I’m no pilot, but I imagine that if I were flying a plane and a mountain appeared in front of me, I’d pull up to avoid crashing. Instead, I am an economist and business person and I see an economic mountain looming in front of the U.S. I only wish I could explain why Washington insists on flying straight into the mountain rather than pulling up.
Washington politicians are pointing the U.S. economy straight into a liquidity trap and instead of a bright economic future, the U.S. is looking at years of high unemployment, weak GDP growth and the possibility of widespread deflation.
When the economy is in a liquidity trap, monetary policy is ineffective because individuals and businesses hoard money rather than spend it. The more money the Fed makes available, the more consumers hoard.
Will I be able to feed my family and pay the bills? Is my job secure? Is my house worth less than the mortgage? Will the government help me when I am old or will Medicare be denied when I need it the most? Why is the school board cutting pay and firing teachers? Does a government shutdown mean that I won’t be paid? Is the Treasury raiding my pension to pay bondholders?
When ordinary people aren’t sure how to answer those questions, they become gripped by fear and uncertainty. To assuage their fears, they spend their time and resources getting ready for whatever bad news comes their way. They hoard cash and try to save for the rainy day that they are convinced will come. As a result, demand for goods and services falls causing prices, wages and living standards to plunge. Before you know it, we’re in the midst of what economists call a deflationary spiral with no end in sight.
Last week the Federal Reserve of Bank St. Louis published an update to its M1 Money Multiplier chart that shows ordinary Americans are holding on to cash. In the last six months the Money Multiplier has gone into a downward spiral. When the Money Multiplier falls, it’s tough for the economy to sustain growth.
It’s not just the M1 Money Multiplier that is falling; M2 Velocity is falling as well. M2 velocity is a measure of how fast broadly defined money supply turns over each year. When M2 velocity falls, consumers, businesses and investors are slowing the rate at which they spend and invest their money. Annual GDP equals the amount of money available to spend multiplied by the number of times the money turns over in a year. When velocity goes down it is a sure bet that a recession is right around the corner.
As the below chart illustrates, M2 Velocity resumed its downward trajectory about six months ago after recovering a little from the 2008 financial crisis.
Falling velocity is a sign that consumers and businesses are losing confidence in the future.
Beyond the obvious inclination to hoard, one of the side effects of falling monetary velocity is the tendency of investors to sell more risky and less liquid assets and invest in Treasury bonds which are considered “as good as cash.” Right on queue in the last two months, the stock market has been in decline while the Treasury market has been rising.
Confidence in the future is needed to get money turning over again. Yet, confidence is being destroyed by a lethal combination of natural and man-made disasters.
In the last six months there have been natural disasters of epic proportion, but the worst disasters are man-made and causing self inflicted wounds.
The earthquake and tsunami in Japan were natural disasters with wide spread economic consequences for both Japan and the global economy. Flooding in the Midwest and tornadoes throughout the East were no one’s fault, but still rocked the world of millions of Americans.
Even so, it’s man-made disasters that are hurting the most.
Conflict in the Middle East is a man-made disaster that has the potential to take a turn to the dark side with lasting consequences. Also, the European sovereign debt crisis is a man-made crisis that still isn’t under control.
However, by far the biggest economic disaster is being created in Washington and in state capitols. The deaf ear of politicians and policy makers to the unintended side effects of their words and deeds is almost beyond comprehension. Certain politicians seem to think that they were elected to play Russian roulette with the economy and don’t understand the consequences of their actions.
In the last six months investors, businesses and consumers have watched the U.S. come within minutes of defunding itself and shutting down.
This month everyone is wondering if Congressional leaders will commit collective suicide and fail to pass an increase in the debt limit. Every night on TV members of Congress seem almost giddy at the prospect of serving the U.S. economy cyanide-laced Kool-Aid.
Consumer and business confidence requires public sector certainty. It can’t be up for debate whether or not the government should honor its commitments.
Several state and local governments aren’t doing any better. Solving budget problems by going to war with workers and constituents is like pouring acid on confidence.
The Fed’s ability to help the economy is very limited when fear drains money from the productive economy. For better or worse, when the Fed can’t help, it’s up to our elected officials to fix the economy. Unfortunately, it’s these elected officials that led us into the shadow of the valley of economic death.
Despite evidence to the contrary, politicians continue to believe that their words and personal deeds don’t matter; that there are no consequences to creating uncertainty by threatening to unilaterally break contracts and bankrupt people that trusted the word of the United States.
Until our elected officials stop threatening an economic Jonestown, we are doomed for as far as the eye can see.
In ordinary times it would be ignorant to ask, “Who’s going to bail out the Fed?” — but then again these aren’t ordinary times.
Solvency of the Federal Reserve Bank shouldn’t be an issue because it carries the full faith and credit of the United States of America. In theory, the only way the Fed could need a bailout is if the federal government fails.
While theory is interesting, political reality is an entirely different story. The Federal Reserve is putting its future at risk by ignoring its own likely financial results when it raises interest rates. Simply put, rising interest rates will hurt the Fed by making interest costs higher and asset values lower.
