Google To Reach $100 Billion In Revenue; Increased 31% Last Year

By Loyd Eskildson

In 1990 the world's first web-page was created, and by 1992 there were all of 26. Today there are about 150 websites for everyone on the earth-- population (6.7 billion) and Google daily users number in the hundreds of millions. 
 
Google's chairman believes that Google (now $22 billion revenue firm) will someday reach $100 billion in revenues; revenues increased 31% last year. Googled: The End of the World As We Know It (Penguin Press/ Nov 2009) by Ken Auletta, is another in a line of books covering the history of Google's spectacular rise while also trying to explain it and project the future. The very good part of Auletta's work is that it makes readers think about Google's approach and potential in the future; the not so good parts are that many areas recently 'invaded' by Google are not well covered (fortunately, Wikipedia and Google itself can help fill in the gaps), and too many pages are filled with useless anecdotes and detail.
 
Google's search service underlies the company's success. It is based on a secret (to limit spammers' efforts to artificially boost ratings) algorithm (PageRank) developed by Google's founders, based primarily on the 'importance' of the pages (recursively determined by the other pages linking to them), and constantly under change (359 in 2008). About 200 factors are utilized in determining PageRank. Auletta contends that Google also uses cookies to refine search responses over time.
 
Google's advertising revenues account for more than 40% of all ad dollars spent online. Google also pumps additional ad dollars into tens of thousands of Web sites through its AdSense program in which Google serves as matchmaker, uniting advertisers with Web destinations. In effect, AdSense allowed Google to turn everyone's content into a potential place for Google ads. Google charges a fee of about 33%, and the Web destinations pocket about $5 billion/year as a result of visitors clicking on the ads. AdSense for search also allows website owners to place Google search boxes on their websites - Google shares any advertising revenue it makes from those searches with the website owner. 'Google AdSense' has been criticized by some as a large source of "invalid clicks," in which one company clicks on a rival's search engine advertisements to drive up the other's costs; auditing programs are available to help detect and correct for this.
 
Google AdWords, however, is the company's main source of revenue. AdWords allows potential advertisers to bid to place small text ads (95 character limit - less intrusive and bothersome than typical banner ads) next to the results for key search words. All auctions for ads are run online and automated. The highest bidder gets to place a small text ad to the right of the search results; up to ten lower bidders also win ad space below it. The order is set by a combination of comparative bid levels and the "quality score" of all ads shown. (The quality score is calculated by historical click-through rates, relevance of an advertiser's ad text and keywords, an advertiser's account history, and other determined by Google.)

Minimum bids per keyword are set by Google, also using the quality score - a commonly searched word or phrase like JetBlue might cost only a penny or two, while more esoteric phrases like helicopter parts might go for $50/click. Advertisers can choose to pay either according to the number of viewers or clicks. Google Analytics allows advertisers to track day by day, hour by hour, the number of clicks and sales, the traffic produced by the keywords used, the conversion rate from clicks to sales, where viewers came from (referrers, as well as physical location), etc. It helps advertisers target by age, sex, income, zip-code, personal preferences for leisure time activities, product preferences, news preferences. etc.
 
Google bought YouTube for $1.65 billion in 2006, the idea being to use it's free content as another platform for selling Google ads. YouTube, however, is losing money ($100 million expectation in 2009) so far. In 2008 Google also bought DoubleClick, a service that tracks users and records what commercial advertisements they view. It's main service is to automate the administration effort in the ad buying cycle for advertisers and the management of ad inventory for publishers to increase the purchasing efficiency of advertisers and to minimize unsold inventory for publishers - eg. allowing last-minute substitutions of higher-paying advertisers and filling unused ad space. Auletta reports DoubleClick as posting 17 billion display ads/day.
 
