After the fallout from the crash of 2008, banks, especially regional and local banks, are finding they need to adapt to a profit squeeze. Add on top of this new regulations from the financial overhaul bill, and these banks are going to look more like banking utilities than profit centers.

According [...]]]> Banks Don’t Want Your Money

After the fallout from the crash of 2008, banks, especially regional and local banks, are finding they need to adapt to a profit squeeze. Add on top of this new regulations from the financial overhaul bill, and these banks are going to look more like banking utilities than profit centers.

According to a report released by Accenture:

“The subprime segments that drove very high margins prior to the crisis have effectively disappeared,” said the study, which was issued last week. “They are too expensive for many banks to serve now that their risk profile has been fully recognized and priced in.”

Of the 46 banking executives contacted, just under half told Accenture that the profitability of their average customer had dropped 5% to 11% since the crisis began. A further 11% cited a drop in profitability of greater than 15%. And nearly two-thirds of the executives reported an increase in “shopping around” for services, meaning customer-bank relationships are becoming more volatile.

It turns out that customers want more control over their banking activities.

A look at earnings reports show that bank earnings are improving, but:

These small banks continued to get hit with nonperforming loans and chargeoffs, but they did not take as bad of a beating as they did the previous quarter and a year earlier. Median net income rose by 4%-9.6% from the previous quarter depending on the region, according to a report from Sandler O’Neill & Partners LP and SNL Financial LC. At the same time, regional declines in nonperforming loans ranged from 2.3% to 9.5%.

The key to profitability: “Lower expenses, higher net interest income, and the strides in credit quality fueled earnings growth.”

Many community and regional banks have aggressively charged off loans, mostly in commercial and construction financing. Despite signs of stability in delinquencies, banks still have to reappraise properties that serve as collateral. And when appraisals come in lower, the bank has to write it down, whether or not the loan is delinquent which in turn, hurts capital. …

Though there is still a lot of liquidity, there is not much loan demand, so banks continue to contract balance sheets overall …

Here’s the shocker: banks don’t want your deposits because they are too expensive to maintain when their margins are being compressed:

With attractive lending opportunities hard to come by, bankers are finding themselves doing what would have been unthinkable just two years ago: discouraging deposits. Most large and regional banking companies are drowning in deposits, raising concern that excess liquidity could be a drag on earnings in coming quarters.

Though interest rates on deposit accounts are manageable, due in part to historically low rates, costs remain associated with handling those relationships. Banks have also seen their ability to charge certain fees, on overdrafts, for example, constrained by the recent wave of financial reforms.

Now the primary options left for banks involve turning depositors away or housing deposits at the Federal Reserve. … “The only way to get a higher yield is to take on more risk, and bankers are saying they aren’t willing to do that yet” …

“The bottom line is that it hurts your margin if you get a lot of deposits and have nowhere to put them” …

Early this year, a large inflow of deposits benefited banks despite limited opportunities to turn around and lend the money. Instead, bankers could let higher-rate brokered certificates of deposits mature, replacing them with the lower-cost “core” deposits. They were also investing some excess funds in securities, but regulators this year warned against such a strategy due to the interest rate risk associated with hefty portfolios.

More unintended consequences of legislation just at a time when the Fed and the Administration want to increase liquidity.

Some excerpts:

One of the nation’s last sources of no money down financing for home loans appears to be making a comeback: Legislation that restores a Department of Agriculture home-buying program is headed to President Barack [...]]]> This was reported today in the Wall Street Journal. I have nothing to add to this except: Yikes!

Some excerpts:

One of the nation’s last sources of no money down financing for home loans appears to be making a comeback: Legislation that restores a Department of Agriculture home-buying program is headed to President Barack Obama’s desk for signature.

The legislation makes the USDA’s Single-Family Housing Guaranteed Loan Program self-sufficient, the National Association of Realtors reports. Borrowers will have to pay a higher “guarantee fee” of 3.5%–essentially upfront mortgage insurance–but the fee can be folded into the mortgage.

Buyers won’t mind paying a bit more in fees, says Sue Botelho, a senior mortgage advisor with Waterstone Mortgage Corp. in Ft. Walton Beach, Fla. “It’s great news,” she said. “It’s a huge part of my business. I am thrilled.” …

… [T]he program, offering no-money-down loans in certain parts of the country for low- and middle-income borrowers, exhausted its $13.1 billion funding earlier this year, leaving some would-be buyers fearful their financing would fall through. USDA loans were particularly popular this year as first-time buyers tapped the government’s federal home buyer tax credit. They have until Sept. 30 to close. …

… The USDA program is considered safer because up to 90% of the purchase amount is guaranteed, meaning the agency will pay should the borrower default.

