Monthly Archives: January 2012

Holder & Obama’s Propaganda is “Belied by a Troublesome Little Thing Called Facts”

By William K. Black

The Obama administration’s record of prosecuting elite financial frauds is worse than the Bush administration’s record, which is a very large statement. Syracuse University’s TRAC issued a report on November 11, 2011 entitled “Criminal Prosecutions for Financial Institution Fraud Continue to Fall.”

Neither administration has prosecuted any elite CEO for the epidemic of mortgage fraud that drove the ongoing crisis. This contrasts with over 1,000 elite felony convictions arising from the S&L debacle. The ongoing crisis caused losses more than 70 times greater than the S&L debacle and the amount of elite fraud driving this crisis is also vastly greater than during the S&L debacle. Bank CEOs leading “accounting control frauds” now do so with impunity from the criminal laws. They become wealthy through fraud and even if they are sued civilly they almost invariably walk away wealthy with the proceeds of their frauds.

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Anschluss Economics – The Germans Launch A Blitzkrieg on the Greek Debt Negotiations

News stories continue to suggest that Greeceonce again appears on the verge of reaching a deal with its private sectorcreditors on how much of a loss they would be willing to accept on their bondholdings. The latest numbers suggest a 70% write-down. A pretty strikingcomedown for what is supposed to be a “voluntary default” and, hence,not subject to the triggers of a credit default swap on Greek debt.
 
Naturally, the spin surrounding the proposedagreement is that this is a “one-off” and that other troubledperiphery nations shouldn’t even begin to think of securing a comparable deal.But the inherent tension between securing a write-down on Greek debt which moreclosely mirrors the disaster which is now the Greek economy, and the desire tominimise the potential contagion effect is rearing its ugly head already, andmay help to explain some of Germany’s recent machinations.

MMP #34 Functional Finance and Exchange Rate Regimes: The Twin Deficits Debate

By L. Randall Wray

In theprevious weeks, we examined the functional finance approach of Abba Lerner. Itis clear that Lerner was analysing the case of a country with a sovereigncurrency (or what many call “fiat” currency). Only the sovereign government canchoose to spend more whenever unemployment exists; and only the sovereigngovernment can increase bank reserves and lower (short term) interest rates tothe target level. It is important to note that Lerner was writing as theBretton Woods system was being created—a system of fixed exchange rates basedon the dollar. Thus it would appear that he meant for his functional financeapproach to apply to the case of a sovereign currency regardless of exchangerate regime chosen.

Still itmust be remembered that all countries in Lerner’s time adopted strict capitalcontrols. In terms of the “trilemma” they had a fixed exchange rate anddomestic policy independence, but did not allow free capital flows. We haveseen that domestic policy space is greatest in the case of a floating currency,but that adopting capital controls in combination with a managed or fixedexchange rate can still preserve substantial domestic policy space. That isprobably what Lerner had in mind. Most countries with fixed exchange rates andfree capital mobility would not be able to pursue Lerner’s two principles offunctional finance because their foreign currency reserves would be threatened(only a handful of nations have amassed so many reserves that their position isunassailable). Managed or fixed exchange rates, with some degree of constrainton capital flows, can provide the required domestic policy space to pursue afull employment goal.

Weconclude: the two principles of functional finance apply most directly to asovereign nation operating with a floating currency. If the currency is pegged,then the policy space is more constrained and the nation might have to adoptcapital controls to protect its international reserves in order to maintainconfidence in its peg.

The US Twin Deficits Debate. Deficit hawks in the US frequentlyraise three objections to persistent national government budget deficits: a)they pose a solvency risk that could force to government default on its debt;b) they pose an inflation, or even a hyperinflation, risk; and c) they impose aburden on our grandkids, who will have to pay interest in perpetuity to the Chinesewho are accumulating US Treasuries as well as power over the fate of theDollar. This often leads to the claim that the US Dollar is in danger of losingits status as international reserve currency.

We haveseen that national budget deficits and debts do not matter so far as nationalsolvency goes. The sovereign issuer of the currency cannot be forced into aninvoluntary default. We also have dealt with possible inflation effects of deficitspending (more on that later). To summarize that argument as briefly aspossible, additional deficit spending beyond the point of full employment willalmost certainly be inflationary, and inflation barriers can be reached evenbefore full employment. However, the risk of hyperinflation for a sovereigncountry like the US is low.

Later wewill address the connection among budget deficits, trade deficits and foreignaccumulation of treasuries, the interest burden supposedly imposed on ourgrandkids, and the possibility that foreign holders might decide to abandon theDollar.

Let us setout the framework thoroughly examined in previous blogs. At the aggregatelevel, the government’s deficit equals the nongovernment sector’s surplus. Wecan break the nongovernment sector into a domestic component and a foreigncomponent. As the US macrosectoral balance identity shows, the governmentsector deficit equals the sum of the domestic private sector surplus plus thecurrent account deficit (which is the foreign sector’s surplus). We will put tothe side discussion about the behaviors that got the US to the currentreality—which is a large federal budget deficit that is equal to a (large)private sector surplus (spending less than income) plus a rather large currentaccount deficit (mostly resulting from a US trade balance in which importsexceed exports).

There is apositive relation between budget deficits and the current account deficit thatgoes behind the identity. All else equal, a government budget deficit raisesaggregate demand so that US imports exceed US exports (American consumers areable to buy more imports because the US fiscal stance generates householdincome used to buy foreign output that exceeds foreign purchases of US output.)There are other possible avenues that can generate a relation between agovernment deficit and a current account deficit (some point to effects oninterest rates and exchange rates), but they are at best of secondaryimportance if not wrong.

To sum up:a US government deficit can prop up demand for output, some of which isproduced outside the US—so that US imports rise more than exports, especiallywhen a budget deficit stimulates the American economy to grow faster than theeconomies of our trading partners.

Whenforeign nations run trade surpluses (and the US runs a trade deficit), they areable to accumulate Dollar denominated assets. A foreign firm that receivesDollars usually exchanges them for domestic currency at its central bank. Forthis reason, a large proportion of the Dollar claims on the US end up atforeign central banks. Since international payments are made through banks,rather than by actually delivering US federal reserve paper notes, the Dollarsaccumulated in foreign central banks are in the form of reserves held at theFed—nothing but electronic entries on the Fed’s balance sheet. These reservesheld by foreigners (mostly, central banks) do not earn interest.

 Since the central banks would prefer to earninterest, they convert them to US Treasuries—which are really just anotherelectronic entry on the Fed’s balance sheet, albeit one that periodically getscredited with interest. This conversion from reserves to Treasuries is akin toshifting funds from your checking account to a certificate of deposit (CD) atyour bank, with the interest paid through a simple keystroke that increases thesize of your deposit. Likewise, Treasuries are CDs that get credited interestthrough Fed keystrokes.

In sum, aUS current account deficit will be reflected in foreign accumulation of USTreasuries, held mostly by foreign central banks. You can see the evidencehere, in Figures 2 and 3:  

While thisis usually presented as foreign “lending” to “finance” the US budget deficit,one could just as well see the US current account deficit as the source offoreign current account surpluses that can be accumulated as treasuries. In asense, it is the proclivity of the US to simultaneously run trade andgovernment budget deficits that provides the wherewithal to “finance” foreignaccumulation of US Treasuries. Obviously there must be a willingness on allsides for this to occur—we could say that it takes (at least) two to tango—andmost public discussion ignores the fact that the Chinese desire to run a tradesurplus with the US is linked to its desire to accumulate Dollar assets. At thesame time, the US budget deficit helps to generate domestic income that allowsour private sector to consume—some of which fuels imports, providing the incomeforeigners use to accumulate Dollar saving, even as it generates Treasuriesaccumulated by foreigners.

In otherwords, the decisions cannot be independent. It makes no sense to talk ofChinese “lending” to the US without also taking account of Chinese desires tonet export. Indeed all of the following are linked (possibly in complex ways):the willingness of Chinese to produce for export, the willingness of China toaccumulate US Dollar-denominated assets, the shortfall of Chinese domesticdemand that allows China to run a trade surplus, the willingness of Americansto buy foreign products, the (relatively) high level of US aggregate demandthat results in a trade deficit, and the factors that result in a US governmentbudget deficit. And of course it is even more complicated than this because wemust bring in other nations as well as global demand taken as a whole.

While it isoften claimed that the Chinese might suddenly decide they do not want UStreasuries any longer, at least one but more likely many of these otherrelationships would also need to change. For example it is feared that Chinamight decide it would rather accumulate Euros. However, there is no equivalentto the US Treasury in Euroland. China could accumulate the Euro-denominateddebt of individual governments—say, Greece!—but these have different riskratings and the sheer volume issued by any individual nation is likely toosmall to satisfy China’s desire to accumulate foreign currency reserves.Further, Euroland taken as a whole (and this is especially true of itsstrongest member, Germany) attempts to constrain domestic demand to avoid tradedeficits—meaning it is hard for the rest of the world to accumulate Euro claimsbecause Euroland does not generally run trade deficits. If the US is a primarymarket for China’s excess output but Euro assets are preferred over Dollarassets, then exchange rate adjustment between the (relatively plentiful) Dollarand (relatively scarce) Euro could destroy China’s market for its exports.

