The Fragility of the Financial System

Is the stock market crazy with its recent belly flops? In the past 5 weeks, it's dropped over 15%, with the Dow adding another 519 points today (over 4%). We're getting close to a bona fide bear market. While the trading may look like panic selling, maybe it's not. Over half the market is computerized trading. The firms that do this stuff leave it to the algorithms and machines. Many of the non-computerized sellers are institutional investors--mutual funds, pension funds, hedge funds, and so on. The money managers of these institutions presumably have the professional experience to stay focused even when under stress. Are they right to jump ship so quickly?

The heart of the world's economy is the financial system. Banks and other firms that comprise the financial system are unusually fragile. Even the biggest banks have Achilles heels where their commercial counterparts don't. A bank's principal asset is the confidence in which it is held by those that deal with it. Without that confidence, the bank would be overwhelmed by a flash mob of depositors, counterparties and creditors all trying to get their money out immediately. By contrast, the Apples, Googles, Microsofts, and even Fords of the world can't go under in a matter of a day or two or three, no matter how little confidence others have in them. They need months, and even years, to collapse.

Confidence in the big banks has been shaken. The European debt crisis is the biggest reason. Europe's big banks hold large amounts of EU sovereign debt. If the EU's debt crisis keeps metastasizing (and it likely will, by all indications), these banks will have greatly shortened half-lives. While the major U.S. banks hold only modest amounts of EU sovereign debt, they are bound by numerous interconnections to Europe's big banks (through the settlement and clearance process for checks, trade financings and the like, interbank lending, derivatives exposures and so on). If Europe's big banks become insolvent, America's big banks will be living in a world of ships (or something like that). Just a couple of days ago, Spain and Italy were the focus of domino-like rumors as the next shoes to drop in the EU crisis. Now, France is vigorously denying that it has problems. Many in the market are taking this as confirmation that France does have problems (on the theory that if you have to deny it, you're already toast). The EU debt crisis acts like a battering ram on confidence in the world's big banks.

Another confidence shaker was the S&P downgrade of U.S. Treasuries. The proximate connection of the downgrade to the big banks is they hold boatloads of U.S. Treasuries. Since the 2008 financial crisis, the big banks have played a sure-win game where they borrow from the Federal Reserve, for virtually nothing, and reinvest the money in U.S. Treasuries. The Treasury securities effectively give the big banks a wash with the federal government, except for a net positive interest payment. In effect, the Fed has been sending income to the big banks for free. There was also no credit risk, that is, until the downgrade. While Treasuries have momentarily risen in market value due to flight to quality buying, the rating downgrade highlights the risks of the concentration of bank assets in Treasury securities.

Taken together, the large holdings of EU sovereign debt by EU banks, and the large positions of U.S. banks in U.S. Treasuries, make the international banking system unusually sensitive to difficulties with sovereign debt. And lately there have been difficulties galore. Hence, the financial system looks shakier and stock values less certain.

To make the situation worse, the Fed's relentless campaign to drive down interest rates along the length and breadth of the yield curve has, perversely, weakened the banks. Banks, in a nutshell, make their money by borrowing on a short term basis, usually at the low rates available at the short end of the curve, and lending longer term at the higher rates usually available for longer maturities. This strategy works when long term interest rates are sufficiently higher than short term rates (i.e., the yield curve is sufficiently upward sloping). The flatter the yield curve gets (i.e., the lower long term rates go, relative to short term rates), the less profitable lending is for banks. The Fed's various policy measures, most recently QE2, have flattened the yield curve quite a bit. Recent flight to quality has flattened it even more. Perhaps one reason why the Fed hasn't yet announced QE3 is because it doesn't want to further stifle the profitability of bank lending by making the yield curve resemble the horizon.

Thus, the Fed's interest rate policies are probably adding to the fragility of the banking system. Folk wisdom on the Street holds that when the yield curve inverts (i.e., the short end rises above the long end), a recession is likely. Today, it's hard to apply this thesis, since the Fed artificially prescribes rates. But if we could extrapolate somehow to what a more normal, less government controlled market would look like, we'd have to be concerned that prospects for the economy are far from rosy.