The USDA has previously said that last fiscal year’s foreclosure rate was 1.72%, well below the Federal Housing Administration’s 3.32%. Borrowers also can’t make more than 115% of a county’s median income, preventing McMansion-sized loans: The average USDA loan is $112,000.

The strong guidelines weed out potentially troublesome borrowers, Ms. Botelho said. “When they approve a loan, it’s a very, very good loan,” she said.

Economic activity has continued to increase, on balance, since the previous survey, although the Cleveland and [...]]]> The Fed came out with its Beige Book today, a summary of economic activity for June to mid-July in all of its twelve districts. The report overall noted “modest” growth if not slowing growth. According to their report:

Economic activity has continued to increase, on balance, since the previous survey, although the Cleveland and Kansas City Districts reported that the level of economic activity generally held steady. Among those Districts reporting improvements in economic activity, a number of them noted that the increases were modest, and two Districts, Atlanta and Chicago, said that the pace of economic activity had slowed recently.

Of note in their report:

Commercial and industrial real estate markets continued to struggle in all twelve Districts. Overall, vacancy rates were flat to slightly increased and continued to exert downward pressure on rents.

Nearly all Districts reported sluggish housing markets in the months since the homebuyer tax credit expired on April 30.

Reports on retail sales during the early summer months were generally positive, although in most Districts the increases were modest.

Manufacturing activity in most Districts continued to move up since the last report, although the pace of activity slowed or activity leveled off in the New York, Cleveland, Kansas City, Chicago, Atlanta, and Richmond Districts.

Reports on banking conditions were largely mixed across the Districts.

Most Districts reporting on credit standards continued to note that lending standards remain restrictive.

The Fed doesn’t like to sound too negative in its reports, and it won’t indicate a slowing until we are well into it. I have reported that a slowing economy is a trend. Chairman Bernanke said last week:

[That] there was “unusual uncertainty” over the economy’s outlook. He told Congress the Fed, which has already slashed interest rates close to zero, was ready to take further measures to support the economy if necessary. …

The U.S. economy shed jobs in June for the first time this year and the unemployment rate remained high, adding to concerns that the pace of the recovery could slow in the second half.

Also today, the report on durable goods orders came out:

The manufacturing sector sputtered in June, according to new durables orders. New factory orders for durable goods in June fell 1.0 percent, following a 0.8 percent drop the month before. The June numbers fell well short of market expectations for a 1.0 percent boost. The June decline was led by the transportation component. Excluding transportation, new durables orders slipped 0.6 percent, following a 1.2 percent gain in June.

Durable goods are an indicator of future business spending.

Courtesy of the Wall Street Journal

On Wednesday a consumer confidence report from the Conference Board was quite negative:

Consumer confidence dipped in July-again over worries about the jobs picture and over income prospects. The overall consumer confidence index slipped to 50.4 in July from an upwardly revised 54.3 in June (initially 52.9). Analysts projected July to print at 51.0. The latest decrease was led by a drop in expectations to 66.6 from 72.7 in June. But the present situation sub-index also declined-to 26.1 from 26.8.

Courtesy of the Wall Street Journal

This morning he came out with a long-term analysis of inflation which I don’t think is right. I [...]]]> Before I start I wish to say that I highly respect David Rosenberg at Gluskin Sheff, one of the few mainstream economists to call the crash, and whose observations about the markets are always worth reading.

This morning he came out with a long-term analysis of inflation which I don’t think is right. I urge you to read his commentary, below, but in general he sees one to two years of continuing “deflationary” pressure that favors the bond market and he says “inflation” will be at zero. He then see the beginning of “inflation” as the result of war and the need of government to fund it. The result, he says, will be high inflation and perhaps hyperinflation.

While you would think as a fellow doom and gloomer I would hop on his bandwagon, but for the most part I think Rosenberg’s analysis of the forces behind inflation and deflation are wrong. He uses historical analysis to prove his point, but he doesn’t explain the underlying factors that cause inflation or deflation, which, as I have discussed before, have to do with increases and decreases of money supply by the Fed.

He assumes that Boomers will cut back on consumption and increase savings. I agree and I went into detail on that in my Megatrends and other articles. He says that will result in “deflation.” But deflation is a monetary phenomenon, not a savings problem or lack of consumption problem. We will see deflation because money supply is declining, and it has been declining since late last year.

Rosenberg conflates increases and decreases in prices with inflation and deflation.

Let’s use hypotheticals to analyze this.

Assume we have an economy with a fixed supply on money.

Hypo 1: Assume that from technological advances, the cost of consumer goods decline. That is, people spend less on goods than they previously did. Rosenberg assumes that is deflation. In fact it is a supply and demand factor resulting from economic competition. It doesn’t result in a decline of consumer spending. Since consumers have more money to spend on goods because of technological efficiencies they will spend more and the economy expands.