Congress has gotten used to spending profits made by the Fed. Based upon first quarter results the Fed is on track to turn over more than $110 billion in 2011.But what happens if the Fed’s profits suddenly turn to losses? Will Washington remember the Fed’s enormous earnings and cut them some slack?
In the mafia, you are only as good as your last envelope. Congress works in much the same way. It’s a sure bet that Congressional memory won’t last more than a single missed payment. When the Fed stops kicking up to its Congressional bosses, it’s future will be in serious jeopardy.
While the Fed isn’t like any other bank in America, it is still subject to the immutable rules of math and interest rate risk. If the Fed starts to earn less on its investments than it pays in interest on its deposits, it will lose money.
That is exactly what the Fed is facing when interest rates rise — that it will pay more for deposits than it earns on its investments.
Taken in isolation the Fed’s balance sheet looks more like an overleveraged hedge fund than a shining example of prudent risk management. The Fed has almost no capital to back up its big macro bet on interest rates and the shape of the yield curve. Higher interest rates or an inverted yield curve where long-term assets yield less than short-term assets will cause problems.
The Fed borrows money by accepting short-term floating rate deposits from banks. It uses its cash to purchase mostly long-term fixed rate bonds. Through the monetary stimulus programs of QE I and QEII the Fed has purchased a boat load of long-term fixed rate bonds and now owns approximately $2.3 trillion of these assets.
When short-term interest rates increase the positive difference between what the Fed earns on its investments over what it pays to borrow money will shrink. If interest rates rise enough, the Fed will start booking losses.
A simple stress test on the Fed suggests that an increase of between 3.00% and 3.50% in the federal funds rate will turn the Fed into a text book example of a Congressional basket case. For the vast majority of the Fed’s existence, the Federal Funds rate was above its breakeven point of around 3.25%.
Even worse, the Fed’s assets, Treasury bonds and mortgage-backed securities, will fall in value when interest rates go up. It is a universal bond truth that when interest rates rise, the market value of fixed rate investments falls. Falling market values will restrict is ability to trade into higher yielding assets without realizing market value losses.
Unlike all other banks, the Fed has essentially no equity to absorb losses. It is required by law to transfer the vast majority of its profits to the Treasury every year and as a result has only $53 billion of equity backing up almost $2.7 trillion of assets. If the Fed were a private bank it would be immediately classified as critically undercapitalized and seized by regulators.
The Fed was there for Citigroup and Goldman Sachs and the entire financial sector but who will be there for the Fed?
As a practical matter the Fed cannot hedge its interest rate risk. While other banks can buy interest rate swaps, futures and options, the Fed is not like other banks and will be subject to a double standard.
The Fed will never collect on hedge contracts bought from Wall Street oligarchs. Hedging is a zero sum game —if the Fed makes money that means someone on Wall Street loses.
The “too big to fail” banking crowd will make the Fed’s hedging contracts uncollectable in less time than it takes to clean up after a K-Street cocktail party. There is just no way that Wall Street will voluntarily pay the Fed a few hundred billion when Congress is around for a bail out.
I happen to be a supporter of the Fed’s monetary policy and think that Mr. Bernanke and the Fed staff have done an amazing job. I am not suggesting that the Fed balance sheet is out of control or that they have been irresponsible by accumulating $2.3 trillion of assets.
However, the Fed staff just is not anticipating the firestorm of criticism it will receive when it stops earning money for Congress.
Mr. Bernanke has not laid the groundwork with the public for losses and is giving Fed haters ample ammunition to attack the institution. Just imagine if the Congress had to include funding for the Fed in debt limit debate.
In a perfect and intellectually honest world, losses at the Fed would be a non-event. But we don’t live in a perfect world. The Fed is setting itself up for political opportunists to take cheap shots without consequence.
By not dealing with the certain math of interest rate risk, Bernanke risks becoming the guy who gives Congress an excuse to end Fed independence.
At separate news conferences Democratic and Republican leaders accused each other of political opportunism after Congress again failed to raise the debt ceiling and banks refused the President’s request to fund a government bailout.
As a result, the federal government shutdown that began in 2011 will continue for another year.
Fed future for Ryan?
Federal American Reserve Bank Chairman Paul Ryan stated ”It isn’t fair that the president is asking banks to pay taxes. If we pay taxes this year, he will just come back next year for another handout. The cycle has to be broken. I used to be one of those irresponsible tax and spend officials and I know how things work in Washington. If we give in now to paying taxes there is no telling where this will end up.”
Chairman Ryan’s comments were circulated on the House floor just before today’s critical vote.
Ever since the mega bank American National acquired the Federal Reserve Banking system the government has been unable to collect tax revenue without Chairman Ryan’s help.
Sticky issue of taxes
The President responded to Ryan’s criticism by pointing out that because corporate taxes were eliminated and personal income tax rates are only 0.001% for anyone earning more than $250,000 per year the government hasn’t been able to balance the budget. ”Since the last tax reduction the government has been forced to live off of parking fees at the national parks. It just isn’t enough to fund essential services and invest in the future.”
It didn’t take long before Economics Nobel Prize Laureate Glenn Beck shot back at the President. ”We need to take back our country from the liberal elites. All they want to do is take from you and me and give it to the poor. We can’t let Marxists run this country anymore.”