Last, but certainly not least, the real estate/mortgage crisis still haunts the banking system. Recently, the robo-signing foreclosure debacle has operated like a pipe bomb in bank balance sheets, with escalating costs that the banks have been desperately trying to cap through court settlements. Once the banks are able to foreclose again, they'll have to book losses by writing down a lot of loans currently held in suspension because foreclosures remain in limbo. It will be years and many more losses before the real estate disaster is cleaned up.

So have investors been freaking out and selling in a panic? Or does it make sense that the sudden flaring of the EU sovereign debt crisis over the past few months, coupled with the debt ceiling dance of governmental dysfunction, and the nine lives of the real estate/mortgage crisis, would reveal the ethereal foundations of stock market valuations? This isn't necessarily a situation where the market must be crazy. Maybe the world really is screwed up, and market valuations are adjusting to reflect that reality.

The Federal Reserve's Most Dangerous Game

The Fed announcement today that it would hold short term rates down until mid-2013 represents the agency's farthest reach in a very dangerous game. This policy will tolerate a bit more inflation than the Fed has acknowledged it will accept. At the same time, it guarantees that savers will get a negative yield on their short term holdings, net of inflation. What is the Fed doing?

Committing to hold short term rates at zero for two years won't do much to stimulate the economy. Rates have been effectively zero since the end of 2008, and look where we are now? Mired in stagnation. Corporations hold mountains of cash, so promising them ultra low borrowing costs won't make them borrow more. Consumers have been strangled by credit card interest rates that rose even as interbank borrowing costs evaporated. Perhaps consumer credit rates will rise some more.

What the Fed's announcement does is attempt to support stock prices. The Fed is promising to punish any and all investors who have the temerity to hold cash. It wants capital to move into risk assets and prevent the stock market from tanking. Momentarily, its tack seems to have worked.

But ultra low short term rates don't change the perverse risk-reward dynamic that has been punishing stock prices of late. With the Fed delivering more moral hazard, bug-eyed Tea Partiers and shrill liberals have less incentive to compromise than even a day ago. When 401(k) losses were exponentially increasing the critical e-mail traffic streaming into Congressional offices, the incentives for legislators to be constructive and productive were rising. The Fed has help them slip off the hook and get back onto the bully (pun intended) pulpit. Expect renewed political dysfunction.

Ultra low short term rates also do nothing to usher the EU toward an effective resolution of its debt problems. Today's announcement is just more of a central bank dumping corn syrup on the financial system. Asset values get a sugar high. Much of the actual downside risk in today's financial markets comes from the EU. The Fed's announcement only eases the pressure on the EU for meaningful reform.

Governments can't win when they try to artificially support asset values over any length of time. All the King's horses and all the King's men haven't saved the real estate market, which keeps edging lower. Farther back, in the 1990s, the British pound was blown out of the EU currency "snake" when the U.K. government tried to maintain it at a higher value than fundamentals gave it. The Fed is putting its credibility on the line, in a way where it has limited upside potential and buckets of downside potential. Five years from now, we might be saying that today, the Fed ventured a bridge too far.

So the Market Dropped 634 Points. What's For Dinner?

It isn't surprising the Dow dropped 634 points (5.55%) today. Since the 2008 financial crisis, governmental action has been the largest force behind the economic recovery. But European efforts to stabilize the EU sovereign debt crisis have repeatedly stumbled. And America's recent debt ceiling debacle more vividly than ever demonstrates federal dysfunction. The revival of organic economic activity has been limited, and corporations remain very cautious about expanding and hiring. The financial markets need government spending and bailouts. Consequently, political instability translates into market volatility. When government is ineffective, the markets will pout and throw a hissy fit.

