A starting point is to consider the financial system, which raises the first point of interest. I have used the term the 'financial system', but what exactly that might be is a difficult problem of itself. In particular, the government and federal reserve appear to have identified the financial system as being comprised of several major banks, such as Bank of America and Citi. They do not seem to include in their considerations the many medium size banks and financial institutions that are also a large part of the system. As such, when statements are issued which effectively say that they must 'save the financial system', they are referring to the 'too big to fail' financial institutions rather than the whole financial system.
I will not detail the epic bailouts that have already occurred (of which there has already been enough coverage), suffice to say that they are indeed epic, and that the scale of the support is being obscured by the secrecy of the Federal Reserve (see here for total borrowings of depository institutions from the Federal Reserve - a bit shocking). Having done everything humanly possible to prop up the banks, including changing accounting rules to allow them to show illusionary profits, the state of the 'financial system' is still dire. News is leaking of the outcome of the so-called stress tests on the major institutions, and it is not looking very positive. Bank of America is reported as needing to raise an additional $34 billion of capital, and Wells Fargo $15 billion, and rumours suggest that 10 of the 19 banks tested need fresh capital. Whilst some of the other institutions are said to have passed the tests, analysts are pointing out that the tests are themselves flawed:
"The exams are too easy, the banks get to take them home with cheat sheets; and if they don't like their final grade, they can appeal for a better one," said Martin Weiss, president of Weiss Research Inc.The same article points out that the pessimistic assumptions used by the Federal Reserve are simply not pessimistic enough, and this criticism has been echoed elsewhere. This raises the problem that the health of the banks is built upon assumptions for the state of the wider economy, and that mainstream economists have pretty well consistently underestimated the scale of the economic problems.
Perhaps the most important point to take from the stress tests is that, even with the gargantuan support offered by both the government in the US and the Federal Reserve, the 'financial system' still appears to be on the verge of insolvency. The IMF has suggested that the financial system may still need up to an additional $US 500 billion in order to achieve solvency, a figure which appears to suggest that the stress tests are really not stressful enough. Furthermore, the IMF estimates that losses in US banks might reach $US 2.7 trillion, a figure that is simply beyond comprehension. An even greater figure comes from Nouriel Roubini, as well as a damning evaluation of the banks, as follows:
This would be good news if it were credible. But the International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak -- $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators' conclusions.
The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' "worst case" scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010.
The stress tests' conclusions are too optimistic about the banks' absolute health, although their relative assessment is more precise, because consistent valuation methods were used. Still, with Thursday's announcement of the results, it shouldn't be a surprise when the usual suspects emerge. We fear that we are back to bailout purgatory, for lack of a better term.
What this all amounts to is a process of smoke and mirrors. In essence, the tests are set up to allow as many banks to pass as possible, and for those that do not pass to need a minimal additional capital infusion. Despite all the bailout money from the TARP, and the massive support of the federal reserve, the changes in accounting rules and so forth...the 'financial system' is still largely insolvent.
In particular, the situation that now exists is that the bank insolvency is being rescued at a (future) cost to the wider economy. One way or another, the socialised losses of the banks will be paid for by individuals or companies. If we actually think about what the financial system is for, this makes absolutely no sense whatsoever. The purpose of the financial system is surely to provide credit for businesses and consumers through the distribution of savings of other businesses and consumers, and to safeguard their savings and investments. It is not entirely clear how the (indirect) provision of credit to insolvent banks by business and consumers makes any sense. Instead of safeguarding and redistributing savings, the banks are (for want of a better expression) burning the (future) savings and money of consumers and businesses.
The fundamental problem that perhaps allows this, is the indirect and future nature of the policy. For example, if the cost of the bailouts were hypothecated and payable immediately, then how far would the policy have gone?
As I have often emphasised in this blog, any borrowing now represents a future contraction in the economy. If government borrows X to spend on Y today, then either the government, businesses or consumers will have X (+interest) less to spend tomorrow. The standard response is that (at some future point) growth in the economy will help to pay for the borrowing now. This raises the question of when the growth will arrive, and from what source/s?
