Monthly Archives: March 2010

Operation Twist, Part Deux?

by Marshall Auerback and Rob Parenteau

Who funds our budget deficit? It is a question taking on increasing significance, given the recent back up on longer-dated bond yields, which has been explained by many as a “buyers’ strike” in response to growing government profligacy. We think this argument displays a seriously lagging understanding of how much modern money has changed since Nixon changed finance forever by closing the Gold window in 1973. Now that we’re off the gold standard, neither our international creditors, nor the so-called “bond market vigilantes”, “fund” anything, contrary to the completely false & misguided scare stories one reads almost daily in the press.

In his usually effective fashion, Bill Mitchell debunks the notion that “the markets” determine our interest rate structure, as opposed to the central banks. Mitchell discusses this in the context of his analysis of a BIS paper, “The Future of Public Debt: Prospects and Implications”, which raises the old canard about a potential “bond market buyers’ strike” as a consequence of rising public debt.” “[T]he debt ratio will explode in the absence of a sufficiently large primary surplus”, argues the author of the BIS paper. 

From which – Mitchell deduces- “the governments [should] either stop allowing the bond markets to determine yields – that is, use their capacity to control the yield curve or, better still, abandon the practice of issuing debt.”

Mitchell then poses the question: “Why will yields spike dangerously so that real interest rates exceed real output growth rates? There is no answer to this question provided.”

There is no answer provided because, as a point of economic logic, Bill’s critique of the BIS is (as usual) unassailable. BUT as any regular observer of the markets can tell you, bonds have begun to rise again over the past few weeks, notably in the US. This might have occurred for the dumbest reasons imaginable (one person foolishly tried to link the rise in US yields to Portugal’s downgrade by the benighted ratings agencies).

On the other hand, one of the great insights of George Soros was the notion that markets could act on incorrect or imperfect information and thereby create a new kind of economic reality. It might well be that very few understand MMT or basic public reserve accounting, but that doesn’t alter the reality that bond yields have risen 20 basis points in the past week or so. And a central bank which is underpinned by a market fundamentalist ideology, coupled with a bunch of “big swinging dicks” in the trading pits is a potentially toxic combination. The Fed follows the price action at the long end of bond market. Long bond investors often try to force Fed’s hand. Around and around they go,dog chasing tail style.
There’s a power dynamic here – who’s really in control: Big Swinging Dick Finanzkapital (BSDF)or policy geeks who understand basic public reserve accounting?
The Fed clearly has a dilemma. It needs to finesse expectations management for BOTH Treasury bond and equity investors. Bond investors need to know they are not going to get screwed by inflation, so they want the fed funds rate renormalized. Equity investors want the “extended period” of ZIRP to last for, well, an extended period. Free money is good for specs.
So what’s a central banker like Bernanke to do?
How about a modern version of “Operation Twist”, which was implemented originally by the Fed in 1961 to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. It was only marginally successful back then.
So why should it work better today?
Well, the Fed has more tools in its policy box, thanks in part to its policy of paying interest on excess reserves (IOER). Scott Fullwiler has an excellent paper on this (“Paying Interest on Reserve Balances: It’s More Significant than You Think”), in which he demonstrates that this change in Fed policy has severed the relationship between the policy rate target and the level of reserves outstanding (if there ever was one – some indications in recent years were that all Fed had to do was announce new fed funds rate target, and primary dealers would take it there, knowing Fed had capacity to change reserves outstanding – all of which meant Fed did not have to change reserves, since they had a credible threat they could, making the textbook story about Fed ops even more outdated and incorrect).
So the Fed can tell everybody that they are renormalizing the fed funds rate and take the IOER up to 100bps. Note, the Fed does not need to remove any reserves to do this – they can just do it administratively. That’s how the IOER works – it severs the link between reserves in the system and the target policy rate, right?
Then, if the bond gods don’t rally Treasuries on the Fed’s efforts to renormalize the policy rate, Mr Bernanke calls up Bill Dudley (President at the NY Fed) and gives him instruction to buy all the 10 year UST on offer until the 10 year UST yield is down to, oh , say 3.5%. It is an open market operation, which the Fed performs all the time. They won’t have to call it QE, but it is in effect the same thing.
Then, every time some big swinging dick bond trader tries to push it above 3.5% by shorting Treasuries, the Fed slams their face into the concrete by having the open market desk buy the hell out of UST until the 10 year yield is back to 3.5%. Burn Fido enough times, yank his chain enough times, and like the Dog Whisperer, he gets it and stops.
No less than one of the leading “bond market vigilantes” has conceded this point. In his October 2003 Fed Focus, PIMCO’s Paul McCulley has acknowledged that “any market induced—foreign or domestic-driven—upward pressure on U. S. intermediate or long-term interest rates would/will be limited by the leash of the Fed’s . . . anchoring of the Fed funds rate . . . . Put differently, there is a limit to how steep the yield curve can get, if the Fed just says no—again and again!—to the tightening path implicit in a steep yield curve”.

What happens if the 10 year bond breaks out of the 3.5% to 4% range significantly even with no changes in expectations regarding the Fed? Could that happen, or is there some arbitrage mechanism that brings it back? Of course, there will always be smart bond traders (such as our friend, Warren Mosler), who will understand the potential arbitrage opportunity at hand and react accordingly, but a signal from the Fed that it desires a certain rate level or term structure for rates will facilitate the process.

Operation Twist, Part Deux, then? It strikes us as the optimal way to finesse the expectations management dilemma.

It seems to us that we are now approaching a very critical juncture in terms of potentially settling the debate between those who think that central banks establish the rate structure (as most readers of this blog believe) versus those who believe that this is done by the markets (such as the usual band of deficit hawks, and the writer of the BIS report critiqued by Bill Mitchell). Of course, like most MMT adherents, we feel that the whole debate would become less relevant if the US Treasury responded to today’s environment through sensible proactive fiscal expenditure, but it’s hard to sustain political support for that amidst sock puppet politicians who dole out goodies to their corporate contributors, and an Administration which genuinely believes we’re “running out of money”.

That places an unnecessarily large burden on the Fed, hardly an appealing prospect, given Mr Bernanke’s own neo-classical economics framework. Keynes himself was quite explicit about the importance of investor portfolio preferences in determining interest rates specifically. Indeed, Ch. 12 of “The General Theory” is all about the beauty contest aspect of asset price determination in the face of fundamental uncertainty and asset markets organized to optimize liquidity for existing holders. Does the Fed understand this? It may well not happen, but no question an aggressive move to counter short term portfolio preference shifts on the part of private investors could do much to resolve this “who determines rates” question once and for all.

There’s a power dimension here. Does the Fed really want to be led around by the nose by the very same people who created today’s economic disaster?