Hypo 2: Assume that Boomers, formerly big spenders and a significant part of the consumer market, now decide to cut back spending and save more. Retailers will see sales decline. They will lay off workers, have sales to reduce inventory, and hope for the best. It would be safe to say that retail goods will decline in price until supply meets demand. That’s not deflation; it is a supply-demand issue.

You have to ask: what happened to the money Boomers didn’t spend? Was it just locked up in the bank? No.

By saving, Boomers are saying, “We don’t wish to buy stuff right now and we will save our money for future consumption.” They plow money into savings accounts. As a result, interest rates decline because of the influx of Boomer cash into banks. Since consumer goods aren’t selling, that sector of the economy won’t borrow. What happens is that the manufacturers of industrial production goods, or goods that take a long time to make (such as homes), see the opportunity and borrow at the cheaper rate. They spend the money on commodities, machinery, technology, and labor. As the money spreads through the economy, eventually, consumption picks up, manufacturers and retailers of consumer goods see that and order consumer goods. Money is diverted from industrial production to consumer production. This is how recoveries begin. Some prices increase because of demand, others don’t. It’s not inflation. In inflation all prices rise over time because new money, money created out of thin air, is pumped into the economy.

Hypo 3: Assume all of a sudden everyone has $200 in their pockets rather than $100, does that make us wealthier? No. The amount of goods hasn’t changed but we have more pieces of paper chasing them. This is just an increase in money supply. No new wealth was created. One of the results of an increase in money supply (inflation) is that prices go up. If the government could make us wealthy this way, why not just print money? Who needs to be productive? Price increases are not the only result of inflation; many things occur that distort the economy and lead to booms and busts.

Rosenberg associates our current “deflation”, or as he sees it, declining prices, with lack of demand. He never mentions money supply. He assumes that we had low “inflation” in the last several decades because globalization and technology reduced production costs and reduced prices. That is like saying that since computers are dirt cheap today because of competition, that is deflation. No, it is a factor of supply and demand.

He then says that “deflation” will end when the government sees the need to fund its wartime expenditures. He says, “Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew.” He then says that, as families and the government rebuild their balance sheets, then you’ll have inflation.

I am not sure what he means here. If the government borrows more, there is a crowding out effect which makes credit more expensive for businesses. That would make it more difficult for the economy to expand. But this has nothing to do with inflation. According to his theory this would all lead to less consumer demand because of the resulting decline in GDP and that would be “deflationary.” This is a Keynesian view of the economy.

When you do have inflation is when the government prints money to pay for their expenditures because they feel they can’t tax folks more without getting voted out. The influx of fiat money is inflation. It doesn’t have to be war. It could be the massive entitlement and spending programs recently created by the Bush and Obama Administrations. They borrow to pay for it, but taxes will pay it back. They favor inflation because it makes debt cheaper.

The nice thing about Rosenberg is, that despite his errors, his timing on deflation/inflation might be pretty good. Money supply is now declining which is deflation. In my Inflation-Deflation article, I suggest that since money supply leads the economy by 6 to 9 months, we’ll have deflation and deleveraging will continue. When the Fed is convinced that GDP is declining, then they will pull out the stops and hit the “print” button through Open Market Operations which eventually will lead to an increased money supply and inflation. This monetary inflation will take another 6 to 9 months to impact the economy. So he may be right for all the wrong reasons.

It’s rather disappointing to see this kind of analysis from an economist I admire and follow.

Here is his article:

From Breakfast with Dave, July 28 , 2010

THOUGHTS ON THE LONG-TERM OUTLOOK FOR INFLATION

Let me start out by saying that I do not believe that bonds are any “better” an investment than stocks, at least in principle. They both have their advantages.

For bonds, the advantages are that they provide an income stream – the principal and the interest payments are guaranteed in the case of most government securities; and in the case of the corporate sector, it inevitably comes down to the quality of the credit and the longevity of the company in question. In addition, the yield at the time of purchase is almost always at some significant positive spread over CPI inflation.

Stocks represent ownership in corporations that have assets and strive to make a profit, often paying out a portion of the profit in the form of dividends and retaining earnings to grow the business and increase the dividends in the future.

But the primary purpose of this comment is to suggest what things may look like when the Great Bull Market in Bonds, which began in 1981 with 30-year Treasury Bonds yielding 15.25%, finally comes to its glorious end.

For starters, I think it is safe to say that the bull market in bonds will end reasonably close to the point in time that inflation (or deflation) bottoms. This is because we have determined that by far the major economic factor that correlates consistently with the direction of market-determined interest rates, at least for long term Treasury Bonds, is CPI Inflation (headline and core).

The bond market, like politics, is an emotional issue and not well-liked in general by Wall Street because it has a negative correlation to the stock market most of the time. For a growth bull, the bond is the “enemy”. The economic environment that most favours the long end of the bond market tends to be low or no growth and bonds have traditionally been an asset allocation decision that is bearish on the stock market.