Better get used to volatility, because it may well become part of our daily routine. There's no prospect of true economic recovery anywhere on the horizon. The markets will continue to look to politicians for succor, and nothing is as unpredictable as politics. You'd never want to bet your hard earned savings on political action. But the truth is the balance in your 401(k) now depends on how well mouth-foaming Tea Partiers, wailing liberals and befuddled moderates interact with each other. Keep saving, because this isn't exactly a safe bet.

Just about the entire world is now slyly pretending they aren't glancing at the Federal Reserve. Almost surely, Chairman Ben Bernanke is on the verge of ordering his troops to mount up and the regimental band to play "Garry Owen." The command to charge will come soon. Let's hope that, against the odds, Bernanke succeeds, because he's not leading a regiment of cavalry, he's leading an entire nation's economy.

The Weird and Unknown From the U.S. Credit Rating Downgrade

We learned in a big way during the 2008 financial crisis that what we don't know can really hurt us. That would still be true today, after S&P lowered America's credit rating from AAA to AA+. We also know that weird stuff happens when the financial markets get a tummy ache. They seem likely to be queasy from the downgrade when the markets open tomorrow. The weird and unknown may surface soon.

Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.

Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.

Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.

Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.

Inflation: the Last Bazooka

We seem to have had a little queasiness in the stock markets today, with the Dow Jones Industrial Average dropping over 50o points (more than 4%). Money is fleeing Europe, where investors have suddenly focused on the fact that the EU is dealing with its debt crisis by increasing, rather than paying down, its debt. That's like reaching for ever larger amounts of the hair of the dog that bit you. You may feel better for a little while. But a hangover is coming, and plenty of investors don't want to stay around to find out how bad it will be.

Meanwhile, back in the States, rumor has it that the economy is fluttering toward another recession. If not, then stagnation is clearly indicated by the economic data.

Because the government is expected to solve all problems that everyone has, the question now arises what can and will the federal government do. In terms of fiscal policy, the answer is nada. Tea Partiers and other conservatives in Congress now hold fiscal policy hostage. No significant stimulus, which would require one or more of increased federal spending, increased taxes and increased deficits, is politically possible. Hank Paulson's bazooka--TARP--is winding up, and there's no prospect of resupply.

That leaves only the Federal Reserve. It can't push rates any lower at the short end, because they're already at zero. It can (and probably will) do more quantitative easing, by buying longer term U.S. Treasuries and perhaps other debt instruments. The ostensible purpose of a third round of QE would be to lower already very low long term interest rates in the hope of stimulating growth. But QEII was done for that purpose, and its beneficial impact appears to be increasingly modest as statistics firm up. QEIII, in all likelihood, would offer even less benefit.

But QEIII might be inflationary. And that, dear reader, may be the point.

Debtors, like America, reduce their debt burdens by paying them down, refinancing them at better rates (and eventually paying them off), or, in the case of a nation, by inflating its currency. Inflation reduces the real cost of paying off old debt, with debtors using less valuable money to extinguish their obligations. Creditors, quite arbitrarily, take the hit from inflation. But in an overleveraged situation, losses are inevitable. The only question is how and where they will fall.

In many, and perhaps most debt crises, creditors take losses when debtors default. These losses appear as recoveries of cents on the dollar. But America cannot afford to default. That was the lesson of the recent debt ceiling debacle. The U.S. dollar is the foundation of the world's financial system, and a U.S. Treasury default simply cannot be allowed. But America's political system, paralyzed when it comes to raising taxes, cutting federal spending, and, most importantly, reaching reasonable compromises, can't figure out a way to pay off America's debt.

So the only way to reduce America's debt burdens is for the Fed to inflate the dollar. That's been done before. From 1945 to 1950, the Fed kept interest rates low and the price structure inflated by a third. Meanwhile, the economy grew briskly in real terms. The result was that the burden of paying off the war debt from the Second World War was significantly eased. In the 1970s, the U.S. was running large (for that time) deficits because of the Vietnam War. In addition, oil price hikes imposed by OPEC threatened an enormous transfer of real wealth from the industrialized West to the oil producing nations. The Fed responded by keeping money available on easy terms, allowing inflation to drive down the cost of debt repayment, and the amount of real wealth transferred overseas.