William Black on the Financial Crisis, Mortgage Fraud, and the Top Ten Ways to Crack Down on Corporate Financial Crime

Part I:

Watch PARTS II-III-IV-and IV here.

Part II:

Part III:

Part IV:

Part V:

Hat tip new deal 2.0

The Chinese Are Coming! The Chinese Are Coming! Oh My!

By Yeva Nersisyan and L. Randall Wray

One of the scare tactics in the toolbox of the deficit hawks is the argument that Chinese ownership of U.S. government bonds is dangerous, economically and politically. Portraying the government as a currency user akin to households, they argue that after reaching some debt to GDP threshold, sovereign governments face difficulties in finding takers for their debt so that they have to pay higher interest rates to compensate holders for higher risk of default. Indeed, it is frequently claimed that China is responsible for “financing” a huge portion of our federal government’s deficit—and that if China were to suddenly stop lending to Uncle Sam, he might be unable to finance his deficits except at usurious rates. So China controls Uncle Sam, holding his debt hostage.

This is nonsense.

The true effects of government deficits and debt on the economy have been discussed here and here. But these previous posts have not addressed in detail the distinction between domestic and foreign ownership of Treasury debt. In this post we would like to clarify what foreign ownership of treasury securities really means and whether it represents any real dangers for the U.S.

The following figure shows foreign ownership of US federal government debt, by percent of the total publicly held debt. The percent of the total held by foreigners has indeed been climbing—from less than 20% through the mid 1990s to nearly fifty percent today. Most of the growth is by “official” holders—foreign treasuries or central banks, now accounting for more than a third of all publicly held federal debt. This is supposed to represent US government ceding some measure of control over its purse strings to foreign governments.

The heavy purple line shows the US current account balance—largely made up of our trade deficit. (Note the sign is reversed: a deficit is shown as positive; a surplus is negative.) Since 1980 this had fluctuated near a range of minus 1 or 2 percent of GDP. However, after 1999 the current account balance plummeted to a negative 6% of GDP; while it has turned around to some extent during the global downturn, it was still nearly a negative three percent of GDP. Note that the rapid growth of foreign holding of treasuries coincided with the rapid growth of the current account deficit—a point we return to below.

The final (light blue) line plotted above shows domestic financial sector holdings of treasuries. This had been on a downward trend until the current global crisis—when a run to liquidity led financial institutions to increase purchases. Note also that financial sector holdings act as something like a buffer—when foreign demand is strong, US financial institutions reduce their share; when foreign demand is weak, US institutions increase their share. In recent months, the current account deficit has fallen dramatically; this has reduced foreign accumulation of dollar assets—with a small reduction of the percent of treasuries held by foreigners.

Of course, new issues of treasuries have increased with the growing budget deficit, and US financial institution holdings at first increased (the run to liquidity in the crisis). Foreign official holdings have also continued their climb. This could be because the US dollar is still seen as a refuge of safety, but more likely it is because nations still want to accumulate dollar reserves to protect their currencies. That is the other side of the liquidity crisis coin, of course—if there is a fear of a run to liquidity, exchange rates of countries thought to be riskier would face depreciation. Indeed, the graph shows that foreign official holdings of US treasuries began a long term trend in the late 1990s, after the Asian Tiger crisis. The lesson that seems to have been learned by at least some governments is that holding US treasuries offers protection to nations that try to peg their exchange rates.

The next figure displays the top foreign holders of US treasuries. While most public discussion has focused on Chinese holdings, Japanese holdings had been greater than Chinese holdings previous to 2008—and again surpassed those of China as of December 2009. Indeed, Japanese holdings reached nearly forty percent in the mid 2000s—far greater than the Chinese peak holdings. As we discussed above, there is a link between US current account deficits and foreign accumulation of US treasuries. Note also that the most recent data from China indicate that it ran an overall trade deficit; its accumulation of foreign assets must have slowed. It is too early to know whether this will continue—since it probably is due to relatively rapid growth in China in the context of a global recession. If it does, however, Chinese accumulation of US treasuries will probably slow.

Looking at it from the point of view of holders of dollar assets, their current account surpluses allow them to accumulate dollar-denominated assets. In the first instance, a trade surplus leads to dollar reserve credits (cash plus credits to reserve accounts at the Fed); since these balances have until very recently earned no interest they were most often exchanged for US treasuries and other financial assets. Thus, it is not surprising to observe a link among US trade deficits, foreign trade surpluses, and foreign accumulation of US treasuries. To put it concisely: Japan and China are big holders of foreign assets because they are exporters; and as the US is a target for their exports, dollar assets including US treasuries accumulate in Japan and China.

While this is usually presented as foreign “lending” to “finance” the US budget deficit, the correlation between US budget deficits and foreign accumulation of US treasuries does not actually demonstrate causation. The US current account deficit can just as well be taken as the source of foreign current account surpluses that can take the form of accumulations of US treasuries. In fact, by identity, the only way the rest of the world can net export to the US is if it accumulates an equal amount of US financial assets (adjusted by US official transactions). And it is the “propensity” (if not willingness) of the US to simultaneously run trade and government budget deficits that provides the wherewithal for foreign accumulation of treasuries. Obviously there must be a willingness on all sides for this to occur—we could say that it takes (at least) two to tango—and most public discussion ignores the fact that the Chinese desire to run a trade surplus with the US is linked to its desire to accumulate dollar assets. At the same time, the US budget deficit helps to generate domestic income that allows our private sector to consume and invest—some of which fuels imports, providing the income foreigners use to accumulate dollar saving—even as it generates treasuries accumulated by foreigners. So in this case, it takes three to tango.

In other words, the decisions cannot be independent—it makes no sense to talk of Chinese “lending” to the US without also taking account of Chinese desires to net export. Indeed all of the following are linked (possibly in complex ways): the willingness of Chinese to produce for export, the willingness of Chinese to accumulate dollar-denominated assets, the shortfall of Chinese domestic demand that allows China to run a trade surplus, the willingness of Americans to buy foreign products, the high level of US aggregate demand that results in a trade deficit, and the factors that result in a US government budget deficit. And of course it is even more complicated than this because we must bring in other nations as well as global demand taken as a whole.

While it is claimed that the Chinese might suddenly decide they do not want US treasuries any longer, at least one but more likely many of these other relationships would also need to change for that to happen. For example it is often said that China might decide it would rather accumulate Euros. While this could tend to promote more exports to the euro zone, there are complications on the financial side. For example, there is no equivalent to the US treasury in the eurozone. China could accumulate the euro-denominated debt of individual governments—say, Greece!—but these have different risk ratings. And with the sheer volume of Chinese exports, China’s purchases of national government euro debt further increases risk by driving down risk premiums—with China absorbing too much country-specific risk to feel comfortable purchasing individual euro nation debt.

