Enlightened Economics

Economics for an Enlightened Age

Posts Tagged ‘credit creation’

• Severe Debt Scarcity Coming to US

Posted by Ron Robins on December 30, 2010

By Ron Robins. First published December 26, 2010, in his weekly economics and finance column at alrroya.com

If US consumers believe it difficult to borrow now, just wait! In the next few years credit conditions are likely to go back seventy years when private debt was difficult to obtain. Most Americans intuitively believe there is too much debt at every level of society. But the economic and political vested interests do not want them worried about that. They want to give them credit to infinity to keep this economic mess from imploding. The US Federal Reserve’s new round of quantitative easing (QE2) is clear evidence of that. However, Americans are right about their inordinate debt load, and future economic conditions are likely to create a severe debt scarcity.

The principal reasons for the coming debt scarcity are that ‘debt saturation’—where total income cannot support total debt—has arrived, say some analysts; also, the growing understanding that adding new debt may not increase GDP—it could decrease it; and that the banks and financial system are a train wreck in waiting, eventually being forced to mark their assets to market, thus creating for them massive asset write-downs and strangling their lending ability.

The realization that debt saturation has arrived will not surprise many people. But understanding that new debt can decrease economic activity might surprise them. And the numbers illustrate this possibility. In Nathan’s Economic Edge, Nathan states, “in the third quarter of 2009 each dollar of debt added produced NEGATIVE 15 cents of productivity, and at the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP!”

In fact Nathan also shows that for decades, each new dollar of debt produces less and less in return, from a return of close to $0.90 in the mid 1960s to about $0.20 by 2007. One explanation for this is that as societal debt increased it focused disproportionately on consumption rather than productive enterprise, whose return appears greater.

On the subject of consumption, the renowned economist David Rosenberg in The Globe & Mail on August 16 stated that “U.S. household debt-income ratio peaked in the first quarter of 2008 at 136 per cent. The ratio currently sits at 126 per cent, but the pre-2001 norm was 70 per cent. To get down to this normalized ratio again, debt would have to be reduced by about $6-trillion. So far, nearly $600-billion of bad household debt has been destroyed.” This data reaffirms Americans growing aversion to debt, that debt has become too onerous, and is suggestive of debt saturation.

Replacing declining consumer debt is the exponential growth of US government debt. For 2009 and 2010, the combined US government’s fiscal deficits required or require borrowing an extra $2.7 trillion or so. Yet with all that spending—combined with about $2 trillion of ‘money printing’ from the US Federal Reserve (the Fed)—it created only around $1 trillion in increased economic growth!

One may argue that the phenomenal US government borrowings will provide returns far into the future and that the present low economic returns are due to not funding areas with potentially better returns. Some economists say that spending on infrastructure and education provides the best returns. However, with economists such as Nobel Laureate Paul Krugman and numerous others predicting huge continuing deficits for years ahead, and with a Japan-like slump in economic activity, the odds are likely that any new borrowed dollar will continue to provide only poor returns for years to come.

A further, major reason for the coming debt scarcity will be the tremendously impaired financial condition of the banks. The values assigned to many bank assets are fictional according to numerous experts. QE2 is about many things but one of them is aimed at delaying the potential for implosion of the banking system. In 2009, the Financial Accounting Standards Board (FASB) caved in to government and banking industry lobbyists to allow many bank assets to be ‘marked to fantasy’ and not ‘marked to market.’

This viewpoint is best expressed by highly respected Associate Professor William Black (and formerly a senior regulator who nailed the banks during the savings and loan debacle) and Professor L. Randall Wray, who wrote an article on October 22 in The Huffington Post, entitled, “Foreclose on the Foreclosure Fraudsters, Part 1: Put Bank of America in Receivership.” They wrote that, “FASB’s new rules allowed the banks (and the Fed, which has taken over a trillion dollars in toxic mortgages as wholly inadequate collateral) to refuse to recognize hundreds of billions of dollars of losses. This accounting scam produces enormous fictional ‘income’ and ‘capital’ at the banks.”

However, the Federal Reserve may be realizing that it might not have been such a good idea to buy some of these ‘toxic’ securities. Bloomberg reported on October 19 that, “citing alleged failures by Countrywide to service loans properly… Pacific Investment Management Co., BlackRock Inc. and the Federal Reserve Bank of New York are seeking to force Bank of America Corp. to repurchase soured mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit, people familiar with the matter said.”

Also, on November 2, CNBC reported that Citigroup could be liable for huge amounts of toxic security buy-backs as well. “If all four mortgage acquisition channels turn out to be equally as defective… Citi’s liability for repurchases could soar to about $100 billion dollars at a 60 per cent defect rate – and to around $133 billion dollars at an 80 per cent defect rate.”

Clearly, such numbers are staggering. These, as well as many other banks and financial entities, could collapse. Politically, in the present circumstances, it would be difficult for the US government to provide massive new funds to support the financial system. Therefore, it will be up to the Fed to decide what to do.

