Slowing Productivity Growth Portends Private Sector Hiring

Does your company have you pulling your hair out because they fired all your colleagues and expect you to do all the work? Perhaps relief is on the way.

The latest issue of Bloomberg Businessweek had a great segment titled "Seeking the Number That Explain It All: Four economists discuss their favorite indicators as they try to gauge where the U.S. economy is headed". Dean Maki of Barclay's Capital weighed in citing Real Consumer Spending as his primary tool. Dan Greenhaus of Miller Tabek prefers to watch Nonfarm Payroll data while David Rosenberg of Gluskin Sheff + Associates prefers watching Home Prices.

The most interesting commentary came from James Paulsen of Wells Capital Management. He uses productivity as his leading indicator on the economy. While Greenhaus looks at Nonfarm Payroll data, Paulsen is attempting to see the signs of improvement before they are reflected in the jobs reports. As Paulsen explains, when a recession begins CEOs initially clamp down and look for ways to cut costs. The cost-cutting initiatives seen in the US led to a surge in productivity as employees were forced to maintain output while relying on fewer co-workers.

Year 2008	%Δ in Productivity		Year 2009	%Δ in Productivity		Year 2010	%Δ in Productivity
Q1 2008	(0.9%)		Q1 2009	3.5%		Q1 2010	3.5%
Q2 2008	1.2%		Q2 2009	8.3%		Q2 2010	(1.8%)
Q3 2008	(1.1%)		Q3 2009	7.2%		Q3 2010	2.5% r
Q4 2008	(0.3%)		Q4 2009	6.1%

Source: Bureau of Labor Statistics

As the chart above shows, the year 2009 was the year of productivity enhancements. With three quarters registering above 6% growth in productivity, firms were able to accomplish more output with fewer workers. This cost-cutting fueled the surge in corporate earnings even while top-line revenue growth was much less impressive.

Fast forward to 2010 and we now see productivity growth slowing. In order for firms to continue growing they will need to begin hiring much more aggressively. Recessions are often healthy in a broader economic sense squeezing out inefficiencies and redundancies and we are emerging from a very deep one. As these streamlined companies start to add employees again average costs will likely be lower as productivity has been vastly improved. Paulsen boldly predicts that "we're going to have job gains around 225,000 average monthly next year". Let's hope he's right!


Brandon R. Rowley
"Chance favors the prepared mind."

Inflationists Inadvertently Do the Fed's Bidding, Commodity Rise Not From QE

It struck me last night as I was watching Ron Paul on CNBC criticize the Federal Reserve's actions that the crowd heretofore referred to as the inflationists are the greatest promoters of the Fed's real agenda. Bernanke has successfully shifted the dialogue in just a few months to one solely focused on the danger of future inflation rather than the deflationary/disinflationary environment we have found ourselves in for quite some time.

Fed's goal is to change inflation expectations

Bernanke has stated that general consensus among economists (if there is such a thing) and his belief is that a 2% inflation rate is ideal for fulfilling the dual mandate of stable prices and maximum employment. Over the last several years we have battled with deflation which presents the greatest possible worry to the Fed. A deflationary environment is harmful because keeping money in risk-free cash accounts actually makes money when the aggregate price level falls. This curtails the desire to invest as gains are made by assuming no risk. This causes growth to further stagnate. If this positive feedback loop continues uninterrupted the economy can fall into a deflationary spiral, Bernanke's greatest worry after decades of studying the Great Depression.

With the FOMC's recent announcement of quantitative easing 2.0 the debate has quickly shifted to the dollar's demise and the imminent onslaught of high inflation rates. The ironic point to be made however is that for every average person that becomes convinced the Fed is stupid and will cause high inflation the closer the Fed gets to accomplishing its goal. The Fed wants to be hated right now! By effecting a rise in the general level of inflation expectations more people will perceive the need to invest and thus cause said inflation. Also, it must be said that the dollar is at exactly the same level it was at the beginning of the year. It rallied and then fell during the year but it is exactly where it was when the clocks rolled over to 2010.

The inflationists play right into the Fed's hand. It is very interesting to see so much debate about the assumed consequences of the Fed's actions instead of focusing on the current predicament. The goal of the Fed is to balance the trade off between inflation and employment by adjusting the money supply. Every action it takes in positive goals: taming inflation or promoting employment has effects on the other side of the equation: depressing employment or stoking inflation. At a time when we face a reported unemployment rate of ~10% and inflation sub-2%, the goal should be to pursue expansionary/inflationary monetary policy.

While I have been somewhat skeptical of the need for further easing, I understand why the Fed did it and it makes sense. The Fed cannot spurn its obligation to fulfill its dual mandate. I believe fiscal policy is a better option but the Fed would not be satisfying its purpose by sitting on the sidelines.

Commodity inflation: the story that never was

The inflationists point to the rise in commodity price as the clear and convincing evidence that we already have high inflation but is that the case? With several metals at all-time highs and grains in a strong summer rally, the proof is in the pudding, no? Well, commodities are very volatile assets and their supply/demand is affected by a lot more than just US monetary policy. Metals were in a bull move long before 2008 and we certainly cannot ignore the massive wildfires in Russia when looking at grain prices this summer. The most important driver of demand is not liquidity, it is global demand particularly from emerging economies.

Assuming the Fed completes the $600 billion in asset purchases over the next year, they will have expanded their balance sheet by roughly $2 trillion throughout this entire recession. This expansion is against the backdrop of approximately $40 trillion in gross domestic production here in the United States. The scale of printing is quite large indeed but it has been done during the worst contraction in the US economy in 80 years. In an attempt to avoid another Great Depression unprecedented action is certainly called for and historical metrics are invalid.

For the inflationists, if they're willing to not shoot the messenger on this one, Paul Krugman has two great blog posts succinctly summarizing the commodity inflation story. In his post yesterday he shows that commodity prices are very volatile and milk and gas, two oft-cited consumer needs, are not higher than prices pre-2008 crisis. The chart below shows the CRB Index, the best way of measuring the broad moves in commodity markets. At a glance it is clear that even if the 2008 oil bubble is removed, prices are not even back to the highs in 2006.

The global demand story is the driving force behind the secular bull market in commodity prices. Even with the collapse in 2008, the trend is still upward for these markets and will likely continue for the foreseeable future. As Krugman points out today the United States is not the world. Industrial production in emerging markets are the key drivers of demand. The obsessive focus on inflation is unwarranted and it should be recognized that QE 2.0 is having its intended effect of raising inflation expectations. Once we see real inflation, then we'll have to look at the FOMC's response in judging whether they can handle inflation or not.


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

Bernanke Gives Us $600B in QE 2.0, Equities Soar

US Futures are trading up 1% following the Fed's announcement for QE 2.0 yesterday in the amount of $600 billion. Republicans also handily captured majority in the House of Representatives and gained seats in the Senate. Tokyo followed yesterday's rally in the US with its own 2.2% gain and London trucked higher up 1.8%.

