create accounting” techniques.  This is why these state governments find themselves with $3 trillion of unfunded pension plans and $1 trillion of unfunded health care plans.

And these states must take care of building the new infrastructure of America, of providing a new health care program for America, and of dealing with cries for better schools, a better social net, and a fully staffed organization.   

In addition, this whole state and local government mess is going to get caught up in the next “big” fight about the existence of labor unions!

The health of the labor unions is tenuous.  “The number of workers who belong to a union has plummeted about 20 percent over the last decade.  Only 8 percent of all workers are unionized.”  This from a recent New York Times article, which discusses the future of unions. 

Unions in the private sector have declined dramatically over the past forty years, and, the only real source of strength in the union movement has been in the public sector.  But, now with the sour economy and with a depressed housing market, government budgets are being stretched to the limit and the “creative accounting” is coming back to haunt the state and local governments.  The resolution of these difficulties is not going to take place in the near term and this will lead to more and more fights between governments and public labor unions.

Evidence of this was seen in the tussle that recently went on in Wisconsin between pro-union supporters and Wisconsin Governor Scott Walker. Furthermore, as the New York Times article states “nonunion workers tend to resent rather than applaud the better pay and benefits of their unionized brethren,” adding to the pressure against unions trying to achieve their goals.

But, there will be a fight in the public sector because public sector unions grew up on little resistance from public sector officials.  This was because the public sector officials could always tap into, without much complaint, the rising value of property values and pass-off these rising costs.  If not that, then there was always the deep pockets found in Washington, D. C.  Now, however, the “free lunch” is over.

So, expect a lot of turmoil in state and local governments over the next five years or so.  Budget realities are setting in at all levels. Pensions cannot go unfunded indefinitely.  Health care costs cannot go unfunded indefinitely.  And, public sector jobs need to be filed in order to cover ordinary, day-by-day operation.

Moreover, the federal government is looking for ways to tap into more revenues, like taxes on municipal bonds, or more cuts in expenses, like less funding of state prisons along with their call for more state and local participation in health care and law enforcement.   

 

There are massive structural problems that must be dealt with in the United States.  Correcting these structural problems is a part of what must be done to help get the US economy growing at a more rapid pace. At the end of this time, it is likely that labor unions in general, and more, specifically, public labor unions, will be an even weaker part of the United States economic scene than they are now.