The Setting for Ben Bernanke's Speech at Jackson Hole

Anticipation is rising for the annual late summer speech given by the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke.  The basic economic environment surrounding this speech is what I would like to touch on in this post.

This environment along with what the Federal Reserve does…or doesn’t do…is crucial to the possible “macro” position a person could in their investments and in their business decisions.

For example, John Paulson, the hedge fund investor, has apparently started placing his bets with respect to current economic and financial conditions and with respect to what the Fed can…or can’t do.  Mr. Paulson, according to recent regulatory fillings, has been re-arranging his portfolio…increasing his position in gold and reducing other positions…in anticipation of higher future levels of inflation.

Future inflation is certainly a concern and I will discuss this a little later, but there are also other issues that need to be discussed as well.

For example, dominating discussions about the current environment is the rate at which the economy is growing.  In the second quarter of 2012, real GDP grew at a 2.2 percent year-over-year rate.  I am expecting this growth rate to remain around 2 percent for the next year or so.  This expectation is backed up by other numbers, like that for industrial production.  Economic growth has been tepid, is tepid right now, and is expected to remain tepid for the near term. 

There are numerous reasons why economic growth is likely to remain slow.  I have reported on these in many recent posts.  A short list of reasons include continued deleveraging of the private sector; under-employment of eligible labor; residential mortgages being underwater; bankruptcies and foreclosures; commercial real estate losses; health of a large portion of the banking system; the financial condition of state and municipal governments; the uncertainty that exists with respect to government policy and regulation; the European recession and sovereign debt crisis; and the slowdown in other countries like China, Brazil, and India.

I believe the American economy will continue to grow but only at or below a 2 percent year-over-year rate.  This is an environment of stagnation with unemployment and under-employment staying high and capacity utilization of industry remaining historically low. 

Given this basic scenario, interest rates will rise over the next year or so.  There are, I believe, three reasons for this. 

First, interest rates in the United States are as low as they are because of the “haven” nature of US government debt.  Large quantities of “risk averse” funds have flown into American security markets escaping the mess in Europe.  As a consequence, the yield on 10-year US Treasury securities closed at 1.82 percent on August 17.

If one subtracts an “expected rate” of inflation from this figure, let’s use 2.00 percent (which is about what the inflation rate is in the United States using the year-over-year rate of increase in the GDP implicit price deflator).  Then an estimate for the “real” rate of interest is a negative 18 basis points.  This is not too far off the yield on the 10-year TIPS bond, which was a negative 45 basis points on August 17.

And, what “should” this real rate of interest be?  I have always argued that “the” real rate of interest should be somewhere around the level of the “expected” real rate of growth of the economy.  Thus, from the 1960s through the end of the century a 3.0 percent rate worked out to be a good working estimate of the real rate.  If we use my current “expected” rate of growth of the economy, 2.0 percent, then the “real” rate of interest in the United States should be in the 1.50 percent to 2.00 percent range. 

Therefore, as the “risk averse” money leaves United States shores, the yield on TIPS should rise fairly steeply.  Whether or not this rise will be resisted by the Federal Reserve is a question that remains unanswered at this time.  Resisting the rise will just cause to Fed to flood the banking system with more excess reserves, which may cause other problems.  But, this is something that the monetary authorities are going to have to face.

The second reason for a rise in interest rates is that there should be, sooner or later, demand pressure on interest rates due to a pick up in economic activity…or,  Right now, commercial banks are awash with funds while at the same time loan demand seems to be particularly weak.  Thus, there is little or no pressure for interest rates to rise.  This is certainly something we need to watch out for. 

However, we could see interest rates rise for a third reason…a rise in the expectation of future inflation.  This is something many people…like John Paulson…are worried about.  Never before has the commercial banking system had so many excess reserves “hanging around.”  In August 2008, before things fell apart, the excess reserves of the whole banking system amounted to less than $2.0 billion.  In the two banking weeks ending August 8, 2012, excess reserves in the banking system averaged $1.5 trillion. 

