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.    

Municipal Governments: Default Rates Higher Than Thought

“Moody’s Investment Service has reported that from 1970 to 2011, there were only 71 municipal bond defaults.  But (a Federal Reserve Bank of New York) report counted 2,521 defaults.”

“The report found a similarly vast gap in the raw numbers of defaults when it looked at data from Standard & Poor’s.  The Fed’s combined database indicated 2,366 defaults from 1986 to 2011, compared with S & P’s 47 defaults during this same period.”

These quotes are taken from the New York Times article, "Muni Bonds Not as Safe As Thought".

The difference in the figures is that Moody’s and Standard & Poor’s just report on rated bonds whereas the report of the Federal Reserve Bank of New York considers both rated and nonrated bonds.

Now most investors and investment funds just invest in rated bonds so that the report of the rating agencies represents what most of these investors face.  And, the default rate of the rated municipal bonds rests slightly below one percent.

However, if we are looking at the state of the economy and the state of municipal finances we need to look at all defaults and not just the defaults of the rated issues. 

But, we need to look deeper into the whole municipal financial to really understand what it going on in the municipal area.  “The Fed researchers said that debt backed by a city’s own general obligation pledge seldom defaults, while debts backed by revenues generated by individual projects were more uncertain.”

Bonds related to housing projects contributed 17 percent of the defaults; nursing homes accounted for 12 percent; and health care projects provided 11 percent.  But, the largest contributor was industrial development bonds, which made up 28 percent of the defaults.

And, it seems that municipalities are taking more and more risks on bonds, some of them related to educational efforts.  See the reference to the issue by the San Diego educational authorities mentioned in my August 11 blogpost, "Sour Time for Cities".  In this case, Poway Unified, one San Diego educational district, issued 7 percent “capital appreciation” bonds.  There is no need for Poway Unified to pay back interest or capital until 2033, and when the bond is repaid in 2051, the district will have paid back to investors 10 times the amount initially borrowed.

The total default rate on municipal bonds, both rated and non-rated appears to be about 4.5 percent.  This in not a huge number, but it is certainly not as low as most of us perceived the default rate on municipal bonds to be. 

Also, the Fed researchers noted that municipal defaults are not as closely tied to economic downturns, as are corporate issues.

The trend in municipal defaults seem to be tied to longer, more secular movements in the economy and not just business activity.

For example, at the start of the period covered by the research, 1970, public labor union membership was a very small of the labor union movement and not particularly strong.  Currently, public labor unions make up over 50 percent of the membership of labor unions in the United States.

Furthermore, in 1970, homes in the United States had not become the “piggy bank” of the middle class.  The inflation of home prices really began in the late 1960s and early 1970s and the almost continuous rise in the price of housing became the “go to” source of revenue for governments to raise the salaries, pensions, and other benefits of rapidly growing municipal employment roles.

According to the Federal Reserve figures, only 155 municipal defaults took place between 1970 and 1986…sixteen years.  This meant that about 10 defaults took place every year during this time period. 

From 1986 through 2011, 2,366 defaults took place.  Over this latter 25 years, the country averaged almost 95 defaults per year. 

And, the number of defaults was much greater during the latter part of the period than it was in the late 1980s and early 1990s.

Bottom line: municipal bond defaults are much more of a problem than many people have believed to be the case.  And, from all indications we are not out of the woods yet in terms of turning this situation around!

I have written a lot over the past year or so about the problems facing state and local governments.  Unfortunately, many state and local governments are not unlike the Greek government in under-reporting their fiscal situations.  And, in many cases we are just learning about them now.

I believe that we are still facing many problems in the state and local government realm due to unreliable accounting practices, declining tax base, promises to constituents relating to social services and education, and militant public labor unions.  Working out these problems is not going to be pretty…but, state and local governments cannot return to a prudent operating condition until they are worked out.