Beck’s rival, Treasury Secretary Paul Krugman, worried that the government might have no choice but to permanently shut down. “The government has been on the ropes ever since we adopted the gold standard and closed the Federal Reserve. I warned everyone that this would happen but no one listened to me. The Republican’s even made fun of me. But, facts are facts. With gold at $18,829 per ounce we can’t afford to buy the currency needed to run government anymore.”
Long time TV commentator Sean Hannity interrupted his long running cable news show and devoted an entire 5 minutes to an in-depth examination of the issue. ”Let not your hearts be troubled. The only thing permanently shutting down is Krugman — he’s even older than me, and I am so old I have trouble thinking straight. I say government can be delivered by the private sector cheaper and more effectively than through the public sector. People just need to trust the private sector and free markets to take care of them and everything will be OK. Look at me, I have been taken care of all my life and I am doing just fine.”
In separate economic news, the Pay Czar delivered a new report criticizing the compensation of public sector employees including school teachers, fire fighters and sanitation workers as being excessive. ”When school teachers earn more than their students…well that just isn’t right. After all, who works for whom?”
The Pay Czar was especially disparaging of workers at the Department of Motor Vehicles. ”Those workers don’t deserve to be paid. I had to get my license renewed and I know — no one wants to pay for the DMV. If we could do it over again, why would there be a DMV at all?”
See the original version of this post at Forbes.com.
Today I heard it again on the car radio — an advertisement claiming that since gold has topped $1,500 an ounce it’s a “must buy” for every responsible saver.
If only it were true that I could protect my family from economic Armageddon by buying gold.
Unfortunately, the hard facts are that increasingly since 2000 gold has been the opposite of an inflation hedge. Even worse, when interest rates rise in response to inflation, gold will fall in value, and maybe by a lot.
The historical relationship of gold to inflation, i.e., that it is a hedge, is no longer true. Gold has been “financialized” by Wall Street and its price is being driven by institutional speculators that buy it by borrowing money at near 0% interest. As long as interest rates remain low, the cost of betting on gold is very low and money flows into the gold market.
As gold prices soar individual investors need to beware. One day interest rates will start to rise and gold prices will plummet. Innocent victims that buy gold because of a mass market sales pitch will be sorry.
My strong advice to readers is don’t be a gold bug. It’s only a matter of time before the Fed exterminates you.
I have received a big response to my recent article about credit card bills and whether or not consumers are being overcharged. A lot of frustrated readers have privately e-mailed me with their own very strong overcharging suspicions.
Fortunately, the credit card overcharging problem can be fixed with simple solutions that can be implemented immediately. Every day grammar school kids learn three basic lessons which if applied to bank credit card billing will instantly solve the problem. The three lessons are…
Show your work
No free do overs
What’s good for the goose is good for the gander.
Banks need to “show their work” and tell their customers how they got to the answer. It isn’t good enough to get an answer without explaining how they got it.
Showing their work means putting on credit card statements columns that show the actual daily balance and the debits and credits that were used to calculate the balance. Currently, banks show the monthly average daily balance that is subject to finance charges but not the actual daily balance that is used for the calculation.
There is a big difference between showing the monthly average balance and the actual daily balance, and that difference prevents consumers from figuring out whether or not they were overcharged. Without the daily balance calculation (and the daily finance charge which is included in the daily balance) banks aren’t showing their work.
My daughter always gets points taken away for not showing her work. Banks should have regulatory points taken away as well.
Some of the readers who e-mailed me asked me to try to reconcile the finance charges on their bill. One reader had a balance of approximately $2,500 on her September bill. She sent in a payment to the credit card company of approximately $3,500 which resulted in a credit balance, i.e., the credit card company owed the reader money because of overpayment. The September payment was sent in to the bank right after the bill was received and credited to the account approximately 15 days before the due date. During the month of September my reader used her credit card and charged approximately $3,500 of purchases (no cash advances). Based upon the contract she believes she shouldn’t have had a finance charge on her October bill. But, the credit card company said that she had an average daily balance of approximately $1,500 and she owes approximately $15 in finance charges. While $15 isn’t a lot, she can’t recalculate the average daily balance to figure out how the charge was incurred and suspects that she wasn’t given credit for her overpayment of the previous bill. Moreover, she believes that since she paid her previous bill in full and before the due date she shouldn’t have incurred any finance charges.
Another reader told me that despite him and his wife paying all of their credit card bills in full every month and upon receipt, his last bill had a charge of $69 on approximately $800 of purchases. Looking at the bill it is clear that the credit card company calculated finance charges from the date of purchase despite the contract saying that if payment in full was made on time there wouldn’t be any finance charges. And, a one month charge of $69 on $800 of purchases is close to 100% compound interest. It’s a pretty good guess that the bill is in error.
Just like when our kids get answers wrong on a test or make an error in a game that counts, there needs to be a penalty for the error of overcharging. Refunds for overcharges don’t cut it. Refunds are like free do overs and every kid knows that when they take a test or play for keeps there are no free do overs.