The monetary base, the foundation of credit expansion in the United States, was around $2.7 trillion in the banking weeks ending August 8: it was at $842 billion in August 2008!

Few people believe that the Fed can withdraw a major part of these funds from the banking system once banks start lending again…and inflation starts to increase.  Inflation and credit expansion go hand-in-hand.   And, the lending could pick up even if real economic growth does not pick up.

A further question exists: how can the Federal Reserve withdraw funds while the federal government is still running annual budget deficits of $1.0 trillion or more?

So the third reason for interest rates to rise is that as inflation accelerates in the United States, the expectation of future inflation will also rise.  When this will begin and how fast will it take place is, of course, the big question.

There are other possible “macro” effects surrounding this picture.  For example, what will happen to the value of the dollar given this view of the world?  These will be addressed in future posts.

Does one get a sense of potential “stagflation” in what is written above?  Slow economic growth, rising inflation, and rising interest rates.  How does a central bank combat such a situation?

The situation that Mr. Bernanke and the Fed face is a very challenging one.  It is a situation that they have helped to create.  But, getting out of it will not be much fun for them.

As far as the private investor is concerned…a situation like this presents a ton of possible “investment” opportunities.  And, one should always ask, “How can I make money from a situation like the ones described above?” 

As one reads a book like “More Money than God” by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes.  The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes.  However, these “tools” are not available to most people.  Maybe that is why the distribution of wealth in the United States has become so skewed.    

The Debt Crisis Goes On and On

When it comes to a debt crisis almost everyone seems to quote from the book “This Time Is Different” by Carmen Reinhart and Kenneth Rogoff.  A debt crisis takes a long time to create and it takes a long time for a debt crisis to unwind.

Yet, no one seems to heed this conclusion.

Instead we hear that we need more monetary stimulus, a QE3, before the upcoming presidential election in the United States.  We need immediate tax cuts.  We need fiscal stimulus.  We need an export policy to spur on the economy.

Let me repeat the conclusion written above: it takes a long time to create a debt crisis.

In my mind it took the United States approximately fifty years to create its debt crisis. 

Now, the second part of the equation: it takes a long time to unwind a debt crisis.

How long?

Jamil Baz, chief investment strategist at GLG Partners, a part of the Man Group, suggested that the current debt crisis “will take a minimum of 15 years for the economy to reach escape velocity and attain a level consistent with healthy growth.  This is because debt levels need to come down by at least 150 percent of GDP in most countries.  History suggests that you cannot reduce debt by more than 10 percentage points a year without social and political dislocation.”

Fifteen years!

Geeeeeeeeeee!!!!!!

Over the past five years, the debt situation has gotten worse.  According to Mr. Baz, for eleven the eleven developed countries most mentioned when it comes to the debt crisis, the weighted average of government debt to GDP has risen from 381 percent in June 2007 to 417 percent at the present time.

Deleveraging, at least in the public sector, has not taken place during these sad economic times…in fact, just the opposite has occurred.

And, when you add on the private debt the situation has deteriorated even more amongst these developed nations.

Why aren’t businesses hiring?  Why aren’t people spending?  Why aren’t government policies working? 

Because, Mr. Baz argues, deleveraging has not even started yet! 

All we have heard is a lot of hot air escaping from the balloon.  But, the balloon is not taking off and will not take off as long as there is still substantial deleveraging left…in the United States…and in most of the rest of the developed world.

And, when the debt begins to be reduced…watch out for economic growth.  The International Monetary Fund has estimated that, under current circumstances, every dollar cut from government deficits will lead to a two-dollar reduction in GDP.  This multiplier effect is higher now, the IMF states, than it was before 2008…four times higher!