This shouldnot be interpreted as an argument that the current situation will go onforever, although it could persist much longer than most commentators presume.But changes are complex and there are strong incentives against the sort ofsimple, abrupt, and dramatic shifts often posited as likely scenarios. Thecomplexity as well as the linkages among balance sheets ensure that transitionswill be moderate and slow—there will be no sudden dumping of US Treasuries—thatwould destroy the value of the financial wealth held by the Chinese, as well asthe export market they currently rely upon.

Beforeconcluding, let us do a thought experiment to drive home a key point. Thegreatest fear that many have over foreign ownership of US Treasuries is theburden on America’s grandkids—who, it is believed, will have to pay interest toforeigners. Unlike domestically-held Treasuries, this is said to be a transferfrom some American taxpayer to a foreign bondholder (when bonds are held byAmericans, the transfer is from an American taxpayer to an American bondholder,believed to be less problematic). So, it is argued, government debt really doesburden future generations because a portion is held by foreigners. Now, inreality, interest is paid by keystrokes—but our grandkids might decide to raisetaxes on themselves to match interest paid to Chinese bondholders and therebyimpose the burden feared by deficit hawks. So let us continue with ourhypothetical case.

What if theUS managed to eliminate its trade deficit so that it ran a perpetually balancedcurrent account? In that case, the US budget deficit would exactly equal the USprivate sector surplus. Since foreigners would not be accumulating Dollars intheir trade with the US, they could not accumulate US Treasuries (yes, theycould trade foreign currencies for the Dollar but this would cause the Dollarto appreciate in a manner that would make balanced trade difficult tomaintain). In that case, no matter how large the budget deficit, the US wouldnot “need” to “borrow” from the Chinese to finance it.

This makesit clear that foreign “finance” of our budget deficit is contingent on ourcurrent account balance—foreigners need to export to us so that they can “lend”to our government. And if our current account is in balance then no matter howbig our government budget deficit, we will not “need” foreign savings to“finance” it—because our domestic private sector surplus will be exactly equalto our government deficit. Indeed, one could quite reasonably say that it isthe budget deficit that “finances” domestic private sector saving.

Yet, thedeficit hawks believe the federal budget deficit would be more “sustainable” ifforeigners did not accumulate Treasuries that supposedly burden futuregenerations of Americans. But how could the US eliminate the current accountdeficit that allows foreigners to accumulate Treasuries? The IMF-approvedmethod of balancing trade is to impose austerity. If the US were to grow muchslower than all our trading partners, US imports would fall and exports wouldrise. In fact, the “great recession” that began in the US in 2007 did reducethe trade deficit—although only moderately and probably temporarily. In orderto eliminate the trade deficit and to ensure that the US runs balanced trade,it might need a much deeper, and permanent, recession. By reducing American livingstandards relative to those enjoyed by the rest of the world, the nation mightbe able to eliminate its current account deficit and thereby ensure thatforeigners do not accumulate Treasuries said to burden future generations ofAmericans.

Now, canthe deficit hawks please explain why Americans should desire permanently lowerliving standards on their promise that this will somehow reduce the burden onthe nation’s grandkids? It seems rather obvious that grandkids would prefer ahigher growth path both now and in the future, so that America can leave themwith a stronger economy and higher living standards. If that means that thirtyyears from now the Fed will need to stroke a few keys to add interest toChinese deposits, so be it. And if the Chinese some day decide to use dollarsto buy imports, America’s grandkids will be better situated to produce thestuff the Chinese want to buy.

Inconclusion, while there are links between the “twin deficits”, they are not thelinks usually imagined. US trade and budget deficits are linked, but they donot put the US in an unsustainable position vis a vis the Chinese. If theChinese and other net exporters (such as Japan) decide they prefer fewer dollarassets, this will be linked to a desire to sell fewer products to America. Thisis a particularly likely scenario for the Chinese, who are rapidly developingtheir economy and creating a nation of consumers. But the transition will notbe abrupt. The US current account deficit with China will shrink, just as itssales of US government bonds to Chinese (to offer an interest-paying substituteto reserves at the Fed) decline. This will not result in a crisis. The USgovernment does not, indeed cannot, borrow Dollars from the Chinese to financedeficit spending. Rather, US current account deficits provide the Dollars usedby the Chinese to buy the safest Dollar asset in the world—US Treasuries.

To beclear: the US Dollar probably will not remain the world’s reserve currency.From the US perspective, that might be a disappointment. In the long view ofhistory, it is inconsequential. There is little doubt that China will becomethe world’s biggest economy. Its currency is a likely candidate forinternational currency reserve, but that is not a foregone conclusion—norsomething to be feared.

Banks Weren’t Meant to Be Like This. What Will their Future Be – and What is the Government’s Proper Financial Role?

By Michael Hudson
This article first appeared at FAZ

The inherently symbioticrelationship between banks and governments recently has been reversed. Inmedieval times, wealthy bankers lent to kings and princes as their majorcustomers. But now it is the banks that are needy, relying on governments forfunding – capped by the post-2008 bailouts to save them from going bankruptfrom their bad private-sector loans and gambles.

Yetthe banks now browbeat governments – not by having ready cash but bythreatening to go bust and drag the economy down with them if they are notgiven control of public tax policy, spending and planning. The process has gonefurthest in the United States. Joseph Stiglitz characterizes the Obamaadministration’s vast transfer of money and pubic debt to the banks as a “privatizingof gains and the socializing of losses. It is a ‘partnership’ in which onepartner robs the other.”[1]Prof. Bill Black describes banks as becoming criminogenic and innovating“control fraud.”[2]High finance has corrupted regulatory agencies, falsified account-keeping by“mark to model” trickery, and financed the campaigns of its supporters todisable public oversight. The effect is to leave banks in control of how theeconomy’s allocates its credit and resources.

If there is any silver lining totoday’s debt crisis, it is that the present situation and trends cannotcontinue. So this is not only an opportunity to restructure banking; we havelittle choice. The urgent issue is who will control the economy: governments,or the financial sector and monopolies with which it has made an alliance.
Fortunately, it is not necessary tore-invent the wheel. Already a century ago the outlines of a productiveindustrial banking system were well understood. But recent bank lobbying hasbeen remarkably successful in distracting attention away from classicalanalyses of how to shape the financial and tax system to best promote economicgrowth – by public checks on bank privileges.

How banks broke the social compact,promoting their own special interests
            
People used to know what banks did.Bankers took deposits and lent them out, paying short-term depositors less thanthey charged for risky or less liquid loans. The risk was borne by bankers, notdepositors or the government. But today, bank loans are made increasingly tospeculators in recklessly large amounts for quick in-and-out trading. Financialcrashes have become deeper and affect a wider swath of the population as debtpyramiding has soared and credit quality plunged into the toxic category of“liars’ loans.”
            
Thefirst step toward today’s mutual interdependence between high finance andgovernment was for central banks to act as lenders of last resort to mitigatethe liquidity crises that periodically resulted from the banks’ privilege ofcredit creation. In due course governments also provided public depositinsurance, recognizing the need to mobilize and recycle savings into capitalinvestment as the Industrial Revolution gained momentum. In exchange for thissupport, they regulated banks as public utilities.
            
Over time, banks have sought todisable this regulatory oversight, even to the point of decriminalizing fraud.Sponsoring an ideological attack on government, they accuse publicbureaucracies of “distorting” free markets (by which they mean markets free forpredatory behavior). The financial sector is now making its move to concentrateplanning in its own hands.
            
The problem is that the financialtime frame is notoriously short-term and often self-destructive. And inasmuchas the banking system’s product is debt, its business plan tends to beextractive and predatory, leaving economies high-cost. This is why checks andbalances are needed, along with regulatory oversight to ensure fair dealing.Dismantling public attempts to steer banking to promote economic growth (ratherthan merely to make bankers rich) has permitted banks to turn into somethingnobody anticipated. Their major customers are other financial institutions,insurance and real estate – the FIRE sector, not industrial firms. Debtleveraging by real estate and monopolies, arbitrage speculators, hedge funds andcorporate raiders inflates asset prices on credit. The effect of creating“balance sheet wealth” in this way is to load down the “real”production-and-consumption economy with debt and related rentier charges, adding more to the cost of living and doingbusiness than rising productivity reduces production costs.
            
Since 2008, public bailouts havetaken bad loans off the banks’ balance sheet at enormous taxpayer expense –some $13 trillion in the United States, and proportionally higher in Irelandand other economies now being subjected to austerity to pay for “free market” deregulation.Bankers are holding economies hostage, threatening a monetary crash if they donot get more bailouts and nearly free central bank credit, and more mortgageand other loan guarantees for their casino-like game. The resulting “too big tofail” policy means making governments too weak to fight back.
            