I recently read a report (sorry, in this case I forget where) that painted a sunny and optimistic outlook for sources of growth from emergent technologies. There can be little doubt that there is significant potential in such growth, but a larger question is whether such growth can reverse the ongoing contraction, and provide broad enough growth to replace the debt based economy. In particular, there is still an ongoing deficit in the balance of trade of goods and services. If you doubt the severity of the situation, you may wish to see the broader current account balance for the US here.
Whilst the deficits in the current account and trade are narrowing, this reflects that the US consumer is reigning in his/her spending, and such a contraction is therefore inevitable. The big question is as to whether this will eventually become a surplus, which is necessary if the US is to start repaying debt. In other words, the US needs to climb the mountain from deficits to surplus, before it can even start to repay debt. In light of the ongoing deficits for such a long period, this is a very tall proposition.
Meanwhile, the pile of consumer credit (i.e. a foregoing of future consumer spending) that is outstanding is quite monstrous, as can be seen in a chart here which shows $US 2500 billion outstanding (I use the Federal Reserve of St. Louis for much of the data in the post), and a chart here showing a rise in personal bankruptcy (albeit from a low base). Meanwhile, the savings rate is climbing from negative territory towards 5%, as individuals have realised that rainy days do indeed come about. The consumer is saving instead of spending, which is healthy in the long term, but means an ongoing contraction in the service economy.
As for a big driver of the credit bubble, the housing market, it continues its relentless decline, albeit that the rate of decline has slowed somewhat. At the same time there are reports of increases in consumer confidence, which are puzzling in light of the record contraction in consumer credit and the ongoing climbs in unemployment exceeding half a million a month (curiously the brief slow down in the pace of unemployment is being seen as a positive sign of recovery). Also, where might the consumer spending come from, if savings are increasing and credit contracting?
For business, manufacturing indexes have been in freefall, corporate tax growth is sharply negative (sorry for the idea of negative growth). Meanwhile investment is down sharply, as can be seen in this report:
Business investment contracted by a record 37.9 per cent, as firms scrapped expansion plans and axed jobs, pulling down overall output. GDP was also hit by a record $103.7bn (£70.2bn) reduction in inventories, or stockpiles of unsold goods – and while that accounted for 2.8 percentage points of the decline, it was hailed as good news by many economists.I was hoping to provide statistics on bankruptcy, but could only find figures for 2008, which show growth in bankruptcy, albeit from a low baseline. However, there is no doubt that one of the key sectors in the US economy is in deep trouble, and that is the automotive industry. Whilst the government is keeping the industry on life support, it does not bode well for the wider state of the economy.
Bernanke is proposing that as inventories are restored, there will be some kind of recovery in the coming months. Whilst an undershoot on inventory sizes might lead to a brief upswing, it is difficult to see where renewed demand will actually come from, or at least demand that will possibly start to match pre-crisis levels. As for an underlying indicator of business health and confidence, commercial real estate is expected to be the next phase of the melt-down:
Schonberger: What's your outlook for the commercial real estate market?Just as for consumers and businesses, the government has long been on a borrowing binge, with total debt now exceeding $US 11,000,000 million and the curve is (of course) rising rapidly. The Congressional Budget Office is predicting a further growth in debt of about $2 trillion in 2009, busting through the congressional debt ceiling of $US 12 trillion. The scale of the borrowing is simply astounding, and the debt is growing at a time of considerable economic contraction, and just as the baby boomer generation is set to retire. Quite simply, it is difficult to see how such levels of debt can be justified.
Kemper: I think commercial real estate has yet to play out in the banking system.
I think that we've played out subprime largely, but I think that the same practices and the same players extended lost credit into the commercial real estate space in the past five years or so, and I think those losses are yet to be realized in the system.