Free do overs are for learning experiences. Credit card banks aren’t supposed to be in the business of learning. They are already supposed to know what they are doing and take responsibility for their errors.
Dollar for dollar refunds provides no incentive for banks to try to get it right when they bill their customers. Instead of dollar for dollar refunds, I think refunds should have added to them an amount equal to whatever the highest finance and overdraft fees that the bank would have charged a customer that overdrew his account by the same amount. Since each bank has a different set of penalty charges, each bank will have a different penalty for making mistakes.
Banning free do overs by charging banks penalties and giving the penalty to their customers seems pretty fair to me. After all, I believe “what’s good for the goose is good for the gander”.
In practice that means if your bank charges and overdraft fee of $35 per over draft (with a maximum of 7 charges per day) plus 24.9% interest, then your bank will have to pay for its mistakes at the same rate, i.e., $35 per mistake (with a maximum of 7 charges per day) plus 24.9% interest. And, if banks don’t own up to their mistakes and refuse to credit consumer accounts on a prompt basis, fees should accrue at $1,000 per day (after a 30 day grace period to fix the error). With real money on the line I am pretty sure that banks to get it right the first time they send out a bill.
On September 29th the Federal Reserve Board proposed amendments to Regulation Z (truth in lending) and while the proposed reforms are a good first step they need to do more and go farther.
It’s a shame that simple grammar school lessons seem to be revolutionary ideas for banks. Show your work, no do overs and what is good for the goose is good for the gander shouldn’t be controversial concepts that need a lot of thought to implement.
The U.S. economy has a long way to go before the economic recovery will be either sustainable or robust.Monetary indicators don’t look good and are once again getting worse.I am concerned that the financial system hasn’t recovered enough for the Federal Reserve to withdraw from its program of quantitative easing.
While most of the large financial institutions seem to be currently stable, abet with hundreds of billions of dollars of government investment and support, they aren’t strong enough to service the needs of Main Street.Almost all of the monetary and financial indicators point to shrinking lending and constrained credit.The part of the banking sector that supports business and consumer isn’t working and, in many ways, is getting worse.And, the shadow banking system is continuing to disappear and can’t be counted on to pick up the slack of banks.
Until the charts presented below start to point up, I don’t think there is going to be a real economic recovery (as contrasted with technical bounces from inventory adjustments and changes in population).
All of the data suggests that the U.S. remains in the grips of a liquidity trap, i.e., a period of time when interest rates are at or near 0% but yet traditional monetary policy is ineffective.The Obama administration needs to reexamine its cautious approach to the big banks and think about whether or not the largest banks are sapping the economic strength of the rest of the economy.
Money Supply and Bank Lending Charts — Important Note — Each chart is a link to a full page view of the chart. Sorry I am not better at presenting graphics.
The below chart indicates that, contrary to popular belief, money supply is somewhere between stagnant to shrinking.A growing economy requires an increasing money supply and an increasing money supply is a sign of a growing economy.
The velocity of money, i.e., the number of times a year money is spent and re-spent, continues to fall (which is very bad).Sustainable economic recovery can’t happen until the velocity of money starts to rise.The current velocity of money is signaling money hoarding by banks, businesses and individuals.Hoarding is a type of savings in cash and cash equivalents that is motivated by fear rather normal savings that signifies a desire to invest in the future because tomorrow will be better than today.
The money multiplier is below 1x which means that as banking reserves are created, money supply is actually shrinking.I think that this is the first time in my life time that the money multiplier is less than 1x.The money multiplier has fallen below 1x despite the Federal Reserve’s quantitative easing program.One way to think of the money multiplier is as a sort of economic thermometer.As long as the money multiplier is below 1x then the banking system (including the effects of Federal Reserve quantitative easing) is sick.Without Federal Reserve emergency measures the diseased banking system would probably have been sick enough to kill the rest of the economy.Sick banks shrink, deleverage and cut back on loans (which are riskier than owning Treasury securities and cash equivalents).The money multiplier needs to be well above 1x for the banking system to be able to support economic growth.
All of the most commonly watched measures of bank lending are trending down (except for the purchase by banks of investment securities which includes government securities and cash equivalent securities).The lending trends are bad and sustained economic recovery isn’t happening until they start to look better.Moreover, non-financial commercial paper (a measure of the shadow banking system) isn’t looking very healthy either.
For those readers who aren’t conversant in Fed jargon, some of the below charts refer to MZM which is M2 minus small-denomination time deposits plus institutional money market mutual funds.
All of the charts were compiled by the St. Louis Federal Reserve which has a great research web site and series of publications.
Last week’s late breaking news that the Federal Reserve was following through on its plan to change how it regulates bank compensation is being follow up by this week’s G-20 meeting on how bank compensation curbs can be internationally coordinated among the large economies.Surprisingly, however, the media is acting as if regulating bank compensation is a new issue.It isn’t new at all but rather a problem that they chose to forget about for the summer.
If anyone was wondering what the Federal Reserve and the U.S. government has been thinking, the minutes of the House Financial Services Committee provide the answer.On June 11, 2009, Scott G. Alvarez, General Counsel for the Fed, laid out the compensation plan. Interestingly, his words are almost identical to the breaking news that caused last week’s compensation firestorm.