As a result, fear mongering often takes the place of thoughtful and objective analysis when it comes to bond market commentary. One way or another, the long end of the bond market has continually been characterized as high risk for the last 30 years that it has been outperforming the S&P 500. That’s a little unfair – after all, it is the benchmark risk free asset for funding actuarial liability when taken to the extreme of a 0% Coupon Treasury Strip.

Let’s move on and make a sensible and objective effort at making a long-term forecast for core CPI Inflation. Based on our analysis, we could well see core inflation receding from around 1% now to near 0% in the next 12-to-24 months, which would imply an ultimate bottom in the long bond yield of 2.5% and 2% for the 10-year T-note. We should add that as long as the Fed funds rate remains at zero, reverting to a normal shaped Treasury curve would generate similar results for the long bond and 10-year note at the point at which the inevitable “bull flattener” reaches its climax. As we saw in Japan, this will take time, but yields at these projected levels will very likely come to fruition in coming years.

So what will be the cause of the next secular uptrend in inflation or hyperinflationary shock? It pays to look back at history. Prior to the inflation of the 1970s-early 1980s, periods of very high inflation were primarily associated with war. Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew.

Wars were typically followed by brief periods of deflation followed by stable prices until the next war. In the 1970s several factors other than war led to the brief bouts of hyperinflation and they are much debated. What is perhaps most important to recognize is that whether it is war, OPEC or rampaging Baby Boomers, history supports the notion that high inflation, at least at the core CPI level, tends to occur in brief bouts.

A quick look at the core CPI chart shows that for all but a brief period since WWII, inflation has been well below 5%. But it was the period from 1970 to 1980 that contained all readings above 5%. Coincidentally, this was the period in which the Baby Boomers were buying their first refrigerators to go along with a bungalow as they formed their households.

By 1983, core CPI was back down to 5% and never looked back, but the psychological damage was already done. Inflationary expectations were indelibly etched into the mindset of the Baby Boom cohort. So everyone positioned themselves for inflation by leveraging up their asset purchases. Inflationary expectations were the rationale for overconsumption and depleted savings rates.

What resulted was an interesting dichotomy. Asset prices inflated during the 1980s, 1990s and into the 2000s. Although the secular bull market in equities ran out of steam early in the last decade, most other asset prices (particularly residential real estate) went parabolic into the peak of the secular credit cycle in 2007.

Core CPI on the other hand, has been continually slowing since the peak of 13.6% in 1980 and even at the peak in the ratio of household debt to disposable income in 2007, was running no higher than 3%. Unlike geopolitical disruption or demographic shocks, asset bubbles and the credit cycle tend to have an important secular behavioral impact on society and therefore, the economy.

The credit collapse of the 1930s around the globe dramatically altered social norms related to consumption, speculation and saving. Those who were adults with families in the 1930s shunned debt and believed in “pay as you go” for the rest of their lives. By way of comparison, the inflationary shock of the 1970s enticed the Baby Boomers into a spending and speculative binge. Rather than save, they executed a failed strategy of speculating their way to a dignified retirement.

Now the clock has run out and household behavior is poised for a dramatic change. If the 55 year-old Boomer resolves to work longer and harder, cut the budget to save more and liquidate debt, can we really expect the politics to maintain the status quo? This type of behavior from the developed world will exert enormous deflationary pressure. In addition, the huge amount of debt and entitlement expansion that has occurred at the government level, particularly in response to the financial crisis, will be an enormous drain on economic growth as taxes are raised to service the debt and budgets are dramatically cut.

For this reason, it is appropriate to consider the possibility that the next secular uptrend in inflation must await the rebuilding of the household and government balance sheets to levels that launched the last uptrend. That, by the way was about 30% debt to disposable income in 1950, 60% in 1970, and realistically, it could take a generation to get back to that range from current levels of around 125%.

The outlook is not entirely dependent on the behavior of the developed world’s consumers and governments, however, if we are really trying to envision the next 20 years, the emerging market consumers (in places like China and India) have extremely low debt levels and high savings rates. Changes in emerging market consumer behavior should be, on balance, a source of counteracting inflationary pressure. Then again, the forces that most contributed to disinflation in the last three decades were globalization and technological innovation that lead to dramatic improvement in productivity and lower unit costs.

There is no reason to doubt that these forces will continue to be moderately supportive in the near future, even if higher marginal tax rates and reduced labour mobility (due to the fact that one-in-four Americans with a mortgage have negative net equity in their home and are thus “stationary”) end up constraining the noninflationary growth potential in the United States (and Europe).

While the disinflation from 1980 to 2007 was mostly supply-side related, the deflation pressure now is coming from the demand side – a deficiency of aggregate demand caused principally by the contraction in credit (40% of the private market for securitized consumer and mortgage loans has vanished over the course of the past two years).