Don't fight the Fed

I hit out of my dollar position yesterday after waiting around for a month for a rally. I certainly underestimated the Fed's willingness to stimulate the economy. With GDP growth in the 2% range consistently I thought the Fed would, at the very least, not continue to ease. I understand the Fed's mandate to promote full employment and I'm done fighting them. I lost some in the long dollar trade but what hurt me the most was the distraction it caused from where my strongest abilities lie.

This month I'm going to reduce my concern with the macro picture and focus my time on sectors and companies. Understanding individual companies will yield the greatest amount of benefit to me rather than attempting to guess whether the Fed will roll out large QE or small QE. Ultimately the repeatable and scalable strategy I am always building towards will be dependent on the micro level.

No stopping this rally

And just like that we're back to the April highs in the market. Four months of decline, flash crash, equity fund withdrawls, bond bubbles, range-bound action, double dip recession, Greek bankruptcy, PIIGS, head and shoulders, Hindenberg Omen...it's over. This was the harshest correction in this rally off the March 9th lows. First was the 9% pull-in in June 2009 where panicked traders thought we were heading back to the bottom and second was the 9% pull-in in January 2010 as we doubted the possibility of a positive earnings season. Now we've seen a 17% drop as the first true stall in the economy since the reflation began and we went running for the exits. Yet, our economy remains resilient continuing its long, slow trudge back to life helped by a very accommodative Federal Reserve.

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.

Contrarian Trade: Buy the Dollar (UUP)

Per my post last week I purchased the dollar through the PowerShares ETF (UUP). My timing in the short-term (< 1 month) may not be perfect but I am willing to step in at the current prices with the expectation of higher prices in the intermediate term (1-6 months). I am still bearish on the dollar in the long-term (1 year +) but probably not for the reasons most would think.

Why be bullish now, isn't QE 2.0 coming?

The primary argument for a lower dollar is Helicopter Ben's "promise" for QE 2.0 which will further debase the currency. Yet, the crucial question in any trade is not whether a certain future event will happen but whether or not that expected event is priced in. By my estimation, QE 2.0 is certainly priced in and we are beginning to see some outlandish calls on the total quantity. Former Bush economic adviser Marc Sumerlin publicly stated that the Federal Reserve needs to pump $6-7 trillion into the US economy to have a meaningful impact (CNBC). I see this possibility as a near impossibility, I only address it as a sign of the level of dollar pessimism and ridiculous easing expectations. The Fed's balance sheet currently stands at $2.3 trillion, up from $800 billion pre-crisis. If the Fed has only bought up $1.5 in assets since the crisis struck, it is extremely unlikely they aggressively expand to the levels Sumerlin is calling for. The legitimacy given to these high-end calls leads me to believe a smaller amount of QE must already be factored into current market prices.

Many relevant minds are announcing their opposition to further quantitative easing. Pimco's Mohamed El-Erian believes further QE will be "ineffective". Renowned economist, Joseph Stiglitz recently stated that "additional monetary stimulus will clearly not solve the problems caused by lack of global aggregate demand" and believes fiscal stimulus is the only solution. George Soros came out to say "quantitative easing is more likely to stimulate corporations to devour each other than to create employment". Clearly, opposition is mounting and I believe even Bernanke understands that liquidity in the system is not the problem, the velocity of money is. Velocity is a force the Fed can do little to influence.

Frankly, I don't think QE 2.0 is coming

The Fed uses a variety of tools a achieve its objections of price stability and full employment. The markets have very positively reacted to Bernanke's added language in the most recent FOMC policy statement released on September 21st in which the committee stated:

The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate. (Federal Reserve)

If we judge asset prices following the FOMC meeting, we can see that the Fed has regained an important policy tool: language. Bernanke has written in the past about the powerful use of language as a tool for influencing market behavior. Given the Fed's willingness under Bernanke to engage in creative methods of easing, the market fully believes in the floor they are providing assets. In response, we see many assets rallying and, most importantly, we see inflation expectations rising: a good thing! The iShares Barclays TIPS Bond ETF (TIP), a proxy for the return on TIPS, has surged 3.5% since the September 21st FOMC meeting.

The break-even rate between TIPS and 30-year bonds reached 2.29% on October 6th, an indication of higher inflation expectations (Bloomberg). TIPS, Treasury Inflation Protected Securities, are a closely watched indicator by the FOMC. Bernanke watches markets and often reacts to their demands. But, through his use of language he is quietly achieving his goal of supporting asset prices and building in inflation expectations. There is no need for more QE if the market itself creates the outcome just by knowing the Fed is willing to fight for said outcome, inflating assets. This is good and should allow the Fed to do nothing.

In the long-term, I am bearish on the dollar because I'm optimistic!

Contradictory? Not in the least. I am bearish on the long-term prospects for the dollar only because I am extremely optimistic about developing countries around the world, especially the BRICs. Brazil, Russia, India and China are the world's rapidly growing economies marked by millions of people lifting themselves out of poverty every year and improving their lots in life. As countries around the world rise relative to the US, their currencies will appreciate against ours. I cannot say it enough, this is not to the detriment of the United States. Increased trade and higher standards of living are better for everyone. We will not be losers, our currency will simply depreciate against others as their economies grow in global influence.

I still believe the US will be a leader in innovation but the inventions in the last few decades will allow economies around the world to make leaps ahead in the race where we had to walk previously. My favorite example is the cell phone, a device that has changed the world dramatically increasing efficiencies in communication and business. Previously, telephony was only possible after miles and miles of lines had been laid in the ground requiring massive infrastructure investments prior to widespread usage. Now, throw up cell phone towers in key places, sell everyone cheap cell phones and viola, you've got telephony for your entire economy. These leaps will allow developing economies to skip steps and advance much more rapidly than we ever did.

Overall, we'll see. This trade has a major catalyst coming up on November 3rd, the Fed's next FOMC meeting, where many believe QE 2.0 plans will be laid out. I think pessimism is far too high and there's a very realistic possibility that QE 2.0 will never occur, or at the very least be lower in quantity than markets are pricing in.


Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Long UUP.

Austerians Winning Deficits Battle, Equities Dropping

Austerity, restoring confidence or killing the patient?

The heightened talk of austerity measures throughout the world is certainly a motivating factor behind the selling in equity markets. The Keynesians are furious that governments are contracting fiscal stimulus too soon arguing that previous measures will be wasted if we pull the plug now. The economy is still on life support they argue and we have not overcome the deflationary forces at work. The worries of financial distress are exaggerated particularly in the United States where interest rates on our debt are at the low end of historical ranges.

The austerians believe government deficits are hurting confidence around the world and reigning in spending will solve these problems. Ultimately, they are more worried about the inflation story and continue to fret that bond vigilantes will attack at some point, drive up interest rates on our debt and we will be unable to fight back. Reducing deficits now they believe will spur investment by the private sector and get ahead of what are inevitably higher interest rates in the future.

