A Slightly Different Way to Prevent Bank Runs

A few weeks ago, while reading yet another book on the financial crisis, I had the beginnings of an idea about how to help financial institutions who have experienced a decline in assets relative to their liabilities. I thought about possible ways to recapitalize these firms without direct government intervention, as happened during the TARP. The idea I came up with was a quasi-convertible bond to be forcibly converted by a regulator during a time of crisis.

This bond is one that can be issued by a financial firm, usually an investment bank, in order to raise funds to use for trading and other proprietary investments. The bonds will have an intermediate to long-term maturity ranging from five to fifteen years. Under normal circumstances the bonds will act in a similar fashion to current debt issues. However, the bonds will have a provision whereby they automatically convert to equity when their government regulator determines that the firm is under capitalized or facing a liquidity short fall.

The purpose of this conversion is to quickly, and forcibly, lower a firm’s liabilities and increase its capital cushion. Such an increase in capital would allow the firm to maintain a sufficient liquidity position and prevent a need for capital injections or support by the government should the firm become sufficiently illiquid. This type of bond would allow financial companies to finance their normal functions under normal credit conditions, but allow the firm to recapitalize itself under excess financial strain.

The decision to convert the bond into equity would rest with the firm’s main regulator, the Treasury and/or the Federal Reserve depending on the type of firm. For example, the Federal Reserve Bank would decide institutions that maintain customer demand deposits. The government decision makers would base their decision on the firm’s capital strength, counterparty risk and balance sheet stability. If the firm is deemed to be illiquid, the debt will be forcibly converted to equity and creditors would become common shareholders. Several tranches of these bonds could be sold for any individual firms. The highest risk could be converted firms, followed by subsequent levels. The government regulators would determine the necessary ratio of this type of debt to overall debt issued by each firm. Likewise, during a conversion, the regulator would also determine the amount of the bonds to be converted.

The purpose of these bonds would be to protect the government from having to use taxpayer funds to bailout or otherwise support solvent but illiquid firms. If a firm begins to run out of liquid securities to post as collateral, it has a liquidity problem. During a crisis, firms become insolvent as they are forced to sell its assets to acquire necessary liquidity, often at a significant loss. A forcibly convertible bond would allow for the firm to tap a reserve of liquidity that would be sufficient for it to ride out the crisis. If the firm is not able to acquire the necessary liquidity, the government can be forced to put taxpayer funds at risk to protect the firm’s counter-parties from its collapse.

Obviously, this type of bond will be less desirable to debt purchasers as it would essentially force them to assume greater risk associated with a firm’s activities. To make up for this risk, the bonds would likely trade at a discount to normal debt. As a result, the government would have to use its regulatory powers and force firms to issue this type of debt. This would prevent the government from having to use taxpayer funds in the future to backstop an illiquid bank during a financial crisis by recapitalizing that bank when it is short of necessary liquidity.

Game Theory and Census Workers

I'd like to make a short thought exercise which might be an example of economic problems which the US census might ultimately cause. And, no, I am not trying to say that the census will cause problems but there might be unintended consequences.

Consider you are either an individual who has been unemployed for a long period of time or a new graduate just trying to enter the job-market. You have had a very difficult time finding stable work, but have found an opportunity to work for several months. This job offers you the chance to work from twenty to forty hours per week, and the choice is entirely yours. Along with hundreds of thousands of others in your situation, you've decided to take this job opportunity.

Being a person who is in need of money who would like a full time job, instead of working about twenty hours a week you would likely decide to work towards the forty hour mark. You do your work eagerly and try to get as many hours as possible to maximize your income. Much like you, the other hundreds of thousands of people likely decide to follow a similar course and work as many hours as possible.

So, here we are. Individuals who are working for the census have every incentive to maximize their hours worked. Unfortunately, there is a limit to the amount of work these people can do since most census workers were hired to go door-to-door and count those who have not filled out their forms. There were only so many people who failed to return their documents, so there is a upper limit to the trips census workers must take. With employees attempting to work as many hours each week as they are allowed, they will quickly visit all of those who's forms are outstanding.

The unfortunate consequence to this exercise is that census workers will likely complete their door-to-door visits well ahead of schedule. As the documents are gathered in each area, the workers will be released from their employment earlier than they were expecting. The census has caused a major boost in hiring and has helped to lower the national unemployment rate. As the newly hired census workers finish their jobs, they will be released from their employment and will reverse any positive effects from their hiring. The unemployment rate will likely again spike as many hundreds of thousands of former census workers file new claims.

In the coming months, the unemployment rate will increase even though the economy is improving. Potentially, as these people again lose their jobs there can be severe negative effects on the national economy. Companies get scared when unemployment rises and consumers spend less when they lose their jobs. The ultimate loss of employment may cause these concerns to return and output to decrease. The census jobs, once lost, can potentially damage the fledgling economic recovery for these reasons.

Who's Really At Fault

I've been doing quite a bit of reading recently, mostly books about the recent American economic downturn. As is expected, each author tries to determine the causes of the fall and the guilty parties who allowed malfeasance or tried to pull the US financial system apart. The list of guilty parties is quite long: greedy bankers, deceptive borrowers, inept credit ratings, government ignorance and so on.

However, I put the blame for economic crash on those and countless others. In sum, everyone is to blame for a rather simple reason - no one did enough to learn what was actually going on and that a bubble was expanding. People simply became joyfully ignorant at what was actually going on with the economy and financial system. The fault can follow the path of the toxic assets that polluted the system.

First, loan originators looked to find borrowers to buy houses without regard for their ultimate ability to afford those houses. They didn't do the necessary research to learn that the loans couldn't be paid off, only hoping that prices would continue to rise. The borrowers they found to purchase homes did so without understanding the contracts they were signing. They didn't do the necessary research to learn what they were agreeing to, only thinking they were getting a great deal and that they could continue to pull more money out of their homes. The loan originators then quickly sold off the loans to banks to form asset-backed securities. The banks which purchased these loans did so without determining whether they would continue to be serviced over their life-span. Again they did not do the necessary research. Shortly after their purchase, the loans were usually pooled together into larger and larger bonds.

Once these bonds were put together, they were taken to ratings agencies. These agencies were responsible for determining the creditworthiness of the new bonds, however, they lacked the knowledge of the assets they were rating. The agencies did not do the necessary research to understand the bonds and accurately rate them. Instead, seeking higher payments, they often slapped inflated ratings to the bonds and sent them on their way. Once these bonds were rated, they were then sold to investors (often foreign banks, pension funds, etc.) or held by the banks. Again, these investors did not do the necessary research to understand what they purchased, and instead were fully dependent on the ratings from the agencies. They did not do their own research.

In the end, the bonds fell apart as home buyers became unable to pay their mortgages. Their payments often adjusted upwards catching many of them off-guard because they did not understand their contracts. The banks and investors then began to take losses as their investments slowly stopped paying their necessary interest. Once this happened, they stopped purchasing new loans which brought new loan issuance to a halt, bankrupting the loan originators.

Ultimately, the government had to step in and bank-stop a large number of institutions in order to protect the whole financial system. This occurred at great loss to taxpayers. Again, the government did not intervene until the problem was too great. Believing that home ownership was good for the country, government agencies and legislators acted to allow the bubble to continue expanding until it popped. Again, they failed to realize the consequences of its actions.

On the whole, the economic downturn was everyone's fault. People simply did not understand what they were agreeing to, who they were loaning money to, ratings they placed on securities, what they were buying or the actions they were encouraging. If greater due diligence was done, or consequences considered before action, the great recession could have been avoided.

Where Does The Money Come From?