Further, the euro nations, taken as a whole (and this is especially true of its strongest member, Germany) attempts to constrain domestic demand in order to promote exports. In other words, by design, Euroland will not passively allow itself to be a source of net demand for Chinese exports. Therefore if China sold its dollars and bought euros–weakening the dollar and strengthening the euro–it could lose more US exports than it would gain in euro zone exports. China would likely reverse course very quickly. A similar story can be told with respect to an attempt by China to export to Japan—another nation that relies heavily on exports—to accumulate Japanese government debt. And because China does seem to worry about capital losses on its dollar holdings, it would appear to have a low tolerance for dollar depreciation caused by its own actions. In other words, if it caused the euro or yen to rise relative to the dollar, it would quickly change policy to prop up the dollar. For these reasons, we seriously doubt any scenario in which China runs out of the dollar.

We are not arguing that the current situation will go on forever, although we do believe it will persist much longer than most commentators presume, based on our belief that China is intent on supporting its export sector. We are instead pointing out that changes are complex and that there are strong incentives against the sort of simple, abrupt, and dramatic shifts that are posited as likely scenarios. We expect that the complexity as well as the linkages among balance sheets and actions will ensure that transitions are more moderate that many observers currently expect.

Finally, many are concerned with the “interest burden” entailed in foreign ownership of US treasuries: the US is committed to making “costly” interest payments. Referring specifically to China, on an operational level it gets its dollars by selling goods and services to the US. When it gets paid it gets a credit balance in its reserve account at the Fed. Buying Treasury securities entails nothing more than shifting funds in China’s reserve account at the Fed to China’s securities account at the Fed. And when those securities mature, funds are simply shifted back to China’s reserve account at the Fed, with interest also credited to China’s reserve account.

Note that none of these transactions has anything to do with actual government spending, which operationally and independently consists of changing numbers upwards in the accounts of the recipients of government spending—and most of these are domestic residents and firms. The too often invoked imagery of ‘borrowing billions from China to fund health care and the war in Afghanistan and leaving the debt for our children to pay’ is at best an inapplicable absurdity. At worst our children will be simply doing nothing more than debiting and crediting accounts at the Fed just like we do and just like our mothers and fathers did before us. We don’t owe China anything more than a bank statement showing the accounts at the Federal Reserve Bank where their funds are recorded.

Finally, some worry that China might someday present its holdings of reserves and treasuries at the Fed to US exporters, converting its dollar claims to claims on US output. Yes, that could happen. If it does, the demand for US exports will be met by some complexly determined combination of dollar appreciation, rising prices of US exports, and a greater quantity of exports. The later two effects would almost certainly increase US production and hence employment. If there is any burden of Chinese ownership of US dollar assets, it is that US employment and exports to China could be higher. Ironically, most of those who fear US indebtedness to China would actually celebrate these impacts if they were to occur. (They do not understand that imports are a benefit and exports are a cost—but that is a topic we will leave for another day.)

In conclusion, it is time to put the fears about Chinese holdings of US treasuries to rest.

Marshall Auerback on Greece, the Euro and Fiscal Policy

Watch the video here.

Tell your representative to leave Social Security alone

By L. Randall Wray
Ok, here is the dumbest headline the NYTimes has run in recent days:

Social Security Payouts to Exceed Revenue This Year

The system is expected to pay out more in benefits this year than it receives in payroll taxes, a tipping point toward insolvency.

Social Security is a federal government program. Government pays Social Security benefits by crediting bank accounts. It can continue to do this even if payroll taxes fall to zero. The payment is an entry on the balance sheet of the Social Security recipient’s bank. Please write your representative and tell her or him to stop this nonsense right now.

Just as Wall Street went after healthcare, you can be sure that it is now going after Social Security. They hype is just starting. It comes in waves—whenever Wall Street loses a bundle, it looks to government bail-outs. What happened after the bust? Wall Street got President Bush to talk about an ownership society, proposing to dismantle Social Security to give households “ownership” over their own personal retirement accounts. The nonsense was obvious at the time: Wall Street had a big hole to fill, so it wanted households to “invest” payroll tax receipts in Wall Street managed accounts. That way, the same bozos who had just wiped out private savings by inducing gullible households to invest in would be able to wipe out retirements investing in other Wall Street schemes. Wall Street lost that round.

But now it is back. Wall Street’s latest excesses managed to destroy the economy. Those who lost their jobs or who had to take paycuts are paying less in FICA taxes. Hence, Social Security’s “revenues” are lower. That is a big boon to Wall Street—which will now whip up hysteria about Social Security’s looming bankruptcy. This is to direct attention away from the true insolvencies—which is all of the major private banks. It is also designed to scare the population about Social Security: will I ever get my Social Security pension?
Make no mistake about this. Unless voters tell their representatives to keep their dirty hands off Social Security, the Democrats and Republicans will work out a “compromise” to turn it over to Wall Street—just as they did with health insurance “reform” in the HIBOB (health insurer’s bail out bill). This is priority number one for Wall Street now, since it has lost trillions of dollars and is massively insolvent. It needs more government bail-out and it wants your Social Security.

Health Reform.Gov

By L. Randall Wray

Many who supported health care reform are celebrating passage of the Health Insurers Bail Out Bill (HIBOB) and the argument that something–no matter how fundamentally flawed–is better than nothing. Fine. That is a point that Michael Moore as well as Dennis Kucinich make–and they are far more politically astute than I am. How can I criticize them?

A lot of my friends do not want to hear any criticism about the flaws. They ask for a few days to bask in the glorious victory. They think my critiques of the HIBOB are “annoying”. I take that as my job description.

Oh, alright, celebrate. But don’t you think that someone ought to point out what the flaws are, so that we might move forward? Even if the bill were a marginal improvement over what we have, and even if it allows the Dems to claim a victory, no one should be fooled into thinking this was healthcare reform. Health insurance reform? OK, maybe a bit-—but more on that below.

I think that any legislation that forces people against their will to turn over their paychecks to the FIRE (finance, insurance and real estate) sector is a mistake–it does not take too much thought to foresee the kinds of problems this will generate down the road. Also note that the government is going to start taxing and reducing Medicare funding BEFORE anyone gets the “benefits” of the legislation. What a great policy to introduce in the midst of this great depression! (Sound like 1937 deja vu all over again—when government started collecting payroll taxes before Social Security payments started, throwing the economy back into the Great Depression? You betcha.)