While this is a highly complicated issue and I tend not to argue too definitively on either side of the coin, I do lean toward the Keynesian argument. I believe we have an excellent example in the Japanese story as best outlined by Professor Richard Koo. The fears of inflation and higher rates seem overblown as we are still mired in a deflationary storm. Yet, there is a point at which governments must cut spending and 5.9% GDP growth in Q4 2009 followed by 2.7% Q1 2010 growth do not necessarily indicate an economy in desperate need of more Keynesian medicine. Though the 9.3% domestic unemployment rate is not particularly encouraging.

Either way, this debate will be solved by others and I will focus on the effects on financial markets. Lowering deficits will adversely affect equity prices by lowering GDP. The $1.6 trillion budget deficit this year cannot be reduced without negatively affecting GDP at least in the short-term. Contractionary fiscal policy will likely force monetary policy to stay expansionary far longer than otherwise and ultimately this translates to furthered debasement of paper currencies and higher real asset prices.

Gold collapses for 2nd Monday in a row

So much for my post yesterday where I stated I did not see a reason to sell any of my position in NYSE:GLD. Gold rallied early in the day to within $3 of last Monday's all-time highs of $1,266. It based for 30 minutes and then rapidly collapsed $27. Once again, any weak hands in the metal were stopped out in the harsh down move. I have a decent entry price so I continue to hold through the volatility and will only be stopped if prices make a lower low which has yet to happen.

The two moves have definitely shown the perils of chasing new highs in gold. It is also interesting to note the possible impact of NYSE:GLD on the gold futures market. NYSE:GLD made new all-time highs yesterday by a few cents exciting many traders who were only following the ETF and not the futures market. This disconnect could have fueled the early selling as the new high buyers in the ETF dumped their positions at the first sign of weakness.

I expected NYSE:GLD to be a solid risk-aversion holding against equities but it has not yielded much protection in the last week. The long-term looks very promising with gold the only asset class continuing to trade just off all-time highs. If we see a breakdown in the short-term, I will blow out most of my position and return to just a feeler and wait. I expect new highs sooner or later but my timing could be off. For now, I wait.

When you're wrong, stop being wrong

One of the most important aspects of trading is recognizing when you are wrong. The best traders stay very stubborn to a point but then are willing to completely flip their thinking and admit their mistakes. I put together a very nice trade on the long side in early June catching a nice bounce off the $1,040 level.

After making the higher high in the market I began thinking the bottom could be in place. I tried a lot of longs over the last few days and wiped a lot of my gains in short order as the market sliced through buyers like a hot knife through butter. Today, I capitulated off the open and dumped nearly all my remaining long positions to be flat equities. So much for that. The $1,040 level is so closely watched by all technicians, it seems destined to break if only for a short time.


Disclosure: Long GLD.

Markets Dive Again, Financial Reform Bill Passes

As they say, "stocks go up on an escalator and down on an elevator". The Dow dived 376 points today (-3.60%) entering the first official correction (greater than 10% decline) in the entire rally since the March 2009 bottom. Today's closing price puts the S&P 500 12.1% off highs but still 13.5 handles off the "flash crash" intraday lows.

The euro finally found some friends today bouncing today from a deeply oversold condition. After hitting lows of $1.2143 yesterday the currency recouped the psychological $1.25 level hitting highs of $1.2597 before leveling off later this evening.

The US Senate passed the financial reform bill today. The far-reaching bill is a broad expansion of government regulation and oversight of financial firms and markets. Now begins the reconciliation process between the House and Senate versions of the reform bill. All I have to say is it's about time. It's been a year and half since we witnessed the incredible crash of 2008 and Congress has yet to enact any meaningful reform. While the bill goes quite a bit further than I would have liked, I see the need for basic leverage limits and greater transparency in derivatives trading. I would have liked to see the Volcker Rule as part of the legislation but it looks to have been killed in the debate.

Any soccer fans out there? The 2010 FIFA World Cup starts June 11th, only a few weeks away! Nike released an absolutely brilliant commercial that will get even the most ambivalent fan excited for the upcoming games. The first game for the United States is against our arch-rival, England, on June 12th. Let's kick some British ass!

Correction: The Volcker Rule did make it through. Check out the New York Times for a comprehensive chart of the reform bill.

Senate Moves to Vote on Financial Reform

The Senate overcame the filibuster today voting 60-40 to end debate and clear the way for the final vote on passage of the financial reform bill. Republican Senator Brown of Massachusetts flipped on his vote providing the last needed vote to reach 60. The vote is expected to happen by the end of the week after each Senator has had their hour to speak on the bill. Below are the major provisions in the bill. Still up for debate is an amendment for the so-called Volcker Rule which would prohibit banks from proprietary trading (Click here for the full summary.)

• Consumer Protections with Authority and Independence: Creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices.

• Ends Too Big to Fail Bailouts: Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.
  

• Advance Warning System: Creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy.

• Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.
  

• Federal Bank Supervision: Streamlines bank supervision to create clarity and accountability. Protects the dual banking system that supports community banks.

• Executive Compensation and Corporate Governance: Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation.
  

• Protects Investors: Provides tough new rules for transparency and accountability for credit rating agencies to protect investors and businesses.

• Enforces Regulations on the Books: Strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest and manipulation of the system that benefit special interests at the expense of American families and businesses.

Richard Koo Says Maintain Course with Deficits

Richard Koo on Bloomberg. Koo has an excellent perspective of the current "balance-sheet recession" having lived through and learned from Japan's mistakes that resulted in the nearly two lost decades of economic contraction. His speech at this year's Institute for New Economic Thinking event was brilliant.

My buddy, Elliot, over at AZ had some great thoughts today on the current deflation battle.

European Markets Leap on Aid Package

A huge day in Europe boosted US markets with the Dow gaining 404 points on the day (3.9%). The gain was largely a result of a pre-market gap higher in prices with uneventful sideways consolidation price action throughout the trading day.

The €750 billion ($957 billion) debt aid package arranged by the European Union and International Monetary Fund is having its intended effects on debt and equity markets within the Eurozone. The aid deal consists of €440 billion in loan guarantees, €60 billion in emergency European Commission funding and another €250 billion contributed by the IMF. A special purpose vehicle (SPV) will be setup to distribute the aid and manage the loans. Quite a few questions remain as to how this massive undertaking will be structured, how it will be run and what the incentives/disincentives will be for countries receiving aid. In general, the package has been modeled after the TARP plan enacted by the United States during the 2008 financial crisis.

I did some homework on European markets with the results below:

Market	Day's Gain	YTD Return
United Kingdom (FTSE)	5.2%	(0.5%)
Germany (DAX)	5.3%	1.0%
France (CAC)	9.7%	(5.5%)
PIGS
Portugal (PIS)	10.6%	(11.3%)
Italy (MIB)	11.3%	(9.8%)
Greece (ATHEX)	9.1%	(19.0%)
Spain (IBEX)	14.4%	(13.3%)

Investment Banking: Changed Forever?