Some fairly interesting numbers were released last week by the Bureau of Economic Analysis concerning the American public's income. Their statement showed that personal income from private wages (money earned through working at non-government jobs) has fallen from 47.6% at the turn of the century to 41.9% last quarter while income from government transfer payments (Social Security, Food-Stamps, Unemployment Insurance, etc.) has risen from 12.1% to 17.9% in the same period. Simply, less money is earned from private employment while much more comes from the government.

Such an income shift is potentially very troubling for the US economy. The key problem is that most of the government's spending comes from revenue generated by taxing private income. At a time when the share of privately generated income is falling by almost 5%, the government's share has increased by almost 6%. The government is paying a significantly higher share while its pool to tax is shrinking precipitously. Additionally, the government is also paying out another roughly 10% in wages for public sector employees.

Overall, out of every $1 in American income, over $.27 is paid by the government. So, the government must tax an average about 1/3 of Americans income just to pay for its workers and transfer payments. This excludes the costs of goods it much purchase to be used by their workers and in what they produce on behalf of the government. In total, for the government to pay for its obligations and services it needs to tax at a prohibitively high rate. Additionally, this would also need to include extra money to service existing debts.

In sum, the government is spending huge sums of money in proportion to what the rest of the economy is generating for personal income. Obviously, with a recession, incomes decrease and the government has stepped in to fill the gap. But, over the long run this is not sustainable. If the US government spends at an elevated rate for a brief time, there will be little overall effect on the economy. However, should such dependence on the government last for an extended period, the country will be forced to become increasingly dependent on financing itself through debt instead of taxation. Ultimately, this will lead to insolvency and economic collapse.

An Untenable Equlibrium

I recently concluded Crisis Economics and found one of Mr. Roubini and Mr. Mihm's ideas incredibly interesting. They build upon Lawrence Summer's idea that China and the United States are locked in a 'balance of financial terror'. In essence, they argue that the world is in a state of equilibrium that can not last. The Chinese are dependent on the US to purchase their goods and to make good on its debt obligation. The Americans are dependent on the Chinese to continue producing cheap goods and finance their purchase. Such a state is ultimately untenable.

While this is one example of an international equilibrium that will eventually fail, there are countless examples of others. Simply put, the world is teetering on a dangerous precipice. This type of situation was shown during the bursting of the housing bubble in the US. Americans financed the purchase of new homes by borrowing from lenders who created bonds which were then sold to a vast number of investors. A large percentage of this debt ultimately ended up in foreign hands in Europe and Asia. The world was in equilibrium as long as lenders continued to loan money, consumers continued borrowing and home prices continued rising. As soon as any of these conditions failed (home prices stopped rising), the house of cards collapsed.

The United States and China find themselves in a similar situation today. Once either stops fulfilling its end of the bargain the entire system will collapse. The Chinese could stop purchasing American debt which would cause Americans to stop purchasing Chinese goods. Any action by one party would likely harm the other.

However, the Sino-American relation is not the sole unstable equilibrium in the world today. Major oil producers find themselves in a similar suicide pact with the industrialized world. Should they stop selling oil, their economies (in addition to their trading partners') would likely collapse. Similarly; many nations, such as the Greeks, Portuguese and Spanish, are locked in pacts with their creditors. These nations have based their economies on debt-driven social spending and must roll their debt quite often. Should their creditors stop allowing them to do this, their national economies would collapse and those who financed their spending would probably take major losses in any default. Such are the problems faced by many European banks in the current crisis. Likewise, the entire Euro-zone finds itself in an untenable situation as it must help its over-indebted members refinance their debts. A shift could easily cause the currency to fail or break up.

Fortunately (or unfortunately), this world is not one of only a simply equilibrium. There are many possible equilibrium and the current one we are at is likely non-optimal. Many of the situations described above are untenable and likely can not last in the long term. Once those regimes collapse, the world will shift to another point of equilibrium. Such a series of events can occur countless numbers of times. In fact, each recession is just a movement from one point to another. Creative destruction will occur and move the world economy to a more advanced state. The recent recession did not totally reset the world economy. Yet, if there is a double dip the world will likely move away from its previous unstable state into a new, more optimal equilibrium.

The Tail Is Going To Wag The Dog

One of the formerly popular concepts in economics and global politics that was debunked during the recent recession was that of decoupling. The simple idea was that with the emergence of new economic powers around the world like China, Brazil, Russia, India and the European Union, the importance of the United States had begun to decline. In essence, these newly powerful countries were thought to have become able to thrive independently of the US and any American problems would not spread. Obviously the 2008-2010 recession proved this incorrect as problems on this side of the pond quickly spread abroad and recessions followed in many other countries.

A key fact in that is often overlooked in the decoupling myth is the effects that the rest of the world have on the United States. The term 'decoupling' is obviously incorrect, however, the US is no longer as dominant a power as it was over the past few decades. This will become increasingly evident as the European Union faces an existential crisis caused by a number of its Mediterranean members.

Starting with Greece and quickly followed by Spain, Portugal and perhaps Italy and Ireland, the EU's common currency is going to be threatened. It is a serious possibility that the currency will fail or be forced to eject some of its members. When either of these events happen, the Euro zone will be thrust into its most serious recession since the Second World War. Trade agreements will break down while new currencies will be introduces and experience severe growing pains. The entire Euro area will face growing civil unrest as draconian fiscal austerity will be introduced and currencies devalued.

Much like the American problems emanated across oceans in 2008, the European problems will quickly spread around the globe. As the contagion moves into the United States financial institutions will again begin to experience lending and borrowing problems due to fear of counter-party exposure to European sovereign debt emerges. This problem will probably not cause a return to the 2008-2009 state of frozen credit but will hamper lending to governments around the world. When this happens, interest rates will quickly rise and threaten the young economic recovery.

In the end, the likely threat to recovery caused by the European contagion will likely be enough to force the US, Europe and many other parts of the world back into recession. A double dip will be experienced. This second dip will likely be much longer in duration than the 2008-2010 dip because governments, such as the US, will find it difficult to finance artificial stimulus measures which could mitigate the decline.

Unlike the past recession where the United States drove the rest of the world into decline, a future recession will likely be an event where the US is driven into decline by the rest of the world. The tail is going to wag the dog...

The End of the Euro

With recent events in Greece, Portugal, Spain, Italy and Ireland, the common European currency has been threatened. The governments in these, and other countries, have made a practice of running huge fiscal deficits to finance lavish social spending. Those deficits were often far beyond the agreed upon limits defined by the treaties which created the European Union and the common currency. The large deficits are becoming more and more problematic because the borrowing countries are reaching the point where they are no longer able to service the interest on the debts.

When countries run up huge national debts, there are often a number of ways for them to repay the debts. A common method is to cut spending or raise taxes. Unfortunately, this is not a popular practice in Europe when major unions riot and protest whenever cuts are made that can threaten their income. Additionally, in a number of European countries tax avoidance is a common practice, so raising taxes might not necessarily raise revenue. Another method to lower national debts is to grow out of the problem. If a country can increase its GDP and national income enough, the debts will be swamped with new, increased, tax revenues. However, Europe is currently only recovering from a major recession, to which it might fall back into. With such a shady economic outlook, growing out of debt seems unlikely. Another of the most common methods to eliminate national debt is to inflate it away. Countries often print new money and use that cash to pay off their debts. This practice eliminates the debt at the expense of current money holders. Again, this would likely be impossible for Europe as it would pay off one country's debt at the expense of others.

Unfortunately it appears as though all of the common methods countries can use to eliminate their excessive national debts can not be used for the problematic European nations. What appears to be happening is that a major international consortium of EU countries and the International Monetary Fund are going to create bailout packages for the individual countries, starting with Greece. This will take some of the debt burden off of the Greeks and allow them to artificially reschedule their debt. They will also need to implement drastic austerity measures which will be incredibly unpopular domestically.