The process that began with centralbank support thus has turned into broad government guarantees against bankinsolvency. The largest banks have made so many reckless loans that they havebecome wards of the state. Yet they have become powerful enough to capturelawmakers to act as their facilitators. The popular media and even academiceconomic theorists have been mobilized to pose as experts in an attempt toconvince the public that financial policy is best left to technocrats – of thebanks’ own choosing, as if there is no alternative policy but for governmentsto subsidize a financial free lunch and crown bankers as society’s rulers.
            
The Bubble Economy and its austerityaftermath could not have occurred without the banking sector’s success inweakening public regulation, capturing national treasuries and even disablinglaw enforcement. Must governments surrender to this power grab? If not, whoshould bear the losses run up by a financial system that has becomedysfunctional? If taxpayers have to pay, their economy will become high-costand uncompetitive – and a financial oligarchy will rule.

The present debt quandary
            
The endgame in times past was towrite down bad debts. That meant losses for banks and investors. But today’sdebt overhead is being kept in place – shifting bad loans off bank balancesheets to become public debts owed by taxpayers to save banks and theircreditors from loss. Governments have given banks newly minted bonds or centralbank credit in exchange for junk mortgages and bad gambles – withoutre-structuring the financial system to create a more stable, less debt-riddeneconomy. The pretense is that these bailouts will enable banks to lend enoughto revive the economy by enough to pay its debts.
            
Seeing the handwriting on the wall,bankers are taking as much bailout money as they can get, and running, usingthe money to buy as much tangible property and ownership rights as they canwhile their lobbyists keep the public subsidy faucet running.
            
The pretense is that debt-strappedeconomies can resume business-as-usual growth by borrowing their way out ofdebt. But a quarter of U.S. real estate already is in negative equity – worthless than the mortgages attached to it – and the property market is stillshrinking, so banks are not lending except with public Federal HousingAdministration guarantees to cover whatever losses they may suffer. In anyevent, it already is mathematically impossible to carry today’s debt overheadwithout imposing austerity, debt deflation and depression.
            
This is not how banking was supposedto evolve. If governments are to underwrite bank loans, they may as well bedoing the lending in the first place – and receiving the gains. Indeed, since2008 the over-indebted economy’s crash led governments to become the majorshareholders of the largest and most troubled banks – Citibank in the UnitedStates, Anglo-Irish Bank in Ireland, and Britain’s Royal Bank of Scotland. Yetrather than taking this opportunity to run these banks as public utilities andlower their charges for credit-card services – or most important of all, tostop their lending to speculators and gamblers – governments left these banksoperating as part of the “casino capitalism” that has become their businessplan.
            
There is no natural reason formatters to be like this. Relations between banks and government used to be thereverse. In 1307, France’s Philip IV (“The Fair”) set the tone by seizing theKnights Templars’ wealth, arresting them and putting many to death – not onfinancial charges, but on the accusation of devil-worshipping and satanicsexual practices. In 1344 the Peruzzi bank went broke, followed by the Bardi bymaking unsecured loans to Edward III of England and other monarchs who died ordefaulted. Many subsequent banks had to suffer losses on loans gone bad to realestate or financial speculators.
            
By contrast, now the U.S., British,Irish and Latvian governments have taken bad bank loans onto their nationalbalance sheets, imposing a heavy burden on taxpayers – while letting bankerscash out with immense wealth. These “cash for trash” swaps have turned themortgage crisis and general debt collapse into a fiscal problem. Shifting thenew public bailout debts onto the non-financial economy threaten to increasethe cost of living and doing business. This is the result of the economy’sfailure to distinguish productive from unproductive loans and debts. It helpsexplain why nations now are facing financial austerity and debt peonage insteadof the leisure economy promised so eagerly by technological optimists a centuryago.
            
So we are brought back to thequestion of what the proper role of banks should be. This issue was discussedexhaustively prior to World War I. It is even more urgent today.

How classical economists hoped to modernizebanks as agents of industrial capitalism
            
Britain was the home of theIndustrial Revolution, but there was little long-term lending to financeinvestment in factories or other means of production. British and Dutchmerchant banking was to extend short-term credit on the basis of collateralsuch as real property or sales contracts for merchandise shipped(“receivables”). Buoyed by this trade financing, merchant bankers weresuccessful enough to maintain long-established short-term funding practices.This meant that James Watt and other innovators were obliged to raiseinvestment money from their families and friends rather than from banks.
            
It was the French and Germans whomoved banking into the industrial stage to help their nations catch up. InFrance, the Saint-Simonians described the need to create an industrial creditsystem aimed at funding means of production. In effect, the Saint-Simoniansproposed to restructure banks along lines akin to a mutual fund. A start wasmade with the Crédit Mobilier, founded by the Péreire Brothers in 1852. Theiraim was to shift the banking and financial system away from debt financing atinterest toward equity lending, taking returns in the form of dividends thatwould rise or decline in keeping with the debtor’s business fortunes. By givingbusinesses leeway to cut back dividends when sales and profits decline,profit-sharing agreements avoid the problem that interest must be paidwilly-nilly. If an interest payment is missed, the debtor may be forced intobankruptcy and creditors can foreclose. It was to avoid this favoritism forcreditors regardless of the debtor’s ability to pay that prompted Mohammed toban interest under Islamic law.
            
Attracting reformers ranging fromsocialists to investment bankers, the Saint-Simonians won government backingfor their policies under France’s Third Empire. Their approach inspired Marx aswell as industrialists in Germany and protectionists in the United States andEngland. The common denominator of this broad spectrum was recognition that anefficient banking system was needed to finance the industry on which a strongnational state and military power depended.

Germany develops an industrial bankingsystem
            
Itwas above all in Germany that long-term financing found its expression in theReichsbank and other large industrial banks as part of the “holy trinity” ofbanking, industry and government planning under Bismarck’s “state socialism.”German banks made a virtue of necessity. British banks “derived the greaterpart of their funds from the depositors,” and steered these savings andbusiness deposits into mercantile trade financing. This forced domestic firmsto finance most new investment out of their own earnings. By contrast, Germany’s“lack of capital … forced industry to turn to the banks for assistance,” notedthe financial historian George Edwards. “A considerable proportion of the fundsof the German banks came not from the deposits of customers but from thecapital subscribed by the proprietors themselves.[3]As a result, German banks “stressed investment operations and were formed notso much for receiving deposits and granting loans but rather for supplying theinvestment requirements of industry.”
            
Whenthe Great War broke out in 1914, Germany’s rapid victories were widely viewedas reflecting the superior efficiency of its financial system. To someobservers the war appeared as a struggle between rival forms of financialorganization. At issue was not only who would rule Europe, but whether thecontinent would have laissez faire or a more state-socialist economy.
            
In1915, shortly after fighting broke out, the Christian Socialistpriest-politician Friedrich Naumann published Mitteleuropa, describing how Germany recognized more than any othernation that industrial technology needed long‑term financing and governmentsupport. His book inspired Prof. H. S. Foxwell in England to draw on hisarguments in two remarkable essays published in the Economic Journal in September and December 1917: “The Nature of theIndustrial Struggle,” and “The Financing of Industry and Trade.” He endorsedNaumann’s contention that “the old individualistic capitalism, of what he callsthe English type, is giving way to the new, more impersonal, group form; to thedisciplined scientific capitalism he claims as German.”
            
Thiswas necessarily a group undertaking, with the emerging tripartite integrationof industry, banking and government, with finance being “undoubtedly the maincause of the success of modern German enterprise,” Foxwell concluded (p. 514).German bank staffs included industrial experts who were forging industrialpolicy into a science. And in America, Thorstein Veblen’s The Engineers and the Price System (1921) voiced the new industrialphilosophy calling for bankers and government planners to become engineers inshaping credit markets.
            
Foxwellwarned that British steel, automotive, capital equipment and other heavyindustry was becoming obsolete largely because its bankers failed to perceivethe need to promote equity investment and extend long‑term credit. They basedtheir loan decisions not on the new production and revenue their lending mightcreate, but simply on what collateral they could liquidate in the event ofdefault: inventories of unsold goods, real estate, and money due on bills forgoods sold and awaiting payment from customers. And rather than investing inthe shares of the companies that their loans supposedly were building up, theypaid out most of their earnings as dividends – and urged companies to do thesame. This short time horizon forced business to remain liquid rather thanhaving leeway to pursue long‑term strategy.
            
Germanbanks, by contrast, paid out dividends (and expected such dividends from theirclients) at only half the rate of British banks, choosing to retain earnings ascapital reserves and invest them largely in the stocks of their industrialclients. Viewing these companies as allies rather than merely as customers fromwhom to make as large a profit as quickly as possible, German bank officialssat on their boards, and helped expand their business by extending loans toforeign governments on condition that their clients be named the chiefsuppliers in major public investments. Germany viewed the laws of history asfavoring national planning to organize the financing of heavy industry, andgave its bankers a voice in formulating international diplomacy, making them“the principal instrument in the extension of her foreign trade and politicalpower.”
            
A similarcontrast existed in the stock market. British brokers were no more up to thetask of financing manufacturing in its early stages than were its banks. Thenation had taken an early lead by forming Crown corporations such as the EastIndia Company, the Bank of England and even the South Sea Company. Despite thecollapse of the South Sea Bubble in 1720, the run-up of share prices from 1715to 1720 in these joint-stock monopolies established London’s stock market as apopular investment vehicle, for Dutch and other foreigners as well as forBritish investors. But the market was dominated by railroads, canals and largepublic utilities. Industrial firms were not major issuers of stock.
            