So, putting it all together, it is reasonable to conclude that prices are most likely to be stable for a generation. By stable, I mean flat and perhaps oscillating around plus or minus 2% (look at Japan, where there has been no such downward price spiral – the CPI sits right where it was 18 years ago). Because the economy is still gripped with overcapacity in several sectors, real estate and labour in particular, we may be headed towards an outright deflationary backdrop over the near- to intermediate-term, but a deflationary spiral seems overly pessimistic considering all the good things in the mix, including a reflationary policy backdrop which certainly helped establish a price floor in Japan in recent years.

That said, a “V” shaped recovery has always been off the table from our perspective because we still have so far to go in the secular credit collapse, so all the balance sheet expansion that the Fed has done and will do in the future should continue to offer up little more than an antidote. In turn, a reversal of CPI or core CPI trend to the upside for the next couple of years seems like a low- probability event, particularly given the demographic and retirement pressures that increasingly favor savings over spending in the broad consumer sector.

And what about the end of the Great Bull Market in Bonds? It could come pretty soon. You heard right. Long-term Treasury Bond yields could reach a secular bottom in the next couple of years. And what will it look like?

Well, rates will likely be much lower than anyone expects and, as typically occurs at secular market peaks, the public will probably swear by long bonds at the primary lows in yields. After all, what other safe investment has delivered inflation plus 2% or much better, guaranteed, in the past 30 years? But in order for the public to adore 2.5% yielding long Treasury Bonds, it will first have to believe in stable or modestly deflating core CPI as a long-term forecast. At last count, households still have a near-3% long-run inflation expectation according to the most recent University of Michigan survey.

The public will also need to be fed up with risk and, judging by the performance of stocks and real estate in recent years, who could blame them? And for the Baby Boomer at 55 or 60, “Gambler’s Ruin” isn’t an option. We can see that they are already voting with their feet as the mutual fund flows clearly indicate – increasingly towards income and away from capital appreciation strategies.

Finally, the public will probably need to be afraid to be out (of the bond market, that is). That will most likely be due to a “flight to quality” as we continue suffer the secular bear market in stocks and real estate and suffer the economic setbacks of renewed recession sooner than many pundits think.

One last thought on stocks: Like I said before, bonds are not better than equities. They are different. Every asset class has its time to be the leader. It goes without saying that the best time to allocate to equities is at the point of maximum pessimism and when the market is trading very inexpensively as it was at previous post-war secular bear market bottoms.

We know that historically, that “moment” has coincided with valuations below 10x on trailing “reported” earnings and dividend yields above 5% as measured by the S&P 500 Index. Note that while many a pundit cites the consensus as being $96 EPS for “operating” earnings for 2011, it is closer to $76 on a true “reported” basis (so apply a 10x or even a 12x multiple on that estimate!).

We also know that the conventional wisdom is oh, so wrongly linear at inflection points, so not only is the market cheap at these secular lows, but the future is much brighter than generally perceived. Pulling the trigger at that magic moment when bonds have peaked (yields have bottomed) and stocks can’t hurt you anymore, with dividend yields secure at twice the Treasury rate, would be nice. But you never know for sure at the right time, or you think you know for sure but are too early.

For now, we are not even close. Sentiment toward long bonds and inflation are still extreme and recent survey data show the typical balanced institutional portfolio manager with a 68% allocation towards equities. As for bonds, the yield on 30 year Treasury was recently core CPI plus 3%; 4% for a BBB corporate bond; and a 6% real yield in the BB space. The S&P 500, meanwhile, sports a P/E multiple of close to 15x and the dividend yield is barely over 2%.

In this light, it would seem highly appropriate to maintain a SIRP – Safety & Income at a Reasonable Price – strategy for the near- and intermediate-term, while keeping a close eye on the exit plan from this recommendation, though that could still be a few years down the road.

Today’s Wall Street Journal has [...]]]> There have been a number of articles lately about the efficacy of Keynesian theory. You see this discussed in the mainstream media because they, for the most part, have no real understanding of other economic theories so they have no larger frame of reference from which to compare Keynes.

Today’s Wall Street Journal has yet another article by reporter Jon Hilsenrath that attempts to raise the central question about whether or not Keynesian fiscal stimulus works. I discussed his last article on deflation in “Economists ‘Don’t Understand Deflation.’”

I suggest you read the Journal article to get an idea of what the controversy is. I have written about Keynesian economics many times and I do not wish to repeat myself again. But the main points are that: it has never been proven to work in any crisis, it fails as a theory under analysis, and it causes long-term harm to the economy. Hilsenrath makes many errors in his analysis. Further he fails to grasp what Keynesian theory is, what Monetarism really is, and he has no understanding of Austrian theory.

Whatever.