The investment banking and securities dealing industry underwent massive disruptions over the past two years. The year 2008 saw a complete makeover of the industry as Bear Stearns fell into the hands of JP Morgan, Lehman Brothers filed for bankruptcy protection, Merrill Lynch staved off collapse with a Bank of America takeover and the two remaining giants, Goldman Sachs Group and Morgan Stanley, converted into bank holding companies to qualify for government assistance. We have seen an incredible destruction of the industry that was years in the making. Many of the causes came from perverse regulatory incentives as the industry transitioned from a natural oligopoly into freer competition.


Structure

The investment banking industry directly correlates to economic growth given that its ability to profit derives from the securitization of businesses. Generally, mergers, acquisitions and other underwriting services depend on the overall level of corporate activity. Corporate activity directly follows from earnings increases of individual companies and the general economic outlook and confidence in business prospects. So the fate of investment banking revenues relies heavily on the fate of the overall economy. Given some of the key structural characteristics of the investment banking industry, investment banks must seek to form long-term relationships with individual firms while respecting others banks’ relationships in a naturally oligopolistic industry.

First, investment banks must perform significantly deep and pointed research into the companies that they offer securitization services to. The initial enticement into private placements is largely dependent on the solid reputation of the lead investment banks promoting the security. In order to find buyers for a particular stock issue that the investment bank wishes to sell to the public, the bank puts its own reputation on the line claiming its high-standards and due diligence of financial statement review give the investor security. An investor needs to be able to trust the investment bank’s opinion on the future prospects of the company and the investment. No investment bank will survive long should it promote the securities of soon-failing institutions. Any individual bank promoting worthless companies will soon go bankrupt as investors realize the ill-advised investments they are taking. This is clearly why so-called “chop shops” and penny-stock promoters typically never gain respected status and fail in short order or are shutdown by the SEC for fraud. The major players in the industry have had collective breakdowns in underwriting standards in times of the past but generally banks must be trustworthy and provide accurate assessments of future business prospects. (2001 Anand & Galetovic)

Initially, then, a bank must study the company and its prospects and assign an appropriate valuation. This initial due diligence is costly and results in sunk costs in order to begin a relationship with outside firms. The costs are necessary but are undertaken because the bank clearly believes it can garner greater profits in the future by having a relationship. (2001 Anand & Galetovic) These unrecoverable costs are worthwhile if the bank can create a lasting relationship where it reuses the same information for future deals and is able to recoup the costs associated to that particular company as well as the sunk costs lost on firms where potential deals were rejected due to lower credit quality.

These sunk costs relate to another trait in the investment banking industry, the misaligned connection between costs and fee revenue. (2001 Anand & Galetovic) Investment banks only generate revenue when they create and execute a particular security deal. While banks may spend months and months studying a company, gauging market buying interest, promoting a deal, offering advice, they are only paid fee income once the deal is finally consecrated. Ultimately a bank may provide a great deal of services and never collect fee revenues.

A third characteristic of the industry is a bank’s inability to claim any rights over the information it generates about a particular firm it is investigating for a potential deal. (2001 Anand & Galetovic) The firm may spend hundreds of man hours dedicated to deal but it has difficulty maintaining that information as proprietary. The risk of a lead person on the deal team to be hired away by another bank is high. Banks can attempt to reduce this risk through non-compete agreements but given the global nature of today’s financial system, non-competes can fail rather easily given their geographical limitations. Then, this employee who is hired away would bring with them all the information they had gathered in hours of research at the bank. Also, once the bank has researched the potential company for underwriting, it must use its reports to generate outside interest among investors. In seeking these outsider investors, the research is pushed into the public forum and its privacy is lost.

These three traits of the industry point to why investment banking is naturally oligopolistic. In perfect competition, investment banks would allow other firms to incur the initial sunk costs for a deal and then free ride off the information obtained. A bank could easily achieve this by stepping in late in the deal just before the security is actually created and sold and undercut the initial firm. A simple way to create the relationship would be to hire away the lead employee on the deal who has the most intricate knowledge of the company and the deal at hand. “For example, Deutsche Bank built a global investment bank in a year (Deutsche Morgan Grenfell) by hiring away staff en masse from other major banks” (2001 Anand & Galetovic). The information and advice exchanged prior to a deal’s completion give strong incentive for another investment bank to free ride and offer the deal at a much lower price having not incurred the setup costs. Therefore, the investment banking industry cannot be perfectly competitive and must result in a voluntary cooperation among banks not to undercut each other in ruinous competition that will ultimately destroy the incentives to create long-lasting relationships with firms. Evidence of this dynamic has been studied in various literatures. In Struggle and Survival on Wall Street written in 1994, Matthews found that firms have charged 7/8 percent for underwriting top quality bonds for decades. Matthews concluded that there must be some type of unspoken collusion among banks for this to occur so systematically for so long. Chen and Ritter reported that “gross spreads received by underwriters on initial public offerings in the United States are much higher than in other countries. Furthermore, in recent years more than 90 percent of deals raising $20-80 million have spreads of exactly seven percent, three times the proportion of a decade earlier.” The spreads were not near or around seven percent, they broke down to exactly seven percent. In a more competitive industry, one would expect to find spreads in a range where banks would compete with each other at least to some degree. Chen and Ritter go on to claim that investment bankers will openly admit that “they don’t want to turn it into a commodity business” so banks do not compete on the prices charged for initial public offerings. The ability to perform high-yielding securities deals is the lifeblood of the investment banking industry and executives have made sure not to cause a breakdown in the fee schedule. These implicit agreements show the oligopolistic structure of the investment banking industry.

In such a structure, there is a relatively fixed size of each individual dominant firm in the industry. If firms are all too small, they will free ride off each other’s information and ruin each other. While if a particular firm is too large relative to the others, the smaller firms will have increased incentive to free ride to the detriment of the large firm. Therefore, no firm can become too large without other, smaller firms attacking it and driving up its costs and reducing its fee revenues through undercutting. The large firms operate on mutual high reputations and an implicit agreement not to fall into ruinous competition. This creates the “boys club” that Wall Street is sometimes seen as.

The high barriers to entry in the industry also help support the Wall Street club. The Securities and Exchange Commission has set a high standard of capital and regulatory requirements that must be passed in order to setup as an investment bank (2009 IBIS). The capital standards require large initial investments for conducting business. More recently, increased regulation of the industry is likely thus further increasing the barriers to entry for companies not able to produce significant economies of scale to spread the high costs of compliance with legal regulations. Yet, once a bank is established, their fixed capital costs are relatively low in comparison to variable labor costs. The services provided by investment banks require a large amount of administrative work and are highly labor intensive in general (2009 IBIS). These employees are typically highly educated and very specialized in their field resulting in outsized wage expenses to maintain the workforce. This relatively large portion of variable costs helps banks deal with downturns in economic activity and massive layoffs are an understood part of the business in times of economic contraction. But, as a barrier to entry into the industry, it can be difficult to attract the well-qualified candidates in order to setup an enterprise especially in investment banking because of its reliance on a bonus as a significant portion of an employee’s compensation. This bonus is very large relative to the employee’s salary and is only guaranteed if the firm can guarantee its ability to perform high profile securities deals. In this way, the top firms of the industry are naturally supported by their employees who stay with the reputation and success guaranteeing their income at the end of the year.