In anycase, after earning their commissions on one issue, British stockbrokers werenotorious for moving on to the next without much concern for what happened tothe investors who had bought the earlier securities. “As soon as he hascontrived to get his issue quoted at a premium and his underwriters haveunloaded at a profit,” complained Foxwell, “his enterprise ceases. ‘To him,’ asthe Times says, ‘a successful flotation is of more importance than a soundventure.’”
            
Much thesame was true in the United States. Its merchant heroes were individualistictraders and political insiders often operating on the edge of the law to gaintheir fortunes by stock-market manipulation, railroad politicking for landgiveaways, and insurance companies, mining and natural resource extraction.America’s wealth-seeking spirit found its epitome in Thomas Edison’shit-or-miss method of invention, coupled with a high degree of litigiousness toobtain patent and monopoly rights.
            
In sum, neither British nor Americanbanking or stock markets planned for the future. Their time frame was short, andthey preferred rent-extracting projects to industrial innovation. Most banksfavored large real estate borrowers, railroads and public utilities whoseincome streams easily could be forecast. Only after manufacturing companiesgrew fairly large did they obtain significant bank and stock market credit.
            
What isremarkable is that this is the tradition of banking and high finance that hasemerged victorious throughout the world. The explanation is primarily themilitary victory of the United States, Britain and their Allies in the GreatWar and a generation later, in World War II.

The regression toward burdensomeunproductive debts after World War I
            
The development of industrial creditled economists to distinguish between productive and unproductive lending. Aproductive loan provides borrowers with resources to trade or invest at aprofit sufficient to pay back the loan and its interest charge. An unproductiveloan must be paid out of income earned elsewhere. Governments must pay warloans out of tax revenues. Consumers must pay loans out of income they earn ata job – or by selling assets. These debt payments divert revenue away frombeing spent on consumption and investment, so the economy shrinks. Thistraditionally has led to crises that wipe out debts, above all those that areunproductive.
            
In the aftermath of World War I theeconomies of Europe’s victorious and defeated nations alike were dominated bypostwar arms and reparations debts. These inter-governmental debts were to payfor weapons (by the Allies when the United States unexpectedly demanded thatthey pay for the arms they had bought before America’s entry into the war), andfor the destruction of property (by the Central Powers), not new means of production. Yetto the extent that they were inter-governmental, these debts were moreintractable than debts to private bankers and bondholders. Despite the factthat governments in principle are sovereign and hence can annul debts owed toprivate creditors, the defeated Central Power governments were in no position to dothis.
            
And among the Allies, Britain ledthe capitulation to U.S. arms billing, captive to the creditor ideology that “adebt is a debt” and must be paid regardless of what this entails in practice oreven whether the debt in fact can be paid. Confronted with America’s demand forpayment, the Allies turned to Germany to make them whole. After taking itsliquid assets and major natural resources, they insisted that it squeeze outpayments by taxing its economy. No attempt was made to calculate just howGermany was to do this – or most important, how it was to convert this domesticrevenue (the “budgetary problem”) into hard currency or gold. Despite the factthat banking had focused on international credit and currency transfers sincethe 12th century, there was a broad denial of what John MaynardKeynes identified as a foreign exchange transferproblem.
            
Never before had there been anobligation of such enormous magnitude. Nevertheless, all of Germany’s politicalparties and government agencies sought to devise ways to tax the economy toraise the sums being demanded. Taxes, however, are levied in a nation’s owncurrency. The only way to pay the Allies was for the Reichsbank to take thisfiscal revenue and throw it onto the foreign exchange markets to obtain thesterling and other hard currency to pay. Britain, France and the otherrecipients then paid this money on their Inter-Ally debts to the United States.
            
AdamSmith pointed out that no government ever had paid down its public debt. Butcreditors always have been reluctant to acknowledge that debtors are unable topay. Ever since David Ricardo’s lobbying for their perspective in Britain’sBullion debates, creditors have found it their self-interest to promote adoctrinaire blind spot, insisting that debts of any magnitude could be paid.They resist acknowledging a distinction between raising funds domestically (byrunning a budget surplus) and obtaining the foreign exchange to payforeign-currency debt. Furthermore, despite the evident fact that austeritycutbacks on consumption and investment can only be extractive,creditor-oriented economists refused to recognize that debts cannot be paid byshrinking the economy.[4]Or that foreign debts and other international payments cannot be paid indomestic currency without lowering the exchange rate.
            
The more domestic currency Germanysought to convert, the further its exchange rate was driven down against thedollar and other gold-based currencies. This obliged Germans to pay much morefor imports. The collapse of the exchange rate was the source ofhyperinflation, not an increase in domestic money creation as today’screditor-sponsored monetarist economists insist. In vain Keynes pointed to thespecific structure of Germany’s balance of payments and asked creditors tospecify just how many German exports they were willing to take, and to explainhow domestic currency could be converted into foreign exchange withoutcollapsing the exchange rate and causing price inflation.
            
Tragically, Ricardian tunnel visionwon Allied government backing. Bertil Ohlin and Jacques Rueff claimed thateconomies receiving German payments would recycle their inflows to Germany andother debt-paying countries by buying their imports. If income adjustments didnot keep exchange rates and prices stable, then Germany’s falling exchange ratewould make its exports sufficiently more attractive to enable it to earn therevenue to pay.
            
Thisis the logic that the International Monetary Fund followed half a century laterin insisting that Third World countries remit foreign earnings and even permitflight capital as well as pay their foreign debts. It is the neoliberal stancenow demanding austerity for Greece, Ireland, Italy and other Eurozoneeconomies.
            
Banklobbyists claim that the European Central Bank will risk spurring domestic wageand price inflation of it does what central banks were founded to do: financebudget deficits. Europe’s financial institutions are given a monopoly right toperform this electronic task – and to receive interest for what a real centralbank could create on its own computer keyboard.
            
But why it is less inflationary forcommercial banks to finance budget deficits than for central banks to do this?The bank lending that has inflated a global financial bubble since the 1980shas left as its legacy a debt overhead that can no more be supported today thanGermany was able to carry its reparations debt in the 1920s. Would governmentcredit have so recklessly inflated asset prices?

How debt creation has fueled asset-priceinflation since the 1980s
            
Banking in recent decades has notfollowed the productive lines that early economic futurists expected. As notedabove, instead of financing tangible investment to expand production andinnovation, most loans are made against collateral, with interest to be paidout of what borrowers can make elsewhere. Despite being unproductive in theclassical sense, it was remunerative for debtors from 1980 until 2008 – not byinvesting the loan proceeds to expand economic activity, but by riding the waveof asset-price inflation. Mortgage credit enabled borrowers to bid up propertyprices, drawing speculators and new customers into the market in theexpectation that prices would continue to rise. But hothouse credit infusionsmeant additional debt service, which ended up shrinking the market for goodsand services.
            
Under normal conditions the effectwould have been for rents to decline, with property prices following suit,leading to mortgage defaults. But banks postponed the collapse into negativeequity by lowering their lending standards, providing enough new credit to keepon inflating prices. This averted a collapse of their speculative mortgage andstock market lending. It was inflationary – but it was inflating asset prices,not commodity prices or wages. Two decades of asset price inflation enabledspeculators, homeowners and commercial investors to borrow the interest fallingdue and still make a capital gain.
            
This hope for a price gain madewinning bidders willing to pay lenders all the current income – making banksthe ultimate and major rentier incomerecipients. The process of inflating asset prices by easing credit terms andlowering the interest rate was self-feeding. But it also was self-terminating,because raising the multiple by which a given real estate rent or businessincome can be “capitalized” into bank loans increased the economy’s debtoverhead.
            
Securities markets became part ofthis problem. Rising stock and bond prices made pension funds pay more topurchase a retirement income – so “pension fund capitalism” was coming undone.So was the industrial economy itself. Instead of raising new equity financingfor companies, the stock market became a vehicle for corporate buyouts. Raidersborrowed to buy out stockholders, loading down companies with debt. The mostsuccessful looters left them bankrupt shells. And when creditors turned theireconomic gains from this process into political power to shift the tax burdenonto wage earners and industry, this raised the cost of living and doingbusiness – by more than technology was able to lower prices.

The EU rejects central bank money creation,leaving deficit financing to the banks
            
So the plan has backfired. When“hard money” policy makers limited central bank power, they assumed that publicdebts would be risk-free. Obliging budget deficits to be financed by privatecreditors seemed to offer a bonanza: being able to collect interest forcreating electronic credit that governments can create themselves. But now,European governments need credit to balance their budget or face default. Sobanks now want a central bank to create the money to bail them out for the badloans they have made.
            
For starters, the ECB’s €489 billionin three-year loans at 1% interest gives banks a free lunch arbitrageopportunity (the “carry trade”) to buy Greek and Spanish bonds yielding ahigher rate. The policy of buying government bonds in the open market – afterbanks first have bought them at a lower issue price – gives the banks a quickand easy trading gain.
            