The policy tools that people are turning to are not effective.  Additional government stimulus, or even the talk of it, points to even more debt being created which, in a cumulative way, just adds to the problem.  Monetary stimulus that creates inflation to reduce the real value of the debt will just result in higher bond yields that would raise the costs of servicing the debt and this just will exacerbate the problem.  And, policies to cause exchange rates to fall to jump-start an export-driven recovery are being tried by just about everyone with no one winning the game.

Fifty years of credit inflation…here in the United States…and in Europe…have created the debt crisis.  More of the same policy will only add to the crisis…not solve it. 

But, for fifty years, public officials would not listen to warnings that more and more credit inflation would result in a situation like the one we are now in.

Another five…or, ten…years of credit inflation will not heal the situation!

Unfortunately, there are no good, painless solutions. 

The ironic thing is that interest rates are so low in this situation!  The ten-year United States Treasury issue is trading just under 1.50 percent.  The ten-year German government bond is trading around 1.25 percent. 

The investment community is so spooked by the debt crisis that the “safe” bet today is in either US Treasury securities or German Bunds.  And, some US Treasury indexed bonds are trading at more than a NEGATIVE one percent rate of interest.  The ten-year indexed bond is trading around a NEGATIVE 0.60 percent.

In economics, everything is relative.

However, officials don’t acknowledge the problem.  Debt is subject that is best not discussed.  For most of the past fifty years, debt has not been present in aggregate models of the economy…academic, private, or government models. 

Still, it takes a long time for a debt crisis to become the dominant factor of an economy.

Unfortunately, it takes a long time for the debt crisis to subside.  This debt crisis will not be over when the next president of the United States is elected.  In all likelihood, the debt crisis will not be over when a president of the United States is elected in 2015. 

Maybe it is time to acknowledge this problem and really start to deal with it.  We have seen what continuing to ignore it does.   

The Piggy-Bank Got Smashed: The Collapse of Median Wealth of the American Family

The Federal Reserve just released figures on the median wealth of the American family. 

“The median family, richer than half of the nation’s families and poorer than the other half, had a net worth of $77,300 in 2010” according to the New York Times.

The 2010 is almost exactly the same as it was in the early 1990s when the latter figure is adjusted for rising prices.  The recent financial crisis has, therefore, erased “almost two decades of accumulated prosperity.”

This accumulated wealth reached a peak of around $126,400 in 2007, the Fed said.

The primary culprit for the roughly $50,000 decline? 

Well, the “crash of housing prices explained three-quarters of the loss.”

Over the past fifty years or so, homes were the piggy back of the middle classes.  Most of the income earned by the middle classes went into their homes with little else left over for any other kind of wealth accumulation.  And, the middle class saw their wealth rise over this time period.

Over the past twenty years or so, the federal government tried about as hard as it could to create a similar piggy bank for people with little or no personal wealth and little or very little income.

Now this goal of the government has all come crashing down.  To a great extent, the credit inflation begun in the early 1960s aimed at building up the housing piggy bank has unwound.

The aftermath of the federal government’s great experiment has left a confused and, in many cases, a desperate number of households.  And, this is after three years in which the United States economy has been growing.

Why can’t fiscal stimulus correct the problem as so many fundamentalist Keynesians recommend?

The answer is that the government programs aimed at keeping the price of houses rising, year-after-year-after-year could just not continue to sustain this inflation forever.  There had to be some real earnings supporting the continually rising prices.  Somewhere, sometime the “bubble” had to stop.  The cash flows supporting the increasing market values of the housing stock could not keep up…so the market values of the housing stock had to, at some time, collapse.

The continued credit inflation created by the federal government resulted in a dislocation of resources.  And, where there is a dislocation of resources, the economy must, over time, attempt to return the allocation of economic resources to a less artificial distribution. 

That is what we are going though now.  Of course, some pundits recommend more of the same.  If the credit inflation being created by the government is not “getting things going again” then the government must step up its efforts to produce more credit inflation. 