The nature of the government / Obama $US 787 billion bailout plan for the economy is such that it has been widely criticised for being highly political, and including various pet projects and so called 'pork barrel'. A typical criticism can be found here and another here:
"The stimulus bill was supposed to be about jobs, jobs and jobs, and it turned into spending, spending and more spending," Boehner said. "And then we've got this budget. ... And the fact is, we've got trillion-dollar deficits in his budget proposal for as far as the eye can see."The criticism of the bailout appears to divide into two broad camps; those who say it is not enough and is directed into the wrong projects which will also take to long to enact, and those who just consider it wasteful and a burden on future generations. Perhaps the most worrying aspect of the bailout and growth in spending is the massive declines in income for the federal government, which can be seen on a chart here.
There is a more fundamental problem in the government attempts to spend its way out of trouble. Even if Keynesian economic policy is accepted (which is not the case in this blog), the increases in government spending would be difficult to square with Keynesian policy. One of the principles of the policy is to save during the 'good times' and spend during the 'bad times'. As can be seen on the earlier chart on government spending, the government had massively increased spending even before the economic crisis hit. There was also the equivalent of a stimulus in the form of the massive credit bubble that formed, such that the economy was subject to two artificial stimuli before the crisis hit. How spending on top of a credit bubble, and government debt binge might be justified is completely baffling.
In essence, what the massive government spending is seeking to do is return the economy to a level of activity that was itself dependent on the credit bubble and excess government spending. In other words, all the stimuli are aimed at returning the US economy to a position which was of itself inherently unsustainable. Is this a Keynesian stimulus? I think it would be hard to describe it as such.
The real tragedy in all of this is that the Federal Reserve has also chosen to lend support for the economy through quantitative easing (printing money), with this from the FOMC:
To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.The Federal Reserve is now embarking on a great experiment in monetary policy, and pumping ever more $US into the world economy. A good way to get a grip on the massive increase in the monetary base that is taking place is to look at the chart here, which gives an excellent sense of the dramatic increases taking place.
An underlying principle of such a policy is that, as soon as the economy tends towards inflation, the expansion in the money supply will be reversed by selling the assets accumulated by the Federal Reserve, and thereby destroying the money. This all sounds fine in principle, but the US government is, for example, already selling huge amounts of treasuries. As such, the Federal Reserve will add to the flood of treasuries already entering the market as soon as it attempts to reverse the money printing policy. There are already rumblings about the extent of the issue of treasuries from China, as well as concerns that the printing of money will inflate away the value of the $US:
We also have an article in the Financial Times, which suggests that the $US is set for a major fall if China finally loses faith in the currency:
“A policy mistake made by some major central bank may bring inflation risks to the whole world,” China’s central bank said in the report today. “As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies’ devaluation risks may rise.”
Chinese Premier Wen Jiabao expressed concern in March that the dollar will weaken, eroding the value of China’s holdings of Treasuries, as the U.S. borrows unprecedented amounts to spend its way out of recession. China’s Treasury holdings climbed 52 percent in 2008 and stood at about $744 billion as of the end of February, according to U.S. government data.
The problem might be summarised as follows. The US government is borrowing gargantuan amounts of money at a time when the economy is in freefall, and at a time when the government had already racked up massive debts through spending too much. All the while that the government was racking up debts, consumers and businesses were doing the same. The result of this were massive imbalances in the economy which created an unsustainable boom, with continual current account and trade deficits. Essentially, much of the US economy has been supported by this massive accumulation of deficits.
US policy is pushing China towards developing an alternative financial system. For the past two decades its entry into the global economy rested on providing cheap labour to multinationals and pegging the renminbi to the dollar. The dollar peg allowed it to leverage the US financial system for its international needs, while domestic finance re-mained state-controlled to redistribute prosperity from the coast to the interior. This dual approach has worked well. China could have its cake and eat it. Of course, the global credit bubble was what allowed the approach to be effective; its inefficiency was masked by bubble-generated global demand.
China is aware it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects its anxiety over relying on the dollar system. The US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.