Also, one of the greatest components for success for an investment bank is its reputation. Reputations are not made in short order but rather take years of quality servicing and then decades to establish the firm commitment to maintaining integrity in its dealings. Gaining acceptance from firms as a desired promoter and underwriter of securities is a long, hard-won battle that substantially hinders new entrants from the market. Reputation and brand can be measured by goodwill accounting within the financial statements. Goldman Sachs, for example, records an asset value of over $5 billion for its goodwill and intangible assets on its financial statements (2009 GS). UBS valued its goodwill at over $4 billion for the year ended December 31, 2008 (2008 UBS). These goodwill measurements indicate the value of the business segments that exceed the discounted expected future cash flows and point to a valuation of a company’s reputation, brand image and customer loyalty.


The Panic of 2008

According to U.S. Census Bureau statistics, the investment banking industry had 5,583 firms in 2007 generating a total of $207.4 billion in sales and employing over 140,000. The industry experienced rapid growth over the previous five-year period with a 109.7 percent growth in revenues fueled by a relatively minor 19.7 percent growth in the number of firms coupled with a miniscule 6.4 percent increase in the number of employees. Compensation increased 57 percent over the same period from 2002 to 2007, a 9.5 percent compound annual growth rate. (2009 Census)

The state of New York is, by far, the dominant player in the investment banking industry in terms of revenue, but not hardly so in terms of the number of institutions. While accounting for only 20.8 percent of the total firms in 2002, New York firms produced 77.9 percent of the total revenues generated in the industry. California takes up second in the total revenues with a measly 4.1 percent of total sales. This divergence clearly points to the dominance of Wall Street and the large market shares of a limited number of firms. (2009 Census)

The year 2008 saw an extraordinary 93.0 percent drop in industry revenue as the sector imploded in the wake of the subprime mortgage meltdown. As recently as the year 2007, the top six investment banking firms accounted for 86 percent of the total market. By the end of 2008, major consolidation had occurred and the top three firms now had market share of 65 percent. The top six investment banks in 2007, in order of market share, were Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns and JP Morgan. By the end of the 2008, Goldman Sachs and Morgan Stanley had survived only by converting to bank holding companies to qualify for government capital infusions. Merrill Lynch was forced into an acquisition by Bank of America after Lehman Brothers dramatically collapsed in a short time. Bear Stearns was the first to fall in early 2008 forcing a takeover by JP Morgan. The composure of the investment banking industry has dramatically changed and will continue to change in the future. There are no independent investment banks remaining of any sizable importance. (2009 IBIS)

The current industry now has four key players accounting for 80 percent of the market. JP Morgan, after acquiring Bear Stearns in May of 2008, now holds a 26 percent share operating with assets of $1.6 trillion and 180,000 employees. JP Morgan bartered an exceptional deal with the Federal Reserve Bank bearing only the first $1 billion in potential losses from the acquisition while the Fed bears the next $29 billion offering JP a great chance to snap up huge market share gains without excessive risk of losing capital. JP participated in the same leveraged loans and mortgage investments that other banks did but on a much more conservative scale so that still maintained profitability in 2008 with incomes declining 64%. (2009 IBIS)

Goldman Sachs, one of the two remaining firms from the group of the five independent investment banks, comes in second in market share with 23 percent. Goldman also weathered the subprime meltdown relatively well as it hedged its positions wisely and experienced an 80 percent decline in net income in the year 2008. Morgan Stanley ranks third in share with 16 percent and Bank of America rounds out the top four with 15 percent market share. These four companies dominate the investment banking industry in the United States now. Citigroup is the fifth largest and holds a measly one percent share. (2009 IBIS)


Causes of the Collapse

The 54 percent drop in the equity market from the October 2007 high to the March 2009 low has left many market participants asking why the crisis occurred. Given that the crisis was first felt within the walls of Wall Street firms, it makes one ask how investment banks could have incurred such massive losses. The top five firms as well as other commercial banking institutions threatened the collapse of the entire global financial system with their extraordinarily excessive leverage and concentration in subprime mortgage backed securities. Much of the changes in banking habits can be traced back the Gramm-Leach-Bliley Act (GLBA) of 1999.

The GLBA most notably repealed Section 20 of the Glass-Steagall Act of 1933 (2009 Geyfman & Yeager). After the stock market crash in 1929 the Federal government passed many new wide-ranging sweeping measures to curtail excessive risk-taking in the financial markets by large banking institutions. The SEC was formed to regulate entities and Federal Deposit Insurance Corporation was founded to insure the deposits of individual customers. Along with these two entities which have proved to be major successes in creating stability in financial markets, the Glass-Steagall Act had the specific provision of Section 20. Section 20 prohibited commercial banking institutions from engaging in securities activities. Banks that held customer deposits were now prohibited from engaging in or having affiliations with firms that “engaged principally in the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stock, bonds, debentures, notes or other securities” (Title 12, U.S Code, Section 20).

Section 20 intended to separate the riskiness of activities that dealt with securities and the necessity of safety for consumer depositors. Glass-Steagall looked to curtail the negative effects losses in securities dealing would have on the security of banking deposits in a firm participating in both aspects of the financial system. As with many other industries, the move to deregulation seen in the United States throughout the 1980s had its effects on the financial services industry as well. The slow erosion of Section 20 finally culminated in the passing of GLBA, otherwise known as the Financial Services Modernization Act in 1999. This Act allowed bank holding companies to convert into financial holding companies and perform dealings in securities through subsidiaries without regulatory limits. (2009 Geyfman & Yeager)

The repeal of Section 20 was strenuously lobbied for in Congress by banking institutions on the premise that major synergies could be achieved without it creating significant economies of scale. Investment banks must undergo costly creditworthiness evaluations in order to underwrite securities. These activities are linked to a firm’s day-to-day financial activities. A bank holding company holding the deposits and providing credit lines to an institution will have already conducted evaluations of the firm that can then be transferred into underwriting activities without repeat of the initial sunk costs independent investment banks must endure. Recent studies have shown a “modest risk diversification benefits in the post-GLBA era” (2009 Geyfman & Yeager) and “significant revenue synergies between IB and commercial banking” (2005 Yasuda). On the other hand, now banks are participating in a significantly riskier world of securities dealing with the downside of the risks to be felt by those seeking safety in simple depository transactions with the bank. Geyfman and Yeager found that “universal banks had similar systemic risk but sharply higher total and unsystematic risk than more traditional banks” (2009). This finding points to the inherent risks in securities dealing and the possible spillover disruptions these activities could have on traditional commercial banking activities.
The GLBA led to significant changes in the investment banking industry. The five largest independent investment banks that had operated under implicit cooperation were forced to produce earnings elsewhere as many new competitors entered the market. Previously an unhindered oligopoly, the top five independent investment banks found themselves competing for securities deals with the new so-called universal banks, major players like JP Morgan, Citigroup and Bank of America. Every banking institution was now allowed in on the deal-making turf and held significant sway over firms making securitization decisions because of the existing relationship with banks holding depository funds. A study in 2005 showed that companies having existing banking relationships will more often choose that particular bank as their underwriter in securities deals (2005 Yasuda). This poses a great challenge to investment banks that do not hold deposits because customers that were previously forced to seek out an independent investment bank were now choosing the bank holding companies they already had established relationships with for securities deals.