There is very little in the bill that requires health insurers to actually pay for the provision of any additional services–and most of the small improvements in that area do not kick in until 2014 or 2018. Read the fine print. Existing insurers are not subject to new requirements–only new insurance providers. The “legacy” firms get grandfathered–business as usual for them, and time to fight the provisions to ensure they never take effect.

Yes more people will get INSURANCE. Will they actually get more CARE PAID FOR? Not necessarily. They will get hit with deductions, co-pays, annual limits (for several more years), exclusions, out of pocket expenses. This will ensure that health CARE remains too expensive to actually take advantage of their new INSURANCE. And many currently insured people are going to get higher taxes. Premiums will rise. Government is going to shovel more of the costs to you. Wall Street needs your money.

There will be revolts of uninsured who do not like the mandates. We might need more riot police and prisons. More costs to bear to keep Wall Street insurers flush.

Exactly how it all turns out will take years to determine. I expect that insurer abuses will increase significantly; there will then be a regulatory reaction–as in Massachusetts. We will try to impose regulations, restrictions, fees, fines, taxes, and what-have-you on the insurers to force them to do what they do not want to do. Indeed, we will try to force them to do what no insurance company ought to do. That is because health insurance is fundamentally at odds with healthcare. Always has been, always will be. It is a crazy way to pay for healthcare.

So ultimately, that is what the problem with the HIBOB really comes down to: the insanity of running healthcare through the for-profit private health insurance industry, and thus an attempt to increase the insanity by running more healthcare through the insurers. This is a pro-Wall Street bill, by design. That is why the focus of the HIBOB was mostly on finance/insurance and not really on any (mostly minor and unintended) healthcare benefits that come out of the bill. And if we had actually had a HEALTHCARE bill, it would have been mathematically impossible to have one with fewer benefits than the HIBOB that passed—which by design was just a bail-out for Wall Street.

Many supporters say that this bill was the best we could do under the circumstances, and that in coming years we will make improvements to it. So, we will take the small benefits now and work for bigger ones incrementally. I am sorry but I do not buy the “incrementalist” defense of the HIBOB.

This is not incrementalism. It is a huge and unprecedented mandate to benefit private insurers. Fifty million people are being told they must turn over their paychecks to private companies. Protests and lawsuits have already begun. States are trying to change their constitutions. here If we had wanted incremental improvements to HEALTHCARE there are infinite combinations of small policy changes we could have pursued—without involving insurers at all. And celebrations by Dems of this great victory by Wall Street are laughable. I think Robert Prasch is right—it is the biggest giveaway to the GOP the Dems could have managed. here (But hold on, they are now preparing to turn Social Security over to Wall Street—the debates are just now getting underway.)

Here is what the whole HIBOB “reform” was all about (and Prasch suggests this was candidate Obama’s plan from the beginning; I have no strong reason to doubt him): health insurers were losing premiums because employers were dropping coverage (in part because they could not compete since no comparable country uses private insurance to provide health care); healthy individuals were dropping because no reasonable calculation could show insurance to be good value for the money. And it is not just the healthy young people who were dropping coverage. If you are single and have no chronic conditions, you are far better to pay out-of-pocket (UNLESS your employer pays most of the premiums and will not give you wages instead). 80% of healthcare costs are due to the 20% of the population that is unhealthy and perhaps unlucky. If you can make it to age 65 without chronic conditions (you don’t smoke, are not obese, were not born with too many preexisting conditions, and so on) it is quite rational to avoid health insurance. And if you get extremely unlucky, you do not have to have health insurance to get some kind of health care. Sure it is probably going to be inferior—but it could well be adequate. And in any case, you might not have that much faith in traditional medical approaches, anyway.

But the insurers were terrified. They could see the writing on the wall–they were losing the healthiest members from their pool, forced to raise rates, and that pushed more healthy people out in a vicious cycle. Hence, they went after Hillary Clinton and later Obama to get a HIBOB to force healthy people back into the pools so they would pay premiums. Yes, insurers knew there would be a trade-off because they’d have to take some unhealthy people. But giving them insurance IS NOT THE SAME THING AS paying for their care. So insurers agreed to accept some pre-existing conditions but never agreed to actually pay for treatments for those conditions. And they won’t.

I hope that those who are interested in this topic will actually read the Policy Brief I wrote with Marshall Auerback. here The point is that healthcare is not insurable. There is a fundamental conflict between provision of healthcare and insurance.

Compare it to auto insurance. When I was young and poor and perhaps somewhat foolish and irresponsible I drove without car insurance (it was not mandated at the time). I managed to drive for about two decades with only 2 accidents—both caused by drunk drivers who ran over me. Their insurers were more than happy to pay me to avoid a law suit. Actually these were not accidents (random Acts of God)—they were criminal infractions. The perps lost their insurance and licenses (and I believe one went to jail because he had already lost his license—he was driving his firm’s car, and it was his firm’s insurer that paid me). Later I started buying insurance. Last fall while driving home from OK at a rather high rate of speed (but within the limit, I hasten to add!), I was struck by an Act of God. She had a large buck leap in front of my car. $10k and 4 months later my car was almost repaired. I paid $1k deductible and my fellow insurance premium payers paid the other $9k (thanks guys!).

Now, we do not know why God did it. Maybe the deer blasphemied, or God hated my car, or she wanted me to stop begrudging the thousands I have paid over the years to car insurers; or she wanted a bit of stimulus for the local body shop. In any case, we do not know her Plan and for all intents and purposes it appears random to us. So we insure against Acts of God. On average of course, car insurance is a very bad deal. But for those of us targeted by God it is a good deal; and none of us really knows who will be chosen next. Further, by basing premiums on individual behavior and by charging large deductibles, we induce safer driving. I avoid speeding—mostly not due to fear of the fine but rather to the higher premiums to be paid for years. Ditto safer driving in parking lots (given that I made the decision—actually now mandated—to purchase insurance). And speaking of mandates, of course you can always avoid paying premiums by not driving. No one is mandated to hand over a paycheck to auto insurers.

Ok, turn to health “insurance”. For reasons discussed in detail in our Brief, health is not insurable. Every infant is a bundle of pre-existing conditions. You cannot provide insurance against a house already afire. After you hit a deer, you cannot go buy insurance. NOR WOULD YOU WANT TO BUY IT! Because the actuarially sound premium would exceed the cost of repairing your car. You cannot insure a pre-existing condition—and would only insure it if you could hide it from the insurer (that is of course called fraud). God already acted. She chose you, and nobody would even think about insurance: you don’t want to pay for it, the insurer doesn’t want to provide it, and your potential pool of fellow premium payers do not want you to be added to their pool.

An insurer cannot sell insurance against diabetes to a person who has diabetes; nor would that person want to buy the insurance; nor does any pool want that person included.