Ads constitute over 95% of Google's revenue, yet its tentacles are exploring numerous other areas. These include Google Earth, Google Maps, Google Scholar, Google Finance, Google Product Search, Google Calendar, Google Desktop (Docs, Spreadsheets, collaborative forms), Google Chrome (Google's browser), Google Sites (free and assisted way to create websites), Google Android (new mobile phone operating system, with over 1,000 released applications in 2008), Gmail, Google Reader, and Google Voice (provides people with a single phone number that can be used to reach them on their work, home, or cell phones, has 1.419 million users), as well as Google's efforts to digitize all books and to provide cloud computing (no installation). Part of this reflects Google's efforts to return more than just web sites in response to inquiries (eg. videos, books, photos, maps), and to respond to inquiries from more than PCs (about one-third of 2008 Google queries in Japan originated from mobile phones). Google's potential business model for all these is not clear - on the other hand, Google began without a business model, so it doesn't allow that to be an initial hindrance. (Google engineers are all allowed one-day/week to work on a project of their own choice, again without regard for profits; some of its non-engineers are also afforded that privilege.)
 
The cloud in Google's future - possible antitrust regulation, and lawsuits over copyright infringement (eg. Google Books). On the other hand, Fortune recently noted that Google and the Obama administration have generally good relations, with top company executives participating in a number of government projects.
 
Bottom Line: Readers need to read Googled slowly and carefully, thinking how this behemoth might affect their businesses. Newspapers, TV and cable stations are already undergoing dramatic changes as a result of Google. They also need to carefully read Wikipedia and Google sites for additional related information to fill in the holes Auletta left.

Ken Auletta is the author of ten books, including four national bestsellers. These include Three Blind Mice: How the TV Networks Lost Their Way, Greed and Glory on Wall Street: The Fall of the House of Lehman, and World War 3.0: Microsoft and Its Enemies.  You'll find the author online at www.kenauletta.com

Loyd Eskildson is retired from a life of computer programming, teaching economics and finance, education and health care administration, and cross-country truck driving.  He's now a reviewer for Basil & Spice.

Book Review: The Google Way by Bernard Girard

Copyright © 2006-2010, Basil & Spice. All rights reserved.

Ben Bernanke Makes 3rd Major Mistake: It's Solvency, Not Liquidity

 

John M. Mason-

The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.

I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.

I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.

Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.

The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.

If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.

But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.

Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.

The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.

A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.

First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.

And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.

The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.

To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.

Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.

Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?

And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.

To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.

One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MAJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!

John M. Mason writes on current monetary and financial events. He is a professor at Penn State University and has taught in both the Management Division and the Engineering Division. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania. Dr. Mason has been President and CEO of two publicly traded financial institutions and the Executive Vice President and CFO of a third. He has also served as a Special Assistant to the Secretary of the Department of Housing and Urban Development in Washington, D. C. and as a Senior Economist within the Federal Reserve System. Dr. Mason has served on the boards of venture capital funds and other private equity funds. He has worked with young entrepreneurs, especially within the urban environment, starting or running companies primarily connected with Information Technology.

Mervyn King, Gov Of Bank Of England Sets Off A Storm

2010 And Beyond: Inflation A Real Factor

U.S. Gov Debt Rose 36%, Largest In History $1.9 Trillion

Copyright © 2006-2010, Basil & Spice. All rights reserved.

U.S. Losing 30- 40 Million Main Street Jobs To Free Trade, Illegals, Automation

By Loyd Eskildson

Voter thinking this Tuesday focused on jobs and the economy, and sent a clear message of dissatisfaction with economic progress to-date. Reinvigorating Main Street America's employment picture, however, will not be easy. Problems have been building for years, long before the sub-prime crisis. Some believe automation is the major source of recent job losses. However, it is difficult to look at the constant parade of long trains carrying shipping containers inland, or the millions of illegals turning up all across America, and conclude that this is the case.
 
Substantial improvement on Main Street will primarily require drastically limiting 'Free Trade.' Free Trade supporters repeatedly cite the imposition of Smoot-Hawley tariffs as substantially deepening and prolonging the Great Depression, and conclude that we must not turn protectionist. Reality, however, is that prior to Smoot-Hawley, the 1929 Trade Surplus was an insignificant 0.38% of our GDP, and could not possibly have had significant impact even if lost entirely. True, international trade plays a much bigger role than in 1930 - however, the fact that we've run large and increasing trade deficits for decades is prima-facie evidence that no trade whatsoever would at least stop the bleeding.
 