How are these giveaways lessinflationary than for central banks to directly finance budget deficits androll over government debts? Is the aim of giving banks easy gains simply toprovide them with resources to resume the Bubble Economy lending that led totoday’s debt overhead in the first place?

Conclusion
            
Governmentscan create new credit electronically on their own computer keyboards as easilyas commercial banks can. And unlike banks, their spending is expected to servea broad social purpose, to be determined democratically. When commercial banksgain policy control over governments and central banks, they tend to supporttheir own remunerative policy of creating asset-inflationary credit – leavingthe clean-up costs to be solved by a post-bubble austerity. This makes the debtoverhead even harder to pay – indeed, impossible.
            
So we are brought back to the policyissue of how public money creation to finance budget deficits differs from issuinggovernment bonds for banks to buy. Is not the latter option a convoluted way tofinance such deficits – at a needless interest charge? When governmentsmonetize their budget deficits, they do not have to pay bondholders.
            
I have heard bankers argue thatgovernments need an honest broker to decide whether a loan or public spendingpolicy is responsible. To date their advice has not promoted productive credit.Yet they now are attempting to compensate for the financial crisis by tellingdebtor governments to sell off property in their public domain. This “solution”relies on the myth that privatization is more efficient and will lower the costof basic infrastructure services. Yet it involves paying interest to the buyersof rent-extraction rights, higher executive salaries, stock options and otherfinancial fees.
            
Most cost savings are achieved byshifting to non-unionized labor, and typically end up being paid to theprivatizers, their bankers and bondholders, not passed on to the public. Andbankers back price deregulation, enabling privatizers to raise access charges.This makes the economy higher cost and hence less competitive – just theopposite of what is promised.
            
Banking has moved so far away fromfunding industrial growth and economic development that it now benefitsprimarily at the economy’s expense in a predator and extractive way, not bymaking productive loans. This is now the great problem confronting our time.Banks now lend mainly to other financial institutions, hedge funds, corporateraiders, insurance companies and real estate, and engage in their ownspeculation in foreign currency, interest-rate arbitrage, and computer-driventrading programs. Industrial firms bypass the banking system by financing newcapital investment out of their own retained earnings, and meet their liquidityneeds by issuing their own commercial paper directly. Yet to keep the bankcasino winning, global bankers now want governments not only to bail them outbut to enable them to renew their failed business plan – and to keep thepresent debts in place so that creditors will not have to take a loss.
            
This wish means that society shouldlose, and even suffer depression. We are dealing here not only with greed, butwith outright antisocial behavior and hostility.
            
Europe thus has reached a criticalpoint in having to decide whose interest to put first: that of banks, or the“real” economy. History provides a wealth of examples illustrating the dangersof capitulating to bankers, and also for how to restructure banking along moreproductive lines. The underlying questions are clear enough:
  • Have banks outlived their historical role, or can they be restructured tofinance productive capital investment rather than simply inflate asset prices?
  • Would a public option provide less costly and better directed credit?
  • Why not promote economic recovery by writing down debts to reflect the abilityto pay, rather than relinquishing more wealth to an increasingly aggressivecreditor class?


Solving the Eurozone’s financialproblem can be made much easier by the tax reforms that classical economistsadvocated to complement their financial reforms. To free consumers andemployers from taxation, they proposed to levy the burden on the “unearnedincrement” of land and natural resource rent, monopoly rent and financialprivilege. The guiding principle was that property rights in the earth,monopolies and other ownership privileges have no direct cost of production,and hence can be taxed without reducing their supply or raising their price,which is set in the market. Removing the tax deductibility for interest is theother key reform that is needed.
            
A rent tax holds down housing pricesand those of basic infrastructure services, whose untaxed revenue tends to becapitalized into bank loans and paid out in the form of interest charges.Additionally, land and natural resource rents – along with interest – are theeasiest to tax, because they are highly visible and their value is easy toassess.
            
Pressure to narrow existing budgetdeficits offers a timely opportunity to rationalize the tax systems of Greeceand other PIIGS countries in which the wealthy avoid paying their fair share oftaxes. The political problem blocking this classical fiscal policy is that it“interferes” with the rent-extracting free lunches that banks seek to lendagainst. So they act as lobbyists for untaxing real estate and monopolies (andthemselves as well). Despite the financial sector’s desire to see governmentsremain sufficiently solvent to pay bondholders, it has subsidized an enormouspublic relations apparatus and academic junk economics to oppose the taxpolicies that can close the fiscal gap in the fairest way.

            

Itis too early to forecast whether banks or governments will emerge victoriousfrom today’s crisis. As economies polarize between debtors and creditors,planning is shifting out of public hands into those of bankers. The easiest wayfor them to keep this power is to block a true central bank or strong publicsector from interfering with their monopoly of credit creation. The counter isfor central banks and governments to act as they were intended to, by providinga public option for credit creation.



[1] Joseph E. Stiglitz,“Obama’s Ersatz Capitalism,” The New YorkTimes, April 1, 2009
http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html.
[2] http://neweconomicperspectives.org, and The Best Way to Rob a Bank is to OwnOne (2005).
[3] George W. Edwards, The Evolution of Finance Capitalism (NewYork: 1938):68.
[4] I review the literaturefrom the 1920s, its Ricardian pedigree and subsequent revival by the IMF andother creditor institutions in Trade,Development and Foreign Debt: A History of Theories of Polarization v.Convergence in the World Economy (1992; new ed. ISLET 2010). I provide thepolitical background in SuperImperialism: The Economic Strategy of American Empire (New York: Holt,Rinehart and Winston, 1972; 2nd ed., London: Pluto Press, 2002),

Response to Comments on Blog #33: MMT and Inequality

OK there really were only two themes inthe comments: first a question about sovereign vs nonsovereignissuers of IOUs and second questions about the MMT position oninequality.
The first has been dealt with all alongin the MM Primer. The sovereign chooses the unit of account, taxes inthat unit and issues IOUs in that unit that can be used to payobligations to the sovereign. Q. E. D.
On the second: MMTers reject the notionthat sovereign government uses taxes to “redistribute” income.No, taxes destroy income. If we want poor people to have income, wegive them jobs and keystroke their bank accounts. If we think richpeople are too rich we can reverse keystroke their bank accounts.
Here’s the problem. I suppose all ofyou looked at Mitt Romney’s (who on earth would name their kidafter a leather implement used in a baseball game?) tax return.Q.E.D. Forget taxes. Ain’t going to reduce wealth of the rich. Intruth, Romney pays way too much in taxes for someone in his incomeclass—remember, he knew he would run for president and so avoidedall questionable evasions. In spite of what the news is nowreporting, most really rich people do not pay taxes. Don’t take myword for it. Bartlett and Steele (two reporters in Philly) got famousfor going through the thousands of pages of the tax code andidentifying thousands of exemptions for well-connected rich folksthat exempted them from paying taxes. They actually figured outexactly who these people were. There were thousands more they couldnot identify—but the exemptions were so specific that it wasobvious they were meant for some favored individual.
Anyway, suppose someone’s income is$20 million a year like Mitt’s (a piker by Bill Gates standards),what tax rate would we need to levy to significantly reduceinequality? Not 30%. Not 70%. 90%? Ain’t never going to happen. Youwill not pass a tax law imposing a rate of 90% much less actuallymake it stick.
So here is what I wrote:
MMTers have written lots on poverty,inequality and the recent massive concentration of wealth income atthe top, so I have no idea where you get the idea that we avoid thesetopics. Indeed, Kelton and I did a detailed study contrasting the Waron Poverty (which did not reduce poverty at all) with the JG/ELRproposal which would have wiped out two-thirds of all poverty even ifthe wage was set at the minimum wage. I have no idea why you belive JG/ELR would lead to massive underemployment–it leads to fullemployment. So far as I can tell, the complaint is that we have notput them in the Primer? That does not mean we have ignored theissued. For those who want to read our study, go here:
“Public Policy Brief No. 78 | June2004
The War on Poverty after 40 Years: AMinskyan Assessment
Twenty to 25 years ago, a debate wasunder way in academe and in the popular press over the War onPoverty. One group of scholars argued that the war, initiated byPresidents Kennedy and Johnson, had been lost, owing to the inherentineffectiveness of government welfare programs. Charles Murray andother scholars argued that welfare programs only encouragedshiftlessness and burdened federal and state budgets.In recent years,despite the fact that the extent of poverty has not significantlydiminished since the early 1970s, the debate over poverty hasseemingly ended. In a country in which middle-class citizens struggleto afford health insurance and other necessities, the problems of theworst-off Americans seem to many remote and less than pressing.Moreover, the welfare reform bill of 1996 has deflected much of thecriticism of the welfare state by ending the individual-levelentitlement to Aid to Families with Dependent Children benefits (nowknown as Temporary Assistance to Needy Families) and putting timelimits on welfare recipiency, among other measures.” Download:Public Policy Brief No. 78, 2004 at www.levy.org.And while you are there browsing the Levy pices you will see I wrotemany other pieces on related topics.
So: to reduce inequality, first youstart at the bottom: give jobs. That eliminates 2/3 of all poverty.Then you gradually raise wages over time, by increasing the JG/ELRbasic wage.
And yes, you tackle income at the top.And as some comments indicated, most of the increase of inequality inrecent years is due to the outrageous rewards in the FIRE sector(finance, insurance, real estate). So you must reduce the rewards inthat sector. There is nothing “natural” about such high rewards.They are due largely to government policy. That is not the topichere, but it begins with the fraudsters and then changescompensations, incentives, and rewards. This is not difficultstuff—American management’s rewards are totally out of linecompared with compensation around the globe. And financialinstitutions—where the biggest rewards are—are inherentlypublic-private partnerships.
On progressive taxes, yes I propose acubic-foot-of-dwelling space tax. It is also environmentally sound.
However, we need to understandpolitical economy as well as MMT. First we do not need to”redistribute” from rich to poor. We can give the poor anyincome we want (hint: “keystrokes”) and any income we takefrom the rich goes no where (hint: reverse those keystrokes). So thatis a bogeyman. We can take BMWs away from the rich and give them tothe poor, if you like. But don’t confuse that with taxes—which areimposed in monetary form. Taking BMWs away is confiscation.
Finally, Americans oppose high taxeson the rich. We may not agree with them but it is the truth. In theUS taxes have never “redistributed” income–the rich justavoid and evade taxes and if that doesn’t work they hire Congress togive them loopholes. Forget it, it will not work in America.
Best to confrontthe problem head-on: jobs for the poor, better wages at the bottom,support for unions, and constraints at the top.