So, in the end, how does this all shake out? Simply, the Euro will either collapse or certain countries will be forced out of the common currency. For starters, the countries who are footing the bill for the bailout packages will do so grudgingly. Such packages will be incredibly unpopular and while initial packages may pass, subsequent requests for help may be ignored. Secondly, countries receiving the bailouts will be forced into draconian spending cuts. Such cuts will make governing impossible for incumbent administrations. Minority parties will simply run on platforms to eliminate the cuts - and they will likely be successful. This will result in countries receiving aid not cutting their spending per agreements. The countries giving aid will likely pull back their aid forcing their neighbors into default. The European Central Bank will be forced to print new money to stabilize the currency if the defaulting nations are not forced out. Either way, the Euro will collapse or break up.

Early Signs of Inflation

New Commerce Department numbers out today show that inflation is starting to be felt. While core inflation is at comfortable annual rate of 1.3%, prices for energy and food are up over 18% in the past year. These figures show that the economy is starting to rebound, but the dollar might be losing some value thanks to the government's expansionary fiscal and monetary policies. Even though the core numbers are not at dangerous levels, overheated prices for energy will slowly filter through the economy and force the cost of other goods to increase - thus fueling additional inflation.

Another potentially dangerous statistic released showed that consumer spending increased faster than income while the savings rate decreased. This demonstrates that people might be reverting to spending based more on credit than earnings, a problem which was a major cause of the recent recession. Additionally, there might be mixed results of individuals saving at a lower rate. This could be a bad sign as it means that less money is available for investment, but it might be good as companies will be able to sell more goods and services.

Effects of inflation might cause an economic recovery to become toxic if not monitored closely. With so much money pumped into the financial system in the last three years, the value of the dollar can be endangered. The funds should be carefully pulled out so that dangerous of rising price levels are averted. The easy money also can make it possible for individuals and companies to again over-leverage themselves and repeat the recent experience.

The Federal Reserve should act decisively to defend the value of the dollar while concurrently acting to prevent the abusive use of credit. By allowing excess cash, used to prevent a collapse, to remain in the system the Fed is risking a devaluation of the dollar. They should slowly raise their interest rates and attempt to mop up some of the vast amounts of excess liquidity pumped out over the last three years.

Are We There Yet?

As the nation plods along during what is a quite long recession citizens begin to ask whether or not the downturn is over. The questions are similar to those asked by a child pestering their parent during a long car trip - 'are we there yet?' Almost since the start of the economic decline people have been asking when or where the end is, especially those in the media. Obviously, no one wants to experience an economic downturn. However, hope and questions alone will not make it go away. Like the parent in the car being continuously asked if they have reached their destination, the answer to the economic question is very simple.

The children never seem to understand that they will know when they get to where they are going. Similarly, people in a recession will know when it is complete. While officially only NERA can dictate the timing of a recession, the true end is much more obvious. Factories will open, spending will increase, jobs will be found; just like that - the recession will be over.

I, for one, feel that the economic data released today by the Commerce Department marks a clear end to the recession which lasted from December 2008 until sometime around January-March 2010. Their report shows that the US Gross Domestic Product grew by 3.2% on an annual basis in the first quarter of 2010. Combined with reports showing that consumers are starting to increase their spending and declines in the unemployment rate the GDP numbers provide ample evidence to show the recession to be ending (or possibly over).

While questions can be raised over each of the individual numbers, the combination of all factors makes for a convincing argument that growth can soon restart. What must be done now is simple - impediments to growth must be removed. Specifically the government must be very careful in their fiscal and monetary policies not to retard growth in any way. The economy is still quite weak and the recovery does not have much steam. However, if barriers are not erected growth can soon resume.

Preventing Another Crash

This past week President Obama gave a speech a few steps down my block on financial reform. During his talk, the President outlined a number of steps which, it is hoped, would prevent the country's economy from ever collapsing again. Many of the economic policies which the current administration has put into place seem to reflect a belief that with proper regulation, the economy will never again fall. Enough government intervention can end the series of up and down business cycles which have been prevalent throughout history.

This idea strikes me as fairly impractical for a number of reasons. I might be biased as I've just completed the book 'This Time is Different,' wherein the authors take a quantitative look at financial crisis on a government level for the last few hundred years. One of their major theories is that situations like the recent US economic decline have happened before (which they clearly demonstrate in their data) and will happen again. During each run-up to an economic crisis, people always believe that 'this time is different' and something will set them apart to prevent a downturn. Alas, during each crisis that belief is proven wrong. In the 2007-current crisis, people believed that the economy had been fixed and they were beyond a cyclical economy. Obviously they were wrong.

So, the question becomes: how come the government can 'fix' the economy now to prevent future downturns, but they never could before? I believe the simple answer is that they can not. Remember, the Federal Reserve was created by the Wilson administration to prevent downturns - the Great Depression proved it could not. The FDIC and SEC were just two examples of Roosevelt era organizations designed to prevent banking crisis' and asset price bubbles. It has been proven many times that they can not prevent those problems. If the US government has many times created new regulations, organizations and frameworks to control the business cycle, but failed - why would this time be any different.

The belief here is that the current government will create some new organizations to 'prevent' future economic problems. These agencies will likely be designed to prevent specific abuses and failures that caused the most recent economic downturn. However, two problems will ensue. First, these agencies will have a great deal of unintended consequences. Businesses will find some loophole or framework which will cause greater abuses or failures in the economic system. The second problem is that the new organizations will not prevent future cycles unless they are so overly regulating that they stifle all economic growth. Prior examples have shown that each time the government tries to control the economy, they fail. Their programs create a vast number of unintended new problems and are still unable to achieve their ultimate goal of a permanent upward economic trajectory.

The Benefits of Extending Benefits

The San Francisco Federal Reserve released a fairly interesting paper this week about the effects of benefit extensions on the unemployed. The author, Rob Valletta, came to the conclusion that the large number of benefit extensions by the Federal government have a very small effect on the duration of time job losers are out of work. He looked at a fairly large data set and determined that the extensions, up to 99 weeks in some cases, added only 0.4 percentage points to the almost 10% unemployment rate. This paper contradicts some claims that extended benefits are creating disincentives for people who are laid off to find new employment.

I find Valletta's research very timely in the current economy. Last week, after much partisan wrangling, Congress passed an extension continuing their program of support for unemployment benefits. In normal situations, a person who is laid off is entitled to about 26 weeks of benefits. The amount of their benefit depends on their state of residence but averages about $350 a week. This formula takes into account their prior earnings and length of employment. During the current recession, the Federal government passed a series of laws granting extensions of several months to individuals who are facing the loss of benefits after their 26th week.

The San Francisco paper attempts to quantify how involuntary job losers are not voluntarily extending their periods of unemployment compared to those who decide to quit their job or enter the market. The unemployment benefits only serve to provide a cushion to those out of work. In most cases the benefits are only sixty percent, or less, of a person's prior income. And it is obvious that such a drastic cut in earnings force people to severely cut back their expenses or deplete their savings. The jobless benefits only provide for part of the earnings loss.

Clearly it is not in a person's best interest to remain on the unemployment rolls, even when they can receive benefits for almost two years. The immediate result of a layoff is not the loss of all income, but the loss of about half. In an era when most individuals are spending either more than or their entire income when they have a job, to take away such a large portion of their funds can create sizable shocks to an individuals finances. Thus, while the government provides a cushion of money to soften the economic blows to the unemployed, they are by no means comfortable receiving such a fraction of their prior income. In most cases, rational individuals will do whatever they can to move back to their prior earnings level by finding new work as quickly as possible. Or at least that's what a new San Francisco Fed paper says...