As for Adam Smith's famous Free Trade support, that occurred 200+ years ago - before across-the-board very large and low-cost competitors like China, India, Japan, Korea, Taiwan, and Vietnam, the Internet, jet planes, and massive cargo ships made a much large proportion of economies vulnerable to offshoring than ever before. We need to also remember that protectionism is what allowed the U.S. and its new Asian competitors to achieve their original economic strength. (Smith himself warned against taking Free Trade too far - such that a nation's security was endangered.)
 
Free Trade defenders might assert that manufacturing and IT have borne the brunt of offshoring to date, and their future offshoring is not likely to increase. Recent trends and data, however, suggest service jobs will increasingly also become affected.  American firms are already establishing R&D facilities in China; Asian competitors not only have a cost advantage competing for engineering work, they also have the advantage of greater experience in production gained through producing our manufactures.

Unfortunately, this also provides them with a natural lead-in to new areas - eg. offshored CRT-tube manufacturing experience helped Asians in new areas of plasma, LCD, photovoltaic, solar, and LED screen development and manufacturing, and this trend probably will extend into nanotubes as well. Data reported in Business Week's 11/09/2009 issue confirms the shift - over the past year, U.S. employment of scientists and engineers has fallen by 6.3%, while overall employment has fallen only 4.1%.
 
Proposed U.S. economic remedies frequently suggest increasing the proportion of Americans receiving college degrees as a defense against offshoring. Alan Blinder, former Federal Reserve Vice-Chairman and current economics professor at Princeton, warns that the key distinction in whether a job is likely to be offshored or not will be in whether a particular service is delivered in person (haircuts, brain surgery) or not (computer programming) - not whether it is education intensive. (Elective brain surgery can also be offshored.) Thus, a college degree may no longer be a panacea. Blinder also believes it is quite likely that offshoring (unless changed) will depress the real wages of many U.S. workers who do not lose their jobs, the offshoring transition will continue for 2 - 3 decades and bring gross potential job losses in the range of 30- 40 million, and that American standards of living will decline.  Proposals by still others to deal with offshoring job losses via more jobs in high-tech areas (eg. biotechnology) become ludicrous when viewed in the light of these numbers. Professor Blinder's suggestion makes much more sense - increased vocational education.

Additionally, some Free Trade defenders contend that Chinese labor costs will soon become non-competitive. There are two problems with relying on this 'defense:'

1) Chinese productivity has also increased considerably. Economist Steven Roach (author of The Next Asia) lives and works in China and reports that productivity in China's industrial sector surged nearly 20%/year from 2000-2004. Further, even after six years of double-digit increases, average hourly compensation for Chinese manufacturing workers was only 3% that of the U.S. average in 2004. (It's difficult to get reliable up-to-date information on China.)

2) By 2020 it is estimated that there will be 553 million non-agricultural workers in China - 100 million more than in all the developed world, according to Martin Jacques in When China Rules the World.
 
Others contend that China cannot continue its rapid economic growth without Democracy, something it shows few signs of doing. Jacques, on the other hand, provides data showing that most Chinese believe the political climate has improved since 1989 (Tienanmen Square), and 72% of its population are satisfied with the condition of the country vs. only 39% in the U.S. (As for the widely reported large number of civil disturbances within China reported each year, Jacques contends most have nothing to do with the central government - eg. local land issues.)
 
Finally, there is the large and growing problem of illegal immigrants taking jobs from American citizens. The U.S. already has enough problems finding work for its own citizens, and the problems are going to become much more severe via currently unfettered offshoring. It is numerically impossible for the U.S. to also provide jobs for the current number of illegal immigrants from Mexico, Central, and South America - we must sharply reduce the estimated 12 million illegal immigrants in the U.S. 
 