Today's Fed faces tremendous temptation to pull the same maneuver. No one else in the federal government will do anything. Ben Bernanke has made it clear that he'd rather do something controversial than nothing at all. The outcome is hardly clear. In the late 1940s and the 1950s, the Fed had a rapidly growing economy to leverage the debt reducing impact of inflation by providing more real wealth to pay creditors even as the value of the dollar shrank. In the 1970s, the economy grew hardly 1% a year. But personal income tended to keep up with inflation (in part because the work force was more heavily unionized in those days), insulating consumers from real sacrifice. Today, recession may return, reducing real wealth. And middle class Americans seem not to be able to keep up with inflation, cutting many expenses to have money for food and gasoline. But, rightly or wrongly, inflation may be the last bazooka for federal policy makers. And they could be taking aim even as we write.

Where Is Financial Safety?

The debt ceiling deal was, more than anything else, an agreement to disagree. It had commensurate impact on the financial markets (i.e., nada). Because the deal resolved very little, Congress will continue to convulse over budget deficit issues. The stock markets, which are driven by politics as much as economics, will convulse synchronously.

Meanwhile, across the pond, the Euro bloc sovereign debt crisis is all the rage again, with Italy getting smacked around by the bond vigilantes. The EU doesn't seem to understand that its strategy of solving debt problems with bailouts that, net net, increase the amount of its debt will only lead to more instability. Because the EU has, in effect, collectively assumed liability for all of the debts of all Euro bloc members and all of their banking sectors, the aggregate amount of continental debt is what matters. The EU's relentless expansion of its liabilities, with each bailout diminishing its capacity for further bailouts, guarantees that the bond bandits will have a never-ending stream of dominoes to knock over. The average citizen, working on a brown bag lunch in a cubicle, will opine that reducing debt is the way to get out of financial trouble. But the hoi polloi, lacking sophistication, just don't understand that these things are complicated.

So, we can look forward to more stock market volatility. Where is there financial safety?

Swiss bonds have risen in popularity. But they don't have the liquidity of U.S. Treasuries. If you buy Swiss bonds, you had better like them because they won't be that easy to exit.

Japanese debt has also gotten attention, even though Japan's sovereign debt is about 200% of GDP, well above American levels. With almost all of Japan's debt held by its own citizens, it isn't likely to face serious capital flight. Indeed, the Japanese government seems to prefer a little capital flight. With the popularity of the yen pushing up its price, Japan's export-based economy is at risk. Even as we write, the Japanese government is intervening in the currency markets to push down the yen. If you buy yen-denominated debt, understand that you'll earn almost no yield and be at risk of currency losses from Japanese government yen smackdowns.

So what's left? Well, oddly, U.S. Treasuries. At least until the current debt ceiling is reached, probably in early 2013, U.S. government debt is safe. You may face some moderate inflation risk. But the long term picture for U.S. Treasuries--which isn't pretty--won't emerge for the next year or two. So, if you're worried about the stock market swan diving into a correction or bear market, Treasuries may be a safe place to hit the mattresses, at least for a while. Money market funds invested solely in U.S. Treasury securities are comparably safe, albeit exceptionally low-yielding.

FDIC insured bank accounts are also safe. The European debt crisis, in the worst case, could hit the U.S. banking sector pretty hard (because of interbank lending, derivatives exposures, and other bank interconnectedness). But the FDIC, with the backing of the U.S. Treasury, will protect insured deposits come hell, high water, plagues, swarms of locusts, loathsome diseases, or anything else. One hard lesson the government learned from the thousands of bank closures leading up to and during the Great Depression is that the loss of bank deposits wallops consumer confidence more than anything else. People don't look to their stockholdings or the equity in the house to cover next month's expenses. But if you take away their bank deposits, you create immediate household crises on a wholesale level. Make sure your bank deposits stay within insured levels (for more detail, see http://blogger.uncleleosden.com/2011/07/fdic-insurance-coverage.html).

