James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

While it may well be a case of cut the U.S. budget or suffer a bond crisis, the current debate begs a question: who will pick up the slack in the economy and who exactly will finance them?

Democrats and Republicans raced, in a plodding sort of way, on Wednesday to reach a compromise budget deal that would keep the government operating past a Friday deadline.

Regardless of what may be wise, the likelihood is that there are going to be further substantial cuts in government expenditure, though this won’t begin in earnest until after the 2012 elections.

That is when the fun is going to start.

It is a simple fact that every dollar less in government expenditure is a dollar less received by the private sector.

Households in the U.S., being already in a sort of adrenal failure, are in no shape to expand spending and borrowing when the government contracts. Even the most extreme monetary policy over the past three years has only managed to bring on a tepid resumption in consumer spending, and, given the state of the housing market and the depressing path of wages, families beneath the top 10 percent are simply not going to go on a spree.

That leaves the corporate sector, and that is where we come to the role of the banks; their fantastic profits and their doubtful ability to finance a substantial recovery.

“The current balance sheet ratios of U.S. banks remain a serious impediment to the economy’s sustained recovery,” according to Andrew Smithers, economist at Smithers & Co in London.

If government is cutting and households are moribund, corporations are going to feel the strain in the form of reduced cash flow. This may mean increased investment, which implies taking on additional debt, or it may mean a fall in profits from their current historically high levels.

The state of corporate profits, as outlined in the national accounts released at the end of March, are really astounding. Overall corporate profits margins are at a record above 35 percent, their highest level ever in records stretching back before the crash of 1929.

The lion’s share of these profit margins are being generated by financials, which are at about 54 percent, well above their previous 1929 peak and more than 40 percent above mean. While that mean argues for a reversion, it is interesting to consider exactly why profits in finance recovered so quickly and with such an extreme trajectory.

ECONOMY TAILORED FOR BANKS

All of this is because the economy has been engineered by the authorities to allow for a bank recovery via profits, almost certainly at the expense of the rest of the economy. It is especially striking that while financial firms are far smaller than the rest of the corporate world in terms of the value they generate, they are twice as profitable per dollar of output. We also can’t expect banks to lead an investment recovery; they make fixed investments of only about a tenth of what nonfinancial corporations do.

Of course Geithner, Bernanke and Co were frantic to save the banks because they play a vital role in the economy; they must finance the assets that lead to expansion.

The problem though is that retained profits of the banks are only barely sufficient to support the growth in assets that would come with a healthy recovery, according to Smithers. If financial profits revert to mean, as is likely, especially in a rising interest rate environment, the banking sector may not have the muscle to fulfill its role. Bank equity ratios too, though high compared to recent standards, are not when looked at in the longer term.

Asset growth is crucial; looking at FDIC figures, asset growth in the banking system is running at about 6.75 percent, below the 7 and 8 percent growth of most of the last decade. Considering that securitization remains largely shut down, with the exception of the government-backed housing markets, this implies really quite tepid asset growth.

So, we have a government that is going to embark on painful cuts, a household sector that will suffer rather than compensate and a corporate sector dominated by finance, which leaks huge amounts of its profits in excess compensation and can’t even be relied upon to play its role in financing the economy.

It would have all been very different if the U.S. had forced proper writedowns and banking recapitalizations. The economy would not have had to be engineered for bank health and Main Street malaise, as it is today, and the healthy financial sector would be better able to support growth.

Budget cuts are coming, they will be painful and they will expose the weaknesses remaining in the banking system.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

China’s Christmas day interest rate hike may prove to be bad for global growth but good, at least for a time, for risky assets.

From that perspective, the Chinese policy change could end up being a much-needed helping hand to Federal Reserve chief Ben Bernanke, who has engineered a policy partly aimed to boost economic growth through the false miracle of asset price inflation.

The Chinese rate hike, taking the benchmark interest rate up by a quarter of a percentage point, signals an increased willingness by Chinese authorities to do what they must to dampen the party domestically. The move increased the one-year lending rate to 5.81 percent and one-year deposit rate to 2.75 percent.

It is aimed at cooling inflation, which is running at 5.1 percent annually on the consumer level, not to mention making itself felt through a booming property market and gold-rush-like appreciation in things like herbal remedies and rare delicacies.

Of course, higher interest rates, while they may cool speculation domestically, will only make China more attractive to international capital, which is already slavering at the prospect of an eventual appreciation of the yuan.

This is well understood within the People’s Bank of China: “Many domestic academics are worried that interest rate rises may accelerate global speculative inflows into China,” Sheng Songcheng, the head of statistics at the PBOC, wrote in a piece published on the bank’s website, warning that these flows were exacerbating inflation.

That implies that China may be steeling itself to more effectively block international capital flows.

But these flows, so-called hot money, don’t just exist because people think China is going to be a good investment over the next few years.

Those flows are, at least in part, a function of the extremely easy monetary policy in the United States and Europe, policy that is aimed at forcing money from the sidelines into risk asset markets. For a time, the easy implication of that easy policy appeared to be a grand carry trade, in which  investors partook of the generous liquidity and terms available in Frankfurt and New York and plonked it down in emerging markets, notably China.

MONEY NEEDS A HOME

China appears to be becoming less hospitable to that money, but it will not cease to exist. It will find a way into other markets, perhaps other emerging markets or places like Australia that are a play on emerging markets. It will also drive the developed markets of Europe and the United States.