Increasing Debt Through Refinancing

Being tax-day, I thought I would go through a small exercise in looking at the effects of rising interest rates on refinancing the national debt. I have based my thoughts on the premise that the federal government is going to have to refinance a large portion of its debt in the face of rising interest rates. For example, the average dollar of government debt will come due in less than five years and with the government simply refinancing its debt, this dollar will be borrowed again at a higher interest rate. I decided to use a rudimentary model and look at some potential consequences.

To complete this exercise, I used a number of assumptions to simplify this model. First, I assumed that all bonds mature in either 1, 2, 5, 10 or 30 years - respectively: .239%, 1.036%, 2.572%, 3.84% and 4.714%. Obviously there are other maturities, however, the model became increasingly complex for each added maturities. From this assumption, I gathered the interest rate for each of these maturities from CNBC and then looked at the national debt clock for the $12.8 trillion dollar debt number. Secondly, I did not look at any expansion of the national debt. I eliminated new spending or tax cuts from the model and held the debt constant. Again, this was to simplify the model. Yet, if new debt was included it would exponentially increase the cost of financing public debt as it would likely be done at higher interest rates. My next major assumption was that a constant portion of each maturity comes due each year. For example, this year 1/2 of the 2 year bonds need to be refinanced, 1/5 of the 5 year, etc. Meanwhile, all of the 1 year bonds will mature. Finally, I assumed that the average maturity was just under 5 years. This affected how each maturity was weighted. The first two segments were 35%, the third was 15% followed by 10% and 5% for the remaining maturities.

Based on this rather simple model, I determined that on $12.8 trillion of debt, the annual payment is about $187 billion, or 1.45%. I'm sure my numbers are not totally accurate, but my goal here is only to look at the effects of increasing rates on the financing costs.

Next, I looked at future years under several different scenarios. Each of these years assumed that the fraction described above would mature and be refinanced while the remainder of the debt would remain at the old level. The first situation I looked at was to shift the yield curve parallel upward by 1%. In this situation, the payment increased to $258 billion, or 2.018%. If this were to occur, the portion of the government to service the debt would rise by almost 38%! Mind you, this is only for a 1% increase while some experts are calling for rates to rise significantly more.

After this flat increase, I looked at a number of proportional increases to the base interest rates. These were 25%, 50% and doubling the rates. A 25% increase resulted in a 6% increase in the financing cost, while 50% was a 13% increase and doubling the rate was a 26% increase. These are all much rosier cases than the flat shift of 1%, however, they too would be quite harmful to the national budget.

Finally I looked at some rather sharp increases. I started this exercise again assuming a parallel shift, this time of 5%. This move almost tripled the cost of financing the national debt to just under $550 billion. Lastly I assumed that all rates would increase by a factor of five. This practically doubled the finance cost to $385 billion.

What I took from this exercise was that any increase in the interest rate on the national debt would be incredibly costly to the US government. The main problem lies in two parts. First, existing rates are incredibly low and there is little place else to go except for upward. With the increases in government spending and the inundation of international debt markets with US debt, it looks increasingly likely that this will happen. Second, the average maturity on US treasury debt is fairly short term at under five years. As such, much of the debt is short term and will be very sensitive to interest rate increases. Additionally, any new debt would also have to be financed at higher rates.

This practice was done to show the true cost of deficit spending. None of the assumptions made in this exercise assume the principle on treasury debt is ever repaid, it is only refinanced indefinitely. As interest rates rise, the government must divert an ever increasing amount of its money to just paying more in interest instead of on social spending or even debt reduction.

Help Me! But Please Don't Tell Anyone

A number of large commercial banks have vowed to continue their legal fight against a major news organization today, promising to go as far as the Supreme Court to keep their business secrets. Last year Bloomberg News launched a freedom of information campaign to unseal documents at the Federal Reserve showing which banks received emergency lending from the Fed and how much they received during the recent financial crisis. However, the banks are fighting a campaign tooth and nail to prevent those internal Fed records from being made public. Meanwhile, the Fed is remaining non-committal to both sides.

This lawsuit raises a pair of very interesting issues for the banks and the Fed. First, since the Fed is supported by public funds, shouldn't the media be able to report to the taxpayers where their money went? And, secondly, would the publicity of receiving 'emergency' air stigmatize recipients during a time of crisis? Since there is no clear cut legal basis to determine the outcome of this case, these two questions will likely determine it's outcome.

First, the Federal Reserve is technically a public bank supported by the government. In as much, the funds which the Fed uses are an extension of the Federal government and thus belong to the taxpayers. Along the lines of this argument, the media outlets should be allowed to report how public money was lent to private companies. It is not like it was a loan from one private bank to another, this was taxpayer money being lent out. Additionally, this was the type of situation where the Freedom of Information Act was intended to be used - giving public clarity to behind the scenes transactions. Unfortunately, the writers of the bill never imagined such a situation and thus did not specify the Federal Reserve banks under its purview.

The next major issue arises as to whether public knowledge of an emergency loan would stigmatize recipients. One of the famous interactions during the original TARP bill was when Treasury Secretary Paulson made all of the major banks take the aid regardless of whether they individually needed it. This was done so that a bank taking the aid would not be identified as weak and thus subject to predatory competition. By releasing the Fed's records, a decision would effectively identify the weakest banks and prevent others from engaging in future emergency actions.

By virtue of an unclear law and a badgering news organization, a number of large banks have been backed into a corner. When emergency aid was doled out last year, no one imagined potential long term consequences. The current information request by Bloomberg to divulge how taxpayer money was lent to troubled banks is a clear example of these problems. The banks took the aid to protect the system. They were not thinking about a year down the road, but instead only the next day. Such thinking is fraught with holes and future problems.

Two Up Equals One Down

Looking through some headlines this morning I noticed a pair of important numbers moving upwards which have the potential to stall an economic recovery. This pair of numbers was the yield on the 10 year Treasury Bonds (which moved above 4%) and the price of a barrel of oil (which took a run at $87). While these levels are by no means dire their coincident upward movement is concerning, especially with a weakened national economy.

The US government has made its Keynesian approach to economic policy crystal clear. This type of strategy is dependent upon the government being able to fund massive spending projects in order to spur economic growth. In order to fund their expenditures the government has become dependent upon borrowing and issuing new Treasury debt. For the last few years this practice has been relatively cheap with historically low interest rates. The low rates took away incentive for the government to raise taxes to pay their expenses since borrowing money was so cheap.

However, with more and more debt being issued, borrowers are demanding higher rates of interest to protect against a potential fall in the value of the dollar. The movement in the 10 year bond over 4% is evidence that lenders are not going to continue to loan cheap cash to the government and that Keynesian expenditures are going to become more expensive. The interest on a $700 billion dollar stimulus package would cost $28 billion a year at 4% versus $14 billion a year at 2% (obviously not all debt is issued at the same maturity/rate). Clearly the practice of using debt to finance spending is getting more expensive.

Like interest rates on government debt, the price of a barrel of oil has also been making an upward move in recent weeks. The price was close to $87 today before settling just below $86. Another spike in the price of oil could stall an economic recovery faster than rising interest rates. I had theorized in the past that commodity price spikes can tip a healthy economy into recession as the price of a key product, like oil, has the potential to affect the prices of many other goods.

If the price of oil rises, then transportation costs rise and consumers can purchase fewer goods. A weakened consumer demand can threaten the Gross Domestic Product and force decline instead of growth. As a major factor in the determination of a recession, a fall in the GDP would stifle any recovery.