After five years of competing with all other firms in the banking world for securities deals, investment banks needed a new way to make money. The new solution included employing a great deal of leverage. One of the most crucial elements of the financial industry collapse was the major change the SEC passed in legislation in 2004. Since 1975, the SEC had limited broker dealers a debt-to-net capital ratio of 12-to-1. Most banks exhibit leverage ratios between 9 and 12 percent depending on the management’s appetite for risk. Investment banks though, have always found ways to exceed those ratios but the 2004 SEC rules gave them free reign. The SEC now allowed the top five investment banks to leverage up 30, even 40 to 1. (2008 ParaPundit)
One of the most striking elements of the leverage equation is that it does not include many off-balance sheets obligations and does not account for the implicit leverage in derivatives contracts. Unhedged positions in credit default swaps and options can produce catastrophic losses in an extremely short amount of time. American International Group is a prime example of the riskiness of CDS contracts with the asset values of their books plummeting as fear of counterparty bankruptcy skyrocketed after Lehman Brothers’ collapse. Yet, even without the inclusions of these pieces of the equation, the leverage seen on investment banking balance sheets struck market participants as showing astounding arrogance and extreme recklessness.
At first, leverage was a great boon to the industry as evidenced by the 109.7 percent growth in revenues from 2002 to 2007. Investment banks increased their principal trading throughout this period rising from 16% of revenue generation in 2002 to 23% by 2007 (2009 IBIS). Average leverage ratios skyrocketed in a short time after the 2004 enactment at the major five investment banks. On average from 1999 to 2003 the top banks had leverage ratios of: Bear Stearns, 27.6 percent; Goldman Sachs, 19.2 percent; Lehman Brothers, 25.8 percent; Merrill Lynch, 18.5 percent; and Morgan Stanley, 21.7 percent. By 2007 every bank had large increases in their debt to capital ratios: Bear Stearns, 21.5 percent increase to 33.5 percent; Goldman Sachs, 16.6 percent increase to 22.4 percent; Lehman Brothers, 19.2 percent increase to 30.7 percent; Merrill Lynch, 73.2 percent increase to 32.0 percent; and Morgan Stanley, 53.8 percent increase to 33.4 percent (2008 Epicurean). These banks took advantage of the SEC rule change to the fullest extent pushing their balance sheets to the limit, and then over the limit. While the top four investment banks had market share totaling 39.1 percent in 2002, the leverage fueled large gains and by 2007, the top four firms had combined market share of 69.0 percent (2009 IBIS).

Leverage is a great bonus in boom times as seen in the housing market throughout the early 2000s as real estate prices soared. But, leverage is much more of a zero-sum game than most would like to admit and the fall in housing demand towards the end of 2007 caused losses in banking portfolios and ultimately resulted in billions of dollars in writedowns.
In the end, none of the top five investment banks existed in its independent investment banking form by the end of 2008. Bear Stearns collapsed and was sold off to JP Morgan at a pittance of its former stock price. Lehman Brothers found the government unwilling providers of bailout monies and claimed bankruptcy in September 2008. Merrill Lynch, seen as the next domino in a falling cascade, was forced into an acquisition by Bank of America to salvage the company. Goldman Sachs and Morgan Stanley soon converted into bank holding companies to receive access to the Federal Reserve discount window. This conversion dictates a major reduction in leverage for the two banks to comply with regulation.


Conclusion

The underlying regulatory structure created economic incentives that fueled the boom and bust in the investment banking industry. A naturally oligopolistic industry that would fall victim to ruinous competition under a perfectly competitive market found itself in a state of implicit cooperation. Investment banks chose not to compete on price for securities deals as evidenced by clustering of spreads on corporate bonds offerings and initial public offerings in equities sold by banks. The repeal of Section 20 from the Glass-Steagall Act of 1933 allowed a new field of entrants into the investment banking arena. The rise of the universal bank allowed institutions that held depository accounts to now be the one-stop shop for all a firm’s financial needs. As studies have shown, firms are more likely to use the bank they already have a relationship with in going forward on securities deals. So, the independent investment bank found itself in a tough spot. Its oligopoly was invaded by a swath of new competitors and it had to find a new competitive advantage. The solution was disastrous in the long-run even while providing five years of record-setting growth rates.

Investment banks leveraged up their mortgage dealings and engaged in a variety of high-risk derivative bets. It is interesting to note that the two banks with persistently highest leverage ratio prior to the 2004 SEC rule change were the first to collapse in the 2008 panic. Goldman Sachs, the best-surviving member of the top five, exhibited the lowest leverage ratio directly resulting in lessening the blow from the mortgage fallout.
It is unclear whether the investment banking industry will ever be the same again. What is clear is that an underlying regulatory framework that encourages perverse economic incentives can easily cause collapse.



Works Cited

“Banks’ Interactions with Highly Leveraged Institutions”, Basle Committee on Banking Supervision, January 1999.

Chen, H. and J. Ritter, “The Seven Percent Solution,” Journal of Finance, 2000.

Economist, The, “The Living Dead: Restructuring Banks”, November 7, 2009.

Goldman Sachs Group Inc., Stock Report, Matthew Albrecht, Standard & Poor’s, The McGraw-Hill Companies, October 20, 2009.

GS Quarterly Earnings Release, Goldman Sachs Group Inc., September 2009.

Investment Banking & Securities Dealing in the US: 52311. IBISWorld Industry Report, July 29, 2009.

Investment Banking and Security Market Development: Does Finance Follow Industry?, Bharat N. Anand, Harvard University; Alexander Galetovic, Universidad de Chile; February 2001, http://www.people.hbs.edu/banand/investmentbanking.pdf.

Matthews, J. Struggle and Survival on Wall Street. New York: Oxford University Press, 1994.

“On the Riskiness of Universal Banking: Evidence from Banks in the Investment Banking Business Pre- and Post-GLBA”, Victoria Geyfman and Timothy J. Yeager, Journal of Money, Credit and Banking, Volume 41, Number 8, December 2009.

ParaPundit, “SEC Leverage Rule Change Contributed to Investment Bank Failure”, http://www.parapundit.com/archives/005558.html, September 21, 2008.