I recently read an article entitled, “The Self-Defeat of the Keynesian Cross” by Pedrag Raysic, a Ph.D candidate in economics. It is a devastating critique of Keynesian theory based on testing its internal logic. He concludes that if you take it to its logical conclusion, it is self-defeating.

I need to tell you that Mr. Rajsic is heavy into mathematics and mathematical logic. It is not easy to read when you get to his logical analysis unless you are a mathematician. But Keynes’s theory is based on econometrics which employs mathematics to explain its notions. Here is Keynes’s basic theorem: AD=C+I+G. In plain English: Aggregate Demand (GDP) = consumption + gross investment + government spending.

In other words, according to Keynes, the economy is a mechanistic construct of human behavior that can be manipulated by simply adjusting the formula. If consumption “C” is too low, then the answer is to increase government spending “G.” If you really think it is more complex than that, it isn’t. Keynesian econometricians make it more complicated because they assume it works and get lost in creating mathematical constructs that explain the theory in greater detail. Please see GMU professor Russ Roberts’ critique in my article, “Another Explanation of Keynesian Stimulus.” Another excellent commentary is by economist Frank Shostak which may be found in my article, “Can Fiscal Stimulus Revive The Economy?”

A more detailed formula of this is:

Basically if consumption is down, Keynes says you need government spending to stimulate the economy to take up the slack and this formula purports to show how much spending is required to achieve the desired goal. I don’t pretend to be a Keynesian scholar but I have gone through his General Theory. I have read Mrs. Romer’s paper mentioned in the Journal article as well as Professor Krugman’s assertion that Keynesian theory was “proven” to be correct in a 1956 paper by Keynesian E. Cary Brown.

What Mr. Rajsic does is take the Keynesian formula using its own logic and progresses through to its (il)logical conclusion. His result is that the formula doesn’t work on its own logic. His approach is a bit different than testing its theoretical foundations; he demonstrates the internal fallacy of the theory.

Here are some excerpts from Mr. Rajsic’s article:

The Austrian business-cycle theory, initiated by Ludwig von Mises and further developed and elaborated by F.A. Hayek, is by many considered the cornerstone of this school of thought. However, in 1998, Paul Krugman plainly dismissed the theory as not “worthy of serious study.”

More recently in his New York Times blog, Professor Krugman claimed that the Austrian business-cycle theory fails to fully explain fluctuations in output and employment between recessions and booms. From this he concludes that the theory fails to demonstrate how a business cycle can be caused by government intervention. At the same time, he interprets this as a sign of Austrians’ unconscious adherence to Keynesianism in explaining the booms but not the busts. Austrian economists, says Professor Krugman, seem to be “Keynesians during booms without knowing it.”

The assertions about the alleged inadequacy of the Austrian business-cycle theory have been addressed by Robert Murphy and will not be the focus of this article. Instead, I will demonstrate that the common interpretation of the theory that Krugman considers more worthy of studying seriously — J.M. Keynes’ General Theory of Employment, Interest and Money — has serious logical flaws. Ironically, it turns out that these are the same flaws that Krugman attributes to the Austrian theory, namely the inability to explain continuous unemployment during a recession.

The Basics of J.M. Keynes’ Theory

Keynes based his 1936 treatise The General Theory of Employment, Interest and Money on one key assumption, that involuntary unemployment is a possible market-equilibrium outcome. He defines involuntary unemployment in this way:

Men are involuntarily unemployed if, in the event of a small rise in the price of [wage-] goods relatively to the [money-] wage, both the aggregate supply of labour willing to work for the current [money-] wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.

Next, Keynes describes the basic elements of his theory:

This theory can be summed up in the following propositions:

1. In a given situation of technique, resources and costs, income (both money-income and real income) depends on the volume of employment N.
2. The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume.That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.
3. The amount of labour N which the entrepreneurs decide to employ depends on the sum (D) of two quantities, namely D1, the amount which the community is expected to spend on consumption, and D2, the amount which it is expected to devote to new investment. D is what we have called above the effective demand.
4. Since D1 + D2 = D = φ(N), where φ is the aggregate supply function, and since, as we have seen in (2) above, D1 is a function of N, which we may write χ(N), depending on the propensity to consume, it follows that φ(N) − χ(N) = D2.
5. Hence the volume of employment in equilibrium depends on (i) the aggregate supply function, φ, (ii) the propensity to consume, χ, and (iii) the volume of investment, D2. This is the essence of the General Theory of Employment.

These propositions were later formulated by Paul Samuelson into what is now known as the Keynesian cross model. This model has become one of the standard elements of undergraduate macroeconomics courses.

Let me break in here. I’m going to reproduce the Keynesian Cross diagram, but I don’t expect you to have to know its workings. Those who are interested are encouraged to read the article in full.

Enough of that.