We also discuss safe investments at http://blogger.uncleleosden.com/2010/07/safe-investments.html.

Losers and Winners in the Debt Ceiling Deal

LOSERS

Stocks. The market dropped over 2% today, as the debt ceiling deal became law. With federal spending--the last bit of economic stimulus standing--being knocked down, the economy can only follow. State and local government budgets, hit by revenue losses from the Great Recession, are already shrinking. Corporate investment is at stall speed. Consumers have again begun saving more. Even China's and other Asian economies are slowing down, offering less stimulus. Wishful thinkers will latch onto the falling dollar, which will help with exports. But America isn't an exporting nation in the tradition of Japan, Germany and China, and a weakening currency won't by itself make that much difference. The stock market is approaching cold water and icebergs lurk.

Liberal Democrats. The liberal wing of the Democratic Party has been squeezed almost entirely out of power, by a Democratic President. Oddly, the truth is liberals would be better off with a Republican President. When George W. Bush was in the White House, he made no headway with efforts to change Social Security. His big change to Medicare was the Medicare Part D prescription drug program, which significantly increased federal benefits and spending. Democrats tend to unite when faced with a Republican President, and can largely protect their constituencies and priorities. But they have no effective defense against a Democratic President who largely surrenders to Republican diktat.

Barack Obama. He triangulated the political spectrum, and got a deal. But, unlike the congenial Bill Clinton, Barack Obama can't pull this stunt and still schmooze his way back into the good graces of the left. Obama appears to have acted with the hard edge of Chicago power politics, leading some liberal Democrats to seem to refer to him as He Whose Name Shall Not Be Spoken. He had the support of about half the Democrats in the House. But half voted against him, and their votes reflect the views of many of the Democratic faithful. Obama's re-election bid is starting to look like George H.W. Bush's, another moderate president who lost the faith of his party's core and then lost his bid for re-election. Obama leaves many Democrats wondering if he has any goals or principles other than his own re-election. That feeling won't motivate them to line up at the polls.

John Boehner. Boehner's weaknesses as Speaker were never so clearly exposed as during the Sysiphean trek toward a debt ceiling deal. Policy positions are imposed on him by the small number of Tea Partiers in the House. He doesn't dictate, or even hardly influence, anyone or anything. If he continues on his current downward trajectory, there won't be a Boehner Office Building in Washington.

Republicans. The Republican Party is kind of like the mortgage industry, circa 2006. It only looks at upside potential, not downside risk. By pushing through spending cuts now, and more spending cuts in a few months, it has placed itself clearly downrange in the Washington blame game for the impending economic slowdown and has painted a bright red bullseye on itself. Obama and other Democrats can quite plausibly contend that the federal spending cuts that now will hinder economic recovery were forced on them by the Republicans. You can bet that the Republicans on the deficit reducing bipartisan committee prescribed by the debt ceiling legislature will avidly play the role of the Grim Reaper, and in so doing will provide grist for Democratic attack ads in the fall of 2012.

Tea Partiers. People usually learn little from victories. Tea Partiers were victorious this time, although they got much less than they wanted. Having won a victory, but not the war, they will only pursue the same agenda using the same tactics. They won't realize when they go a bridge too far. About half of all Tea Partiers receive benefits from Social Security and/or Medicare. These programs must be cut if Tea Partiers are to see the deficit reduction they claim to desire. Emboldened by victory, they will fail to notice that their point of aim strongly resembles their feet. They will lose benefits they may be relying on, and popularity.

Federal Reserve. Although the Fed has tried to play innocent bystander during the debt ceiling fight, it will come under enormous pressure to provide stimulus taken away by the debt deal. While the Fed won't say so publicly, it's probably already laying the keel for QEIII. Even though such a measure would probably be futile and maybe inflationary, expect it to be launched after a couple more months of bad economic statistics.