If the Fed prints ever increasing amounts of new money to try to moderate the financial collapse, hyperinflation could be the result. If it does not print massive amounts of new money, a deflationary depression could be born.

In high inflationary or hyperinflationary conditions, few will want to lend as they get paid back in dollars that are declining very rapidly in value. In a deflationary episode, lending is reduced due to huge loan losses. Therefore, during either, and/or after such events, debt scarcity will be in full force.

Data indicates that American consumers do not want to increase their debt. Debt saturation is occurring, and with it a declining return on each borrowed dollar—even for the US government. Most significantly, the banks and the financial system will probably soon experience a new round of massive real estate related losses and subsequent financial institutions’ bankruptcies. Thus, a new major financial crisis will likely soon engulf America, greatly impairing its lending facilities and creating a severe scarcity of debt.

Copyright alrroya.com

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• New Bank Regulations Likely to Fail

Posted by Ron Robins on December 22, 2010

By Ron Robins. First published December 15, 2010, in his weekly economics and finance column at alrroya.com

New banking and financial industry regulations in the US and the Basle III rules for banks globally—might fail on key issues. The newly enacted US Dodd-Frank Wall Street Reform and Consumer Protection Act, despite its noble purpose to prevent further financial chaos, is unlikely to do that. And the Basle III requirements for higher and better quality bank reserves are good on paper, but full implementation is improbable amidst likely future hefty bank losses.

At the heart of the financial crises were derivatives, and as Warren Buffett the famed investor has warned, “derivatives are financial weapons of mass destruction.” Yet, after about two years of Congressional wrangling, the Dodd-Frank bill incorporates a rough future structure for derivatives but authorizes yet another committee to report back in the spring of 2011 with detailed regulations governing them. And the old expression, ‘the devil is in the details,’ is never more apt than in this instance.

Already, US Banks are calling for derivatives called ‘foreign exchange swaps’—a $42 trillion market—to be exempt from the rules.

Derivatives are major profit centres for the too-big-to-fail US banks. These banks have repeatedly told US lawmakers—who receive considerable campaign funding from them—not to restrict those profits. Because of the influence of Wall Street on the Obama Administration and the US Congress, it is difficult to be hopeful that when it comes to the detailed regulations, and especially their enforcement, that much will really change concerning US banks’ derivatives’ activities.

Two particular varieties of derivatives are at the centre of our financial debacle. They are mortgage backed securities (MBS) and credit default swaps (CDS). The latter, though originally considered ‘insurance policies’ against debt default, are now frequently gambling vehicles that incentivize the taking-down of struggling companies (AIG)—and now, governments (Ireland?).

The size of the derivative problem for US banks cannot be overstated. As Alasdair Macleod, a British banker and economist remarked on October 28, “according to the FDIC [the US Federal Deposit Insurance Corporation], outstanding derivatives held by US banks increased from $155 trn to $225 trn between mid-2007 and mid-2010. In other words, since the credit-crunch the derivative bubble in the US has grown a further 45 per cent and is now fifteen times total US GDP, literally dwarfing the banks’ total equity, which is only $1.35 trn. Consider this fact: derivative exposure is 189 times total bank equity.”

Aside from the derivatives issue, and also not addressed in the Dodd-Frank bill, are the two massive US mortgage progenitors now on US government life-support, Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac were formerly somewhat private institutions and own or guarantee about half of all US residential mortgages. But as the real estate crises exploded and due to their potential for vast losses that could paralyse the housing markets, the US government commandeered them in September 2008.

The principle offering in the Dodd-Frank bill concerning Fannie Mae and Freddie Mac is that by January 2011 President Obama offers a proposal to Congress to bring them out of government receivership.

Thus, on the two vital issues of derivatives and real estate, the Dodd-Frank bill seems queasy and deficient. These inadequacies allow for a re-ignition of the financial meltdown at almost any time.

Acknowledging the severe problems in the banking industry, banking regulators have introduced new global banking rules. In September, the Bank for International Settlements (BIS) in Geneva, Switzerland—which sets the regulations that banks everywhere generally adhere to—issued its Basel III regulations, which are due to come into effect for all banks between 2013 and 2019.

Basel III’s most important requirement will be that banks hold higher and better quality reserves.

But the BIS may be too optimistic about the ability of many banks, particularly the too-big-to-fail banks, to reach the new reserve requirements. For instance, a Reuters report on November 21 said, “the new Basel III banking rules will leave the biggest US banks short of between $100 billion and $150bn in equity capital, with 90 per cent of the shortfall concentrated in the top six banks, the Financial Times said, citing research from Barclays Capital.”

However, these equity shortfalls may well err on the low side. In the next few years, US and European banks especially, are likely to be hit with big waves of new losses related to real-estate, derivatives, and sovereign debt.