There is a great chance that the current recession will conclude in either Q1 or Q2 of 2010. However, there are factors which can endanger economic growth and tip the American economy back into recession should certain trends continue. Two of the more dangerous trends are a rise in the interest rate on Treasury obligations and a rise in the price of oil. If these trends continue too high for two long, economic growth can be seriously threatened and the economy might not emerge from recession for a lengthy period of time.

Bring On the Discouraged, the Grads and the Census.

With the start of a new month come new jobs numbers. The unemployment rate remained constant at 9.7% while the economy on the whole added about 162,000 jobs. Clearly, in the middle of a recession, adding any new jobs is a good sign but like previous months the numbers must be taken with a grain of salt. A number of factors will combine to cause the unemployment rate to remain elevated in the coming months as the economy begins to recover and continues to add new jobs.

First, as I've said in previous blogs, the unemployment rate is not likely to drop anytime soon even though jobs are slowly being created. During the current recession, the calculated unemployment rate topped out around 10% even though it should have gone much higher. Huge numbers of people either stopped looking for work and dropped out of the labor force or decided to take on less desirable part time work. A more accurate judge of the labor market during this recession was the underemployment rate which added these people into the unemployment rate. This number reached into the high teens and is still around 17%. That means 1 out of 6 people in the United States want more work than they have. Though this number has improved, it is still significantly above the norm.

Another important thing to consider when thinking about the US labor picture are those who are about to graduate from college or high school and enter the labor market. This seasonal event is considered when the overall unemployment rate is calculated. However, the high unemployment amongst the young is another cause for concern. The future labor force is seeing its skills stagnate as many new graduates are sidelined. Unfortunately, while 162,000 new jobs have been created, the economy has still lost jobs since the start of the recession while the population as a whole has increased. Additionally, many graduates have decided to delay their entrance into the labor force when they could not find jobs by continuing in school. This may further bloat the number of new entrants into the labor force over the coming months.

Lastly, there has been one employer who has been adding workers at a breakneck pace - the Census. The government is hiring vast numbers of people for the decennial population count. Yes, giving these large quantities of workers a job is great, however these jobs will not last. For the most part, these jobs are low paying and temporary. The silver lining is that adding these workers temporarily might be just enough to give them work until the recession ends and enough new jobs are created for them to move to permanent positions.

The current employment picture is unclear. There are clearly signs that the economy is improving and that people will move off of unemployment rolls into new work. However, the picture is also very fragile. Many new people are about to join or return to the labor force while many others have moved into temporary work. If enough new, permanent jobs are created in the coming months the economy will recover. But, if permanent positions are not forthcoming the overall economy has the potential to fall again.

Pay Whatever You Want

The US government announced a rather interesting policy change about how mortgage lenders are to treat unemployed homeowners. Essentially, they have been told to write down the loans to what a government formula says the borrower can afford instead of what the property is actually worth. As outlined in the attached article, lenders are supposed to write down the loans so that payments do not exceed 31 percent of the borrowers can afford. What is even more interesting is that in some cases there can be no payments made, period.

This is definitely the most aggressive move that the federal government has made to keep people in their homes. They have, effectively, made it so that many unemployed individuals do not need to worry about making mortgage payments which they can not afford. The government will subsidize the lenders so some of the pain in writing down these loans is blunted. Obviously lenders have previously been reluctant to foreclose on homes and write down the value of their loans, until absolutely necessary, as doing so would force them to admit losses. Neither of those actions were desirable for the holders of mortgage debt.

Such a move by the government was likely made in response to a very high recidivism rate amongst borrowers who have previously had their loans modified along with the abnormally high unemployment rates. This move was made not only to keep people in their homes, but also to prop up home prices and prevent additional mortgages from going under water. The government has long been hesitant to make such policy changes in the past because they realized the numerous moral hazards which would arise from this type of program.

This program is one that will make life easier for a large number of people who have fallen on tough times. Yet it does so with incredible costs, both immediate and potential. The government has essentially taken the losses of the lenders onto its own books with little potential upside. Additionally, they have added a huge incentive for all borrowers to abuse the system. Individuals who purchased homes they could never afford using exotic mortgages now have the potential of their debt being (practically) forgiven. To say this practice would be unfair is a huge understatement and as such there will be a great deal of resentment.

It is impossible for a system to work where a person purchases something based on its market value and then has the value changed, after the fact, not to what the market dictates but to what they can afford. This violates the concept of a contract. Yes, people who are unemployed should have certain safety nets below them. However, they should not be rewarded for failed gambles they have taken.

Consequences of Debt

With the exception of a handful of years during the last half century the United States has funded its government expenditures through debt in addition to taxation. As the government (both at the state and federal levels) discovered that it was more popular politically to issue bonds instead of tax its citizens this practice expanded exponentially. Traditionally, government debt was seen as safer than its corporate or private counterparts. Since it was seen by markets as safer, it has also been cheaper. People would accept less interest payments because they knew they would have a better chance of getting their money back.

However, this era might be in its final stages. I'm not talking about the practice of the government's use of debt to increase spending, but its being able to pay less to do so. There has been much speculation (on this blog and major news outlets) that the US government was in danger of losing its ultra-safe AAA bond rating. If the rating were to go away, the markets would likely demand more interest to make up for the perceived increased risk.

But the market might not be waiting. Bloomberg recently reported that the United States government is now paying a higher interest rate than AAA rated Berkshire Hathaway - a private company. This essentially means that there are people who will loan money to a company than the United States government. The company can only fund its repayment of this debt by earning revenue while the government can back its repayment by taxation and by printing money.

Such a move is very odd. How can the bonds of a private company be cheaper than debt backed by the federal government? Honestly, I don't know - this makes little sense. As I have previously said, the government can just print new money while Berkshire Hathaway can not. It would have to earn money or issue new debt while there always exists a chance it can't repay and goes bankrupt. Is this implying that the United States could go bankrupt? I think not.

Instead, I believe that the US paying more in interest than a private corporation is a sign that those who loan the government money are trying to force it to issue less debt. Foreign countries are scared that the money they are paid back will be worthless. Only the government can devalue the dollar, a private company can not. This message is one that the US government should be very concerned with. If new public debt can not be issued, than the currency must be devalued. Such an action would likely only spiral out of control and lead to hyper-inflation as foreign countries and private citizens become less inclined to purchase treasury debt.

The Piggy Bank Is Empty... And It Has To Be Paid Back

Almost since the inception of the Social Security system, the program has collected more in taxes than it paid out in benefits. Rather than segregating this excess so that it could be used to pay future obligations, the Federal government diverted this money to its general accounts to be spent on all forms of spending. In return the government gave the Social Security Administration (SSA) special Treasury bonds. This has been a very useful way for the government to spend without needing to raise taxes. It was, essentially, a slight of the hand using brilliant accounting.

Unfortunately it looks like this practice is coming to an end. This year, the government will pay out more benefits than it collects, so the bonds will need to be redeemed. While the SSA has the money to pay out its immediate obligations using their bonds, the Federal government may have a difficult time figuring out how to repay without issuing more debt (or printing money) in its place. This is going to become a huge problem for the Federal government as a major source of funds is drying up and they have debt they have never had to pay before coming due.

The practice of the Federal government repaying SSA bonds is one that will only increase in the coming years. With each year that passes, more individuals will collect Social Security benefits and the system will be strained as this is not offset by additional payroll tax revenue. The SSA will redeem more and more of these bonds thus pulling more and more money away from the general accounts of the Federal government. This debt will almost certainly have to be monetized or refinanced. Any attempts to refinance the SSA debt may be made difficult by (potentially) rising interest rates which will make this a very expensive government endeavor.