So what we do is pool the people with diabetes with people who do not have it and who are extremely unlikely to get it, then we have the healthy people subsidize the diabetes care. That is not insurance—it is an expensive way to take money away from the healthy and give it to the sick. You could make the argument that from the vantage point of society as a whole, these Acts of God are sort of random (not really, since obesity results from individual behavior as well as public policy) so if we get everyone into the pool we have got insurable risks. OK, sort of. But for the aggregate, it is always a bad deal—we have to pay the costs of running the insurer, plus profits. But there is no way you can run this through competing private insurers because each one has strong incentives to exclude the expensive cases—and so do all of their relatively healthy premium payers. So the only way to do this is to have mandatory insurance, everything covered, and either only one insurer or multiple insurers operating with identical pools and coverage. That ain’t going to happen. And it ain’t incrementalism.

And, of course, most of the healthcare that most of us receive has nothing to do with Acts of God. We need well-child care. We get pregnant. We get old. We need our teeth cleaned. We want Botox and Tummy Tucks. Nothing random about it. Not insurable risks.

We don’t need more health insurance. We need less. We need health provision; and we need to get it out of the hands of Wall Street.

Think The Democrats Just Scored One for the Little Guy? Think Again.

By Robert E. Prasch
Professor of Economics
Middlebury College

As a resident of Massachusetts, where the backlash is already well underway, I thought I should add a comment.  Let’s begin by considering the origins of “Obamacare”.  It comes from Massachusetts.  It was passed early in Gov. Patrick’s reign because during the campaign it was already in debate as it was Gov. Mitt Romney’s proposal.  Now, one might wonder where the conservative, free market, head of Bain Consulting governor might go finding a healthcare plan?  Well, he got it from the Heritage Foundation.  And why did they have such a plan?  Well, they developed its broad outlines during the 1993-4 years as the Republican ANSWER to Hillary’s effort.  So, that is our new federal plan — it is a warmed over version of the Heritage Plan.  This, I submit, might explain a few things.  (1) It was Obama’s idea all along to “triangulate” the Republicans on this issue, and (2) why many of them are really very bummed out that their leadership did not take up the chance to show “bi-partisanship” on this issue (see David Frum on this).

Now, I tend to be skeptical of Heritage Foundation health-care plans.  For several reasons:

(1) By design, costs are not contained, neither is health care reformed.  This means that “affordability” does not come from controlling costs, but by shifting them.  Shift to whom?  A hallmark of the Heritage/Romney plan is that no change of the distribution of income is to occur with the financing of this plan.  NONE.  Rather, funding is to be from three sources — those with supposedly “Cadillac” plans, those who have “opted out’ because of the laughably high cost of coverage relative to their own risks, and to the state general fund.  (2), In light of state budget shortfalls, it is no surprise that the latter source is declining quickly, and tens of thousands of Mass residents have ALREADY lost their subsidies (this trend will certainly occur on Capitol Hill over the next several years as ‘deficit mania” kicks in).  So, get this, as your income declines and your house is repossessed, the cost of your health care rises with higher premiums AND lower subsidies.  But, make no mistake, even as the subsidies decline, the mandate will stay — why should the big companies give up this huge windfall of unchecked access to the wages of the low paid?

(3) I also wish to warn against the ‘NPR version’ of the story that this bill “gives” health care for those without.  Nothing is given, it is a MANDATE.  Now, while the original ‘vision’ of the bill had subsidies, these are fading rapidly.  So, now we have a dramatically underfunded mandate.  Solving the lack of insurance by mandating the poor to buy it is, to be blunt, Dickensian.  Obama himself stated it very well during the campaign “It is like solving homelessness with a mandate that those living on the streets buy a house”.  Those who are poor understand this point, and resent it.  True, there are some young people who are in good health and, understanding statistics and rapacious health care insurance firms, “choose” not to get health insurance (as I did for several years in my 20s as the teaching assistantship I got from DU during my years studying for my MA could not cover my living expenses AND health insurance), yet the bulk of non-buyers are people who have found that with little in the way of family funds, other priorities (rent, car repairs, food, school fees, etc.) are a greater priority.

So, now the Democrats have taken it upon themselves to decide the priorities of millions of our poorest citizens.  Thus, thanks to the Democrats, non-negotiable required fees from the insurance industry will be several multiples of the current income taxes of the lowest paid.  This is sticker shock at its worse.  Even Republicans know that the money will go to rapacious, soulless, insurance companies under the careful guidance of the IRS (here in MA, we have several extra highly-complex pages on an already long tax form where we have to prove that we have insurance).  Stated simply, the Democrats have decided to go into the business of being the “enforcers” of the big insurance firms.  This is NOT a good place to be in an election year.  This is ESPECIALLY not a good place to be when you are already presenting yourself to voters, as Obama seems committed to do, as the die-hard supporter of the big banks that foreclosed on people’s homes and blew up their economy.

With such a context, along comes someone who calls himself a “regular guy” with a pickup truck (he failed to mention that he has five homes, one in Aruba, but the truck was in all the ads), and he takes Kennedy’s seat in Mass.  In MASSACHUSETTS!  Only one year after Obama wins this state by 20 points!  Wow.  This, folks, is what a backlash looks like, and it is enormous.  Turning the wages of the working classes over to the insurance companies, without recourse or mercy, is not going to win this state, and it will not win in many others.  If the Democrats lose any less than 35 house seats this election I will be amazed.  And, note my wording, the Republicans did not, and will not, win them.  No, the Democrats have decided to lose these seats.  Amazing.

Sorry about bringing the bad news.  But this bill is a disaster, and it is worse than nothing, as it will destroy the incomes of those it purports to help along with the Democratic Party.  It is especially bad since a public option was always an option, I do not believe the D.C. spin on this for even a minute.  Just as Obama never wanted to renegotiate NAFTA or leave Iraq, it was clear from the outset that the White House never wanted a public option, which explains why Rahm said so early last summer.  Why?  Because the big insurance companies did not want it, so Rahm did not want it.  End of issue.

Geithner and Greenspan do Standup

By William K. Black

My friends have to put up with my complaints that Brits think Americans are incapable of irony when, in reality, we are world class. Further proof of our preeminence in the irony department comes in the last five days from Geithner and Greenspan. The G2 are locked in a competition for droll humor. Today, in prepared remarks – he didn’t make some impromptu slip – he told Americans that when it comes to financial regulatory reform:

Listen less to those whose judgments brought us this crisis. Listen less to those who told us all they were the masters of noble financial innovation and sophisticated risk management.