Bottom Line: Main Street America cannot withstand continually losing jobs to Free Trade, illegal workers, and automation. Wall Street, on the other hand, has benefited immensely from these job losses and shows no signs of changing direction.  The recent financial crisis clearly demonstrated that financial markets are not self-correcting, and that Adam Smith's 'invisible hand' is not infallible. Immediate government redirection is required.

Loyd Eskildson is retired from a life of computer programming, teaching economics and finance, education and health care administration, and cross-country truck driving.  He's now a reviewer for Basil & Spice.

China's Surplus Labor: 745 Million; Its SS Fund $80 Billion

Copyright © 2006-2010, Basil & Spice. All rights reserved.

Gross Federal Debt To Increase 35.4% And 21.9% In Next 2 Years

John M. Mason-

Yesterday, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.

In the proposed strategy the Federal Reserve is developing, what is missing that might be crucial to the success of this strategy?

How about the fiscal deficits that the government is in the process of producing?

The deficit for the fiscal year ending this fall recorded the largest deficit in United States history: $1.4 trillion. And, some projections for the next ten years place the cumulative federal deficits around $15 trillion, more or less.

The Gross Federal Debt rose by 11.6% in fiscal 2008 and the estimates published by the government for fiscal 2009 and fiscal 2010 are 22.3% and 15.4%, respectively. The federal debt held by the public rose 15.2% in fiscal 2008 and is projected to increase by 35.4% and 21.9% in the following two years.

A lot of debt is going to be created by our government in the upcoming future and the assumption is that the public is going to absorb greater increases in the amount of debt they hold than ever before in peacetime!

The increases in debt over the past seven years have been of epic proportions. Carmen Reinhart and Kenneth Rogoff, in their informative new book This Time is Different, state of this buildup: “Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost…” They continue, “Over the longer run, the U. S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.”

Why do the exchange rates of nations that exhibit such fiscal irresponsibility decline?

The answer to this is that, sooner or later, the central banks of these nations have to become active in supporting the placement of the debt and this results in the monetization of that debt.

The question then arises, “Can the Federal Reserve reduce the amount of excess reserves it has injected into the banking system given the market pressures that surround the problem of the placing of the federal debt that is going to be created?”

Let’s look what seems to happening right now.

Some have argued that the Federal Reserve’s policy of “buying everything in sight” has created an asset bubble. The result has been that the prices in many different asset classes now move together: the movements in these asset classes now possess a high positive correlation rather than a zero or negative correlation. Thus, investors can achieve very little diversification across markets. And, as a consequence, the market volatility indexes have risen to remarkable highs.

The extremely low target interest rates, the quantitative easing, and the massive flows of capital into the United States resulting from the accumulation of foreign exchange reserves by foreign central banks keep Treasury bond prices high, prices of mortgage-backed securities high, United States equity prices high, and global asset prices high. (A bubble you say?)

To support the bond market and the market for mortgage-backed securities, that is, to keep interest rates low, the Fed has continued to pump reserves into the banking system. The reserve balances that commercial banks hold at Federal Reserve banks jumped $236 billion from September 30 to October 28 so that they totaled $1.080 trillion on this latter date. Excess Reserves held by commercial banks rose by around $190 billion from the end of August to the end of September, to around $1.0 trillion.

If these security prices are artificially high (and interest rates artificially low) due to Federal Reserve support, what will happen when the economy picks up activity and the Fed has to back off its underwriting of low interest rates? What will happen if this “backing off” coincides with the need of the Federal Reserve to “exit” from its excessively loose policy?

As I wrote earlier, the proposed exit strategy that the Federal Reserve is exposing to the public seems “logical and reasonable” given that “all other things are held constant.” Unfortunately, policy makers do not work in a world in which “all other things are held constant.”