Rajsic goes through the formula and explains its mechanisms in some detail. Econometricians would be proud of him. His goal is to show that Krugman’s criticism of Austrian theory, that it fail to “explain continuous unemployment during a recession,” is wrong. It is wrong because Krugman has no idea of what Austrian theory is, and he obviously doesn’t understand Keynesian theory as well.

Rajsic says that Keynesian theory has a big hole in it: it assumes, when taken to its logical extreme that the unemployed must have zero consumption:

But consumption of the unemployed is not met by an equivalent expenditure because unemployed labor does not earn income. This physical output must be given to the unemployed without monetary compensation. However, nowhere in this model is it specified that there is some surplus production of physical output that will be given away to the unemployed without monetary compensation. Thus, it seems that the model assumes zero consumption for the unemployed, which directly implies that the unemployed will not be able to sustain their physical existence in a prolonged recession. …

Alternatively, if the consumption of the unemployed were to be included in the expenditure of the employed (i.e., the employed used a portion of their income as charity for the unemployed), we would end up with a paradox: that, as the propensity to consume reduces, the employed are more able to feed more unemployed by spending ever smaller portions of their income. Thus, it must be concluded that, in this model, the consumption of the unemployed is not included in the consumption expenditure of the employed.

But the model at the same time implies that the consumption of the unemployed cannot be outside of the expenditure of the employed if the model is expected to produce a nonzero equilibrium output. This leaves the only remaining option — the consumption of the unemployed must be zero.

I know this is complicated to explain, which is why those who are interested should read Rajsic’s article. What he is saying is that its internally logical conclusion results in an internally inconsistent formula. Keynesian theory has been critiqued and disproven many times by Austrian scholars on theoretical grounds. While Austrians tend to stay away from empirical research to prove or disprove a theory, I would say, that, based on my understanding, it has never been proven to actually work at any time it has been used.

But Rajsic has done a brilliant job of examining the Keynesian cross’s internal logic and disproving it. Rajsic says,

Contrary to the commonly used interpretation of the “Keynesian cross,” continued fluctuations in output and employment cannot be produced by this model if its strict logic is coupled with the logic of human existence. In this case, the Keynesian model implies that prolonged business cycles could not persist in the absence of an intervention external to the market processes. However, for Keynes, government intervention was the cure, not the cause, of the business cycle. It then turns out that the Keynesians are Austrians during recessions “without even knowing it.”

Interesting things have been happening in the real estate markets.

Residential

The home sales index spike from the home buyer tax credit has almost run out. If you didn’t have a deal in escrow by April 30, you didn’t get the credit. The time to close a deal was extended to September [...]]]>

UPDATED

Interesting things have been happening in the real estate markets.

Residential

The home sales index spike from the home buyer tax credit has almost run out. If you didn’t have a deal in escrow by April 30, you didn’t get the credit. The time to close a deal was extended to September 30. The predictions were that we’d see a fall in July activity which is exactly what is occurring.

The reports that are currently coming in don’t yet reflect July sales which will show a drop in sales. For example, the Case-Shiller report came in today for May, 2010, but that report is a three-month average of prices. The report said prices were up 1.2% MoM, and 5.4% YoY. That was the peak of housing credit driven sales. According to S&P which publishes the index:

“While May’s report on its own looks somewhat positive, a broader look at home price levels over the past year” doesn’t show that the housing market “is in any form of sustained recovery,” said David M. Blitzer, chairman of S&P’s index committee. “Since reaching its recent trough in April 2009, the housing market has really only stabilized at this lower level.”

Last week the National Association of Realtors reported that June sales of existing homes declined 5.1% from May but up 9.8% YoY. Sales declined 9.3% in the west. Inventory rose in June:

The supply of homes available for sale in 27 major metropolitan areas at the end of June was up 3.7% from one month earlier, according to figures compiled by ZipRealty Inc., a real-estate brokerage firm based in Emeryville, Calif.

Ivy Zelman of Zelman Associates says for the past 27 years inventories have declined in June by 0.5%.

I showed this chart last week:

Yesterday the FHA reported that the level of its insured mortgages more than 90 days overdue or in foreclosure jumped 35% YoY. But,

According to the FHA June single-family operations report, the total volume of mortgage in-force increased more than 24% to 6.4m in June compared to the same month one year ago. The total value of unpaid FHA mortgages was $865.5bn in June, up 30.3% from $663.8bn one year ago and up 3.3% from $837.8bn in May. … But with that increase came a rise in serious delinquencies, 7.6% last year, compared to 8.3% in June. …

Based on applications received, the FHA said the seasonally adjusted annual rate of applications was nearly 1.9m, down 13% from the previous month’s rate and the lowest since January’s rate of 1.69m.

What this means is that most home loans are being financed with government guarantees from the FHA, Freddie and Fannie. I had thought the FHA had run out of money, but apparently their limits have been extended. The last numbers I saw said that 90% of loans are government backed.

