On behalf of the Federal Reserve...

In this bi-weekly update we will have a closer look at the Quarterly Flow of Funds published by the Federal Reserve earlier this month. However as things are still following each other up rapidly we would like to start with the new reform plan President Obama has unfolded this week and which will trigger a clash between Capitol Hill and Wall Street.

Let us first outlay the most important parts of the Regulatory Reform Plan:

• The Federal Reserve Bank will become the ultimate systemic risk regulator
• Creation of a ‘Council of Regulators’
• Requirement of the originator and/or broker of a securitisation deal to participate over the lifetime of the structure
• Regulation of all OTC derivatives
• Increase Consumer Protection on financial advisory and investments
• New resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system, including large hedge funds and major insurers such as AIG.
• Lead the effort to improve regulation and supervision around the world


The first thing that strikes us is the increased power that is given to the Federal Reserve. In its mandate of ultimate systemic risk regulator the Fed will have day-to-day supervision of the largest bank holding companies. It will also have the power to supervise non-bank financial companies (read hedge funds) that reach a size and complexity comparable to these banks. The Fed is also likely to be given the final word on bank capital requirements, including a surcharge for the systemically important financial institutions. This is a lot of power given to a single institution which could come at a cost. One should not forget that the Federal Reserve until now has a lot of credibility and respect in the international financial market scene as a non politicised and independent institute. This reform plan will undermine this.

Secondly by getting access on a day-to-day basis to the management of banks and non financial institutions (read once again hedge funds) it is abandoning the free market principle which is the most important fundamental on which the US became a world leading nation.

We do agree that new rules have to be put in place to lower the systemic risk and force banks to pay attention to their mismatches on the ALM side. But directly interfering in the daily management is a step too far. Simple rules such as limiting the possibility of funding long dated assets (15-20-30 years) with 90 days CP would avoid a large part of the problems that we are in right now. A clearing house for the credit derivative market would make securitisation more transparent. A simple 70-30 ratio on mortgage financing versus equity participation of households buying a property could easily avoid that people leverage up on their housing and will limit the creation of a housing bubble.

The requirement of the originator to take a stake in the securitisation he is bringing to the market is a good initiative, however we want to point to the fact that a large number of banks already did this. Unfortunately there are a lot of examples of securitisation deals where the bank in question took a considerable stake but nevertheless the deal suffered considerable losses.

Consumer protection is also a noble initiative. However such regulatory initiatives have been taken already two years ago in Europe under the Mifid guideline and this has not made a significant difference. We would also like to warn against a pampering of the consumer. To a certain extent one should expect from every investor to do his own analysis properly. Why can a consumer do it when he decides to make a significant investment in for example a house, but does not have the same discipline when he decides to put the same money at work in a bond or stock or even a structure?

Part II on behalf of the Fed…

Last week Federal Reserve chairman Bernanke gave a less optimistic outlook on the economy. Although it is still ignored by the market as they are too occupied with their search for the famous “green shoots”. Prospects remain very worrisome even to a point that Mr. Bernanke came to admit that in certain places in the US things are even deteriorating.

Do not get us wrong. We would love to see things picking up. There is nothing more beautiful when the green shoots and the blossoms from spring are turning into tulips, roses and the caterpillar turns into a butterfly that can flirt from flower to flower.

The only problem in this debate is the lack of underlying fundamentals to justify the arguments. When we start a discussion with the romantics we do lack hard facts from their side. The only argument you hear is that confidence data are rapidly improving. Previously we referred to optimism growing on rising confidence data such as ZEW and consumer confidence surveys. We warned at the time to be very cautious with this kind of data as it is based upon a diffusion index and there is a statistical trap built into it. Remember our argument we made at the time that for example a rise from 25 to 35 is less significant as an increase from 45 to 49. The smaller gain is actually more significant, since it will only require a small further improvement, before actual economic growth is achieved. Apart from that, confidence is nothing more than a perception. The band on the Titanic was playing like there was no tomorrow too…

We on the other hand try to rely on quantitative data which leaves little room to argue with. In our ever lasting search for this type of data, the Fed is very helpful. Earlier this week we came across the Fed’s Flow of Funds Report which is a quarterly highly detailed statistical release on the shape of the US economy. Basically this was the data that made Mr. Bernanke admit last week that things aren’t that sunny as previously indicated.