After you read the below excerpts of Mr. Alvarez’ June 11th statement try taking the simple 6 question quiz I have prepared on bank compensation.It is a basic bank test that you can use to see where you fit in the bank compensation debate.
Chairman Frank, Ranking Member Bachus, and other members of the Committee, thank you for the opportunity to offer some perspectives on the subject of incentive compensation in banking and financial services. Recent events have highlighted that improper compensation practices can contribute to safety and soundness problems at financial institutions and to financial instability. Compensation practices were not the sole cause of the crisis, but they certainly were a contributing cause…
…As the events of the past 18 months demonstrate, compensation practices throughout a firm can incent even non-executive employees, either individually or as a group, to undertake imprudent risks that can significantly and adversely affect the risk profile of the firm….
…the Federal Reserve is developing enhanced and expanded supervisory guidance in this area to reflect the lessons learned in this financial crisis about ways in which compensation practices can encourage excessive or improper risk-taking….
…Compensation arrangements are critical tools in the successful management of financial institutions. They serve several important and worthy objectives, including attracting skilled staff, promoting better firm and employee performance, promoting employee retention, providing retirement security to employees, and allowing the firm’s personnel costs to move along with revenues…
…It is clear, however, that compensation arrangements at many financial institutions provided executives and employees with incentives to take excessive risks that were not consistent with the long-term health of the organization. Some managers and employees were offered large payments for producing sizable amounts of short-term revenue or profit for their financial institution despite the potentially substantial short– or long-term risks associated with those revenue or profits. Although the existence of misaligned incentives surely is not limited to financial institutions, they can pose special problems for financial institutions given the ability of financial institutions to quickly generate large volumes of transactions and the access of some institutions to the federal safety net…
…in some cases, the incentives created by incentive compensation programs to undertake excessive risk appear to have been powerful enough to overcome the restraining influence of these processes and risk controls…
…in many instances, risk-management frameworks did not adequately take account of the potential for compensation arrangements themselves to be a source of risk for the firm. The risk-management personnel and processes at financial institutions, thus, often played little or no role in decisions regarding compensation arrangements. It is possible that aggressive pursuit of highly skilled financial specialists in recent years caused some financial institutions to relax or forego usual safeguards and controls in the interest of hiring and retaining what they believed to be the best talent…
…These weaknesses were not limited just to financial institutions in this country. These types of problems were widespread among major financial institutions worldwide, a fact recognized by the governments comprising the Group of Twenty, international bodies such as the Financial Stability Board (FSB), and the industry…
…Correcting these weaknesses will require improvements in both corporate governance and risk management at financial institutions. Boards of directors and senior management of major financial institutions must act to limit the excessive risk-taking incentives within compensation structures and bolster the risk controls designed to prevent incentives from promoting excessive risk-taking. In many cases, boards of directors that have analyzed the connections between incentive compensation and risk-taking have focused only on a handful of top managers. However, incentive problems may have been more severe a few levels down the management structure than for chief executive officers (CEOs) and other top managers. Indeed, recent experience indicates that poorly designed compensation arrangements for business-line employees–such as mortgage brokers, investment bankers, and traders–may create substantial risks for some firms. Thus, boards of directors must expand the scope of their reviews of compensation arrangements…
…The Federal Reserve also is actively working to incorporate the lessons learned from recent experience into our supervision activities. As part of these efforts, we are in the process of developing enhanced guidance on compensation practices at U.S. banking organizations. The broad goal is to make incentives provided by compensation systems at bank holding companies consistent with prudent risk-taking and safety and soundness…
…First, shareholders cannot directly control the day-to-day operations of a firm–especially a large and complex firm–and must rely on the firm’s management to do so, subject to direction and oversight by shareholder-elected boards of directors. Incentive compensation arrangements are one way that firms can encourage managers to take actions that are in the interests of shareholders and the long-term health of the firm. However, compensation programs can incentivize employees to take additional risk beyond the firm’s tolerance for, or ability to manage, risk in the course of reaching for more revenue, profits, or other measures that increase employee compensation. Second, where managers have substantial influence over compensation arrangements, they may use that influence to create or administer incentive arrangements in ways that primarily advance the short-term interests of managers and other employees, rather than the long-term soundness of the firm…
…Since 1995, the Federal Reserve and the other federal banking agencies have had in place interagency standards for safety and soundness (Standards) for all insured depository institutions.2 These Standards, which were adopted pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), prohibit as an unsafe or unsound practice both excessive compensation and any compensation that could lead to material financial loss to the insured depository institution. The Standards provide that compensation will be considered excessive if the amounts paid are unreasonable or disproportionate to the services performed by the relevant executive officer, employee, director, or principal shareholder and set forth a variety of factors that will be considered in determining whether compensation paid in a particular instance is unreasonable or disproportionate. Importantly, FDICIA specifically prohibits the agencies from using the Standards to prescribe a specific level or range of compensation permissible for directors, officers, or employees of insured depository institutions…