As a consequence, there will be many more bond defaults in the future, especially municipal bond defaults.  They may be non-rated bonds, but they are municipal bonds, but they are municipal bonds none-the-less.  These defaults will continue until these institutions get their act together and their budgets and accounting by in line. 

The US Economy: Modest Growth Continues

The July numbers for industrial production have just been released and all one can say about them is that the economy is just showing “more of the same.”  The year-over-year rate of increase of industrial production for July was 4.4 percent.  The average rate of increase for the first six months of 2012 was 4.8 percent.   

Economic growth, as captured by the rate of increase in industrial production, has not been strong and economic growth remains weak.  This growth is not inconsistent with the rate of growth of real GDP, which has been around 2 percent, year-over-year, through the second quarter of 2012.

This rate of growth is not sufficient to reduce the amount of unemployment in the United States and is specifically not sufficient to reduce the amount of underemployment in the nation, which remains in the 15 percent to 20 percent range. 

It is also not sufficient to raise the rate at which manufacturing capacity is used in the United States.  Although the rate of capacity utilization has moved up modestly in recent months, it still remains below the level it was at just before the recent recession set in.

There is much unused economic capacity in the United States these days and the economy is not growing sufficiently to cause this unused capacity to shrink much at this time.  For one, there are just too many problems that people have to deal with before full blown economic growth can continue again.  

Some of these problems have to do with the amount of debt still outstanding in the United States; one out of four residential mortgages are still “underwater”; the are substantial problems in the area of commercial real estate; state and local governments still have massive problems in the area of pensions and debt outstanding (see my recent post titled "Sour Times for Cities"); and there remain many problems in the banking sector…among other things.

Many of these problems need to be “worked out” before people, businesses, and governments can start spending again.   And, this spending must be stepped up if the economy is to return to a level of economic growth more consistent with the last half of the twentieth century.

In addition, people and businesses still need some indication of where government policy is going to go.  This is perhaps the ultimate need.  Right now there is little or no indication of what future government economic policy is going to be.  People and businesses find it very difficult to commit in such an environment.  I am afraid that we are just not going to get much pick up in the commitment people and businesses until they get some idea about what kind of environment the government is going to create for the future.  Right now all they can focus in on is more deficits of one trillion dollars or more and more and more debt.  And, this provides little or no help to them in making decisions about how to spend their funds. 

So, economic growth is going nowhere.  As a consequence, a substantial amount of economic resources are going to remain unused. 

This scenario is not going to change before the presidential election in November.  It is highly unlikely that it will change much over the next year or so. And, this will be the environment we all are going to face in making spending and investment decisions during this time.    

 

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.

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. 

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.   

More Banks Downgraded

Today’s news: 28 Spanish Banks were downgraded by Moody’s Investors Service.  Included in this list were Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA (BBVA).

Moody’s’ cut the ratings of 16 Spanish banks on May 17. 

Again, the argument can be made that this move was "too little, too late."

Yet, perhaps the most important thing to realize is that especially if the move by Moody’s is “too little, too late,” the situation in the banking system has not improved even though a substantial amount of time has passed since the banks entered into this “dark” region.

That is, maybe the banks should have been downgraded six months ago…or, nine months ago…or twelve months ago.  What we should reflect upon is that the banks have not improved their financial condition over this six months…or, nine months…or, twelve months…so that the ratings would not have had to be dropped!

The banks did not respond to the conditions because everyone in Europe seemed to believe that the problems faced by the banks were “liquidity” problems and not “solvency” problems, and that eurozone governments also did not face “solvency” problems.

The conditions cited by Moody’s for the downgrade included the weakness of Spain’s sovereign debt and the increasingly larger losses being recognized by the banks on commercial real estate loans.

Today, Spain requested funds for a banking bailout from members of the eurozone.  The lingering question still remains about when Spain, itself, is going to ask for a formal bailout.  Spain’s bonds are now trading near peak level spreads over German bonds of the same maturity.  The concern here is that these high yields cannot lead to a sustainable financing of the national government.