For those who want to do some real number crunching themselves we share you the website where you can find the data. We had a closer look at it as well and picked out a number of bullet points that caught our eye immediately.

http://www.federalreserve.gov/releases/z1/Current/z1.pdf

To start with on page 7 we come across the borrowing activities split up per sector. We made a quick chart of it and see that basically the abrupt deleveraging process of the financial sector has been taken over by the government. One can argue that the deleveraging is completely offset by the fiscal stimulus pumped in by the US government.

Of course this phenomenon you can notice as well when one has a closer look at the expansion of the Fed’s (and other central banks) balance sheet. The government is replacing the private sector and on previous occasions we have pointed out that the multiplicator effect of governmental stimulus towards growth is very low. We reckon that per USD spend by the government only maximum 30 cents is added to growth.

Table US Borrowing by sector

Source: Federal Reserve Flow of funds

One page 11 we get a good indication about the condition of the credit market. The data clearly shows that the credit market is not improving at all. On the contrary there are even signs that after the Lehman collapse things were more or less contained. It is more specifically in Q1 of this year that circumstances deteriorated. This is the same quarter that government officials started to talk about green shoots.

For example if one has a look at the “open market paper” you will see that in Q4 the activity was to some extent stable, USD 81.5 bln. Only since Q1 of 2009 things are falling again of a cliff: minus USD 662.5 bln.

Also what direct lending concerns from banks things only started to deteriorate in the last quarter: minus USD 856.4 bln. Basically this means that banks are pulling out of the credit market at a pace never seen before.

Similar developments are seen from non bank lenders which contracted by USD 468 bln and mortgages and consumer credit.

This shows that demand is only driven by people who have cash on their accounts. The only borrower in this market is the government, this with an astonishing USD 1,442.8 billion in Q1 (line 3).

The ABS market, one of the markets that the US government identified as need to be supported, is not showing any signs of stabilization. Once again in the last quarter it fell further to a new record low of minus USD 623.4 bln. This is a crucial part in trying to stabilize the housing market.

When we scroll further in the document to page 36 we find out that Security Brokers and Dealers are still disinvesting massively. In Q4 of last year there was of course the exceptional effect of the Lehman debacle where USD 3,336 bln got unwound. However in Q1 of this year this still went on and $ 1.159.2 bln of investments got turned back into cash. The US Treasury, who is desperate to find any investor willing to put money in their bonds, saw the brokers selling off $ 424 bln.

A similar phenomenon comes from the households who are dumping their Fannie Maes and Freddie Macs like there is no tomorrow in the hunt for cash. USD 1,395.7 bln of GSE securities were sold in Q1 of this year.

We have talked about the issues in the Letter of Credit market on several occasions. International trade, due to the implosion of the trade credit market, is as good as dead. Similar as the households, as an entrepreneur or business leader you better have cash in the bank if you want to maintain your inventories as the trade credit door is closed. (cfr. page 51 lines 3 and 10 make this picture very clear)

Towards the end of the report the most astonishing number arises and shows how deep the wounds have been cut by the crisis: the loss of wealth among households. Over 2008 in total USD 10.88 trillion of wealth was lost. The trend continues during the Q1 of 2009 where another USD 1.33 trillion of wealth was destroyed. From the start of the Great Credit Crisis in 2007 in total approximately USD 13.9 trillion went lost in the US alone.

Losses of this dimension are going to take a very long time before people start spending back like in the good old days. All of this has a deep impact on the retail sector and restaurant industry. Quite anecdotally we observed it with our own eyes during one of our latest business trips to the US. In Greenwich and Westport, which are the Beverly Hills of the East Coast, you see supermarkets and high brand international chains closing their doors.

We agree with one of our favourite overseas analysts Mr. Weiss that all we have seen so far is rhetoric of perceptions creating the ultimate pitfall for investors by making them believe that the situation is improving and soon we will be seeing (robust) growth again. In the meantime however, as the report clearly shows, the Federal Reserve is stretching its balance sheet to such an extreme that it has transformed itself in the ultimate SIV that has to keep the US economy on the rails.

The question remains how long can they keep doing this? Can Mr. Bernanke take even MORE radical steps? Can he boldly go where no other modern-day central banker has ever gone before?