Because I took his advice to heart I stopped reading his prepared remarks at that point and cannot report to you on the remainder of the regulatory advice given by an exemplar of “those whose judgments brought us this crisis.” The gentle reader will recall that Geithner testified to Congress that he had never been a regulator. True, but you’re not supposed to admit it. Your job statement required you to be a regulator and protect the public. Geithner’s advice means that we should all stop listening to Rubin, Summers, Greenspan, Bernanke, Gramm, Dodd, Patrick Parkinson (the Fed’s anti-supervisor), Dugan (OCC), Bowman (OTS), and Mary Shapiro (SEC). Thank you Mr. Geithner! Your advice is incredibly liberating.

Moreover, the Geithner corollary is that we should listen more to those that warned that war on regulation was producing an epidemic of fraud, a massive bubble, and an economic crisis. I trust that similar calls will be coming any minute to Ed Gray, Mike Patriarca, and our colleagues that led the successful reregulation of the S&L industry and prevented the S&L debacle from causing a recession (much less a Great Recession). Geithner’s novel idea that we should take our regulatory advice from regulators with a track record of success, courage, and integrity hasn’t been tried in over a decade.
Greenspan’s entry into the irony sweepstakes was a paper entitled “The Crisis” in which he purported to give advice about financial regulation. Seriously! The man that Charles Keating, the most infamous S&L fraud, used as a lobbyist to troll the Senate office buildings to recruit the infamous “Keating Five,” who wrote that Keating’s Lincoln Savings posed “no foreseeable risk of loss” (it turned to be the most expensive failure), and who praised the types of investments that Lincoln Savings’ (unlawfully) made that caused its catastrophic failure – all this before he became Fed Chairman – went on to become the leading anti-regulator that ignored copious warnings of the bubble and the “epidemic” of mortgage fraud to produce the environment that caused the Great Recession. Greenspan giving advice on regulation is standup at its finest.

Neoliberal Deficit Hysteria Strikes Again

ADVICE TO PRESIDENT OBAMA AND PRIME MINISTER BROWN: Tell the IMF, the European Commission, and the Ratings Agencies to Take a Hike

By L. Randall Wray and Yeva Nersisyan

In recent days, articles in Der Speigel, the NYTimes, and the AP have all highlighted Neoliberal commentary warning of the dangers of growing budget deficits in the wealthiest nations—specifically in the US and the UK.

Marco Evers, writing in Der Speigel helpfully argues that the UK’s deficit to GDP ratio (at 12.9%) is actually larger than the ratio of Greece (12.2%), which is already in crisis. According to the AP report, the European Commission has somberly warned London to tighten its budget–to bring its deficit down to 3% of GDP by 2014-15 as promised–through higher fees and taxes, as well as cuts that “will be more drastic than those under (former Prime Minister) Margaret Thatcher”, according to economist Carl Emmerson. It should be remembered that Thatcher oversaw the downsizing of the UK economy, moving it to second-rate status so far as economies go. (In 1980 the UK’s per capita income was 79% of that of the US; by 1985 it had fallen below half. It is now the third largest economy in Europe, and sixth in the world—but it ranks 21st on the Human Development Index.) Apparently the EC would like to see the UK reduced to a third-rate economy—perhaps as punishment for dealing with the global financial crisis in more reasonable manner than the EC has. According to PricewaterhouseCoopers’s calculations, to cut the budget deficit in half by 2014, spending in most areas will have to be cut by 10% per year beginning next year. The EU warns that these cuts will have to be made even in an economic climate that could be “distinctly less favorable” than the UK is now assuming. In other words, fiscal tightening should be undertaken even without economic recovery. That ought to bring the profligate Brits to their knees!

Not to be outdone, the IMF’s John Lipsky (deputy managing director) “offered a grim prognosis for the world’s wealthiest nations, which are at a level of indebtedness not seen since the aftermath of World War II.” Even if fiscal stimulus is ended, he warned, debt ratios on average will rise to 110% by 2014. “Maintaining public debt at postcrisis levels could reduce potential growth in advanced economies by as much as half a percentage point annually.” And to reduce debt ratios appreciably will require an 8 percentage point swing, from structural deficits of 4% of GDP to surpluses of 4% annually by 2010. Note that in the case of the US, this would be equivalent to a reduction of national income by more than a trillion dollars. In other words, the Neoliberal doctors at the IMF recommend lots of pain.

Finally, Moody’s warned that the US and UK have moved closer to credit downgrades, negatively impacting their ability to borrow at favorable interest rates. Presumably, they can look to Greece and Portugal for lessons on the folly of ignoring the warnings of Neoliberal credit raters. Moody’s also warned that these nations cannot rely on growth alone to work their way out of debt. They will “require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.” Moody’s repeated the assertion that the UK is relying on overly rosy economic forecasts—tax receipts will be lower than anticipated, hence the pain that Brown must inflict on his economy is higher—presumably high enough to provoke the kind of civil unrest we now see in Greece.

It is very hard to avoid the conclusion that the Neoliberals at the EU (which seems to act on these matters as a front for the Bundesbank), the IMF, and the ratings agencies are trying to do to the UK and US what they already did to Greece. A real conspiracy theorist might even wonder whether they are trying to succeed where the Third Reich could not—destruction of the US and UK economies in a bid to annihilate the nations themselves. Obviously, that is not a view we suggest. But if one were to adopt it, it could be noted that Neoliberals in Germany have been picking off its neighbors one-by-one, first Greece, then Portugal and Spain, then on to Italy and finally France. (here) These Neoliberals use a combination of mercantilism—trade surpluses that suck demand and jobs out of its fellow EU nations—and then “market discipline” that punishes any nation that tries to fill resulting demand gaps with government spending. (here) However, a more charitable interpretation is that it is the Teutonic Calvinism that guides EU prognostication on government deficits: today’s “excesses” must surely impose a tradeoff in the form of tomorrow’s costs. But when the EC begins to criticize UK and US policy, that is certainly a step that goes too far—even if it is simply due to muddled thought rather than to a nefarious agenda.

The ratings agencies are another matter altogether. These blessed every kind of Wall Street excess with triple A ratings. They never saw a NINJA loan they did not love. Yet, they are engaged in an ugly form of deficit terrorism, attacking one country after another, downgrading debt, raising interest rates and causing budget deficits to rise, which then pushes up credit default swap prices and triggers further downgrades. Ratings agencies serve no public purpose. They are thoroughly incompetent, and probably irredeemably fraudulent. They should be shut down, investigated, and prosecuted.