The problem with this is that constant application of credit inflation cannot continue on forever and forevermore.  The dislocations created by such a policy grow and grow and grow and the amount of credit inflation applied to the economy must also grow and grow and grow in an effort to sustain the dislocations.  The burden becomes heavier and heavier and heavier.

Eventually, the bubble bursts. 

The United States economy is now going through a re-structuring attempting to remove the dislocation of resources created by fifty years of almost steady credit inflation on the part of the federal government.  We are seeing the consequences of this policy, not only in the collapse of the median level of wealth of the American family, but also in the growing inequality in the distribution of wealth in the country.

Unfortunately, these unintended consequences just inform us that “good intentions” do not always produce the results we want.     

The Case for the Dollar: Nothing Has Changed

If one looks at a chart showing the value of the United States dollar against major currencies, one could argue that what was achieved in the presidency of Barack Obama looks very similar to what was achieved in the presidency of George W. Bush.  Both presidents created substantial amounts of credit inflation during their time in office and both presidents saw the value of the United States dollar decline against other major currencies in the world. 

The only thing that separates the two periods is the time in which there was a “flight to quality” in late 2008 and early 2009 and the value of the dollar rose.  However, as President Obama took charge the decline in the value of the dollar resumed.

The only thing that has made Mr. Obama look “good” over the past three years or so is the weakness in the value of the euro, a weakness derived by the fact that many countries in the eurozone followed an even more liberal policy of creating credit than did the United States and, as a consequence is paying the price for it.  

One can interpret the euro/dollar behavior as one in which both currencies are suffering from excessive government credit creation and one currency will seem to be stronger for a while and then the other currency will recover against it.  Right now, the dollar is showing stronger than the euro.

The point is, however, that overall, the value of the dollar is not doing real well against all the other major currencies excluding the euro.  This is a result of the fact that the economic policies of the Obama administration are little different from those that were pursued by the George W. Bush administration.  And, international investors continue to bet against the dollar…even as lots and lots of money pours into the United States from Europe because of the eurozone financial crisis. 

The international investment community shows little or no confidence that President Obama will turn the situation around in the future once the “flight” money reverses its flow.  Market forces sense weakness and move against it.  The Republicans are fighting the way they are, not because of Obama strength, but because of Obama’s weaknesses when it comes to economics.  They sensed this before the 2010 mid-term elections and politics in the United States has not been the same since.

There have only been two times since the dollar was floated on August 15, 1971 that the United States has really earned a “strong” dollar.  These two periods were connected with Paul Volcker, then Chairman of the Board of Governors of the Federal Reserve System in the early-to-middle 1980s, and with Robert Rubin, then Secretary of the United States Treasury in the last half of the 1990s. 

The rest of the time since 1961, the Federal government has focused on fostering credit inflation, using federal deficits to try and stimulate economic growth and keep unemployment at low levels.  What the government has actually accomplished over this time period, what we are experiencing now, is tepid economic growth, high levels of unemployment, and even higher levels of under-employment.

International investors recognize this and that is why the value of the dollar was floated back in 1971 and why the value of the dollar has declined ever since (with the exception of the two periods mentioned above).  Currently, the value of the dollar has declined by almost one-third of the value it traded at in the early 1970s.

I continue to believe that the value of the United States dollar will continue to decline against other major currencies.  Nothing has really changed…in aggregate.  Obama has created massive amounts of debt during his presidency.  George W. Bush created massive amounts of debt during his presidency.  And, unfortunately, I don’t really see much change coming along in the future. 

Therefore, I believe that the value of the United States dollar will continue to decline…along with the relative economic position of the United States in the world.    

"Little" Problems Here and There: Pension Plans

As I have written many times over the past three years, the societies and economies of the western world are going through a period of transition from an age where we thought we could buy prosperity for almost everyone, to an age…well, we don’t know the answer to that yet.