Not without shooting himself in the foot! It still won't be enough to avert a continuation of the debt crisis. Indeed, all it can accomplish is to kindle inflation fears, drive interest rates even higher, and actually sabotage any revival in the credit markets.

The nearly $14 trillion in financial losses suffered by US households has inevitable consequences. And massive, nonstop borrowings by the US Treasury in the month’s ahead ˜ driving interest rates still higher ˜ can only make them worse.

Our warning: If you fall for Wall Street's siren song that "the crisis is over," you could be in for a fatal surprise.

Don't believe them. Follow the numbers we have highlighted here. Then, reach your own, independent conclusions.

The unemployment - inflation theme

Dear readers,

In this week’s report we would like to pay attention to the debate of unemployment versus inflation, this from an alternative angle by using behavioural economics. The findings will be applied to the current macro-economic situation in the US.

Among classic economists, such as Keynes and Samuelson, there was a strong belief in the positive relationship between low unemployment and permanent high growth, highlighted by the Philips curve (Figure 1) which shows high levels of inflation only to be reached when unemployment is exceptionally low.

Figure 1: Illustration of Philips Curve of US in 1960.



Source: Wikipedia


Friedman was one of the first to neutralise this thesis by introducing the concept of ‘money illusion’, which refers to the tendency of economic agents to think in nominal opposed to real terms. This is a typical pattern among monetarists as they make the assumption in their theories that all economic agents act rationally.

This assumption has been attacked over the last 5-7 years as behavioural scientists are gaining importance in the debate. Proof of this is the Nobel Prize reward to Kahneman in 2002, for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty. (1)

However, the money illusion does play an important role in the mechanics between unemployment and inflation. With the help of behavioural finance we will quickly notice that money illusion is the missing link in the natural rate theory.(2)

In the footprints of Kahneman, G. Akerlof and R. Shiller have done extensive research on this subject and give further guidance on this issue in “Animal Spirits”. Once again it is like a place where tectonic plates come into contact with each other. In this debate it’s the Chicago School under the guidance of the great and late Milton Friedman on the one hand versus the introduction of irrational behaviour to text book economics by the behavioural scientist.

Of course, mainstream economists do not like this approach as it becomes fairly impossible to model or quantify economic relationships when elements like uncertainty are being added to their models. They think in terms of probability which can be mathematically formulated. However, uncertainty, like intuitive behaviour, can not be expressed in a mathematical equation. Here psychology and social group behaviour will lead the way.

The inflation-unemployment debate follows a similar rationale. In the current economic climate jobs are at risk and employers are cutting back on labour as excess capacity outpaces demand. However before an employer (contrary to what many socialists believe) will decide to lay off people, he will look at other options such as reducing productivity which basically comes down to cutting back on the number of working hours and even salary cuts.(3)

Certainly in a deflationary environment wage cuts could be more defendable as disposable income rises as opposed to falling prices. Unfortunately there is something fundamentally rigid between this relationship as we all consider wage cut s as being highly unfair. Of course this is an intuitive approach but statistical date underlines this thought.

“Downward money rigidity can be easily detected from data on wage changes. All one needs to do is look at how often wage changes of different magnitude occur. Suppose we see that wage changes bunch at exactly zero, and there are many more wage changes just above zero, than just below zero. Then we can conclude that employers stop to think before they give their workers wage cuts.”

Further insights are given by Truman Bewley who did a similar qualitative approach.(research conducted in 1999 based upon 334 interviews)

He came to a similar conclusion that in the employers opinion workers would view wage cuts as unfair. They would reduce their commitment to their jobs. Furthermore when the economy revived, they would still be angry and thus more likely to quit.

Employees would only accept exceptional circumstances, such as eminent bankruptcy, as a last effort to save their jobs. Mainstream economists have finally accepted this thesis of wage rigidity but still consider the impact as marginal.

Akerlof did research on this to what extent wage rigidity plays a role. He and his colleague Dickens made simulations on the impact on unemployment of going from 2% to zero inflation. In the benchmark simulation, a permanent reduction of inflation from 2% -> 0% increases the unemployment permanently by 1.5%.(4)

A back-of-the-envelope calculation shows why these results occurred and so robustly. “If workers resist wage cuts, when inflation is lower, their wages will be higher. In the benchmark simulation they would be higher 0.75% if inflation would be 0% rather than 2%. The 0.75% on wages translates into an increase of unemployment by 1.5%.” (5)

How do we know? Akerlof continues that there is a rule of thumb that comes from the Philips curve itself. It takes a 2% increase in unemployment to reduce inflation by 1%. Therefore to neutralise the 0.75% cost increase of the companies, unemployment must rise by 1.5%. This argument is made precisely, with the underlying equations shown, in both Akerlof (1996-200) and Akerlof and Dickens (2007).