Again, the policymakers are faced with the problem of dealing with the aftermath of earlier policy actions. As I have argued, the irresponsible fiscal policy of the early 2000s and the excessively low interest rates maintained by the Federal Reserve during this time (supported by both Greenspan and Bernanke) created the environment for the financial collapse of 2007-2008. The Bernanke Federal Reserve faced this collapse, to accumulating accolades, by throwing everything it could against the wall to see what would stick. (The lesson Bernanke learned from his research on the First Great Contraction was that in order to avoid a great contraction one had to leave nothing on the table for if one is going to err one must err on the side of excessive ease.)

Now we are faced with the problem of dealing once again with the left-over’s of previous fiscal and monetary policy. We are once again faced with a situation in which there are no “good” policies that are painless. As Reinhart and Rogoff conclude from their massive study of “Eight Centuries of Financial Folly,” pain cannot be avoided once financial folly has been committed.

Let me close once again as I closed my post yesterday: the Fed is in a delicate position. They cannot get out of this situation by “throwing everything it can against the wall.” Let’s just hope that they can find a way to get out of their conundrum with the least amount of negative consequences.

John M. Mason writes on current monetary and financial events. He is a professor at Penn State University and has taught in both the Management Division and the Engineering Division. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania. Dr. Mason has been President and CEO of two publicly traded financial institutions and the Executive Vice President and CFO of a third. He has also served as a Special Assistant to the Secretary of the Department of Housing and Urban Development in Washington, D. C. and as a Senior Economist within the Federal Reserve System. Dr. Mason has served on the boards of venture capital funds and other private equity funds. He has worked with young entrepreneurs, especially within the urban environment, starting or running companies primarily connected with Information Technology.

Mervyn King, Gov Of Bank Of England Sets Off A Storm

2010 And Beyond: Inflation A Real Factor

U.S. Gov Debt Rose 36%, Largest In History $1.9 Trillion

Copyright © 2006-2010, Basil & Spice. All rights reserved.

Exit Strategy: Fed Reserve Working To Prevent 1937 Funds Mistake

John M. Mason-

Interest continues to grow about how the Federal Reserve is going to remove all of the reserves that it has injected into the banking system. The articles are getting personal now. See, for example, the article in the Wall Street Journal this morning that actually brings us a name, Brian Sack, who is the head of the markets group at the Federal Reserve Bank of New York and the person responsible for developing the “exit strategy” that the Fed will use to remove the $1.0 trillion, more or less, excess reserves that reside on the balance sheets of the country’s commercial banks. (“Brian Sack Engineers Big Moves at Fed”)

The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.

The first question that arises is exactly what date do we go back to? Do we go back to the week before the week of September 15, 2008 when the financial collapse became paramount? Or, do we go back to the middle of December 2007 when the Bear Sterns deal was cut? Around this latter date we get the creation of the Term Auction Facility (TAF) that was a first innovation of the Fed to meet the financial crisis that was in its early stages. Let’s use both dates to see if there is any substantial difference between the two.

I have made three, rough calculations about the “excess” funds that the Fed needs to remove from the banking system if we are to get back to a Fed balance sheet that looks something like either the ones that existed on either December 19, 2007 or the September 10, 2008. I use the actual Wednesday data and not the averages of daily figures for the banking week ending on those dates.

The three rough numbers are $1.3 trillion to get back to the balance sheet of the earlier date and $1.1 trillion to get back to 2008 date. My third estimate is generated by assuming that the Federal Reserve balance sheet would grow from December 19, 2007, at a (generous) 10% annual rate up to the current reported figure for October 28, 2009. This third figure is $1.1 trillion. All these numbers are rounded off so as to produce general targets so that we have a rough idea of the magnitude of the task.

So, given these estimate the Federal Reserve needs to remove approximately $1.1 to $1.3 trillion from its balance sheet.

Now, there are two parts to the removal of these funds from the balance sheet. The first has to do with very specific responses to the crisis, either in terms of particular markets or in terms of particular institutions. In terms of particular institutions, I am referring to the “line items” on the balance sheet that relate to the Bear Sterns and the AIG deals. In terms of particular markets, I am referring to the facilities set up for Primary Dealers and Broker-Dealers, Commercial Paper Funding, Money Market liquidity funding, Central Bank liquidity swaps and so forth.