Epicurean Dealmaker, “Supermassive Black Hole”, http://epicureandealmaker.blogspot.com/2009/09/supermassive-black-hole.html, September 22, 2008.

UBS Quarterly Financial Statement. UBS Financial Services. http://www.ubs.com/1/e/investors/accounting_standardsandpolicies/criticalaccountingpolicies/goodwill.html, December 31, 2008.

U.S. Census Bureau, http://factfinder.census.gov, November 2009.

Yasuda, Ayako. “Do Banking Relationships Affect the Firm’s Undewriter Choice in the Corporate-Bond Underwriting Market?” Journal of Finance, 2005.

Chart: Financial Reform Components

Courtesy of Wall Street Cheat Sheet

Richard Koo: Balance Sheet Recession

Richard C. Koo, Chief Economist at Nomura Research Institute gave a speech at the Institute for New Economic Thinking's inaugural conference entitled "The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005". The video and PowerPoint below offer fascinating insights into the current economic situation in the United States. I admit I have been ignorant of many of these concepts and I have started to see our situation in a new light.

My Two Cents on Health Care

What's being called the most sweeping health care reform bill in decades passed the House of Representatives last night 219-212. Since everyone has an opinion on this topic, I figured I might as well join the fray. But, for the most part, both sides of the aisle need to be realistic about this bill. No, it will not destroy America. And, no, it will not revolutionize the entire health care industry and provide all Americans with the best coverage at no cost.

First, I have to hand it to President Obama for his ability to get this passed. In December, most of us thought the bill was dead. Some key losses in Democratic seats seemed to act as a referendum on the health care debate. But, Obama refused to give up. He rallied the Democrats and brought Republicans into the debate with a round-table discussion. Love him or hate him, I am impressed with the political ability Obama showed on this issue.

My largest problem with the bill is the cost. As I understood it, the entire reason for addressing health care at this time, a time of record deficits and a crippling recession, was to curtail the burgeoning costs of health care. Obama argued for the economic imperative of lowering the costs on our system. (On that issue, I really dislike the projections made on health care costs as if we can just regress the last 10 years and claim as fact that costs will continue their trajectory.) But even so, assuming those costs and the goal of cost reduction this bill extends coverage to roughly 32 million people and regulates insurance companies' ability to deny coverage. The CBO projects that the bill will increase deficits just under $1 trillion in the first year and then somehow cut the deficit by just over $100 billion over the next 10 years. Frankly, I don't believe it. It'll only take a year to prove me wrong but I don't see how this program will run surpluses for the next 20 years. Increasing coverage and reducing deniability does absolutely nothing to reduce the cost trajectory, absolutely nothing. The only way the CBO estimates work out is through tax increases.

Clearly, the only way for this to be possible is to raise taxes a great deal. There's a variety of taxes that will be raised in order to fund the bill but this is the worst time for that. I fully understand that the federal government will need to increase revenues in the next couple decades to pay down our record deficits and support our current spending habits. The worst thing we can do though is add entirely new entitlement programs that need funding. We cannot pay for what we already have and now we're creating new monsters to deal with. I just don't see how this helps our economic and fiscal situation.

Also, we're stealing from Medicare to pay for this program. One of the biggest problems with running pension and entitlement programs is that the managers of the plans don't save surpluses. This is a classic case of not putting Medicare in Al Gore's "lockbox". This will create shortfalls in leaner times.

Also, why is everyone demonizing the health insurance companies? There is a legitimate argument to be made as to whether we want the health insurance industry to be for-profit. I think support for non-profit firms could help. Though I don't think the profits being made are what's causing the problems. Of our five largest health insurers, 2 of them have margins just over 7% and the other 3 have sub-5% net profit margins. It's not like these firms are just printing money. Regulation on pre-existing conditions and such is important but I don't see the evil insurance company line of thinking.

Anyway, there's my health care debate ramble. This bill has some good stuff in it, some bad stuff. My primary problem is that I don't believe we can afford it. Health care for everyone is a great ideal but I don't see how it happens without sacrificing quality. There's an equilibrium between quality and coverage. America has always tilted the scale towards higher quality, lower coverage and higher cost. Increasing coverage comes with a give in other sides of this equation. I believe costs will be higher and quality will be lower over the long run.

Obama Finally Supports Nuclear

Obama Offers Loan Guarantees for Nuclear Power Plant

President Barack Obama is making roughly $8 billion in federal loan guarantees available to help build the first U.S. nuclear power plant in three decades.

Discussing a plant envisioned for Burke County, Ga., Obama told a union audience Tuesday that the initiative will create thousands of construction jobs and 800 permanent jobs. He called it "only the beginning" of efforts to develop "safe, clean" energy-efficient technologies.

Finally! I have long been a supporter of increasing our nuclear energy capabilities and have been baffled by the excessive fear and nonsense about the radioactive waste. First, no one has ever died from a nuclear plant meltdown. And, given the increasing safety standards, the chances of disaster happening are absurdly small. Second, when comparing nuclear and coal pollution, nuclear makes a lot more sense because it "operates on the principle of containing wastes, not dispersing them". What's better: a small, controlled nuclear rod that is stored for breakdown or the spewing of tons upon tons of waste into the air without controls? I hope this is a beginning and our country makes a real push into the nuclear space, we've got a long way to go to catch countries like France that use nuclear generation for 80% of their electricity use.

I have been arguing for a while that the only way this country emerges from this Great Recession and reclaims its status as economic world leader is an energy technology revolution. The wave of the future is clean energy and the US must be a leader in developing these technologies. We are already being left behind by China and need significant investment in these fields. Let's not forget, even with oil's extreme volatility, crude prices began the decade around $30 per barrel. Today we are at $77, a greater than 10% annual compound rate of increase. This increase significantly curtails economic growth for the US while we get to watch Dubai build the world's tallest buildings.

Prospect of US Default Absurd

(Bloomberg) - Nobel laureate Joseph E. Stiglitz said the prospect of a default by the U.S. or the U.K. is an “absurd” notion constructed in financial markets.

Both nations “deserve to keep the Aaa rating” and “the likelihood of a default is so small, particularly in the U.S. because all we do is print money to pay it back,” he said in response to questions after a speech in London yesterday. “The notion of a default is so absurd, it’s another reflection of the absurdities in the financial markets.”

An excellent point by Stiglitz pointing out the absurdity of Moody's, S&P and Fitch placing credit ratings on countries and a CDS market gauging the probability of default for countries that print their own currency. No country that has its own currency will default, they will just inflate to pay it back. The risk is not one of default, but devaluation of the currency the debt is denominated in. The ratings should be ones that deal with the potential for currency debasement, not credit risk. Obviously, if the country uses a collective currency such as the euro or another country's paper, it makes sense to have these rating mechanisms.

Top Marginal Rate Low Historically

Source: Chart Porn via My Back Pages

It does seem inevitable that we will be seeing higher tax rates in America over the next few decades. As our workforce shrinks with retiring baby boomers, the rest of us will be forced to close the gap as well as pay down our current $14 trillion debt. Taxes are headed higher. Yet, even a 50% raise in the top marginal rate will still put it well below long-run average rates.

