Can Europe Really Reform and Restructure?

Europeans, apparently, don’t want any further integration.   The Pew Research Center in eight EU countries found that “the public is more doubtful about EU membership and the single currency and is shifting decisively against handing Brussels more power over national budgets.”

I have jut returned from two weeks in Italy.  The following comments represent some of the impressions I gathered on the trip.

National divisions are just one reason, although a major one, for the continued failure of the European Union to reach some form of resolution to the ongoing financial crisis.  Whether these divisions can be overcome in the longer term is, of course, a concern of many that a unified solution can be achieved. 

But, there are many other hurdles that work against moving Europe into some greater form of common union.

So much public attention has been given to the fiscal affairs of the national governments and rightly so.  But, there is another aspect to these fiscal affairs that go beyond the ability of the governments to repay their debts.  This other aspect is the social framework that has been built up in these countries through the actual spending that has taken place.

I have often discussed some of the structural problems in the United States created by government spending aimed at keeping people employed in the jobs that they have been working in and to build up government payrolls at the local level, as well as at the national level, to keep people employed and happy.  The consequences of these kinds of policies include rising levels of under-employment, reaching maybe 20 percent of the working age population, and bloated state and local government budgets supporting excessively generous hiring practices and underfunded pensions.

Well, from what I saw and the people I talked with, when compared with Europe, the United States is a “Scrooge” when it comes to this kind of behavior!

And, if the United States has an un-employment rate a little over 8 percent and an under-employment rate of around 20 percent, what is the situation in Europe where countries face 20 to 25 percent government measured un-employment?  What is the level of under-employment in these countries?

In addition, what is the situation in the bloated government bureaucracies and the school systems in these European countries?  The university systems in these countries are, to me, frightening.

Another truly amazing thing to me is three-hour lunch hours…mandated!

What about the spread of information technology?  This, of course, is one of the major things driving modern society.  Read an interesting article that appeared in the New York Times yesterday.  “Italy remains well behind most other West European countries in the reach of the Internet….”

I was discussing the use of information technology in the financial field, especially in banking, with a very advanced thinking Italian, someone who has spent quite a few years in America.  His comment was that Italy was many years behind the United States banks in adopting modern computer technology to daily banking transactions.

And, everywhere I saw industrial zones created to support manufacturing employment with empty parking lots and houses and business buildings standing uncompleted with nothing around them to indicate that activity would return to them soon.

The one thought I took away from trip was that although Europe has a fiscal crisis to deal with in terms of getting their financial affairs in order, the much bigger problem faced by the Europeans is the need for the reform and restructuring of the way they do things.

Modern technology is being used in these European countries, but the technology is being used to maintain a lifestyle that existed in another century.  This is not unlike some radical religious groups that use modern information technology to retain a hold on their medieval social practices. 

In my reading of history, the advance of information technology always wins.  The advancement may be diverted or delayed for some period of time but the spread of information always triumphs in the end. 

The transformation is not easy and will not be easy in the case of Europe.  There will need to be much social change along the way and the existing structure of classes, intellectual as well as wealth and business, along with the current philosophies pertaining to labor unions and governments, will put up substantial barriers to the changes that are needed. 

An example of this given in the New York Times article quoted above is the efforts made by former Italian prime minister Silvio Berlusconi to protect his media business empire from intrusions of the Internet.

The whole world is going through massive changes and no one group, organization, or nation, is going to be able to avoid the changes.  I knew many of the countries in the eurozone were behind the curve in this transition.  I have argued that Europe seemed to be devoid of the leaders needed to guide their countries through this period.  But, my recent trip has made me more pessimistic about the ability of the European Union to throw off their blinders and actually carry out the reform and restructuring that is needed. 

A conclusion like this can only make one more pessimistic about investing in Europe.  I like to think of myself as a value investor that invests for the longer term.  In terms of Europe, therefore, the longer term, in my view, just got that much longer.   

The Unemployment Rate is Not the Most Important Thing

How do I say this gently?  The unemployment rate dropped to 8.1% in April, the lowest it has been since December 2008, but, it seems to me, that this is not the most important thing we should be focusing on. 

If we continue to look at the unemployment problem as a cyclical problem we will do the wrong things. 

I know, I know, there is an election coming up this fall.

Yet, this is where the Obama White House and where the apparent Republican presidential candidate are putting all the marbles.  Listen to this: "Much more remains to be done to repair the damage caused by the financial crisis and the deep recession," wrote Alan Krueger, chairman of the White House's Council of Economic Advisers, in a statement. "It is critical that we continue the economic policies that are helping us dig our way out of the deep hole that was caused by the severe recession that began at the end of 2007."

The financial crisis and the deep recession...come on!