Real estate losses because US and European banks have still not written-off their full potential losses concerning toxic MBS that they may have to buy back due to newfound paperwork improprieties related to the emerging foreclosure fraud, as well as mortgage losses generally, on foreclosed and other properties.

Additionally, banks may suffer further huge derivative losses as they are eventually forced to price certain derivative and other asset classes at more realistic appraisal values instead of the ‘mark to fantasy’ that often now exists.

And recently, an even greater potential hit to banks’ capital has arisen: the possibility of gargantuan losses on bad sovereign debt in the EU and elsewhere.

On September 13, The Economist magazine had this to say on the MBS and derivatives issue relating to Basle III. “The most serious failure in Basel III is that it doesn’t address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights [for instance, risks associated with MBS]… What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.”

The US Dodd-Frank bill either passes the buck or overlooks the very problems that led to the financial meltdown, and the Basel III regulations may be rendered impotent due to massive future bank losses. Thus, these new bank regulations are likely to fail.

As Henry Ford, the founder of the Ford car company once said about banking, “it is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

Copyright alrroya.com

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• Pre-Conditions for a Sustained US Economic Revival

Posted by Ron Robins on April 21, 2008

The US has achieved many periods of sustained and rapid economic growth. And it can do so again. However, as history demonstrates, a big bust results if the growth is spurred by excessive monetary and credit expansion. For the past 25 years or so the US economic expansion has followed the woefully excessive monetary and credit expansion script. The US will not be able to pull itself out of the present economic malaise without dealing with its inordinate levels of debt and ‘exponential’ credit growth.

It is rather sad when most economists and investment industry professionals do not talk about the enormity of the debt and credit expansion problem. Unfortunately, it seems these ‘experts’ are either told to shut-up, prefer to overlook the obvious, or to simply lie about it being a problem! After all, what bank economist wants to tell his bank that its customers should reduce their borrowings, and thereby reduce the bank’s lending and subsequent earnings! More than likely the bank’s stock price would plummet. There is simply no incentive for most establishment economists to be truthful and every reason for them to lie.

For the US to experience a true long-term economic revival, I believe four things need to happen.

1. US debt growth will have to about match, dollar for dollar, GDP and income growth.
Presently it takes around $6 of new debt to create $1 increase in GDP and $4.75 of new debt for every $1 increase in national income. This is bubble territory. Look at this historical chart showing the explosive growth of America’s debt in relation to its national income.

Source: Michael Hodges America’s Total Debt Report/financialsense.com

If income grows slowly while borrowing grows rapidly, eventually there is a solvency problem. That is where the US is today. If the borrowing were primarily to increase overall productive capacity – the increase in production would have created greater income to help offset massively increased borrowing. But this has not happened. Much of this bloated US debt load is concentrated in the financial, mortgage and government sectors, and for the financing of its trade deficits. The debt contraction will be particularly acute in areas related to the financial and mortgage industries and generate extraordinary difficulties for the economy at large.

2. Debt to GDP ratio has to come down by around one-third
Debt at around 350% of GDP and growing 50-100% faster than the rate of GDP growth for more than 25 years – is utterly unsustainable. Following on from point 1 above, the US is basically beginning to experience an insolvency problem. Credit availability is declining while default rates soar. As a result, it has to reduce its overall debt burden. Nations frequently resort to inflating their money supply to deal with their debt burden, as Germany did in the early 1920s and Zimbabwe is doing today. So with the significantly increased amount of money swashing around, debts not being indexed to the growth of the money supply, are more easily paid off. Present moves by the US Federal Reserve now indicate that this is the path they have chosen. According to shadowstats.com, the broadest measure of US money supply is growing at an annual rate of around 17%!

3. Personal savings rates have to move beyond 10% per annum– from around zero at present.
High growth economies have high savings rates. It is that simple. The savings go towards spurring productive capacity – rather than to consumption – and produce fast income growth. In most years between 1952 to the late 1980s, the US enjoyed a personal savings rate above 10% of income. (See this graph by the Bureau of Economic Analysis.)

4. The above 3 conditions have to persist.
It is no secret as to what are good, or bad, macro-economic conditions. The above are key conditions that have to be met to ensure true, long-term, high growth macro-economic performance.

Summary
The message is that the US must significantly reduce its overall debt levels, avoid building-up new debt in excess of GDP or income growth, and for individuals to start saving again. I have no-doubt that these conditions will be met. But before they are met the US is likely to experience an extended period of rolling recessions over many years. And a depression cannot be ruled out either. During this process I expect to see among Americans a transformation to higher consciousness and a growing understanding of economics and its relationship to natural law and the environment. Americans, and people everywhere, will come through this much wiser. A new global Enlightened Economics framework will be created and form the basis for improving living standards and quality of life for all in our world in the years to come.

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© Ron Robins, 2008.

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