The SSA is able to pay its obligations, for now. An additional long term problem that the Federal government may face from the Social Security program is what happens when it becomes insolvent. The SSA can use its bonds to make up its deficits for many years, but not indefinitely. At that point, they will either have to refuse to cover the payments that were promised to workers or to find new money to pay them. The Federal government would become a likely candidate to cover this shortfall (in addition to new taxes).

The headaches that Social Security will cause for the Federal government are about to begin. The government has gotten used to a source of funds that really were not theirs. Now this money needs to be paid back. Not only is the source gone, but the double whammy of having to pay new debts is about to hit as well.

The States Are Broke

I heard rumors that it might happen months ago, but I finally read today that several states would actually do it. Due to budget problems, a number of states, New York in particular, have plans to delay paying tax refunds to their citizens. Obviously there will be severe repercussions for making people wait to be repaid their over-payments. The problems that will likely arise range from voter anger at the polls to retarding the local economy.

Almost all of the states are currently running budget deficits. They generally pay for these deficits by taking out debt against future revenues. However, this practice does not always prevent liquidity problems for individual states. As a states debt increases, they might have the money to cover what they owe but do not always have the cash on hand to physically pay it. Famously, this happened last year in California when the state was forced to make some payments through I.O.U.s. This year, some states have found a new pile of cash to raid in order to remain liquid - unpaid income tax refunds. These states are hoping to use this money to cover their spending while making their citizens wait to be paid. Such a move might be advantageous as it uses cash on hand and, in most cases, is interest free. Hopefully, the refunds will be paid later in the year.

One of the largest problems that delaying refunds will cause is voter anger. Many people are eagerly waiting for their tax refunds to supplement their normal income, or lack-there-of. These citizens will not be quick to remember who caused them to be late on their rent check or car payment. Incumbent politicians in these states will likely be punished come their next election.

Another problem that will likely be caused by delayed payments is the slowing of local economies in these states. By not putting this money into the hands of people, who will likely spend it quickly, local businesses may experience slower sales than otherwise expected. Upon receiving my refund each year, I generally go out and spend a large part of it as do many other people. This spending can provide added revenue for businesses, potentially spurring additional investment and added hiring. Thus, but delaying these refunds local economic activity may be stagnated.

As several states consider delaying paying their citizens tax refunds this year, their governments must consider many potential consequences. They can grant themselves a delay in feeling some fiscal pain and gain an interest free loan. Yet, by following this policy they risk angering their constituents and hurting their economies. Such a decision must be carefully thought over before being implemented.

Breaking the Peg

For the past several decades, the Chinese government has attempted to boost its exports through a policy of undervaluing its currency. They used an artificial currency peg in order to stabilize the value of their currency, the renminbi (also known as the yuan), in comparison to the US dollar. They pegged the renminbi below its market value in order to make their goods cheaper on foreign markets and thus to increase demand for their production.

The Chinese have pursued their peg through a fairly complex policy of buying dollars from their citizens after they sell goods to the United States, then issuing yuan denominated debt and purchasing dollar denominated debt. In essence, they are taking dollars from their people, giving them back renminbi and buying debt from the American government. The net effect of this is to flood their domestic markets with yuan while pulling dollars out of their economy. This makes the dollar relatively expensive in relation to the yuan. The artificially cheap renminbi allows their goods to be relatively inexpensive on foreign markets, and this results in greater demand for Chinese goods. They constantly have a new supply of dollars as their factories sell goods to US companies and then sell the dollars back to the government.

However, this policy may soon be changing. A Chinese central bank governor recently signaled that they may un-peg their currency. He said that they would not be maintaining their current monetary policy 'indefinitely' and that they may allow their currency to float in order to speed up economic growth. The bank has gone so far as to study the potential effects of ending the peg.

Any move to end the peg would have huge effects on the world's economy. First, by increasing the value of their own currency the Chinese would make their goods more expensive in foreign markets. Likely, this would tamp down some of the huge demand for their production. However, the Chinese would likely replace the demand by selling more of their goods domestically. For foreigners, like Americans, this would probably cause the prices of many imported goods to rise. Gone would be the days where imported goods could be sold for a fraction of domestic ones. This might be inflationary for the US, but could likely give some support to the domestic manufacturing industries.

Other major affects would likely take place in the world's financial markets. The huge surplus of dollars the Chinese currently enjoy would likely dry up. This may cause them to purchase less foreign debt. This could force interest rates in the United States to rise as the government finds fewer major borrowers for Treasuries. Additionally, the Chinese would have less currency to invest in foreign companies. This might cause stagnation in the price of financial assets.

The effects of ending the yuan-dollar peg would be many. The Chinese government would cause their exports to decrease by making them more expensive. Such a move might help workers in the US as domestic production would be able to better compete with cheaper imports. However, this would come at a price. The price of goods would likely rise causing inflation. Additionally, such a move would force interest rates to increase making it more difficult to borrow money and issue debt.

To (Re)Pay or Not to (Re)Pay

A rather interesting article appeared a few days ago on the Bloomberg news wire. I for one did not realize that Iceland was having a referendum on whether or not they should repay the debt to the British and Dutch governments they incurred when their banking system had to be bailed out recently. The Icelandic citizens will be able to vote to either repay the debts of about $16,000 per citizen or to refuse to pay back their creditors. The issue here is two fold. First, what happens if the money is not paid back; and, secondly, should the money be paid back.

Obviously, there will be serious ramifications should the repayment measure be defeated. As the author pointed out, Iceland has an application to join the European Union. This would need to be approved by both of their main creditors, the UK and the Netherlands. It is fairly simple to assume that both of these nations would reject expanding the EU if their money is not repaid. Being unable to join the EU would be a blow to Iceland's attempts to expand its' economy and further integrate itself with the rest of Europe. Likely, this would result in slower growth or even economic stagnation. Additionally, Iceland will have an incredibly difficult time issuing new debt. Their credit ratings would crash and they would be forced to pay usurious interest rates on any debt they issued. Of course, this is assuming anyone would loan them money again. If unable to issue new debt, they might be forced to devalue their currency and open their people up to the threat of inflation.

The crucial part of this vote is should the money be paid back to creditors - is it in the interest of Icelandic citizens to allow their government to pay its debts? The article's author makes a three-fold case that the proper vote should be 'no'. His justification is that the debts were not the Icelandic peoples' fault. Instead, the blame lies with the bankers, the foreign governments and the depositors whose accounts needed to be repaid. The bankers took excess risk, the foreign governments wanted to bail out their own citizens (most of the failed deposits were held by UK and Dutch citizens) and the depositors also took risks by putting their money in non-guaranteed, high yield accounts. The problem with this justification is that it was still the Icelandic government who took out a loan to cover their banks' debts. The government did not have to do this, and when it did, it agreed to pay back the money.

Unfortunately for the Icelandic people, though it may be very expensive, the costs of not paying back their debt might be prohibitive. By voting 'no' they would, essentially, push their country away from European integration and borrowing money in the near future. Iceland would be forced to maintain a self sufficient and independent economy. Yet, by voting 'yes' the Icelandic people would force huge sums of their wealth abroad to creditors. This move would weaken the government and force it to take out additional debt as much of their revenue would be pushed to its creditors. However, a 'yes' vote would likely make joining the EU infinitely easier as they would have the support of the UK and the Netherlands.

I, for one, am grateful that I do not need to vote in such an election. The choices for Iceland and essentially lose-lose. There is no way for them to 'win' in this election. They are either forced to separate themselves from the EU and international credit markets or to impoverish themselves by paying huge sums to settle what is a questionable debt. If I was forced to vote, I would probably choose the 'yes' option. The debt was taken out by the Icelandic government, so it should be paid back by the government.