Obama Budget Based on Hope

Obama has now made me understand what the hope is all about. I'm not sure his budget proposal is anything but a unbelievable hope for the future. Obama unveiled a $3.8 trillion budget proposal that needs $1.3 trillion of borrowed money in 2011. The plan will raise taxes on high income individuals and businesses to raise $970 billion and $400 billion, respectively. Now for the shocking part:

The White House budget proposal released Monday assumes the U.S. economy is heading for a six-year run of above-average economic growth with no sign of a worrisome spike in inflation or interest rates...

...It expects six consecutive years of strong growth ranging from 3.2 percent to 4.3 percent — well above what most economists consider the longer-term trend of around 2.6 percent.

The last time the economy saw a similar streak of strong growth was in the late 1990s, during the dot-com boom. Obama has said both that expansion and the housing-powered growth in the mid-2000s were bubble-driven, and he wants the next expansion phase to rest on sturdier pillars...

...The budget forecast reflects a 3.8 percent five-year average. (CNBC)

So raising taxes and overwhelming the loanable funds markets translate into above-average growth. Hope indeed, hope indeed.

Consumers Save in 2009

After negative savings rates in recent years, consumers did a 180 in 2009 saving 4.6% of their incomes, the highest rate since 1998. Consumers, unlike our spendthrift government, are deleveraging and saving their money amid an uncertain economic future. With equity markets still over 20% off their highs, many baby boomers need to save everything they can if they plan on retiring after years of saving too little and then seeing their wealth diminished in the Panic of 2008. Clearly, this is not good news for the White House that needs consumer spending to keep GDP numbers coming in strong. Friday's 5.7% GDP reading was astoundingly good, nevermind the skeptics that point out the large portion resulting from inventory building.

Dear Consumer: Saving is good, keep it up. Indeed, I am worried about a 10% unemployment rate and the likelihood of lowered growth with more saving. But, for years we have talked about how a negative savings rate is unsustainable and the consumer needs to deleverage. The fact of the matter is that this does not typically happen in good times, it takes a shock to scare consumers into doing it. So, let's hunker down and take the pain of slower growth so our elders have a chance at retiring sometime in the future.

What a State of the Union Address!

Presumed Inflation...Really?

The following paper has been making the rounds in the blogosphere and I thought I'd throw in my two cents (all emphasis is mine).

Excerpted from The Elliott Wave Theorist, December 18, 2009

"The Fed’s Presumed Inflation Since 2008 Is Mostly a Mirage"

Many commentators talk about inflationary forces running rampant. We all know that the Fed created $1.4 trillion new dollars in 2008. It has told the world that it will inflate to save the monetary system. So that is the news that most people hear.

But the Fed’s dramatic money creation in 2008 only seems to force inflation because people focus on only one side of the Fed’s action. Even though the Fed created a lot of new money, it did not affect the total amount of money-plus-credit one bit, because the other side of the action is equally deflationary.

When the Fed buys a Treasury bond, net inflation occurs, because it simply monetizes the government’s brand-new IOU. But in 2008, in order for the Fed to add $1.4 trillion new dollars to the monetary system, it removed exactly the same value of IOU-dollars from the market. It has since retired some of this money, leaving a net of about $1.3 trillion. So investors, who previously held $1.3t. worth of IOUs for dollars, now hold $1.3t. worth of dollars. They are no longer debt investors but money holders. The net change in the money-plus-credit supply is zero. The Fed simply retired (temporarily, it hopes) a certain amount of debt and replaced it with money. In fact, if the Fed is to be believed, it desperately wants to sell the rest of these (in)securities and retire the new money. I doubt it will happen, but it doesn’t much matter to inflation either way.

In currency-based monetary systems, the creation of new banknotes causes—indeed forces—inflation. Likewise, the monetization of new government debt creates permanent inflation practically speaking. (Theoretically, the government could retire its debt, but it never does.) But when the Fed simply swaps money for previously existing debt, there is no net change in the amount of dollar-based “purchasing power” on the planet.

The theory among monetarists is that these new dollars are hot money that creditors can now re-lend. Thus, it will multiply throughout the banking system. At first it might seem that new money in banks’ hands should be more powerful for creating inflation than the previously-held FNM mortgages. But this is not the case, because the main thing for which the Fed wants banks to lend out the new dollars is new mortgages. Today, bankers and other creditors are afraid of mortgages, and they don’t want new mortgages any more than they want the old ones. In the mortgage-intoxicated, pre-2008 world, there would have been little significant difference in the paper, because banks were creating new dollars any time they wanted by taking on new mortgages. In the mortgage-repelled, post-2008 world, guess what: there is still little significant difference in the paper, because virtually the only thing banks can use it for is to fund mortgages! The only other outlet for the Fed’s new money is to fund market speculation, which is one reason why the stock and commodity markets rose.

What is very different—as predicted in Conquer the Crash—is the desire of lenders to lend and of borrowers to borrow, which has shriveled dramatically. This abrupt change resulted from the change in the trend of social mood at Supercycle degree that took place between 2005 and 2008, when real estate, stocks and commodities peaked along with the ability of the banking system to write one more mortgage without choking to death.
…
The bottom line is that the Fed hasn’t created much inflation over the past two years. The only reason that markets have been rallying recently is that the Elliott wave form required a rally. In other words, in March 2009 pessimism had reached a Primary-degree extreme, and it was time for a Primary-degree respite. The change in attitude from that time forward has, for a time, allowed credit to expand again. But the Fed and the government didn’t force the change. They merely accommodated it, as they always have. They offered unlimited credit through the first quarter of 2009, and no one wanted it. In March, the social mood changed enough so that some people once again became willing to take these lenders up on their offer.

Frankly, I'm not an economist by training (even though I've studied the subject a bit) but I don't understand this one bit. Maybe I’m slow but this makes absolutely no sense to me. I don’t see how the Fed purchasing the Treasury’s debt is not simple monetization and, therefore, inflationary. Debt holders become money holders (money that was not previously in the system). So, with actionable money they can buy more debt. Doesn’t that support prices and isn’t that inflationary? Whether the Fed buys existing debt or new debt doesn’t seem to matter if the Treasury is issuing debt all the while.

So, granted the money doesn’t go into new debt because no one wants to borrow (the consumer is smartening up and deleveraging). So, “The only other outlet for the Fed’s new money is to fund market speculation, which is one reason why the stock and commodity markets rose.” Isn’t this inflation…the pushing up of asset prices with new money?

The Fed has created huge inflationary pressures in the system. The idea that the data have not shown inflation and, therefore, the actions haven't been inflationary is nonsense. Prices should be deflating much further than have been allowed by the Fed. If anyone can explain to me how the Fed's actions have not been net inflationary I'd love to listen. If Prechter actually is right, then the Fed is pretty worthless at stabilizing prices, one of its two core mandates.