The current strategy of the Federal Reserve with respect to these specific “line items” is to let the dollar amounts decline at their own speed as the need for them dissipates or as the assets are worked off. This strategy is already reflected in the balance sheet results examined in my series on the Federal Reserve Exit Watch.

The total of these accounts, as of October 28, 2009, is $412 billion. These accounts seem to be declining on a regular basis and there is really little or nothing that the Fed can do to speed this decline along. In fact, you want these accounts to be reduced at their own pace because as the need for the assistance goes away, the accounts will fall to zero. True, some of the accounts could remain on the books for an extended period of time, but these will be minor relative to the whole balance sheet.

If you remove these numbers from the shrinkage that needs to take place on the Federal Reserve balance sheet you are left with numbers in the $700 to $900 billion range. The total of Mortgage-Backed securities on the balance sheet as of October 28, 2009 is $774 billion. Federal Agency securities totaled $142 billion on that date. Thus, the “active” strategy for reducing the Fed’s balance sheet relates to these specific security portfolios.

This is where the proposed program called “reverse repos” comes into the picture. Obviously, the Fed cannot just dump $774 billion in mortgage-backed securities on the financial markets. (There is even some concern that Congress may want the Federal Reserve to hold onto a large portion of these securities so as to continue to support housing in the United States. That, however, raises other issues.)

Furthermore, the Federal Reserve is very cognizant of the events of 1937. The United States economy had recovered from the Great Depression (or Great Contraction) and was experiencing relatively satisfactory growth at that time. The commercial banking system, however, was holding onto a large amount of excess reserves (not unlike the current situation). In order to tighter their control over credit, the Federal Reserve, in all its wisdom, raised reserve requirements.

The result was disastrous! The bankers wanted those excess reserves and the removal of them caused the banking system to contract even more and the amount of credit and money in the economy contracted as well. The 1937-1938 depression was the result.

The Federal Reserve does not want to duplicate such a mistake. Consequently, they are going to try and “ease” the funds out, not “yank” them out. This, seemingly, is the reason why the Fed is looking at the “reverse repos’ program as an alternative. Because “reverse repos” would represent the “temporary” removal of funds from the banking system and because they would be undertaken through market transactions, the Fed would not get “ahead of the curve” in removing reserves from the banks. That way, they would constantly be “in the market” and be able to determine if there was any resistance to the removal of funds. In that way, they could proceed incrementally toward selling the securities and then, as the markets allowed, actually sell them outright from their securities portfolio.

The Federal Reserve is in a delicate position. They know that they will need, at some time, to remove the excess reserves from the banking system. However, they don’t want to move too fast and create another financial crisis, as happened in 1937. But, the Fed knows that at some time it is going to have to remove the excess reserves as quickly as it can.

Let me repeat, the Federal Reserve is in a delicate position! In talking about “exit strategies” in the public domain, Fed officials hope to keep the financial community informed and prepared for what might be done and at the pace it at which it will be done.

John M. Mason writes on current monetary and financial events. He is a professor at Penn State University and has taught in both the Management Division and the Engineering Division. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania. Dr. Mason has been President and CEO of two publicly traded financial institutions and the Executive Vice President and CFO of a third. He has also served as a Special Assistant to the Secretary of the Department of Housing and Urban Development in Washington, D. C. and as a Senior Economist within the Federal Reserve System. Dr. Mason has served on the boards of venture capital funds and other private equity funds. He has worked with young entrepreneurs, especially within the urban environment, starting or running companies primarily connected with Information Technology.

Mervyn King, Gov Of Bank Of England Sets Off A Storm

2010 And Beyond: Inflation A Real Factor

U.S. Gov Debt Rose 36%, Largest In History $1.9 Trillion

Copyright © 2006-2010, Basil & Spice. All rights reserved.