What I write here will not be rigorous.? We’ve heard about “peak oil.”? We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

It’s not just the US, debtor-friendly as it has been for most of its existence.? Most of the rest of the world has debt problems.

China has indebted municipalities and banks, and debts to many projects from Party members that will not pay off.? The EU is? overly indebted everywhere, not just the PIIGS, and finds its overall borrowing rates rising as lenders wonder what a Euro will be worth if the Eurozone dies.

In the US, government debt rises more than corporate and consumer debt falls.? We’ll pay the government debt off later.? Don’t worry. 😉

The simple solution to every problem is to say the it is a liquidity problem, not a solvency problem.? How do does one solve a liquidity problem?? Get a loan.? If the assets are really worth more than the liabilities, there should be some unencumbered assets that you can secure a loan with, and pay off the liquidity squeeze.? But absent that, it’s insolvency, regardless of what notional price one places on the assets.

But what if the problem is really a solvency problem?? Will a loan help cure that? No.? You can’t solve a debt problem with debt.

There are generally few liquidity problems relative to solvency problems.? As an example, most corporate bonds don’t default on principal payments, but on interest payments.? For individuals, balloon payments on loans might be relatively more of a problem, but since most people finance their homes, etc., on relatively thin ratios of income to debt service, interruptions of income lead to insolvency more often than balloon payments.

Consider for a moment that every liability is the asset of someone else, but not vice-versa, because some assets are owned free and clear.? Now pretend that we take everything in the world (the same could be applied to a nation), and put it on a single balance sheet, but we don’t net out the liabilities that would cancel out.

Which system would be more stable?? One where the liabilities are roughly equal to the net worth, or one where they are roughly five times the net worth?? The former, of course.? Now, not all liabilities are the same — long-dated claims like pensions only claim a little bit of the assets of the world at a time, whereas a large number of short-dated liabilities would make the system less stable, or perhaps lead to inflation.? Many dollars chasing few goods, or assets, or both.

I’m not sure exactly where the boundary line is for “peak credit.”? It would depend on the structure of the liabilities in question.? But once the fuzzy limits get exceeded:

• Growth can slow.? (Think of the book, “It’s Different This Time.”)
• Debt deflation may arrive. (Extend, Compromise, Default)
• Inflation may arrive for assets, goods, or both, depending on the propensity to save versus consume.
• And, if the debt gets high enough, and immediate enough, any entity may hit the “tipping point” where the market concludes that it is no longer possible for the entity to pay off its debts.? Short-term rates skyrocket, and the prices on long debt discount expected recovery levels.? For countries with their own currency, it may involve a lot of inflation, though a negotiation with creditors might be simpler.

In general, if we were starting over again, there are a lot of things that we should have done differently:

• Dividends would be deductible, and not interest.
• This would apply to all personal and corporate interest, including mortgages.
• We would eliminate the GSEs, and all government lending programs.
• We would run balanced budgets as a nation, and live with the modest volatility that induces.? We would not engage in fiscal stimulus.
• We would eliminate or constrain the Fed, such that it could never let the difference between ten and two year Treasury yields exceed 1.5%, or be less than -0.5%.? We would let recessions do their work of eliminating bad investments, because if you don’t, you end up with the debt deflation we are facing now.
• Or, go back to a gold standard, after analyzing what the proper value for the dollar would be, so as to avoid inflation or deflation.
• We would constrain banks to match assets and liabilities, and not engage in maturity transformation.

Banks would be a lot less profitable under such an arrangement, but it would prevent debt bubbles.? Besides, the banks would make up for it by charging for deposit/checking accounts.

Summary

We may be near “peak credit” at present, and that is true of much of the world.? Better we should have had a smaller financial sector, and avoided the financialization of the economy.? As it is, we face many years of slower growth ahead as we bleed debt out of the economy, or a number of years of inflation ahead, as we inflate away debts.? I suspect the former, but I can’t ignore the latter.

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Comments

• The more I read the Fed statements, the more I think that they are paid to be Pollyannas.? The rose-colored glasses are glued to their faces.? There is never any criticism of their actions; blame always goes elsewhere.? They are similar to modern teenagers that lack talent, but have incredible self-esteem.
• GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.? Inflation has not moderated significantly, either.
• They point to the risks coming from global financial markets.? The Fed is the lead regulator in the US of banks and SIFIs; if trouble abroad leads to trouble here, they have no one to blame but themselves.
• In my opinion, I don?t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located.
• Also, the reinvestment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
• The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
• The Fed is out of good policy tools, so it will use bad policy tools instead.

Questions for Dr. Bernanke:

• Discouraged workers are a large factor in the falling unemployment rate. Why do you think the economy is doing so well at present?
• Why do you think that holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy is located?
• Why will reinvestment in Agency MBS help the economy significantly?? Doesn?t that only help solvent borrowers on the low end of housing, who don?t really need the help?
• Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
• Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
• Could we end up with another debt bubble from keeping short rates so low?
• If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
• Is it possible that you don?t really know what would have worked to solve the Great Depression, and you are just committing an entirely new error that will result in a larger problem for us later?

I wrote about the thoughts of others Wednesday as I took notes on their talks.? I don’t type that fast, so my notes gives synopses of the talks given.