An Opening at the Fed

With the announcement today by Donald Kohn that he will leave the Federal Reserve board at the end of his term has given President Barack Obama an opportunity to shape the future monetary policy of the United States. Kohn, who was initially appointed as Vice Chairman by President Bush has been hailed as an incredibly influential member of the group which effectively determines the country's monetary policy. With this, and any other vacancies, Obama has the opportunity to nominate candidates who are sympathetic to his policy views.

This aspect is incredibly important with the Federal government following an expansionary fiscal policy driven largely by debt. The Fed has become a major purchaser of government obligations as traditional buyers lack the capacity to absorb larger quantities of Treasury Bonds. Additionally, the Federal Reserve's board is tasked with determining several very influential interest rates and dictating how much capital firms are required to hold on deposit.

Obama can, by appointing those who agree with him, shape the board to be sympathetic to the policy he and his allies in Congress carry out. He will likely look for someone who will be relatively dovish on inflation and who might hope to continue the policies of 'quantitative easing' through purchases of government debt.

Some have seen the Federal Reserve as a defacto fourth branch of the Federal government. Much like the Supreme Court, the Executive and Legislative branches have abilities to oversee the bank and nominate some of its members. Some people might even go so far as to say that the Fed is more important than some of the formal branches of government. With this retirement, President Obama has been given an additional opportunity to further influence the bank. Likely, Obama will find a nominee who will fervently support his policies through dovish monetary policy and continued support for purchasing Treasury debt.

Why the Euro Will Save the US Dollar

Many commentators have raised an alarm that the United States is gambling with its debt driven fiscal policy. They believe that the government is continuing to issue debt to pay for social programs. Fears have also arisen because one of the main foreign buyers of US debt, China, is signalling that it may decrease its holdings of dollar denominated debt. Other large buyers might follow similar strategies if they fear for the dollar's value. This could potentially endanger the dollars standing as a worldwide reserve currency. Such a move would likely force the Federal Reserve to increase volume of dollars in circulation. This expansionary policy is, in effect, a devaluation of the dollar which will lead to inflation.

One of the earliest and most influential economic equations I've ever learned was the simple MV=PY. This simple equation states that the supply of money times its velocity will be equal to the price level times output. If the velocity of money and output are constant (or at least moving at a glacial pace), then the price level is depended on the amount of money in the system. Thus, the amount of currency in circulation will drive inflation.

A large problem might exist for foreign buyers of Treasury debt is where they would move their money. Obviously, these countries might use some of this money for domestic spending and investment. Yet, there might be too much money to use just for those purposes. Countries would still need some type of assets to hold their reserves.

It was often mentioned that countries might move assets out of dollar denominated debt and into Euro denominated assets. The Euro was seen as a potential currency competitor of the dollar. However, as recent events, such as the debt problems in Greece, have unfolded the safety and value of the Euro have been questioned. Bets have been placed against the Euro and the value of some Euro denominated debt has fallen precipitously. So, it is increasingly unlikely that major foreign holders of US debt would move into Euro denominated debt.

The question then becomes 'where else?' Fortunately for the US government there really aren't many other options. It is possible that countries would also attempt to move into physical assets such as gold and oil, however, there are not enough of these assets to compensate for a move out of Treasury debt. The pound is unlikely because of domestic currency issue in Great Britain. The yen is unlikely because the Japanese followed a similar monetary policy as the US has, just many years earlier. Their debt pays little to no interest and their currency is not exactly safe from inflation. The only other major world currency is the yuan in China. A move to have that become a reserve currency is almost impossible as it is the Chinese who are a major investor in US debt. They are a country of surpluses to invest elsewhere, not domestically. Additionally, China has attempted to undervalue their currency relative to the dollar - any move away from US debt would likely break this peg.

As the Euro-zone is facing domestic currency problems, it is unlikely that the world would move to the Euro as a replacement for the dollar as a reserve currency. These problems might act to save the value of the dollar even in the face of what are normally inflationary devaluation policies. The dollar's savior is its demand, not its actual value. If there is nothing else to move into, demand will remain high in the face of the government's attempts to devalue.

The Downward Spiral of the States

According to a recent survey, individual American states are about to see worsening economic conditions even as the nation, potentially, emerges out of recession. The problems on the state level mirror those of the federal government save one important difference - the Feds can print money.

Over the last half century, state budgets have expanded as more and more services were provided without the necessary taxes to pay for them. While the federal government has a relatively easy time running a deficit, the states are forced to use much more draconian measures to balance their budgets. Many states are about to (or have been) lay off huge numbers of employees and begin cutting social programs while they may also need to begin raising taxes to cover their costs and service their debts.

The problems for the states may be multi-fold. First, as employees are laid off tax revenues are going to decline as will the demands on the unemployment and pension systems. But, as there are fewer employees, state governments will become less and less responsive. Secondly, as interest rates begin their inevitable move upwards, the cost for states to borrow money will become higher forcing the states to cut even more programs.

Unfortunately, there probably are no painless solutions for the individual states right now. A major part of the 2009 Federal government's stimulus package was transfer payments to the states to help hold up their budgets during the recession. As NJ Governor Chris Christie explained, these payments may have only delayed the inevitable pain which the states are going to feel unless the federal government continues them indefinitely. Such a move is highly unlikely and will be politically impossible.

The states are going to have to accept some pain now and then learn from their mistakes in the future. Plans must be made during prosperous years for the lean years. States also must limit the amount they allow themselves to expand when things are good so they do not need to make such deep and painful cuts when things are bad.

The End of European Sovereignty

George Soros wrote a rather interesting article in the FT this morning to outline some potential problems which the European Union is facing in its potential attempts to prop up the Greek government in the face of its debt crisis. He began his article discussing how the Euro was not a political union, but solely a monetary one and finds it difficult to reconcile such a financial system. A number of flaws are pointed out, specifically putting the proverbial cart before the horse in unifying only the monetary systems instead of the political system.

While I see the reasoning in his argument, I have difficulty fully accepting his arguments. He seems to describe the worst possible conclusion to the Greek (and potential Irish, Spanish, Portuguese) debt crisis as a collapse of the joint monetary system.

My first major issue with his thesis is that the Euro is a politically unifying force in Europe. By tying their monetary systems together, the European governments have intertwined their political structures as well. Stronger countries, like Germany and France are forced to act to protect the strength of their own financial systems from problems which could be caused by a collapse in their currency. When other governments, such as the Greeks, can damage the strength of the Euro, stronger nations must step in to protect not only their neighbors but themselves. Likewise, the European community is nearing steps to force the Greeks to institute austerity programs and increase taxes against their national will. The Greeks would potentially, in essence, cede their sovereignty to its neighboring countries.

Another major problem I see is the thought that the 'Euro' system could fall apart. It would be incredibly unlikely for the nations of Europe to abandon their common currency. Such a move would likely be incredibly unpopular with people who would see their savings and purchasing power collapse along with a defunct currency. Also, a move away from the Euro would likely take quite a long time to implement. Countries would have to re-institute national currencies from scratch - printing, valuing, etc. Such a move would be incredibly costly, not just in terms of the printing and distributing, but also politically and psychologically.

In my opinion, the Euro is here and it is not going anywhere anytime soon. While the value of a Euro may drop, it will not fall to zero or any other point to justify taking it out of circulation. Additionally, counties who have adopted the common currency have given up their independence. When neighbors can damage a country's economy through its currency, that country will act to protect itself however it can. If it must impede on its neighbors sovereignty and force it to take undesirable actions it will. And thus, the sovereignty of the Euro countries is no more.