President Obama and PM Brown should “just say no” to the attempted intervention by these fundamentally misguided deficit hawks into their economic and political affairs. Not only would fiscal tightening now or even within the next several years be a monumental mistake, the notion that continued deficits threaten our economies is unsound. In the remainder of this piece we will briefly explain why. What these Neoliberals do not understand is that the UK and US operate with sovereign currencies—that is both of these nations issue their own non-convertible (floating exchange rate) currencies. For this reason the comparison with any nation that uses the Euro (such as Greece), or with a nation that pegs to precious metals or foreign currencies is invalid. In other words, there is no question of solvency or sustainability of deficits for the US and UK. Sovereign debt of these nations never carries default risk and hence cannot be rated below triple A.

Further, budget deficits are largely endogenously determined by economic performance, so that even if the US and UK adopted the Neoliberal recommendations, the budgetary outcome is not discretionary—indeed, tight fiscal policy would probably increase budget deficits by killing nascent economic recovery. Again, this would not raise any questions about solvency, but it certainly would impose unnecessary pain and sacrifice on the populations of the countries. Since we find it very difficult to believe that the ratings agencies, the IMF and the EU do not understand this, it is equally hard to avoid the conclusion that their policy recommendations are designed to subvert the economies of the US and UK. To what end we can only wonder.

Mr. Lipsky is certainly not alone in arguing that high debt levels will be detrimental for economic growth. A new and influential study by Kenneth Rogoff and Carmen Reinhart, heavily publicized by the media, purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically—by at least one percentage point. But the findings reported in Rogoff and Reinhart cannot be applied to the situation of the US or to the case of many other nations today—those that are not pegging their currency to gold or any other currency. Indeed, the Rogoff and Reinhart study is fatally flawed precisely because it does not recognize the difference between sovereign debt—debt of a national government that issues its own nonconvertible currency—and private debt or the debt issued by nonsovereign government that pegs its currency to precious metal or foreign currency (or Euro nations that adopt the euro).

Governments across the world have inflicted so many self-imposed constraints on public spending that the relatively simple operational realities behind public spending have been obscured. Most people tend to think that a balanced budget, be it for a household or a government, is a good thing, failing to make a distinction between a currency issuer and a currency user. Indeed, one of the most common analogies used by politicians and the media is the claim that a government is like a household: the household cannot continue to spend more than its income, so neither can the government. See here for more on the differences between a household and a government. Yet that comparison is completely fallacious. Most importantly, households do not have the power to levy taxes, and to give a name to—and issue–the currency that those taxes are paid in. Rather, households are users of the currency issued by the sovereign government. Here the same distinction applies to firms, which are also users of the currency.
Operationally the sovereign government spends by crediting bank deposits (and simultaneously crediting the reserves of those banks) at its own central bank, in the case of the US, the Federal Reserve Bank. No household (or firm) is able to spend by crediting bank deposits and reserves, or by issuing currency. Households and firms can spend by going into debt if some entity will lend to them, which is something the national, sovereign government in no case requires when using its own currency. Unlike private debtors it can always make payments, including debt service payments, simply by changing numbers on its own spread sheet at its own central bank. This is a key to understanding why perpetual budget deficits are “sustainable” in the conventional sense of that term because government can always make any payments it desires on a timely basis.

A government that issues its currency that is not backed by any metal or pegged to another currency is not constrained in its ability to spend by the possibility that holders of dollars might ‘cash them in’ for gold, for example, as is the case with a gold standard. With a non-convertible sovereign currency, a government doesn’t need tax and bond revenues to protect its gold reserves—because it does not use gold reserves! While all governments today spend by crediting bank accounts and tax by debiting bank accounts, with convertible currencies budget deficits risk the loss of reserves, while with non-convertible sovereign currencies there is no such risk.

If we take the US as an example, its budget deficits add to the total of the outstanding stock of outstanding US Treasury securities, bank balances in their reserve accounts at the Federal Reserve Bank, and/or cash in circulation, together on a dollar for dollar basis. Treasury Securities are functionally nothing more than ‘time deposits’ at the Fed, held in what are called ‘securities accounts’ at the Fed. They are often measured relative to the size of GDP, as are the annual federal deficits, to help scale the nominal numbers to provide perspective. (Note this is often NOT done by those who try to scare the population with talk of “tens of trillions of dollars of unfunded entitlements” due to retirements of the babyboomers, rather than show those numbers as a % of future GDP.)

Figure 1 shows federal government debt since 1943.

Note that during WWII the government’s deficit (which reached 25% of GDP) raised the publicly held debt ratio above 100%– much higher than the ratio expected to be achieved by 2015 (just under 73%). Further, in spite of the warnings issued in the Reinhart and Rogoff study, US growth in the postwar period was robust— in fact it was the golden age of US economic growth. Ironically, this is even acknowledged in the report by the IMF’s Lipsky—who noted that the average ratio of government debt to GDP in the advanced countries will reach the postwar 1950 peak of somewhat more than 75%. Again, misfortune did not befall those big government spenders after WWII. Actually, debt ratios came down over the postwar period as relatively robust growth grew the denominator (GDP) relative to the numerator (government debt).

Indeed, robust growth reduces budget deficits by raising tax revenue and reducing certain kinds of government spending such as unemployment compensation. That was exactly the US experience in the postwar period. The budget deficit is highly counter-cyclical, and will come down automatically when the economy recovers.

The claim made by Moody’s that growth will not reduce debt ratios does not square with the facts of historical experience and must rely on the twin assumptions that growth in the future will be sluggish and that government spending will grow relative to GDP. However, such an outcome is inconsistent: if government spending grows fast it raises GDP growth and hence tax revenues, reducing the budget deficit. This is precisely what has happened in the US over the entire postwar period. It is only when government spending lags behind GDP growth by a considerable amount that it slows growth of GDP and tax revenues, causing the budget deficit to grow. What Rogoff and Reinhart do not sufficiently account for is the “reverse causation”: slow growth generates budget deficits. This goes a long way toward explaining the correlation they find between slow growth and deficits: as economists teach, correlation does not prove causation!

Actually, there are always two ways to achieve the same budget deficit ratio: the ugly (Japanese) way and the virtuous way. If fiscal policy remains chronically too tight even in recession, economic growth is destroyed, tax revenues plummet, and a deficit opens up. So far, that is—unfortunately—the US path in this recession, a path already well-worn by two decades of Japanese experiments with belt-tightening. The alternative (let us call it the Chinese example) is that a downturn is met with an aggressive and appropriately-sized discretionary response. In that case, growth is quickly restored, tax revenue begins to grow, and the budget deficit is reduced.

We emphasize that the deficit outcome is of no consequence for a sovereign nation. What is important is that the “ugly” Neoliberal path means chronically insufficient demand, high unemployment, and lots of suffering. The virtuous path—which is always available to a sovereign government—means less loss of output and employment, and relatively rapid resumption of economic growth. So it is not the deficit outcome that matters, rather it is the real suffering imposed by slow growth that results when fiscal policy is too tight.