Now for my own thoughts.? I have a sympathy for anyone that wants to take monetary policy out of the hands of the government, because they don’t do it well.? Some sort of hard money standard is necessary, whether gold, silver, or a commodity basket.

Ideals

I have one major ideal here, and I don’t care as much how it is accomplished: get the government out of the monetary policy business.? My secondary ideal is regulating banks properly.

A gold standard could do the job, but I am not wedded to the idea.? Gold standards can be inflationary or deflationary.? It depends on the price at which you link the currency to gold.? Post-WWI, Britain pegged it too high, and got deflation.? France pegged it too low and got inflation. Getting the right level would be important.? Fortunately, we know where it trades now relative to the dollar, and that would be pretty close to the right level, if the stated gold levels of the Fed and the Treasury are accurate.

Practical

A full audit of the Fed is a minimum, as is an audit of the gold at Fort Knox.? Do it once, so that all doubts can be dispelled.

I think that bank regulation for leverage and asset-liability management is more critical than monetary policy itself. Banking crises stem from inadequate asset-liability management.? As James Grant pointed out from the historical example that he gave, deposits should back only self-liquidating assets.? Longer term assets must be backed by matching funding, or equity.

Unseasoned asset classes (i.e., asset classes for which we have no real loss statistics because they have never had failure as a group) should be disallowed as investments for banks except against surplus.? After that, risk based capital should be based off of strict actuarial studies, with a significant provision against adverse deviation, and no credit for diversification.? And, don’t allow banks to score their own riskiness, a la Basel.? That is ridiculous; the fox guards the henhouse.? If a bank has superior risk control, they will earn the results over time; they should not as a result lever up more.

Now, I really don’t care if it makes banks unprofitable, or earn less than their cost of capital.? In that case, we will get fewer banks, the margins of the remainder will rise, and you end up with a genuinely stable system with occasional bank failures that don’t threaten the system as a whole.

There was one idea that I thought could be put into practice immediately, Treasury Trust Bonds optionally backed by gold.? If nothing else, like TIPS, it would give the Fed another indicator on how credible their monetary policy is.

Conference Zeitgeist

The Taylor Rule got some respect.? Many suggested that if it had been followed, we would not have gotten into this crisis.? I’m a little less optimistic there, because bank regulation was co-opted allowing for too much risk to be taken relative to liquidity and capital.

Most felt that the Fed was the major player in causing the crisis, with the GSEs playing a lesser role.? The overpromotion of home ownership, and the constant provision of liquidity to the markets led borrowers to become reckless amid asset price inflation.

Incentives also played a role. Managerial and shareholder liability at banks would help prevent reckless behavior.? Wall Street worked better when it was a bunch of partnerships, rather than limited liability corporations.

Most thought that things are worse now than the ’70s.? The debt levels are higher, which makes demand punk, and businessman more skittish to expand and hire.? Government policy is less predictable as well.

The speakers largely expect more inflation; more debt monetization is the path of least resistance.? Politicians get what they want without a vote being taken.? On the question of where to invest, everyone was an inflationist.? Gold, silver, TBT, were trotted out.? Personally, I’ll stick with my stock investing.

People

Jeffrey Lacker showed courage in coming to the conference.? He made a really good point that the Fed should focus on its liability policies, and limit itself to investing in Treasuries.? The Fed gets bad press and popular dislike when it uses its assets for special lending programs and bailouts, leading to charges of favoritism.

Zoellick was a reasonable guy regarding the problems in the Eurozone.? Germany has to figure out what it wants.? To me, it boils down to this:

1. You can have a suboptimal euro that is not a good store of value, and bail less well-disciplined governments out via the ECB sucking in their debts, or,
2. You can have a smaller Eurozone en route to no Eurozone, or,
3. You can have a Federal Europe, and dissolve Germany into Europe as a state of the whole, as the 13 colonies did after the Articles of Confederation.

Personally, I would choose #2, because people in Europe identify themselves with their nations, not as Europeans.? Political and economic systems must derive from cultural systems or they will not work in the long haul.

It was fun seeing my old professor, Dr. Steven Hanke.? I reminded him of nine years earlier, when he gave a talk to the (then called) Baltimore Security Analysts Society, and we discussed why we thought the Euro would have a tough time surviving.? Most of that discussion is now taking place.

Ron Paul was Ron Paul.? He doesn’t change much — that’s one of his apolitical virtues.

John A. Allison was entertaining; he argued that capital levels are too low, and regulation too high.? He thinks that you can’t expect much, and don’t get much from regulation.? Especially interesting were the discrimination in lending allegations by the regulators that BB&T fought and won twice.

Conferences like this attract cranks.? Lots of people with odd political agendas hoping to get noticed, others with odd business propositions.

Other

As a final note, the concept of free banking and/or competitive currency issuance, I think invites more problems than it solves.? Think of it this way: people aren’t very good at evaluating financial promises.? The fewer the better, and the lower level of complexity, the better as well.? There has to be some monitoring of financial promises, some intelligent regulation of banks, or things can go badly wrong.? US history backs such an idea up, regardless of whether we have a gold-, silver-, or commodity-backed currency, or a fiat currency as we do now.

Update — thanks to Eddy Elfenbein for catching a typo/thoughtless mistake in paragraph 4.? For France, it was inflation, not deflation.