However, as the consumer deficit spending evaporates with the crash in house prices, the US government and Federal Reserve are acting to reverse the loss of unsustainable consumer spending through massive expansion in money, and even greater fiscal deficits. They are making no serious attempts to reverse the deficits, and have no clear plan for how both the government and wider economy might move from deficit to surplus. The recent 'austerity' being proposed by the Obama administration is quite simply pathetic, and will do nothing for the credibility of fiscal policy:
The effort to turn attention to fiscal austerity follows a three-month period in which Obama signed a $787 billion economic stimulus package and a $410 billion spending bill to complete the 2009 budget. The stimulus package includes funding for flood prevention and wastewater treatment programs Obama now says should be eliminated.
His 1,374-page budget for 2010 includes more than $1.2 trillion in funds that must be appropriated by Congress, including big increases in health care, energy and education. The contrast between the proposed new spending and reductions produced derision from Republican critics.
"It's like taking a teaspoon of water out of a bathtub while you keep the spigot on at full speed, and the bathtub continues to fill up," said Sen. Judd Gregg, R-N.H., who Obama tried earlier this year to nominate as Commerce secretary.
For creditor nations such as China, it must increasingly look like the US is initiating the largest default in history - through the destruction of the value of the debts through inflation.
If we then look at US GDP to gain an overview over recent months, the figures are quite simply dire:
It is also important to understand that GDP is a measure of activity in the economy. As such, the figure is itself misleading as an indicator of economic health. For example, borrowed money creates activity, and this is included in the figures. As such, the GDP fall is taking place despite massive increases in government borrowing, which will have increased activity within the economy.
The U.S. economy contracted at a steeper-than-expected pace of 6.1 percent in the first quarter, weighed down by sharp declines in exports and business inventories, according to government data on Wednesday that showed the economy was still deep in recession. [nN28309952]
The figure was weaker than analysts' forecasts of a drop of a 4.9 percent rate, according to a Reuters poll, and it also meant output now has declined for three straight quarters for the first time since 1974-1975. U.S. stock futures trimmed gains but still pointed to a higher open. [ID:nN29390529].
At the moment it is not hard to find optimistic projections for an economic recovery from many in the mainstream media, as well as from government sources. However, if we look at each sector of the economy, the only possible brightspot is a slight upswing in inventories. The idea that the economy might cease contraction overall is very dubious, although the money printing and fiscal stimulus might give a brief appearance of improvement. The trouble with these activities is that they are endangering the value of the $US, through the massive expansion of debt and the potentially inflationary increase in the issuance of the $US.
I received considerable criticism across the web for my predicted collapse in the $US, in particular for getting the time frame wrong. However, as each week goes by, the strains on the $US just seem to increase. The economy is still in freefall; many banks are still insolvent (whatever the stress tests might suggest), unemployment is rising, saving is rising (less consumer spending), businesses are failing, the housing market is falling, businesses are failing, personal bankruptcy is climbing, government deficits are increasing, GDP is falling, manufacturing is declining, commercial real estate is expected to plunge, record amounts of money are being printed, and overseas creditors are becoming ever more cynical.
Overall, it does not paint a very pretty picture. Somehow, people are still managing to be positive and optimistic about the US economy. This is a bit of a puzzle.
Note 1: An interesting debate followed from the post of Lord Keynes. As ever, he offered a well considered contribution, and this was recognised by many of the commentators. As a personal note, I would like to thank him for his effort and contribution, not just for the post, but for his many comments on my own posts. I would also like to thank the many others who contribute comments, which make this blog a lively destination.
Note 2: A review of the US economy proved to be quite challenging. In some respects, there is just too much information. In such a situation there is the possibility of selective bias. As such, if you feel that you have information that contradicts what I have outlined, please feel free to link to the source. I have also, in some cases chosen sources for convenience, and this is simply a matter of the time that I can put in to each post. If you have better sources, again, please feel free to post links. One of the great aspects of the comments on the blog is that commentators often turn up both interesting sources, and some interesting points of view.
Note 3: I did think about waiting for the stress tests before publishing, but decided that the nature of the tests was such that their only importance was in their impact upon confidence. As such I published sooner rather than later.