According to Bloomberg today, in an article about a surge in people renting apartments:

Finances for homeowners didn’t improve fast enough to prevent more than 1.65 million foreclosure filings in the first half, an increase of 8 percent from the same period in 2009, RealtyTrac Inc., a data company in Irvine, California, said July 15. A record 269,962 U.S. homes were seized from delinquent owners in the second quarter as lenders set a pace to claim more than 1 million properties by the end of 2010.

But here is probably the most significant statistic: home ownership rates have fallen to 66.9 from a high of 69.2% in 2004. In my Megatrends article, I expected this to happen as home ownership rates revert to the statistical historic averages. This does not bode well for housing prices unless we see substantial increase in either population or inflation.

The sad fact is that the first time home buyer credit has substantially distorted the housing market and has hampered recovery. One could say that such meddling has set back recovery for nine months, or since last Fall when the tax credit began to artificially stimulate sales. Home prices will now stay under pressure as foreclosures continue to rise which will cause inventory to rise.

Commercial

Last week Fitch reported that defaults of commercial real estate backed mortgages (CMBS — the CRE equivalent of residential mortgage backed securities) are increasing. They pointed to 8 properties held in CMBS portfolios are likely to default in August, each more than $20 million. They are interest only loans that were refinanced five years ago and now cannot get the financing to take out their existing lenders.

In August, Fitch expects 115 loans worth $1.3bn in balances to fall into special servicing and more to come through the rest of 2010, peaking in October at 181 loans at $2.1bn and totaling more than 772 loans worth $7.8bn. …

With more commercial mortgage-backed securities (CMBS) loans on the verge of default this Fall, special servicers are being forced to accelerate them through the REO process to avoid building a shadow inventory similar to the one in residential.

Also Deutsche Bank reported:

… that the number of new transfers into special servicing will continue to outpace commercial loan workouts. But once properties are ready for liquidation, valuations on commercial real estate are missing the mark, according to Deutsche Bank. …

The analysts projected an 18% delinquency rate on CMBS. Since the beginning of 2010, the balance of loans at least 90-days delinquent has increased every single month.

“The implications for special servicers are potentially dire,” according to the Deutsche Bank report. “If they wait too long to foreclose or restructure loans, the number of loans in their portfolios will continue to build, so even when they finally resolve an asset it might not even make a dent.”

Based on my own anecdotal evidence and a review of earnings reports of regional and local banks, it appears that lenders are starting to deal with bad CRE loans rather than just “extend and pretend”:

Many community and regional banks have aggressively charged off loans, mostly in commercial and construction financing. Despite signs of stability in delinquencies, banks still have to reappraise properties that serve as collateral. And when appraisals come in lower, the bank has to write it down, whether or not the loan is delinquent which in turn, hurts capital.

Wells Fargo in its recent earnings release said:

Losses in the commercial portfolio continued to improve from the higher levels experienced last year, including a 10 percent linked quarter reduction in commercial real estate losses.

Reports from people I know who are active in CRE in the L.A. area also lead me to believe that lenders are starting to do deals on REO properties. While two years ago no deals were being made, today there is more opportunity and activity. Further there appears to be less “extend and pretend” as banks are less willing to accommodate defaulting borrowers; lending standards have tightened rather than loosened. They have about $500 billion in CRE loans maturing in the next couple years.

In my view, it is CRE that is critical to a recovery. We will need to see more positive signs, such as an increase in business loans, more CRE foreclosures, and a reduction in bank excess reserves, before we can say there is some kind of trend, but it could be that the CRE logjam is starting to break up. I do not expect any recovery of the CRE market any time soon because of the volume of debt maturing, but I am beginning to think that more defaults will be pushed into special servicing resulting in foreclosures. The result will be further downward pressure on CRE prices (they have already declined 24% since the peak in Fall 2007).

We export know-how.

Ignore the anti free traders who think we’re being left in the dust. Free trade is a win-win.

This information is from the U.S. Chamber of Commerce’s Chamber Post:

The World Trade [...]]]>

Let the Chinese produce inexpensive consumer goods for us. We benefit from it as much as they do.

We export know-how.

Ignore the anti free traders who think we’re being left in the dust. Free trade is a win-win.

This information is from the U.S. Chamber of Commerce’s Chamber Post:

The World Trade Organization (WTO) today issued its World Trade Report 2010, an annual publication that offers definitive statistics on international trade.  In recent months, media reports have widely described China as the world’s largest exporter, but today’s report indicates that the United States remained the world’s largest exporter of goods and services through 2009. China has indeed overtaken the United States and Germany to become the world’s largest exporter of merchandise.

Source: WTO, World Trade Report 2010, pp 28-29.

Thanks to Cafe Hayek for this.