The World Needs 600 Million New Jobs

The International Labor Office (ILO) has just released a sobering report on the growing crisis in world labor markets.  We began the year with 1.1billion people – one out of every three people in the global labor force – either unemployed or among the 900 million working poor who earn less than US$2 a day. On top of the existing glut of 200 million unemployed, global labor markets will see an average of 40 million new entrants each year.  That means that an additional 400 million jobs will need to be created over the next decade in order to prevent a further increase in unemployment. To employ everyone who wants to work, the world needs 600 million new jobs.
The concern, however, is that global growth is decelerating,which means it will be difficult for global labor markets to keep up with the growth of the labor force, much less make up any lost ground.  In 2011, global growth slowed from 5.1 percent to just 4 percent, and the IMF is warning of a further deceleration in 2012.  The ILO report warns that even a modest slowdown in 2012, say 0.2 percent points, would mean an additional 1.7 million unemployed by 2013.  The report also highlights the impact that overly tight fiscal policies have had on growth and employment, beginning with the job-killing austerity programs that have become especially common within the Eurozone. Elsewhere, in nations with ample policy space, governments have lost their appetite for fiscal stimulus, even as heightened insecurity and depressed consumer confidence keep private sector demand weak.
Analytically, the report begins on a high note, with an analysisthat employs the sectoral balance approach that is central to the MMT framework.  Here, the report draws out the (negative) implications of declining public budgets on private net savings.  Unfortunately, the authors of the report fail to grasp enough MMT to develop a cogent analysis throughout, particularly whenit comes to distinguishing between currency issuers and currency users. As aresult, the report concludes with a weak-kneed policy prescription to address “the urgent challenge of creating 600 million productive jobs over the next decade.”
Below are some excerpts (my emphasis) to give you a sense of the study’s main conclusions:
Even though only a few countries are facing serious and long-term economic and fiscal challenges, the global economy has weakened rapidly as uncertainty spread beyond advanced economies.  As a result, the world economy has moved even further away from the pre-crisis trend path and, at the current juncture, evena double dip remains a distinct possibility.
There is growing evidence of a negative feedback loop between the labour market and the macro-economy, particularly in developed economies: high unemployment and low wage growth are reducing demand for goods and services, which further damages business confidence and leaves firms hesitant to invest and hire.  Breaking this negative loop will be essential if a sustainable recovery is to take root.  In much of the developing world, such sustainable increases in productivity will require accelerated structural transformation – shifting to higher value added activities while moving away from subsistence agriculture as a main source of employment and reducing reliance on volatile commodity markets for export earnings.
Further gains in education and skills development, adequate social protection schemes that ensure a basic standard of living for the most vulnerable, and strengthened dialogue between workers, employers and governments are needed to ensure broad-based development built on a fair and just distribution of economic gains.
Housing and other asset price bubbles prior to the crisis created substantial sectoral misalignments that need to be fixed and which will requirelengthy and costly job shifts, both across the economy and across countries.
To address the protracted labour market recession and put the world economy on a more sustainable recovery path, several policy changes are necessary.
First, global policies need to be coordinated more firmly. Deficit-financed public spending and monetary easing simultaneously implemented by many advanced and emerging economies at the beginning of the crisis is no longer a feasible option for all of them.  Indeed, the large increase in public debt and ensuing concerns about the sustainability of public finances in some countries have forced those most exposed to rising sovereign debt risk premiums to implement strict belt-tightening.  However, cross-country spillover effects from fiscalspending and liquidity creation can be substantial and – if used in a coordinated way – could allow countries that still have room for maneuver to support both their own economies as well as the global economy. It is such coordinated public finance measures that are now necessary to support global aggregate demand and stimulate job creation going forward.
Second, more substantial repair and regulation of the financial system would restore credibility and confidence…
Third, what is most needed now is to target the real economy to support job growth.  The ILO’s particular concern is that despite large stimulus packages, these measures have not managed to roll back the 27 million increase in unemployed since the initial impact ofthe crisis.  Clearly, the policy measures have not been well targeted and need reassessment in terms of their effectiveness.  … policies that have proven very effective in stimulating job creation and supporting incomes include: the extension of unemployment  benefits  and work sharing programmes, there-evaluation of minimum wages and wage subsidies as well as enhancing public employment services, public works programmes and entrepreneurship incentives – show impacts on employment and incomes.
Fourth, additional public support measures alone will not be sufficient to foster a sustainable jobs recovery. Policy-makers must act decisively and in a coordinated fashion to reduce the fear and uncertainty that is hindering private investment so that the private sector can restart the main engine of global job creation.  Incentives to businesses to invest in plant and equipment and to expand their payrolls will be essential to stimulate a strong and sustainable recovery in employment.
Fifth, to be effective, additional stimulus packages must not put the sustainability of public finances at risk by further raising public debt.  In this respect, public spending fully matched by revenue increases can still provide a stimulus to the real economy, thanks to the balanced budget multiplier.  In times of faltering demand, expanding the role of government in aggregate demand helps stabilize the economy and sets forth a new stimulus, even if the spending increase is fully matched by simultaneous rises in tax revenues. As argued in this report, balanced-budget multipliers can be large, especially in the current environment of massively underutilized capacities and high unemployment rates. At the same time, balancing spending with higher revenues ensures that budgetary risk is kept low enough to satisfy capital markets.
The report concludes with the following sentence:
At the same time, balancing spending with higher revenues ensures that budgetary risk is kept low to satisfy capital markets. Interest rates will therefore remain unaffected by such a policy choice, allowing the stimulus to develop its full effect on the economy.
And this is my biggest problem with the report: there is no attempt to distinguish countries that must satisfy capital markets from those that need not.  As MMT makes clear, governments that issue “modern money” (i.e. non-convertible fiat currencies) can help restore growth by permitting their deficits to expand to the point where the private sector is satisfied with its net saving position.  Only governments that that operate with fixed exchange rates or other incarnations of a gold standard must cow-tow to capital markets.  A far bolder jobs program could be advanced if people understood the importance of monetary sovereignty.

The New York Times’ Ode to Foxconn and Anti-Employee Control Fraud

By William K. Black

I wrote recently about Apple’s release ofinformation from its “audits” of its major suppliers.  Apple constructed the release to deny thepublic information on the identity of the suppliers that defrauded andendangered the lives and health of their workers.  I explained that criminologists classifythese as “anti-employee control frauds.” Control frauds occur when the persons who control a seemingly legitimateentity use it as a “weapon” to defraud. Anti-employee control frauds defraud the workers.  Apple’s audit, and I explained why it was farfrom vigorous, showed endemic anti-employee control fraud by itssuppliers.  Apple overwhelminglypurchases components from Asian suppliers that are criminal enterprises.  The control frauds operate in fraud-friendlynations with non-Western managers selected for their willingness to cheat theworkers. 

MMP #33: Functional Finance and Long Term Growth


Last weekwe examined Milton Friedman’s version of Functional Finance, which we found tobe remarkably similar to Abba Lerner’s. If the economy is operating below fullemployment, government ought to run a budget deficit; if beyond full employmentit should run a surplus. He also advocated that all government spendingshould be financed by “printing money” and taxes would destroy money. That, aswe know, is an accurate description of sovereign government spending—exceptthat it is keystrokes, not money printing. Deficits mean net money creation, throughnet keystrokes. The only problem with Friedman’s analysis is that he did notaccount for the external sector: he wanted a balanced budget at fullemployment, but if a country tends to run a trade deficit at full employment,then it must have a government budget deficit to allow the private sector torun a balanced budget—which is the minimum we should normally expect.