…More recently, in November 2008, the Federal Reserve, in conjunction with the other federal banking agencies, issued an interagency statement reminding banking organizations that they are expected to regularly review their management compensation policies to ensure that they are consistent with the longer-run objectives of the organization and sound lending and risk– management policies.3 This statement provides that management compensation policies should be aligned with the long-term prudential interests of the institution, should provide appropriate incentives for safe and sound behavior, and should structure compensation to prevent short-term payments for transactions with long-term horizons. In addition, it states that management compensation practices should balance the ongoing earnings capacity and financial resources of the banking organization, such as capital levels and reserves, with the need to retain and provide proper incentives for strong management…
…Broad Review of Compensation Practices. First, care must be taken to properly align the incentives of compensation paid to employees throughout an organization. It is not sufficient to focus only on compensation paid to senior executives…
…Making Compensation More Sensitive to Risk. Second, compensation practices should not reward employees with substantial financial awards for meeting or exceeding volume, revenue, or other performance targets without due regard for the risks of the activities or transactions that allowed these targets to be met. One key to achieving a more balanced approach between compensation and risk is for financial institutions to adjust compensation so that employees bear some of the risk associated with their activities as well as sharing in increased profit or revenue. An employee is less likely to take an imprudent risk if incentive payments are reduced or eliminated for activity that ends up imposing higher than expected losses on the firm…
…Risk Management and Corporate Governance. Third, more can and should be done to improve risk management and corporate governance as it relates to compensation practices. Our discussions with market participants and supervisory experience suggest that risk controls are a necessary complement to–and not a substitute for–prudent compensation systems in protecting against excessive risk-taking…
…Review of a firm’s compensation practices also must involve the board of directors. The board of directors provides an important link between the shareholders of a firm and its management and employees. Active engagement by the board of directors or, as appropriate, its compensation committee, in the design and implementation of compensation arrangements promotes alignment of the interests of employees with the long-term health of the organization…
…Boards of directors will need to take a more informed and active hand in making sure that compensation arrangements throughout the firm strike the proper balance between risk and profit, not only at the initiation of a compensation program, but on an ongoing basis…
…Improving compensation practices at financial institutions is important. Compensation arrangements must continue to allow financial institutions to attract, retain, and motivate talented employees, but they also must not provide incentives for managers and employees to take excessive risks. And while the issues and concerns associated with improperly designed compensation practices are common, no single compensation system will address all types of risks or work well in all types of firms. Each firm ultimately must determine how to address these matters in a way most suited to that firm’s business, structure, and risks…
Now for the quiz.
Question #1 (True/False) – The Federal Reserve and Treasury’s plan for issuing updated guidelines relating to bank compensation is “new” breaking news?
Question #2 (True/False) – The Fed, FDIC and OCC have no legal authority whatsoever to regulate banker compensation and the regulation of banker compensation is a naked power grab by Federal bureaucrats who want to run and ruin the economy?
Question #3 (True/False) – The Fed Board and its staff don’t believe in capitalism and are socialists (just like Stalin, Mao and Ho Chi Min) who want to see Obama create a centrally planned economy?
Question #4 (True/False) –Obama wants to limit what bankers can earn because he wants to tax away their hard earned wages and use it to pay for health care benefits for his core constituents which are needed for reelection, i.e., illegal aliens?
Question #5 (True/False) – Major media pundits are against the regulation of banker pay because they are interested in truth and not their TV ratings?
Question #6 (True/False) – Experts who say that the Federal Reserve is executing an unconstitutional power grab have actually read the Constitution and Federal banking laws and have training in law and bank regulation?
I am pretty sure that some of the readers of this article will answer all of the above questions as “True”.If you are one of those people, you should be applying for a job as a lobbyist for the banking industry because you want to be one of the people that control the debate on bank compensation.
However, if you don’t aspire to work as a lobbyist (or believe that facts, figures and training are more important than dogma), then I think all of your answers are going to be “False” and you, like me, are disgusted with the behavior of the few that stole fortunes from the many.
Fed watchers need to stop panicking when they look at the new supersized Fed balance sheet and monetary base. The Fed’s balance sheet doesn’t necessarily mean runaway inflation is in our future or that the Fed is out of control. The Fed got supersized because Bernanke & Company came to appreciate the U.S.‘s special role in the world economy. The U.S. dollar is the world’s primary reserve currency and a supersized Fed is what this special status requires.
Many Fed watchers believe in a “cause and effect” relationship exists between the rapid buildup in the size of the Fed’s balance sheet and both runaway inflation and a debasement of the U.S. dollar. I don’t agree.
Old school Fed watchers need to set aside their decades old Fed expectations and relearn their trade. “Game changing” shocks of the past few years have made the Fed a very different and more complicated central bank than in the past.
While it’s great to look back on the simpler good old days of a small Fed balance sheet, the lack of Fed assets limited policy options. Since the U.S. dollar is the de facto reserve currency for the world, like it or not the Fed has responsibility to provide liquidity for all dollar denominated trade in the world, whether or not it takes place within the U.S. A puny balance sheet that limits policy options is inconsistent with the reality of the Fed’s extended mission.
The issue that the Fed has to work through is that if it doesn’t have a large enough balance sheet and monetary base for global trade there will be acute U.S. dollar shortages around the world that will shut down the U.S. and global economy. Bernanke & Company adjusted to this reality by putting in place several new policy tools, all of which point to a bigger balance sheet.