WINNERS

Bond market. In the welfare states that 21st Century capitalist nations have become, the biggest welfare recipients of all are holders of debt, especially government and bank debt. They just won another round in Europe, followed promptly by today's debt ceiling deal. But the smart money knows this game can't go on forever. Europe's solution to its debt problem is to increase its debt. That looks like a win-win, but long term is a lose-lose-lose-lose all around. America's debt ceiling deal is really a kick of the can down the road, with the usual Washington solution of creating a bipartisan committee to deal with the big deficits. Whoop de do. Just as the mortgage industry couldn't shift its losses away indefinitely, holders of government and bank debt won't have taxpayers and citizens as patsies forever. Losses in one form or another are inevitable if things remain on today's trajectories.

Liberal Democratic Leaders. In the yin and yang of politics, the seeds of success are sown during stinging defeats. Witness how the Republicans have rebounded from their horrendous losses in 2008. Liberal Democratic leaders need to understand that: (a) they are no longer Middle American (most are, or reflect the attitudes of, upper middle class elites), and (b) they need to find a way to get through to Middle America. Middle America means people who live on $40,000 to $60,000 a year. Most of these people are moderate, and cautious about government. They don't like overbearing government, and that cuts in both directions. An overbearing Republican governor in Wisconsin, bent on not only balancing the state budget but destroying his Democratic opposition, has offended many of the voters who elected him nine months ago. He's delivered badly needed ammunition to labor unions and other Democratic faithful, and revived their flagging spirits. Democrats in Wisconsin had the opportunity to stage weeks of raucous demonstrations in full view of today's 24/7 news media coverage, getting the better of the political debate there. Ten Wisconsin legislators have or will face recall elections--six Republicans and four Democrats. A Democrat has won one. Nine others will be held a week from today. The outcome will be informative.

Liberal Democratic leaders now have an opportunity to rethink their message. With Republicans offering nothing except "no" to government action, the field is left wide open for Democratic initiatives. Democrats have to stop playing defense. The best medicine for a sick economy and large government deficits is a pro-growth program. Tax cuts aren't necessary for growth. The late 1940s, the 1950s and the 1960s, a time when America had a gigantic debt overhang from World War II, enjoyed storied prosperity, even though marginal income tax rates reached as high as 90%. Innovation was rampant--today we may think that improvements to smart phones are a big deal, but remember that the computer as a device was created in the 1940s and 1950s. During the same period, brisk per capita income growth made the American Dream come true from sea to shining sea.

America's transportation systems must be repaired, improved and extended. A transcontinental nation like America needs top tier transportation much more than compact nations like those of Europe. But, today, ours don't even compare. America needs renewable economic resources--i.e., those primary economic activities that perpetuate themselves (unlike homebuilding, which is a secondary economic activity dependent on the health of primary economic activities). Manufacturing is the classic example, and Germany's focus on high quality machine tool work exemplifies the concept of renewable economic resources. America may not have the best lathes, but it has the best geeks. High tech tinkering and inventing should be encouraged and funded. Special scholarship money should be made available to engineering majors and other aficionados of pocket protectors. America's second largest export is entertainment, and protecting copyrights worldwide should be a priority. Maybe the rest of the world's tastes are no better than ours, but if they'll pay for our reruns, why not make a virtue of necessity in a time of economic stress? America's agricultural sector shouldn't be subsidized in wasteful ways, but improvements to our transportation systems and trade negotiations aimed at opening up more foreign markets would assist our highly productive farms. Very few Americans today are farmers, but prosperous farmers buy new trucks and tractors, and lots of computers. Other Americans benefit as a result.

A strong economic growth program may require some shifting of spending away from defense and other large programs, at least for a while, and a renewed battle for tax revenue enhancement. But, it takes money to make money. Let us remember that the Interstate Highway system was initiated during the 1950s, a time of major governmental retrenchment. But it greatly sped up transit times for just about everybody and everything, and was one of the wisest uses of public resources in the 20th Century.

Advocating a strong economic growth program doesn't mean foregoing traditional Democratic priorities of protecting the unfortunate and the underprivileged. What it does is add hope to the Democratic message. Today's Republicans would refuse Oliver Twist another bowl of porridge. That leaves them vulnerable to the political cycle as it comes around.