If we apply these findings on the current economic data of the US we come to the following findings.

US Inflation dropped by a staggering 6.3% (this reflects a drop from its high at 5.6% in July 2008 to a deflation level of 0.7% late in April 2009). Let us now compare this with the US unemployment rate at the respectively dates. July 2008 unemployment was at 5.8%. April 2009 unemployment stood at 8.9%. As unemployment is a lagging indicator, this would mean the US unemployment rate could still potentially rise to 18.4%. This is under the assumption that the Fed does not succeed in fighting deflation.

Of course a number like this needs to be double checked with reality as well. Our own reference in this case is Japan during the 1990s. The December 1991 inflation was 2.7% at the time. This continued to drop over the next three years to a negative number of -0.3% at the beginning of 1995 and stayed there for the next five to six years. Simultaneously unemployment rose from 2% to 6 % over that period.

This is a much lower factor compared to the study of Akerlof, which is 1.33. For further reference we also checked the Philips curve of Germany, which showed an even lower factor of approximately 1.15.

Important to note in the comparisons of wage inflation versus unemployment among several countries one needs to take into account the influence of unions. We can conclude that the factor in countries where the unions have significant power, such as Japan and Germany, the factor will be rather low. A trivial reasoning goes for countries with low union influence such as the US.

In this case let us assume that the factor of Akerlof is overoptimistic and that the relationship is slightly higher than Japan, for example 1.5. In this case we still come out at a potential unemployment rate for the US at 15.25%. Even a similar factor of 1.33 as in Japan would leave us a number of 14.18% for the US.

The major conclusion of this exercise is that unemployment in the US has much further to go in the coming years under the assumption that the Fed does not succeed in re-inflating the economy. This has two major consequences. First of all we need to take into account that the US will face a prolonged period of below par growth. The second and more eminent consequence will be on the state of the banking industry. Remember that the US Government based their stress-test of the solvency of the US banking industry on the assumption of an US unemployment rate of 8.8% which is already lower than the current rate.

Going forward the unemployment rate has further to rise and as a consequence US banks will face another capitalisation round.

This also means that in the current environment the inflation hype is a bit too early to jump on the band wagon. Of course there will be huge inflation concerns 2-3 years from now, but at this very moment we are still in a deflationary environment.

The current rise of US Treasuries and inflation has more to do with the concerns the market has on the aftermath of the astronomical debt build up that now needs to be issued. To put it into perspective, the US government needs to issue $ 1.8 trillion over the next 10 months. Last year this was “only” $ 400 bln. Take into account that also the UK government needs to come to the market with close to a trillion. The EU governments and Japan will have similar amounts and soon we get a situation where everybody is rushing for the same fire exit. It is this which causes great concern and nervousness.

But at the same time, as unemployment rises, salaries remain contained and have a considerable deflationary impact.

This is a great dilemma for central banks who see their QE initiatives not working as the long end of the curve is running away from them..

1. "Nobel Laureates 2002". Nobelprize.org. http://nobelprize.org/nobel_prizes/lists/2002.html. Retrieved on 2008-04-25.
2. The natural rate theory describes this mechanics as mentioned above by arguing that Actual unemployment cannot fall below the NAIRU, and the inflation rate is likely to rise quickly (accelerate) in times of strong labor demands during periods of growth. It is sometimes referred to as the "natural rate of unemployment" as well, although this term describes an estimated unemployment rate derived from the market's actual performance while the NAIRU is calculated from the Philips Curve.
3. See studies of wage stickiness in Australia, Japan, Germany, Switzerland, USA an UK by Kahn, Card and Hyslop (1997)
4.Similar results were obtained from econometric estimations and in hundreds of other simulations, in which parameters were chosen randomly over a reasonable range.
5. George A. Akerlof and Robert J. Shiller, “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism”, Princeton University Press, 2009