This is not because growth prospects have improved in the West — given that Chinese growth may be capped by the rate rise, they haven’t — it is because it is cheap money that is seeking some sort of a home.

Federal Reserve officials have been relatively upfront that the second round of quantitative easing was aimed in part at fomenting a rally in asset prices and with it an increase in consumption and demand. Thanks to the latest PBOC hike, they may find that more of that wealth effect is concentrated in the United States.

This is not to say that a U.S. monetary policy aimed at boosting consumption by inflating asset markets is a good thing; it worked out badly the last 10 years and very likely will work out badly this time as well.

For the time being at least, that will not be in the front of investors’ minds. They will see that markets are going up, and if they are fund managers whose performance is tied to a benchmark, that will compel them to take on risk. This in turn will make a lot of economists inclined to see the glass as half full and the talk will be of how the recovery is becoming something worthy of the name.

One crucial hurdle will be the behavior of companies, which have been sitting on billions in cash and have been reluctant to add jobs even if they have been forced to add hours. Will they see a sustainable increase in demand and put money back to work? Or will it be simply another round of speculative frenzy, profitable for some but disruptive for the economy as a whole?

Ultimately China will likely have to raise rates repeatedly and take other strong steps to brook bank-fueled speculation, none of which will do anything good for global demand.

Even so, unless the market gets a shock, most likely from a troubled euro zone, it is fair to expect risky assets to continue to rally, seemingly without reference to the underlying fundamentals.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

The revolving door between government and Wall Street is wrong, antithetical to both democracy and capitalism and ought to be stopped.

For the second time in two weeks a high-ranking recent U.S. public servant has traded a position of influence in the corridors of power for a massive paycheck working for an institution that owes its very existence to government largess.

This time it is Theo Lubke, who has transitioned smoothly from heading the New York Federal Reserve Bank’s derivative regulation effort to working for Goldman Sachs, where he can be expected to, well, help it do well out of regulation, current and future.

Last week it was Peter Orszag, who until July was the Obama administration’s Director of the Office of Management and Budget, joining Citigroup’s investment banking unit as a vice chairman. Several days before that Citi hired George W. Bush’s Commerce Secretary, Carlos Gutierrez, as vice chairman for its institutional clients group.

To be clear, none of the parties is doing anything illegal and there is no suggestion that any of them wittingly acted against the public interest while in government service.

That, however, is a very low standard and far from an argument for a system in which regulators and high-ranking political appointees oversee the financial industry while at the same time having a near guarantee of being in line to be made rich by it a short time after leaving office.

It would take an angel to stand aloof from that kind of money, especially after having rubbed shoulders for years with their better paid, better shod but not better qualified peers in banking.

Money gives people a warm fuzzy feeling, and so does the prospect of it; it is little wonder that financial regulation has been so loose and so poorly enforced.

And please, don’t tell me that the right to go and make a fortune in finance afterwards is the price a people must pay for the services of the most able policymakers. Larry Summers is a genius and Bob Rubin evidently the wonder of the world, but having them at the center of banking and regulation has hardly been a boon for either taxpayers or investors these past 15 years.

The United States would have been far better off, as it was until the 1980s, with a set of regulations so tight it could be administered by plodders and a banking industry peopled by able but unimaginative types making a decent living.

That, of course, would lower the rewards on offer in banking, both in terms of the money banks could produce and their motivation to offer it. And don’t believe that simple banking can be equated to simple medicine or technology; on the evidence growing complexity in financial services has hurt clients, shareholders and taxpayers, leaving the sole certain winner bank employees. Future bankers in public service have done rather well out of it too, you could say.

NUPTIAL LOGIC

The Orszag-Citigroup marriage is particularly striking, given that he was in the inner circle of an administration that made the controversial decision to keep the bank alive despite ample evidence that it richly deserved to fail. If that does not give you a queasy feeling, and on the evidence it did not for Orszag, consider that Citigroup is now the lucky owner of too-big-to-fail status, giving it an unfair advantage over smaller competitors who haven’t convinced those in power that they are indispensable.

Hanging on to the too-big-to-fail brass ring is arguably job 1 for Citigroup going forward and having someone with Orszag’s experience and, er, contacts is obviously useful. Gutierrez can be viewed as an insurance policy against the fickle winds of political fortune.

As for the Lubke-Goldman nuptials, the attractions and dowry are pretty much the same. While Lubke can’t claim credit for seeing Goldman through its rough patch during the crisis, he was, as head of the New York Fed’s Financial Infrastructure Department instrumental in derivative regulation reform efforts. He is reported to have pushed for on-exchange trading, a policy that is almost certainly against Goldman’s best interest, it must be said. As a former top Fed official he will be banned from any Fed-Goldman meetings or from contacting his former colleagues on matters in the area he once worked, according to Bloomberg News.

That is something, but not nearly enough.

It is all quite a contrast with Kansas City Fed President Thomas Hoenig, who asked by the New York Times about his plans after his coming retirement, said:

“I can tell you one thing. I’ll never work for a too-big-to-fail bank.”

Hoenig, cussed as he is, is a bit of an angel, and so may be Lubke, Orszag and Gutierrez, but depending on angels is a lousy policy.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)