Little Money Secrets

Little things can make a difference in money matters. Just as small adjustments to a swing can change a golfer's game or a batter's average, paying attention to a few details can make you better off financially speaking.

Calculate your net worth. This is the most basic thing you can do. At least every three months, figure out where you stand. If you don't keep score, you won't know how well you're doing and whether or not you're making progress. You can't do any financial planning without knowing your net worth.

Reinvest dividends and interest. Rolling your investment income into new investments allows you to compound your earnings. The leverage from compounding over time is astonishing (see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html). If you reinvest your investment income, you'll have a more reliable source of growth in your wealth than stocks, gold, oil or any other asset class.

Sweep excess income into savings. Let's say, near the end of the month, you've been true to your budget and have some excess income from your last paycheck. Sweep the excess income into a savings vehicle. The savings vehicle can be a savings or money market account at a bank, or a money market fund account. As funds build up in the savings vehicle, you can transfer them to a mutual fund or other longer term investment, if you like. But the point is to get them out of your checking account, where they may be viewed as immediately spendable, and into the category of savings. Resist the urge to view excess income as mad money. Sweeping even small amounts adds up. If you sweep $50 a month, on average, after one year you'll have $600. After ten years, you'll have $6,000, plus investment returns. After twenty years, the total will be $12,000. With investment returns, it might have grown to $20,000. After thirty years, you've swept $18,000, and investment returns may have made the total $30,000 to $40,000. Remember that this is in addition to your 401(k), IRA and other retirement accounts. Little crumbs can be made into crumb cake.

Focus on saving. Too much time and energy are devoted to searching for the ideal investment strategies, and not enough to saving as much as possible. There is no way to pick the optimal investment strategy for the next five years, let alone the next thirty, forty or fifty, because no one can predict the future with certainty. Look at the past five years if you think otherwise. People who save more have more capital to invest and diversify among different asset classes. People who save only modest amounts may find themselves taking big risks in order to ensure a comfortable retirement. The Great Recession has taught us that taking large risks doesn't always yield high returns, or any returns at all. Saving more, and moderating risk, is a smarter long term strategy.

Avoid debt. This is the biggest secret of all, because, judging from the growth of consumer debt in recent decades, so few people seem to understand it. Since most people borrow money to consume, they get no financial return from it. It's a pure cost item, with the repayment of principal and interest coming out of future income. Of course, most people need to borrow to buy large items, like a house, an education, or a car. But borrow only when you must and when there is an important reason. You have a finite lifetime income, and the more of your finite income you devote to debt repayment, the less you'll have for everything else. Why enrich banks? (For more on this point, see http://blogger.uncleleosden.com/2010/07/how-to-think-about-saving.html.)

In baseball, most hits are singles, even for Hall of Famers. The same is true for financial planning. Apply these little secrets, and your golden years will likely glow more brightly.

A Glimmer of Hope for a Debt Ceiling Deal

As the House of Representatives struggles tonight to hold a futile, symbolic vote on Speaker John Boehner's debt ceiling proposal--which the Senate will reject, so the vote achieves nothing except to throw more mud at the other side--there is a glimmer of hope for a resolution. It comes not from a smoke filled room on Capitol Hill, but the stock market.

For five days in a row, the Dow Jones Industrial Average has fallen, dropping a total of almost 4%. The S&P 500 has dropped four days in a row, for a total loss of over 3%. The Nasdaq went slightly off message today, rising 0.05%. However, in the preceding three trading sessions, it dropped a total of over 3%. Although these numbers don't come close to a correction, let alone a bear market, they are large enough to make many registered voters get nervous about their 401(k) accounts. If voters were wondering why the debt ceiling mattered, well, now they know.

The politics of the debt ceiling issue have become more convoluted than the serpents that served as Medusa's tresses. The impasse over the debt ceiling comes, to a large degree, from Tea Partiers and other conservatives seeing the ceiling as a matter of ideology. Just about everyone else understands it's a matter of financial management. But ideologues tend not to compromise on matters of ideology. So the trains no longer run on time in the processes of the federal government.