Somehow allthis understanding was lost over the course of the postwar period, replaced by“sound finance” which is anything but sound. It was based on an inappropriateextension of the household “budget constraint” to government. This is obviouslyinappropriate—households are users of the currency, while government is theissuer. It doesn’t face anything like a household budget constraint. How couldeconomics have become so confused? Let us see what Paul Samuelson said, andthen turn to proper policy to promote long term growth.

Functional Finance versus Superstition. The functional finance approach ofFriedman and Lerner was mostly forgotten by the 1970s. Indeed, it was replacedin academia with something known as the “government budget constraint”. Theidea is simple: a government’s spending is constrained by its tax revenue, itsability to borrow (sell bonds) and “printing money”. In this view, governmentreally spends its tax revenue and borrows money from markets in order tofinance a shortfall of tax revenue. If all else fails, it can run the printingpresses, but most economists abhor this activity because it is believed to behighly inflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’sexperience, or in modern times, Zimbabwe—asa cautionary tale against “financing” spending through printing money.

Note thatthere are two related points that are being made. First, government is“constrained” much like a household. A household has income (wages, interest,profits) and when that is insufficient it can run a deficit through borrowingfrom a bank or other financial institution. While it is recognized thatgovernment can also print money, which is something households cannot do, theseis seen as extraordinary behaviour—sort of a last resort. There is norecognition that all spending bygovernment is actually done by crediting bank accounts—keystrokes that are moreakin to “printing money” than to “spending out of income”. That is to say, thesecond point is that the conventional view does not recognize that as theissuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply itwith the “money” it needs. From inception, taxpayers and financial markets canonly supply to the government the “money” they received from government. That is to say, taxpayers pay taxes usinggovernment’s own IOUs; banks use government’s own IOUs to buy bonds fromgovernment.

Thisconfusion by economists then leads to the views propagated by the media and bypolicy-makers: a government that continually spends more than its tax revenueis “living beyond its means”, flirting with “insolvency” because eventuallymarkets will “shut off credit”. To be sure, most macroeconomists do not makethese mistakes—they recognize that a sovereign government cannot really becomeinsolvent in its own currency. They do recognize that government can make allpromises as they come due, because it can “run the printing presses”. Yet, theyshudder at the thought—since that would expose the nation to the dangers ofinflation or hyperinflation. The discussion by policy-makers—at least in the US—is far moreconfused. For example, President Obama frequently asserted throughout 2010 thatthe USgovernment was “running out of money”—like a household that had spent all themoney it had saved in a cookie jar.

So how didwe get to this point? How could we have forgotten what Lerner and Friedmanclearly understood?

In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:

                “I think there is an elementof truth in the view that the superstition that the budget must be balanced atall times [is necessary]. Once it is debunked [that] takes away one of thebulwarks that every society must have against expenditure out of control. Theremust be discipline in the allocation of resources or you will have anarchisticchaos and inefficiency. And one of the functions of old fashioned religion wasto scare people by sometimes what might be regarded as myths into behaving in away that the long-run civilized life requires. We have taken away a belief inthe intrinsic necessity of balancing the budget if not in every year, [then] inevery short period of time. If Prime Minister Gladstone came back to life he                 would say “uh, oh what youhave done” and James Buchanan argues in those terms. I have to say that Isee merit in that view.”

The beliefthat the government must balance its budget over some timeframe is likened to a“religion”, a “superstition” that is necessary to scare the population intobehaving in a desired manner. Otherwise, voters might demand that their electedofficials spend too much, causing inflation. Thus, the view that balancedbudgets are desirable has nothing to do with “affordability” and the analogiesbetween a household budget and a government budget are not correct. Rather, itis necessary to constrain government spending with the “myth” precisely becauseit does not really face a budget constraint.

The US (and manyother nations) really did face inflationary pressures from the late 1960s untilthe 1990s (at least periodically). Those who believed the inflation resultedfrom too much government spending helped to fuel the creation of the balancedbudget “religion” to fight the inflation. The problem is that what started assomething recognized by economists and policymakers to be a “myth” came to bebelieved as the truth. An incorrect understanding was developed. Originally themyth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation. But like many useful myths,this one eventually became a harmful myth—an example of what John KennethGalbraith called an “innocent fraud”, an unwarranted belief that preventsproper behaviour. Sovereign governments began to believe that the really couldnot “afford” to undertake desired policy, on the belief they might becomeinsolvent. Ironically, in the midst of the worst economic crisis since theGreat Depression of the 1930s, President Obama repeatedly claimed that the US governmenthad “run out of money”—that it could not afford to undertake policy that mostbelieved to be desired. As unemployment rose to nearly 10%, the government wasparalysed—it could not adopt the policy that both Lerner and Friedmanadvocated: spend enough to return the economy toward full employment.

Ironically,throughout the crisis, the Fed (as well as some other central banks, includingthe Bank of England and the Bank of Japan) essentially followed Lerner’s secondprinciple: it provided more than enough bank reserves to keep the overnightinterest rate on a target that was nearly zero. It did this by purchasingfinancial assets from banks (a policy known as “quantitative easing”), inrecord volumes ($1.75 trillion in the first phase, with a planned additional $600billion in the second phase). Chairman Bernanke was actually grilled inCongress about where he obtained all the “money” to buy those bonds. He(correctly) stated that the Fed simply created it by crediting bankreserves—through keystrokes. The Fed can never run out “money”; it can affordto buy any financial assets banks are willing to sell. And yet we have thePresident (as well as many members of the economics profession as well as mostpoliticians in Congress) believing government is “running out of money”! Thereare plenty of “keystrokes” to buy financial assets, but no “keystrokes” to paywages.

Thatindicates just how dysfunctional the myth has become.

A Budget Stance to Promote Long Term Growth. The lesson that can be learned fromthat three decade experience of the US is that in the context of a privatesector desire to run a budget surplus (to accumulate savings) plus a propensityto run current account deficits, the government budget must be biased to run adeficit even at full employment. Thisis a situation that had not been foreseen by Friedman (not surprising since theUSwas running a current account surplus in the first two decades after WWII). Theother lesson to be learned is that a budget surplus (like the one PresidentClinton presided over) is not something to be celebrated as anaccomplishment—it falls out of an identity, and is indicative of a privatesector deficit (ignoring the current account). Unlike the sovereign issuer ofthe currency, the private sector is a user of the currency. It really does facea budget constraint. And as we now know, that decade of deficit spending by theUSprivate sector left it with a mountain of debt that it could not service. Thatis part of the explanation for the global financial crisis that began in the US.

To be sure,the causal relations are complex. We should not conclude that the cause of the private deficit was the Clinton budget surplus; and we should not conclude thatthe global crisis should be attributed solely to US household deficit spending. Butwe can conclude that accounting identities do hold: with a current accountbalance of zero, a private domestic deficit equals a government surplus. And ifthe current account balance is in deficit, then the private sector can run asurplus (“save”) only if the budget deficit of the government is larger thanthe current account deficit.

Finally,the conclusion we should reach from our understanding of currency sovereigntyis that a government deficit is more sustainable than a private sector deficit—thegovernment is the issuer, the household or the firm is the user of thecurrency. Unless a nation can run a continuous current account surplus, thegovernment’s budget will need to be biased to run deficits on a sustained basisto promote long term growth.

However, weknow from our previous discussion that fiscal policy space depends on theexchange rate regime—the topic of the next blog.

Further, wewant to be clear: the appropriate budget stance depends on the balance of theother two sectors. A nation that tends to run a current account surplus can runtighter fiscal policy; it might even be able to run a sustained governmentbudget surplus (this is the case in Singapore—which pegs its exchangerate, and runs a budget surplus because it runs a current account surplus whileit accumulates foreign exchange). A government budget surplus is alsoappropriate when the domestic private sector runs a deficit (given a currentaccount balance of zero, this must be true by identity). However, for thereasons discussed above, that is not ultimately sustainable because the privatesector is a user, not an issuer, of the currency.

Finally, we must note that it is not possible for all nations to runcurrent account surpluses—Asian net exporters, for example, rely heavily onsales to the US, which runs a current account deficit to provide the Dollarassets the exporters want to accumulate. We conclude that at least somegovernments will have to run persistent deficits to provide the net financialassets desired by the world’s savers. It makes sense for the government of thenation that provides the international reserve currency to fill that role. Forthe time being, that is the US government.

Response to blog #32: Friedman’s Functional Finance Approach


Thanks for comments and questions. As I had alreadyintervened, I addressed the main points related to this week’s blog already.Let me pick up a few loose ends, and reformat my earlier response.

Q1: When you said US Debt/GDP reached 500% was that allprivate debt? And how can the private sector get out of debt?

A: No. Here’s the data break-down. You can see that it iscertainly private debt that has exploded, however. This ends in 2008, and afterthe GFC hit and the US slowed down, government debt started growing rapidly andprivate debt came down a bit as a percent of GDP so it would look a bitdifferent today.