Coming out of the World War II period, the United States government decided that it could achieve greater equality of wealth and opportunity in the country if it (1) underwrote high levels of employment by constantly inflating the credit of the economy, (2) subsidized home ownership so that more and more Americans could own their own homes, and (3) by providing generous pensions to people though direct governmental programs or subsidized private sector initiatives.

Today we have the largest degree of income/wealth inequality in the United States since the early part of the last century; we have experienced the worst period of severe price deflation that the housing sector ever experienced where even now 22 percent of the homeowners with mortgages find that their home prices are below what they owe on their mortgages; and many pension funds, both private and public, are underfunded to such a degree that grave concerns exist about their viability.

The pension funds of private corporations have been hurt by the very low interest rates that have existed in the financial markets for the past several years.  Given such low investment returns these companies have found it difficult to make the returns they need to fund their obligations.

One solution to this problem has been to leverage up the pension funds with low cost debt so as “to reduce financing costs, extend our maturity profile and manage our liabilities” said Dave Vajda, vice-president, chief risk officer and treasurer of NiSource, an energy company that issued bonds in 2011. (http://www.ft.com/intl/cms/s/0/76ab592e-5e47-11e1-8c87-00144feabdc0.html#axzz1nEksnbqo)

Companies are not “earning” their way out of their pension problems.  Currently, they seem to be using “borrowing” to fill the gap.  CSX, Kroger, Raytheon, and NiSource are just a few companies that have recently followed this path.  Still JPMorgan estimates that corporate pension plans are only about 77 percent funded.

But, the problem appears to be even worse in the public sector.  I have written about the situation of state and local governments numerous times over the past two years or so.  Research has placed the shortfall in the $3-to-$4 trillion range with others saying that $4 trillion is only a lower bound.  Whatever the number is, most agree it is substantial. 

There seems to be several reasons for this situation.  First, state and local governments don’t like to use mark-to-market accounting to realistically price their obligations.  Second, many state and local governments are still using assumptions about investment returns that are delusional, at best. Most state pension plans use the assumption that their investment portfolios will earn an 8 percent annual return, this at a time when 10-year US Treasury securities are returning about 2 percent per year. 

Additionally, state and local governments have been notorious for using methods to cover-up the position of their pension plans in the face of budgetary requirements to balance budgets and so forth.  The Government Accounting Standards Board, which oversees government accounts, has been sleepy, at best, in the past.  There is some indication that this group is beginning to show some life. (http://www.ft.com/intl/cms/s/0/20b97eb0-5e38-11e1-85f6-00144feabdc0.html#axzz1nEksnbqo)   

The point is, that there are still pockets of problems lodged within the United States economy that need to be worked out going forward.  And, the working out of these problems is not going to be simple and easy. 

Another factor contributing to this problem is that the “social model” that has served as the foundation for these programs (pensions, unemployment, housing, and so forth) is changing.  Mario Draghi, President of the European Central Bank, stated yesterday that the “Social Model is Gone”.  He was referring specifically to the European Continent, but it applies to the United States as well. 

One further problem faced by the pension programs in the United States is that many people are taking early retirement and this fact was not built into the pension schemes.  The reason why many are taking early retirement is that organizations, both in the private sector as well as in the public sector, have been downsizing to meet budgetary needs and this downsizing has resulted in the fact that many who have left these companies are people eligible for their full pension benefits.

This situation is particularly acute in the public sector as employment in government in the United States dramatically increased over the past fifty years while labor unions became very active in the state and local government bodies.  Now, over fifty percent of the members of labor unions in the United States reside in the public sector.

This is all changing.  We have no idea right now where this change will take us.  The difficult part of this, however, is that there are obligations outstanding right now that need to honored in one way or another.  All we can say, at this time, is that the transition is not going to be easy.

There are many of these “little” problems, here and there, that we have built into the United States economy that must be worked off.  How they are worked off can affect the economy and financial markets in many ways.  But, these little problems don’t always get the headlines because the emphasis of the press…and the politicians… is constantly to find the “green shoots” that indicate that the real economy is picking up steam.