Perhaps the biggest new Fed policy tool is one of its most technical; the Fed’s new ability to pay interest on reserves. Basically, that means that when banks deposit cash at the Federal Reserve, these deposits earn interest. In the past, bank deposits at the Fed didn’t earn interest. As a result, banks didn’t deposit their excess cash at the Fed and excess reserves for decades were stuck at a very low amount. But now that the Fed can pay interest on cash deposits, banks have a good reason to deposit their excess cash at the Fed and excess reserves, i.e., excess cash deposited at the Fed, has skyrocketed.
Fed watchers look at the new large excess reserve balances and conclude that these balances are evidence of an out of control Fed. They disregard the fact that the Fed can now pay interest on reserves. There is a great article written by David Altig, Senior Vice President and Research Director for the Atlanta Fed, that discusses the new level of excess reserves and explains why large levels of excess reserves aren’t necessarily bad or inflationary.
By getting excess cash balance deposited at the Fed, Altig argues that policy makers have many more options to implement monetary policy and quicker methods to withdraw reserves from the system. The ability to pull reserves from the monetary base is important when money supply rises as a result of an acceleration of the velocity of money (which may occur when bank lending accelerates).
Bernanke & Company learned a tough lesson during 2007 and much of 2008. They learned that if they don’t provide enough liquidity to the global trade and banking system the rest of the world will take down the U.S. economy. In February the Bank for International Settlements published research that discussed how the European banks had a $2 trillion shortage of US dollars and couldn’t settle their debts because of an acute shortage of dollars. This resulted in LIBOR rocketing upward, even for government insured interbank deposits where there was no credit risk. The LIBOR spike ripple effects started to swamp the U.S. economy through a large rise in effective interest rates for U.S. loans tied to LIBOR and the near collapse of the banking and trade system which started to destroy export and import businesses.
Even the Chinese Central Bank Governor Zhou Xiaochuan understands that the Fed needs to make sure that its balance sheet and monetary base has to be supersized to provide liquidity for global commerce and banking. Zhou was quoted suggesting that use of the U.S. dollar as the primary medium for global trade has created special burdens for the Fed which cause irresolvable conflicts. Zhou recently wrote…
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries’ demand for reserve currencies. On the one hand, the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities; on the other hand, they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists.
The Fed is trying to prove Zhou wrong by “threading the needle” and creating enough liquidity so that global trade and international banks don’t die because of a lack of liquidity while at the same time not over stimulating the domestic economy or over expanding money supply.
So far Bernanke & Company seems to be getting it right but only time will tell if they will be able to satisfy both the domestic and international needs for money without tipping too far in the direction of inflation or deflation, liquidity or crisis. And, only time will tell if Zhou is correct that the competing demands of the domestic economy and international trade are inconsistent and cannot be reconciled. Either way, I am pretty sure that the new normal of a supersized Fed balance sheet and monetary base is going to be with us for a while and is necessary to prevent a meltdown of the global banking and trade system.
Even before posting this article I can already hear the purveyors of the conventional wisdom accusing me of incompetence for not realizing that the current crisis is the Fed’s fault because they kept interest rates too low for too long after 9/11 and they are at it again.
I don’t believe in the conventional wisdom. Monetary policy, interest rates and money supply aren’t the proximate cause of the current crisis. The causes are much easier to recognize and don’t take a PhD in economics to understand. Fraud, mismanagement and overleverage (along with a good dose of white collar crime) put us in the predicament we are in. Too much money supply has about as much to do with the current crisis as Eve blaming her weakness on too many apples in the Garden of Eden. Post 9/11 monetary policy is a convenient scapegoat for those that are trying to deflect attention from their own misdeeds and incompetence.
After publishing my last article suggesting that the Fed may not be running up money supply like a drunken sailor I was roundly criticized for not understanding that even though the results of the Fed’s irresponsible actions weren’t showing up in M1, M2 or estimated M3, the bad effects of Fed policy can be found if I just look hard enough. So, in the next few days I will take a look at recently distributed data to see if there is any evidence of “money” and “credit” being out of control.
What if conventional wisdom about the Fed is wrong and it isn’t printing money like a drunken sailor? Well…that would make most of the media coverage of the bond market and the economy wildly off the mark.
As it turns out while media talking heads were ranting about how the Fed was running their printing presses overtime to push up money supply the facts were very different. M1 has actually declined since the middle of December, 2008. During the same six month period M2 has only risen by a little less than 3%.
For some reason that I can’t explain most financial, economic and media experts don’t bother to read the Federal Reserve’s weekly money supply data before writing authoritative articles or spouting off on TV about money supply and its implications.
Of course, M3 followers argue that M1 and M2 are bad money supply indicators because they are too narrow and that only M3 should be used to measure the growth in money supply. Unfortunately, the Fed stopped publishing M3 a few years ago (because they said it was irrelevant) which started a club of M3 conspiracy theorists, i.e., people that believe the Fed stopped publishing M3 as part of a conspiracy to hide irresponsible monetary policy.