In conclusion, the Neoliberal agenda would impose the ugly path on the US and UK. President Obama and Prime Minister Brown should tell the Neoliberals to take a hike.

“The Hyperinflation Hyperventalists”

By Rob Parenteau**

After a two day blogging slugfest on fiscal deficits, I find that the question of hyperinflation now demands an answer. And here it is: fiscal deficit spending may be a necessary condition of hyperinflation, but it is hardly a sufficient condition.

Think this is yet another rant against the “deficit errorists?” Think again. Paul Krugman treated this question in his March 18th New York Times column:

Hyperinflation is actually a quite well understood phenomenon, and its causes aren’t especially controversial among economists. It’s basically about revenue: when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage – revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.

Krugman locates the source of hyperinflation in what is termed the “monetization” of fiscal deficit spending. He then attributes its perpetuation to shifts in the liquidity preferences of people — that is, the share of their portfolio that households and firms wish to hold in cash or cash like investment instruments (think Treasury bills, or money market mutual funds, for example). Krugman’s logic means that even the liberal wing, or the saltwater contingent, of the economics world has a touch of deficit errorism. We would invite Paul to take a closer look at the UBS research on public debt to GDP ratios and inflation first released last summer, reprinted in a FT Alphaville note, and discussed on Naked Capitalism. The story of inflation and fiscal deficits is more ambiguous, or at least more complex than the deficit errorists would have you believe.

Coincidentally, an investment manager friend forwarded me a letter that Ebullio Capital Management* allegedly sent to its clients after February’s investment results, which took them down nearly 96% for the year – virtually wiping out their stellar gains of the prior two years. The letter reveals that Ebullio was so ebullient about the possibility (inevitability?) of hyperinflation emerging from recent policy excesses that they bet the ranch on hyperinflation plays in the commodity corner of the investing world (metals), and lost big time. While we still have questions as to whether this is a spoof or not, there are undoubtedly people sitting around in gold wondering whether the old yellow dog is going to get up and bark again anytime soon. Although hyperinflation hyperventilation has been catching on in recent months, especially amongst the deficit errorists, gold has been dead money since late November 2009.

What gives? As a piece I wrote in the July issue of The Richebacher Letter explains, hyperinflation requires extreme conditions not just on the demand side, but on the supply side as well. A month after the Richebacher piece, Bill Mitchell published a similar conclusion. To summarize our findings: on the demand side, in order for household spending power to keep up with rising prices, household nominal incomes or credit access must be ratcheted up in synch with price hikes. Otherwise, the price hikes will not stick. Households will have to pull back less-essential spending areas to afford the same quantity of goods in essential items. So your gas, home heating oil, health care, or food bill goes up, and you cut back on your restaurant and entertainment spending, unless your paycheck also increases, or you can tap more credit. That is why hyperinflation episodes need more than just deficit spending. It is true, as Marshall Auerback and I explained in a recent New Deal 2.0 post, that fiscal deficits increase the net cash flow for the household sector as a whole. But we also usually observe some sort of escalator clauses or cost of living adjustment mechanisms built into wage contracts that allow this ratcheting up of household income pari passu with the inflation hikes. Take that element away — and it is a recurring theme in historical episodes of hyperinflation — and households cannot keep up with hyperinflation. The higher prices cannot get validated by higher consumer spending. The hyperinflation flares out.

Beyond this demand side component, which is scarcely to be found in the US wage contracts these days (although we must mention it is built into some government benefit programs like social security), there is the supply side issue. Productive capacity must be closed or abandoned in order for the hyperinflation to really rip. There is a built-in dynamic that encourages this. As the hyperinflation gets recognized, entrepreneurs eventually figure out that they would be much better off speculating in commodities (like Ebullio), buying farmland, chasing gold and other precious metals, or more generally, repositioning their portfolios and reinvesting their profits in tangible assets with relatively fixed supplies. That is, goods that are fairly nonreproducible become stores of value, as it is their prices that tend to rise most swiftly, since higher prices cannot, by definition, elicit any new supplies. Hence, those of you who lived through the ‘70s (and still remember what you were doing) will recall high net worth households were busy hoarding ancient Chinese ceramics while the middle class was chasing residential real estate, and the stock market basically went sideways.

In the case of the Weimar Republic following WWI, and Zimbabwe most recently, remember that war (civil or international), has an impeccable way of destroying productive capacity in a nation, or rerouting it to the production of war material. In the Weimar episode, the final back-breaking run up in hyperinflation accompanied the occupation by the French of the Ruhr Valley, which held a fair concentration of German production facilities. In solidarity with the workers who struck those plants in response, the Weimar Republic continued to pay the workers through fiscal measures. Cut production, but continue income flows, and you have the recipe for the kind of unresolved distributional conflict that often lies at the heart of the inflation process. Mainstream economics and popular lore refuse to see this.

Suffice it to say that hyperinflation takes a very special set of conditions. It is not, contra Paul Krugman, all about fiscal deficits, nor is it only about fiscal deficits. That is why we do not see hyperinflation breaking out all over the place on any given day, despite the fact the governments have to first create the money that you and I use to pay taxes or buy Treasury bonds (because even though we “make” money, we cannot create it, without risking a spell in jail for counterfeiting). Know your history. Try not to pass out with the hyperventilating hyperinflationistas: they are a particularly virulent wing of the deficit errorists, and they may simply leave you in a state similar to the one alleged to have been experienced by Ebullio Capital Management’s clients.

P.S. I have a piece called “On Fiscal Correctness and Animal Sacrifices” appearing on several blogs that formed the basis for the March 2010 Richebacher Letter. It is crucial that this piece get into the hands of Paul Krugman. If anyone knows how to get to him, I would be much obliged. His July 15th, 2009 NY Times diagram, which I call the Krugman Curve, has planted a seed that he would benefit greatly from watering. I believe it would help him escape the trap of continually returning to the manipulation of real interests rates (now requiring that he advocate central banks push a credible plan to deliver higher inflation in perpetuity, since policy rates are near the zero nominal bound in many places) as the holy grail for all countries operating below potential output. Time for him to exit from the IS/LM straight jacket, which even Sir John Hicks, one of its fathers, had his sincere doubts about, as well as the intertemporal utility maximization straight jacket of his more orthodox contemporaries. He knows how to do it…he just does not know it yet, which is why this paper needs to get in his hands, and soon, before the deficit errorists claim him as one of their own.

* You can go to Ebullio’s website, but unfortunately, authorization is required to see their performance, their track record, and their client letters.

**This article originally appeared on new deal 2.0