Here is the number I think we should be focusing on: the participation rate…the share of the population of working age that are in the labor force…is at 63.6 percent, the lowest it has been since December 1981.  And, this was just when women were really starting to participant in the work force.  Within this figure the percentage of working age men in the workforce fell to 70.0 percent, the lowest it has been since the Labor Department starting collecting data in 1948.

The labor force dropped 342,000 in April.  This is not unemployment…it is something worse!

My calculations indicate that about one in five Americans of working age are under-employed.  This is a structural problem…it is not a cyclical one.

And, how did we get into this situation?  We got into this situation because we treated almost everyone that lost a job a consequence of the business cycle. 

And, the proposed solution to this problem?  Inflate the economy with Government deficits and monetary expansion.

Put everyone that lost a job back into the job he or she lost!

This was the political mantra that inhabited both sides of the political spectrum since the early 1960s. And, although the politicians pursued these policies with the intention of achieving high employment…and getting themselves re-elected…it was probably, over the longer run, the worst thing that these individuals did for the people they were trying to help.

The American…and the European…problem right now is a structural one and not a cyclical one. 

Look at the figures: since the Great Recession began in December 2007 payroll employment in construction is down by almost 26 percent; manufacturing payrolls are down by 13 percent; and retail payrolls are down by over 5 percent.  This is after almost four and one-half years of economic recovery. 

And, we know that jobs losses in the public sector are adding more and more to the overall depressing figures.  Last month, government job losses totaled 15,000 a rate that has been roughly maintained over an extended period of time.

We know that there has been a big push for productivity over the past four years of so.  This was one way to combat the recession and get businesses going again.  And, this worked for a time, although the recent increases in productivity may be coming to an end. (http://professional.wsj.com/article/SB10001424052702304746604577381713675051658.html?mod=ITP_pageone_1&mg=reno64-sec-wsj)

The 1990s into the 2000s saw labor hoarding in many manufacturing and other business jobs as the credit inflation policies of the federal government bought out the business exposure connected with the hoarding of labor. Rising property values meant that state and local governments could build their regional empires with the assurance that they would have a constant increase in revenues to cover their expansions.  Housing programs along with financial innovations like subprime loans, underwrote a massive expansion of the housing industry.  There was substantial over-hiring in so many fields during this time period.  And, this was a time when the Internet boom took off resulting in a huge re-structuring of the way almost everything gets done. 

The point is, the only real solutions to the situation we now find ourselves in are long run solutions.  Short-run stimulus will only delay the efforts to re-structure the workforce and postpone any real efforts to make things better.  And, monetary policy cannot, in the longer run, reduce the unemployment rate.    

Long run programs, like education and re-training, are what are needed. I direct your attention to a recent article that addresses this situation: “Education is the Key to a Healthy Economy” by forms Secretary of State George Shultz and Eric Hanushek. (http://professional.wsj.com/article/SB20001424052702303513404577356422025164482.html)

The problem is that politicians work only within a very short time horizon…the next election.  We can expect little help here!

That is why I say that the unemployment rate is almost irrelevant, except to those that are up for election.  People are leaving the workforce.  Many of the people that have left the workforce cannot be hired back into the labor market in positions similar in effort or pay to the jobs they lost because they don’t have the skills or experience to work in any other area than direct customer service…and this region of the jobs market is already over supplied.

We need to shift our focus to things like labor force participation rates, male labor force participation rates, and under-employment and ask the really hard questions about what is needed to turn these trends around.  Given all the blather connected with the current presidential election, one cannot be too hopeful.    

The Federal Reserve Was Quiet in the First Quarter

In the first quarter of 2012, the Federal Reserve was very quiet.  The reserve balances that commercial banks held at the Fed actually declined by about $4.0 billion during the quarter to total $1.563 trillion on March 28.

Securities held by the central bank declined by slightly more than $15.0 billion as the Fed’s portfolio of Treasury securities, Federal Agency securities, and mortgage-backed securities all fell during the period.  Over the last four weeks of the quarter, very little took place in the Fed’s holdings although, in aggregate, there was a small decline.  

The factors supplying reserve funds to the banking system actually declined by about $48.0 billion but this was offset by around $44.0 billion in factors absorbing reserve funds.

The biggest item impacting the decline in reserve funds being supplied was the reduction in Central Bank liquidity swaps that occurred as the financial crisis in Europe resided and most of this took place in the last four weeks of the quarter. This was offset on the liability side of the Fed’s balance sheet by a number of operational factors, none overly significant.

These data just reconfirm the signals that Chairman Bernanke has given Congress, financial markets, and the academic world about the current stance of monetary policy.  The Federal Reserve is not doing a lot right now, but will not back off from the quantity of reserves it has injected into the banking system over the past two years, and stands ready to do more if the need should arise.