However, even without M3 being specifically published we know that broader measures of money supply, like M3, haven’t materially risen in 2009.
M3 followers can get a very rough idea of what M3 would have been, if it were published, by looking at the Federal Reserve quarterly Flow of Funds Accounts of the United States which was distributed yesterday. As it turns out, total net borrowing of the United States (private and public) dropped approximately $255 billion in the first quarter and other indicators of M3 fell or are about flat (on a net basis). The Flow of Funds Accounts data is inconsistent with a large rise in M3 (or a large rise in any money supply measure). By the way, this data supports Brad Setser’s theory that the fall in private borrowing is more than offsetting the rise in government borrowing and therefore, at least for the time being, financing the deficit isn’t a problem.
And, I have a suggestion for the M3 conspiracy theorists; get a life. Worrying about a Federal Reserve conspiracy isn’t worth your time and effort.
Set forth below is a chart that was compiled from weekly Federal Reserve data that illustrates money supply growth, seasonally adjusted, since the week ending December 15, 2008. The data suggests that the Fed is hardly “out of control” or a drunken sailor.
To those readers who want to flame me for not accusing Bernanke & Company of ruining the economy because of the growth in the Fed’s balance sheet, just hang in there. You will get your chance soon enough. Over the weekend I am going to write about the “irresponsible” expansion of the Federal Reserve balance sheet (or maybe why it wasn’t irresponsible at all).
It looks like in the next few years newly issued Treasury and agency guaranteed residential mortgage debt may create a debt tsunami that will swamp the economy. Fortunately, looks can be deceiving.
While interest rates are likely to rise for both long maturity Treasury notes and bonds and agency guaranteed residential mortgage debt, rising rates are not because of a lack of investment demand or failing confidence in the U.S. Government. Instead, as I have written for months, the all-in cost of capital for most domestic institutional investors is higher than the net yield on Treasury and agency guaranteed mortgage debt. The inability of domestic institutions to earn a profit at current interest rates isn’t the same thing as a lack of desire, capacity or confidence.
But of course yields are too low for private market investors to make money. After all, since December the Federal Reserve has been executing a program of open market purchases of Treasury and agency guaranteed mortgage debt designed to drive interest rates below market clearing yields. So, it shouldn’t be a surprise that among private investors there is an upward interest rate drift that can only be offset with more aggressive Federal Reserve intervention.
Private institutions can’t make money buying Treasury and agency guaranteed mortgage debt because the operating expenses of most institutions are very close to the investment yield on the Treasury and agency guaranteed mortgage debt. Unless the Federal Reserve is somehow able to magically force operating expenses of domestic institutions downward, market clearing yields are going to rise. At higher interest rates the private market won’t have any trouble absorbing the forward calendar of debt issuance.
To understand whether or not the volume of newly issued debt will swamp investor demand each type of debt needs to be broken down and analyzed individually and compared to sources of investment liquidity.
Residential Mortgage Debt
The amount of new mortgage debt isn’t a problem because basically there is no net new mortgage debt being created.
There are two ways to create new mortgage debt; (i) refinance existing mortgage debt and (ii) finance home sales.
Refinancings, by definition, result in a repayment of old mortgage debt held by investors. For every dollar of refinanced mortgage debt that is issued there is a dollar of old mortgage debt that is retired. As a result, old mortgage debt investors receive cash that they recycle into newly created mortgage debt (or other investments like Treasury securities).
Mortgage debt created by home sales falls into two categories: new home sales and sales of existing homes.
The proceeds from purchase money mortgage debt created from sales of existing homes generally are used to pay off mortgage debt of the selling home owners. So, mortgage debt created through existing home sales is like refinancing debt, generally it doesn’t create net new mortgage debt.
If for some reason the debt tsunami worriers are agonizing about increased mortgage debt created from new home sales that should be the least of their concerns. If new home sales weren’t stuck in the mud there wouldn’t be a credit crisis or a deep recession which are the underlying causes of the debt tsunami. The United States should only have the problem that new home sales are so high it isn’t clear how they are going to be financed.
There is plenty of demand for long term Treasury notes and bonds, just not at current interest rates. The natural buyers for Treasury debt are domestic banks, thrifts and insurance companies. These institutions have more than $1 trillion of excess liquidity which continues to grow every day. The pool of domestic cash sitting on the side lines gets bigger every day because of a combination of increased U.S. savings and accommodative Federal Reserve policy.
However, domestic financial institutions are sitting on the sidelines and not buying. The problem is that domestic financial institutions know that they can’t make money buying Treasury securities at current interest rates and no matter how much they would like to own long term Treasury notes and bonds they can’t invest.
When interest rates on long term Treasury debt rises above 5% domestic institutions will start to be large scale buyers. These institutions will start to make a reasonable profit without taking on unreasonable risk or leverage from purchasing long term Treasury notes and bonds.
Debt tsunami worriers need to pick something else to anguish about, at least for a while. Obviously, the current deficits can’t last forever but they aren’t in danger of swamping the economy for a long time. And, interest rates are inevitably going to rise but then again long term interest rates aren’t being set by the marketplace. Rising interest rates aren’t a source of worry but rather the beginning of the end of the great recession.