What is going on with the world of finance, and how do you fix it!

I had an interesting question put me last night.  Since I view companies differently than anybody else, how do I view the macro financial world, including national governments and interest rates?

As I have said many times I am not personally responsible for the development of the “Key Concepts” however I spend 24/7 thinking of what I see in the world of finance and reconciling observations back to these concepts.

We have always performed our “Solvency” work on the United States – Balance Sheet.  Every quarter the Federal Reserve releases their “Flow of Funds” data, which encompasses balance sheet data on both government and the private sector.  This data is invaluable and I wish all countries were required to produce such a document.  Anyway, I can go into the nitty-gritty details of these numbers another time but the main objective of this blog post is to focus on the big picture.

Since this is a “Balance Sheet” recession, not a garden variety inventory recession we can analyze balance sheets to see what is going on and more important what we can do to fix this predicament the world finds itself in.

The “Solvency Curve” and The “Solvency Ratio”

Here is the formula for the “Solvency Ratio”.  This formula can be applied to any balance sheet, individual, government and obviously private and public companies.

Once you have the output, the result can be fit on our “Solvency Curve” to see where the ratio resides.  Performing this exercise over time and you can get a feel for the dynamic of what different segments are doing with their balance sheets, both on a macro level (combining balance sheets) and micro level (individual balance sheets).

Here is our Solvency Chart of the United States

So what is Going On?

First, let’s look at the US Federal government.  The “Solvency Ratio” has been at 0.135 for at least a decade.  How is this possible, especially since the US government has added so much debt in the last 5 years?  Good management of the ratio whether intended or not.  As the US Federal debt level increased (P), the Treasury insures there additional cash set aside balancing out the R in the equation above.  R maybe going up in proportion to P, however it’s all with borrowed money.  This is one of the reasons, I believe, last August the markets had such a violent reaction when the debt limit debate erupted in Congress.  With a lack of new borrowing, the “Solvency Ratio” quickly falls below 0.135, which implies “Total insolvency” if not “Total Breakup” of the entity in what we call the “3rd Order of Insolvency”.

Fun stuff!

Don’t put me down with the “Gloom and Doomers”!

The United States is an incredibility rich country.  Yes, the US Federal government maybe a mess, according to some, however when you add the other balance sheet categories, states governments, corporations, financials and individual balance sheets in aggregate the “Solvency Ratio” is over 2.  This reading gives the US a “Super Solvent” reading, which for many is hard to believe.  Now, many may criticize that we didn’t include future off balance sheet mandates, which are not included in the “Flow of Funds” data, but these future obligations can change with a stroke of a pen and political will.

What is my point?

It’s the dynamic that is most important.  If you notice both arrows on the “Solvency Curve” are pointed down the slope on both sides.  The US Federal government is borrowing more money, as total debt increases even though its’ “Solvency Ratio” stays constant.  All the other categories (other than the US Federal government) in the “Flow of Funds” statement indicate balance sheets are shifting to the right side of the curve indicating de-leveraging and/or increased savings or solvency.  This makes sense, in that all organizations will have to pay eventually for the solvency of the Federal US government in the form of taxes or reduced services.  This shifting started under George W. Bush and has accelerated under the 2008 financial crises.

UK, Ireland, Greece, Italy, and those countries hurt by this current financial crisis are experiencing this same movement along the “Solvency Curve”.  We have no specific numbers, unlike the US, but it doesn’t take a genius to figure out the variation on the theme.

The other point I like to make, especially on the accumulation of US Federal debt, in that there is a cost of additional debt being taken on.  Some economists (say the Krugman Camp) take the position the US should borrow more for infrastructure projects and the like.  With interest rates at record lows, now is the time to close the demand gap between potential GDP and current economic activity with federal government demand to fill the gap.  The other side of the argument, say the Tea Party/Republican side, point to the debt of the US as a threat to US freedom and potentially turning America into a third rate global power.  Both sides have interesting arguments, and can be convincing, depending on your frame of mind.

What is the right answer?

First, there is a cost to the additional debt taken on by the US Federal Government.  However it is hidden. By expending the balance sheet of the Federal government, R+P in the above formula, Theoretical Earnings (TE) are getting larger. (See “Key Concepts).  With larger TE, the US by taking on more federal debt becomes less efficient.  In other words, it will take more economic activity to produce the same level of output.  This will become the “heavy hand” on economic activity regardless of where interest rates are.  Unfortunately as you know, there is no such thing as a free lunch.

Also, as the US Federal government borrows more money, the other categories move evermore right.  This has been happening in Japan for more than 20 years.

So hopefully you can picture the dynamic, with more borrowing by the Federal government, the more institutions and other categories in the “Flow of Funds” are going down the other side of the curve – deleveraging and accumulating cash.  This dynamic is being played out all over the world, especially countries that had a banking crisis.

At the time of writing this blog, 12 major nations now have 2-year rates below 1% with 4 of those nations having NEGATIVE interest rates.  Why?  Cash has accumulated to such a degree, and with central bank performing (QE) – quantitative easing, demand for secure savings vehicles is outstripping supply especially in countries viewed as safe havens.

So “Smart Guy” what is the answer?

The answer resides in the national governments.  It is the US Federal government that is driving the other categories down the other side of the curve.  In other words, the solvency of the government is the issue.  Therefore, in my mind the President, or whoever, must layout a fiscal plan to at least balance or close the gap in the fiscal deficit.  When and if, the federal government starts to climb the left side of our solvency curve, the other categories will start to move up the right side of the curve.  The debate of raising taxes or cutting expenses is not the choice Americans have at this present time.  It’s both!  Taxes will have to be raised and expenditures have to be cut substantially in order to rectify the situation.  Once everyone sees the plan and its implementation, the other categories on the right hand side of the curve, especially corporations will start spending their records amounts of cash on hand.  Why?  The right side of the curve “categories” can see sustainability in the future of the federal government.  They can see a limit in terms of taxes and/or reduced services.  This will give them confidence in the future and they will spend money on long-term projects, igniting employment and giving confidence to other groups.  And so on.

You mean substantially increase taxes and the economy will boom – absolutely!  You mean substantially cut federal spending and there won’t be a depression – absolutely!  We have tried all the conventional economic stuff, isn’t it time for the counter-intuitive?

The New Bull Market

Yes, there will be a new bull market – when?  Simple, when both sides of the solvency curve start to move closer together as opposed to further apart.  No, when as in timing?  I don’t know.  But I will know it when I see it!

The other observation I can make, is when we do enter this new bull market, it will be bigger than any other bull market we have ever had.  Why?  The extreme nature of where we are now on the solvency curve.  Obviously, US Flow of Funds data is not available for the great depression of the 1930’s (at least not to us), however the extremes on both sides of the curve, as it is today, haven’t occurred certainly in my lifetime.  So when today’s extremes start to stop and reverse course there will be a lot of “Rocket Fuel” for the next bull market.

I know, this can’t happen soon enough!

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