A New, Mixed Regulatory Approach

While trolling through The Economist this week, I came across an article detailing potential next steps for those regulating the banking system. One section that stuck out to me was in regards to mark-to-market accounting rules for assets held on the balance sheets of financial institutions. While it may seem logical for financial institutions to value their assets at what they could be sold for on the open market, problems can arise when the bank has no intention of ever selling them. Many firms hold securities on their books as reserve assets since they have a greater return than simply holding cash - though there is added security.

Should the institution wish to hold such an asset, they must also value that asset at a 'market' price based on the value for which it could be sold. I do see a value in marking assets which are held for trading purposes at a mark-to-market value, but I think there must be a better way to base instruments meant to only be held on the balance sheet and never sold.

A hybrid solution to the accounting rules is a potential fix. For such an idea to work, the banks will be able to delineate some assets for 'trading' and others for 'holding'. Those assets held for trading would be treated according to the current mark-to-market rules. Their value would be determined on the open market and they would use existing tax regulations.

The difference in this model would be in the treatment of 'holding' assets. These securities would be placed on the balance sheet and have their values determined by a mark-to-model method. This would give the banks protection from declines in their values and the need to increase their reserves at inopportune times. The institution would be forced to declare which assets they would like to classify for this status. If the asset is held to maturity, it would be treated using the existing tax structure. However, if the institution wished to reclassify the asset they would be charged an additional tax surcharge. Such a penalty rate would curtail the reclassification of assets from 'holding' to 'trading' and prevent firms from benefiting under both sets of rules.

This solution would not solve all of the problems currently facing the financial industry, but it might help to support institutions in times of great crisis and would possibly even prevent panic selling of securities. Such actions can, potentially, act to stabilize markets and prevent crashes in the future.

To the Winners: Carry the Losers

As Greece comes close to defaulting on its national debt, the structure of the European Union as a whole is about to be challenged. It has widely been reported (WSJ, FT) that the member countries of the EU, led by Germany and France, have stepped up to prevent a Greek collapse. Such a move was made to protect the value of the European common currency. In the event Greece were to default, the value of the Euro would likely follow downward harming the finances of all EU members.

The safety net created by the EU countries for Greece was an action to protect their common monetary base. However, this move may have severe political consequences for each individual country and the continental system as a whole. What is of yet to be seen is how citizens in countries like Germany and France react to their tax dollars (or issued debt) being used to prop up spending in Greece - and possibly Ireland, Portugal and Spain. Likely, these moves will become increasingly unpopular unless the finances of their practically bankrupt neighbors can be quickly repaired.

The EU nations will likely demand new austerity measures along with increased taxes on countries they are forced to bail out. Unfortunately, as reported this morning, these measures are incredibly unpopular in Greece. It seems a strange situation where the populace of the beggar nation is protesting budget cuts while asking for protection from their creditors. Such actions will likely breed resentment and anger in the populations of the countries that are bailing them out. There can be seen a situation where a Greek government trying to fix their finances falls to a more 'generous' one. Meanwhile the governments in their neighbors may see defeats by more conservative parties who take a harder line on helping to support overly indebted neighbors.

Along those same lines, could this type of event ever occur in the United States? Obviously, the federal government will not see such problems as it could monetize its debts. However, individual states could see such situations. Places like California, New Jersey and New York, with large deficits could potentially run out of funds and access to debt markets. If this were to happen, there is little question that the Federal government would step in and bail them out. But, would these states act to fix their budgets or would they just continue on their paths and hope things get better? If they fail to change their policies there would be large amounts of resentment by the other states in the Union and severe political consequences.

The End of Easy Money

In his testimony before Congress today Federal Reserve Chairman Ben Bernanke gave a clear indication that his bank is to begin tightening monetary policy in the near future. His testimony gave a number of actions the bank is preparing to take to remove the liquidity it has created over the last few years. Once the bank begins taking its actions, such as raising the interest rate it pays on excess bank reserves along with its discount and federal funds rates, loan markets will quickly follow with higher demanded rates on all loans from corporate credit to federal debt. While these actions are necessary to stem any inflationary effects that may begin to creep into the system due to the flood of money in the last two years, they may be ill timed with the fledgling economic recovery and planned increase in government borrowing.

Though Bernanke only described the banks options as something they were beginning to consider, markets likely will not wait for action to price in higher interest rates. Any effects that are going to be felt will likely be felt much sooner than the Fed is predicting. A rise in any and all rates over the coming weeks is increasingly likely along with their associated effects on the financial sector as a whole.

Such a move might also have an impact on the government's upcoming fiscal plans. There have been recent rumors of a third stimulus or 'jobs' bill along with a proposed FY 2011 budget. All of these plans have have included a large amount of new Federal debt issuance. There were a number of relatively conservative estimates of the cost to service this debt in the budget proposal. Should interest rates rise, this debt will become increasingly expensive which may endanger the passage of such spending proposals. The government would be given three uncomfortable choices: spend less, pay more or tax more.

On a small side note, there might be an interesting arbitrage opportunity for institutions with access to the Federal Reserve system. The Fed currently is paying a 0.25% rate on excess deposits within its system while maintaining a overnight Fed Funds rate of 0.00-0.25%. There might be opportunities for banks to bet on a rise in the Fed's interest paying rate by taking longer term loans from the Fed system at any amounts up to 0.25% and holding them as excess deposits. Should the Fed then pay a higher rate of interest at anytime, that bank could essentially have a free 0.25% spread for the term of its loan.

Can An Unemployment Rate Drop Be Bad?

This morning, the national unemployment rate fell from 10% in December to 9.7% in January. On the surface this appears to be positive progress in the country's march out of recession. Yet, the unemployment rate fell as approximately 20,000 jobs were reported to have been lost. This seems to point to serious problems in the economy. Likely, the unemployment rate drop was caused by more and more people running out of unemployment benefits, dropping out of the labor force or taking part time work instead of full time work. These three events would all cause a drop in the purchasing power of the American citizenry which might signal problems on the horizon for businesses who need increased sales to expand and increase hiring. Unfortunately, such a move would have a negative spiraling effect on the national economy. Traditionally, the unemployment rate is seen as a lagging indicator of economic performance; however, in this instance it might be a signal of problems that are of yet to occur.

US Downgrade Danger?

I saw an article today in the Financial Times that Moody's was warning that the US may face a downgrade to its AAA credit rating unless it can achieve either more robust economic growth or do something to limit its increasing need to borrow. Obviously, such a downgrade would inspire political sniping and cause the government to pay more for its debt, but could there ever be a real danger of default? Since the US uses a fiat currency, in such a case where they lacked the funds to service the debt (or could not get anymore credit) they would just print new money. Clearly, this would devalue the dollar but it would also prevent an actual default. There is value in ratings for municipalities, states, corporations and countries that do not directly control their currency (the EU countries), but there is no real harm in a downgrade to a country like the US or the UK who can just print more money to cover their interest expenses. I didn't think it was Moody's (or any other agency's) responsibility to rate the projected future value of money as it appears they are doing with this morning's warning.

Not As Bad As I Thought - The 2011 Budget Deficit

Upon first thought the 2011 budget recently proposed appears to be a ticking time bomb with regards to the US budget deficit. However, upon deeper reflection it might not be so bad. Conceding the point that there are excess amounts of recession related social spending, a large portion of the deficit comes from expanding social security and Medicare payments. This might be what actually neutralizes part of the deficit's size. Looking at the current unemployment and underemployment rates there is a huge base of people not currently paying into these systems. If a quick economic recovery can be achieved, these people can massively increase the tax receipts upon which these programs are dependent. Thus while the expanded 2011 deficit is a major concern it might not be as large as currently feared.