And, short-term interest rates continue to remain exceptionally low.  Since the Fed is doing little or nothing to supply more reserves to the banking system, the fact that the short-term interest rates are staying so low implies a lack of strength in the demand side of the market.  This, I believe, is an important thing to keep our eyes on because if the demand for funds begins to pick up, this will put pressure on short-term interest rates and the Fed will either have to step in to prevent this rise because of economic or banking reasons, or, let the rates begin to increase.  This is an area to watch.    

This all sounds pretty dull, but…the central bank really likes things dull!

For one, only 16 banks were closed by the FDIC in the first quarter of 2012, compared with 18 banks being closed in the last quarter of 2011.  We will have to wait for over a month and a half before we know how many more banks left the banking system through mergers and acquisitions.  Last year, the banking system lost, on average, 60 banks per quarter and only 23 of these were banks that were closed by the FDIC.  The number of commercial banks in the banking system continues to decline, but in an orderly and calm fashion.  Dull is good!

Economic growth continues, but it is not exceptional. (For more on this see my post http://seekingalpha.com/article/469671-gdp-growth-the-road-ahead-and-the-investment-climate.) There is not too much more that the Fed can do in terms of stimulating more rapid economic growth, but it does hope to contribute to a turn-around in the housing area. 

But, the economy is growing, and, baring shocks related to gas prices, a collapse of the eurozone, or an economic slowdown in China…among other things…it should continue to grow over the next several years, although the expansion will not be robust. 

This is not all bad since many households and businesses are still reducing debt loads and trying to get their finances in order. 

The problem is in the employment area.  It is not just that the unemployment rate continues to stay too high, it is that under-employment still hovers around 20 percent.  A reason the unemployment rate might not drop too much over the next six to twelve months is that if the job market becomes more active, people who are now not considered to be a part of the labor force will re-join the labor force hence helping to keep unemployment rate higher than desired.

One thing is apparent and that is the Fed does not seem to be doing anything dramatic about getting the unemployment rate done more rapidly in advance of the Presidential election in the fall.  Given the lag-in-effect of monetary policy, the Fed has done just about all it can to achieve lower unemployment numbers this summer and fall. 

This may be one reason why we are not seeing the announcement of another round of quantitative easing.  The current Fed has already been accused of being one of the most “political” central bank administrations ever.  Announcing another round of quantitative easy at this time would only exacerbate those cries.  And, in my mind, would be able to achieve little or nothing in terms of a more vibrant economy and labor market through the end of the year. 

Thus, I believe the Fed will remain relatively benign over the course of 2012.  Again, dull is good when it comes to central banking.  But, this doesn’t mean that the central bank will not act during the year if there is a real need for action, coming from the banking sector, the economy, Europe, or elsewhere. 

Mr. Bernanke Stands Pat

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System gave his “Semiannual Monetary Policy Report to the Congress” this morning.

Mr. Bernanke basically said nothing. 

The stock market dropped…apparently any hopes for an additional round of quantitative easy were dashed.

What can one say?

The Fed’s forecast for the growth of real GDP: between 2.2 percent and 2.7 percent, slightly higher than the rate of growth experienced in the second half of 2011.

The Fed’s forecast for the inflation in the prices related to consumption expenditures: between 1.4 percent and 1.8 percent, about the same as the annual rate of increase in the second half of 2012.

Unemployment is expected to stay around the level it achieved in January 2012…around 8 percent since economic growth is expected to remain slightly below its long-term trend.

Where does the risk lie in the economy in the future?  It seems that there is still “persistent downside risks to the outlook for real activity.” 

The job market “remains far from normal.”

The fundamentals for household spending “continue to be weak.”

The housing sector is giving off mixed signals, at best.

Manufacturing is improving and real business spending for equipment and software seems to be picking up.

However, the European situation remains a concern.  We are told that the Federal Reserve is “in frequent contact with our counterparts in Europe and will continue to follow the situation closely.”

And, given this environment, the Federal Reserve will continue to keep the target range for the federal funds rate in the 0 to ¼ percent range.  The Federal Open Market Committee “expects economic conditions to warrant exceptionally low levels of the federal funds rate to at least through late 2014.”

There you have it.  Economic growth is expected to continue at a rate that is slightly below its long-term trend of about 3.0 percent through 2013.  Inflation is to stay below the Fed’s target of 2.0 percent for the near future.  And, the risks inherent in the current financial and economic environment continue to be on the downside with the European situation being the main worry.

The banking system will remain flush with excess reserves.  The larger banks will continue to grow larger and take over more and more of the financial system.   Small- and medium-sized commercial banks will continue to fail or be merged out of the banking system. And, regulatory reform will continue to lag behind what is happening in the real world.

That is, there is nothing new to report. 

Thank you, Mr. Bernanke!