The situation of Italy is not unlike that of Spain, so there is concern over when the financial markets are going to turn more strongly on the government of Italy.

But, no one seems to have the will to act.  Still no leaders have arisen.  The general belief that the solution must ultimately rest with Germany receives cries of strong protest from German officials.  Short-term plugging of the dike is about all anyone can do. 

It is becoming more and more obvious that the only way the European situation will be corrected will be when the European governments “bite-the-bullet” and actually accept the fact that there is a massive need for structural reforms in most countries.  However, these government officials, in the past, postponed actions over and over again arguing that the problems were just ones of “liquidity.”  Now they have moved to claiming short-run cash injections will solve the “solvency” problems. 

The possibility that European government officials will really consider structural reforms for their societies still seems a distant fantasy. 

There has been talk of a banking union with the eurozone.  Yet, no one really seems serious about giving up their national interests when it comes to forming a banking union.  And, no one seems to want to create a system of deposit insurance like we have in the United States. And, no one seems to want to bear the burden of forming some central regulation agency.  Without some give, somewhere along the line…nothing will happen!

The deeper problem is that banks are not seemingly resolving their balance sheet problems with the time given them by their respective central banks.  Liquidity has been pumped into both the United States financial system and the European financial system.  Yet, few banks seem to be lending indicating they are in a “holding pattern” until things get better.

Still, things have not gotten appreciably better.  If they had, Moody’s would not have had to downgrade all the banks they have downgraded…at this late date.

And, this applies equally to the United States banking system, where commercial real estate loans also plague many banks.

Furthermore, in Europe and in the United States, economic recovery is not going to take place as long as their banking institutions are not lending. 

To me, moving to a QE3 will do no more to right the banking system in the United States nor will a QE3 do anything more to help the economy start growing faster.  Just as in 1937, having more excess reserves in the banking system does not mean that the banks are solvent or that will start lending.  Other things must happen for the banks to start lending and one of these things is to honestly recognize the serious weaknesses that exist within the banking system and continue to re-structure the banking system as smoothly as possible so as to bring solvency back to the industry.

And, this is true of Europe.  Further provision of liquidity to European banks is not going to help them.  European officials, as well as the banks themselves, must accept the reality of the situation and move on.  The banking system needs bailing out.  Several governments in Europe need bailing out.  Solvency is the issue.  Recognizing this and re-structuring their societies is necessary to move forward into the future. 

Any bright future for Europe will only face further delay by postponing the re-structuring that ultimately needs to take place.      

Federal Reserve Can Do Little At This Time

By historical standards the rate of growth of both measures of the money stock, M1 and M2, are quite high.  Still the reasons for these high growth rates are related to people moving assets around their balance sheets rather than the stimulus injected into the banking system by the monetary authorities.  Money stock growth is not occurring because loan growth is increasing.

In May, 2012, the year-over-year rate of growth of the M1 money stock was just about 16 percent within the 16 to 18 percent range the year-over-year growth rate this measure of the money stock has grown in the first five months of this year.

The M2 measure of the money stock grew at a 9.5 percent rate of year-over-year increase, a rate consistent with its behavior since the end of last year.

These measures are growing as rapidly as they are, not due to the monetary stimulus of the Fed working its way through the lending of the banking system, but because people continue to shift assets in their balance sheets away from short-term interest bearing assets to transactions balances that pay little or no interest.

This shift in funds, as I have argued for over the past two years or so, should not be interpreted as a sign that people are buying things.  On the contrary, people are still moving their funds from short-term interest bearing assets to transactions balance for two reasons.  First, many people are without jobs or without full-time jobs or who face housing problems need to keep their money in a form that can provide for daily needs.  Second, with interest rates so low people are not earning enough in the short-term interest paying assets to justify them to keeping their funds there.

In the first case, the currency component of the money stock is still increasing at historically high rates, 8.5 percent, year-over-year in May, and this I continue to interpret in a pessimistic way.  People need to hold cash when times are tough. 