However, on Wall Street, Main Street and even Pennsylvania Avenue, money talks and bullswaggle walks. When the House got all wound up over TARP and voted it down on September 29, 2008, the market dropped about 8%. Constituents from sea to shining sea communicated with their representatives promptly, frankly and not positively. This captured the full attention of the House, and an amended TARP bill was promptly passed on a second try.

The principal activity of members of Congress is to tell their constituents what they want to hear; that's how they get elected. The debt ceiling squabble has devolved into a lot of posturing for the choir, which not surprisingly admires the Representative's new clothes. Representatives aren't getting enough objective feedback from the political process.

The stock market is just about the only means for imposing legislative discipline. There's no chance of a compromise before this weekend. Another down day in the market tomorrow might work wonders in opening hearts and minds on Capitol Hill to the joys of productive dialogue. Even though more market drops mean investment losses, there is no way to reach a resolution on the debt ceiling problem without pain. If there is no resolution, the pain from the financial markets will be much more acute that what we've experienced so far. If the markets fall again tomorrow, view it as filling the glass halfway.

European Credit Default Swaps: EU 15, Speculators Love?

An undercurrent of the EU sovereign debt crisis is that the Euro zone nations detest the speculators they believe have been gambling on the outcome of the Greek and other bailout efforts. Hedge funds and perhaps some investment banks dabble in credit default swaps protecting against defaults by various Euro zone nations as a way to gain speculative profits. While CDS's may have originated as hedging instruments, just about any financial instrument can be used to speculate as well as hedge. And CDS's, like many derivatives, can be traded on a leveraged basis, which makes them all the more appealing as speculative investments.

Euro zone governments loath speculators in CDS's of EU member nations' debt. Although CDS's nominally take their value from the market for the underlying financial instrument, there is a belief that derivatives markets can affect the markets for underlying financial instruments. In other words, a lot of CDS speculation on a Greek default might push the value of Greek bonds lower, increasing the potential for default by raising the market interest rates Greece must pay. The toxic interaction in the 1987 U.S. stock market crash between stocks and a type of derivatives contract called portfolio insurance fuels such beliefs. Portfolio insurance purported to guarantee the value of portfolios. Mutual funds, pension funds and other institutional investors flocked to this product (which is now extinct). When stocks dipped on Black Monday (Oct. 19, 1987), portfolio insurers began short selling underlying stocks in order hedge themselves against further stock drops. That short selling only increased the downward pressure on stocks, which triggered more selling and short selling. This increased selling impelled more short selling by portfolio insurers, which served only to fuel more panic. The market dropped a total of 22% that day, the greatest percentage drop ever, not excluding the 1929 stock market crash.

The EU's second bailout for Greece involves an expectation of a "voluntary" bond exchange by private holders of Greek debt for longer term debt, something that underlies the credit agencies' view of this bailout as a default. This exchange will entail a 20% loss for those holders. The exchange feature would lower the market value of Greek bonds and, perhaps, might be the sort of thing against which a CDS holder would expect protection. But the International Swaps and Derivatives Association, a trade organization composed of derivatives dealers, has decided that CDS obligations will not be triggered by the second Greek bailout because it doesn't change the terms for all holders of Greek debt. In other words, if a hedge fund holds a CDS on Greek debt and was hoping for a payout because the EU's bailout, part deux, would be considered a default by the rating agencies, it's out of luck.

How many speculators have been hurt by this decision, and how large their losses are, is unknown. The amount is probably not trivial, because all the volatility surrounding the Greek debt situation would provide a plenitude of speculative opportunities. Don't expect a lot of publicity about these losses. The speculators, knowing the EU member nations are probably quietly gloating over this victory, have plenty of reason to lick their wounds in silence. And don't be surprised if the EU, in the next bailout of Greece, Ireland, Portugal or whomever, doesn't try to structure things so that CDS's payment requirements again aren't triggered, and the speculators get spanked again.