In addition, the demand deposit component of the M1 money stock is increasing at a 36 percent annual rate in May, an extraordinarily high year-over-year rate of growth.  Where are these funds coming from? 

Well, small time deposit accounts are down over 17 percent, year-over-year, retail money funds are down 3.5 percent, year-over-year, and institutional money funds are down slightly more than 8 percent, year-over-year.  People are taking funds out of short-term interest bearing accounts and putting these funds into demand deposits.

The increase in demand deposits is not being generated by the commercial banks lending out money to support consumer or business spending!

We can see the effect of this on bank reserves.  Total bank reserves have actually declined year-over-year by slightly less than 2 percent.  However, required reserves have risen by 31.5 percent over the same time period.  The increase in required reserves is a result of the shift in other bank accounts that have lower reserve requirements to demand deposit accounts that have a much higher reserve requirement. 

The interesting consequence of this is that excess reserves in the banking system have actually declined over the past year.  They have not declined by much, but the have declined sufficiently to cover the amount of reserves the banks’ need to cover the increase in required reserves to back up the rise in demand deposits.

This decline in the excess reserves in the commercial banking system is matched by a similar decline in the reserve balances commercial banks keep at Federal Reserve banks. 

Overall, in comparing where the Federal Reserve was last year with where it is at the present time there are two things that stand out in terms of the actions of the central bank. 

First, the Fed supported the substantial increase in the demand for currency in the economy.  In this matter, the Fed supplies currency to the public “on demand”.  That is, the Fed exercises no control over the amount of currency that is in the economy.

Second, there were substantial actions on the part of the Fed over the past year to combat what was going on in the rest of the world.  Three major line items on the Fed’s balance sheet relate to this: central bank liquidity swaps; dealing in assets denominated in foreign currencies; and reverse repurchase agreements with “foreign official and international accounts.” 

This second area that stands out is not surprising given all the problems that have been faced in Europe and elsewhere.  The Federal Reserve has provided help when and where it can.

Otherwise, the other activity that the Federal Reserve has engaged in over the past year can fundamentally be called “operating transactions.”  That is, the Fed acts to offset seasonal or special transactions to maintain relatively steady reserve balances.  For example, when cash flows out of the banking system in the Thanksgiving/Christmas time period, the Fed usually injects reserves to cover the outflow.  After the first of the year when cash flows back into the banks the Fed will reverse their previous injection.

These actions are call “operating transactions” because they help to stabilize the movement of funds in and out of the banking system that are just routinely operational.  And, these operations still have to be maintained even in the face of all the excess reserves that now exist within the banking system.

Bottom line: very little has changed in the banking system in recent months and, hence, the Federal Reserve has been relatively quiet.  There still remains a contingent of individuals in the financial markets that are calling for the Fed to engage in a third effort at quantitative easing.  My guess, however, is that QE3 will not be forthcoming, even in the face of the lower revised numbers for GDP in the first quarter of this year.

There are three reasons for this.  First, further quantitative easing will have little or no effect in stimulating faster economic growth.  There are just two many structural problems in the economy for the United States to achieve faster economic growth at this time.  What would the banking system do with more than $1.5 trillion in excess reserves?

Second, the handling of the insolvency problems within the United States banking system is going very smoothly. (See my post on “The Condition of the Banking System”.) Right now, there is nothing else the Federal Reserve can do to help this process go any better.  Thus, the Fed needs to leave well enough alone.

And, third…this is an election year.  The Fed has been criticized in the past for attempting to ease monetary policy to support a sitting President.  It does not want to look political in its actions.  

The Federal Reserve does not have unlimited capabilities.  The officials at the Fed need to know when to act, but they also need to accept the fact that there are times when they can do little or nothing to help a situation.  In these latter cases they need to back off.

To me, now is a time when the Fed need to stay quiet, continue to execute its routine “operating” duties, but still stay alert.  There is very little benefit that the Fed can achieve now through further actions, but there are potential costs of attempting to be too active.