How does the private sector get out of debt? If GDP andincome grow, households can service more debt all else equal, and the ratiowill decline. They can pay off debt. And yes they can default. Note how sharplythe debt ratio came down after the Great Depression—as all 3 of those thingshappened. The most important was economic growth fueled by government spending(and record govt deficits of 25% of GDP during WWII). It can also go down as theeconomy uses export-led growth but for the US that is not likely. The best waywould be to ramp up government spending today.

Q2: Several questions on US current account deficits,foreign accumulation of US Dollar assets, and so on. Also on the Bretton WoodsSystem.

A: I have discussed that a bit previously and we’ll do a lotmore of it in coming weeks—so let’s hold off. With respect to BW: it was amistake. Failed. Worked in the beginning because ROW needed US exports afterWWII and US lent dollars so they could buy them (Marshall Plan). More coming inthe MMP on exchange rate regimes. But briefly, both the BW system and theSterling system (pre WWI) failed. Such international pegged systems do notwork—they always generate crises and then collapse.

Q3: Didn’t Clinton announce he would retire the debt? Did hebelieve it?

A: Yes Clinton appeared on TV and announced all govt debtwould be retired. Who knows or cares what he believed? I think it was Rubin whopushed the idea. But what matters is that all Democrats after him think thatwas the right thing to do, and claim Bush Jr blew it by not continuing with thesurpluses. And so they want to bring back the good old Clinton-Rubin policy assoon as they can get through this crisis! They learned no lessons from thedeath of Goldilocks. Clinton’s tight fiscal policy killed her deader thanElvis.

Q4: Didn’t budget deficits of big-spending Democrats in the1960s cause high inflation?

A: Deficits of the 60s were miniscule. Don’t take my word for it. You can checkit out. Until Obama, no Democratic administration ran big deficits after WWII.Again, check it out. Yes there was some inflation in the late 60s. Big warsusually do generate some—but the war against Viet Nam plus the wimpy and failed“War on Poverty” did not create big deficits because the economy grew fastenough to generate tax revenue. Republicans have always had the biggestdeficits—not necessarily due to big spending, but due to their rotteneconomies that do not grow. Coincidence? Me thinks not.


Q5: Don’t you accept the dollar because you can convert itto gold?

A: Hah: I’ve never done so and would never consider it. Goldis a fool’s gamut. We all accept Dollars because there is a tax system thatrequires them.

Q6: Later Friedman said inflation results from excessivemoney supply.

A: Yes, and he was wrong then and he’s still wrong. Hisfunctional finance paper is probably the only thing he ever got right. Andnobody reads it!

Anti-employee Control Fraud

By William K. Black

Apple has released a report on working conditions inits suppliers’ factories.  It highlightsa form of control fraud that criminology has identified but rarelydiscussed.  I write overwhelmingly aboutaccounting control fraud because it drives our recurrent, intensifyingfinancial crises.  The primary intendedvictims of accounting control frauds are the shareholders and thecreditors.  Other private sector controlfrauds target customers (e.g., George Akerlof’s 1970 article on “lemons”), andthe public (e.g., the unlawful disposal of toxic waste, illegal logging, andtax fraud). 

Anti-employee control frauds most commonly fall infour broad, but not mutually exclusive, categories – illegal work conditionsdue to violation of safety rules, violation of child labor laws, failure to payemployees’ wages and benefits, and frauds based on goods and loans provided bythe employer to the employee that lock the employee into quasi-slavery.  Apple has just released a report on itssuppliers that shows that anti-employeecontrol fraud is the norm.  Remember,fraud is hidden and is often not discovered and Apple did not have an incentiveto make an exhaustive investigation. Apple calls its inquiries “audits” and it is apparent that most of itsinformation comes from reviewing written and electronic records at itssuppliers.  That is exceptionallyrevealing.  The suppliers know that theycan defraud their employees with such impunity that they don’t even bother toget rid of records that prove their frauds. Apple has resisted making public its suppliers and the report refused toidentify which suppliers committed which violations – often for years despiterepeated, false promises to end their anti-employee control frauds.  Two other facts are evident (but notreported).  First, Apple rarelyterminates suppliers for defrauding their employees – even when the fraudsendanger the lives and health of the workers and the community – and even whereApple knows that the supplier repeatedly lies to Apple about these fraudulentand lethal practices.  Second, it appearsunlikely in the extreme that Apple makes criminal referrals on its supplierseven when they commit anti-employee control frauds as a routine practice, evenwhen the frauds endanger the worker’s and the public’s health, and even whenthe supplier repeatedly lies to Apple about the frauds.  Apple’s report, therefore, understatessubstantially the actual incidence of fraud by the 156 suppliers (accountingfor 97% of its payments to suppliers).

“The company said audits revealed that93 supplier facilities had records indicating that more than half of theirworkers exceed a 60-hour weekly working limit. Apple said 108 facilities didnot pay proper overtime as required by law. In 15 facilities, Apple foundforeign contract workers who had paid excessive recruitment fees to laboragencies.
And though Apple said it mandatedchanges at those suppliers, and some facilities showed improvements, inaggregate, many types of lapses remained at levels that have persisted foryears.”

http://www.nytimes.com/2012/01/14/technology/apple-releases-list-of-its-suppliers-for-the-first-time.html?hp

The New YorkTimes, Wall Street Journal, and theWashington Post articles on the Apple report are all lengthy, but none ofthem has any input from a criminologist and each of the articles misses most ofthe significance of the report.  I havealready brought out several of these deficiencies.  The most fundamental flaws, however, have todo with why anti-employee control fraud is the norm at Apple’s suppliers andwhy the suppliers typically don’t even take the inexpensive efforts necessaryto avoid holding a paper trail that makes the frauds obvious even to a notterribly vigorous audit that they know is coming. 

If there is one single thing that drives uswhite-collar criminologists around the bend it is the implicit assumption thatfraud cannot be common.  There is, ofcourse, no logical (or experiential) reason for this belief.  Nevertheless, it is a common belief and amongeconomists it is a virtually universal dogma. Economists have a tribal taboo against even using the word “fraud” todescribe individual frauds.  The surestway to be considered an un-serious economist is to use the “f” word to describefrauds by elite economic actors. Economists’ taboo is particularly bizarre because it is economic theory,developed by a Nobel Laureate that explains why fraud can become endemic.  George Akerlof, in his famous article onmarkets for “lemons” (largely describing anti-customer control fraud),explained the perverse “Gresham’s” dynamic in 1970.  

“[D]ishonest dealingstend to drive honest dealings out of the market. The cost of dishonesty,therefore, lies not only in the amount by which the purchaser is cheated; thecost also must include the loss incurred from driving legitimate business outof existence.” 

Anti-employee control fraud creates real economicprofits for the firm and can massively increase the controlling officers’wealth.  Honest firm normally cannotcompete with anti-employee control frauds, so bad ethics drives good ethics outof the markets.  Companies like Apple andits counterparts create this criminogenic environment by selecting least-cost –criminal – suppliers who offer components at prices that honest firms cannotmatch.  Effectively, they hang out a sign– only the fraudulent need apply to be suppliers.  But the sign is, of course, invisible andcannot be introduced in court so Apple and its peers also get deniability.  They are shocked, shocked that its suppliersare frauds that cheat their employees and put them and the public’s health atrisk in order to make a few extra yuan ordong for the senior officers.  

Fraudulent suppliers, therefore, have compellingincentives to locate in nations and regions in which they can commit fraud withimpunity.  The best way to evaluate thefraudulent CEOs’ view as to the risk of prosecution for their frauds is toobserve whether they take cheap means of hiding their frauds.  When the CEOs do not even bother to avoidcreating a paper trail documenting their frauds one knows that they view therisk of prosecution as trivial.  Nationsthat are corrupt, have weak rule of law, weak or non-existent unions, poorprotections for workers, a reserve army of the impoverished, and have fewresources devoted to prosecuting elite white-collar crime provide an idealcriminogenic environment for firms engaged in anti-employee control fraud.  The ubiquitous nature of anti-employeecontrol fraud (and tax fraud) in many nations explains why U.S. industries havebeen so eager to “outsource” U.S. jobs to fraud-friendly nations.  Companies like Apple also discovered long agothat Americans often made poor senior managers in these nations because theyobjected to defrauding workers.  Not aproblem – there are plenty of managers from other nations that have no suchethical restraints.  Foreign suppliersrun by Asian managers are increasingly dominant.

The endemic nature of anti-employee control fraudalso demonstrates an important technical point. The wages reported in the most fraud-friendly nations are substantiallyoverstated because workers work far longer hours without receiving thecompensation to which they are entitled. Their hourly rate is much lower than reported, which means that the wagegap between U.S. and the most fraud-friendly nations is significantly greaterthan reported.  U.S. firms that haveforeign suppliers in these nations are well aware of this data bias and maketheir outsourcing decisions based on the real (much larger) wage gap.            

TheHarm to Employee and Consumer Health is Grave

The NYT article notes that it was badpublicity in the U.S. that finally forced Apple to make greater disclosuresabout its suppliers’ frauds.
“The calls for Apple to disclosesuppliers became particularly acute after a series of deaths and accidents inrecent years. In the last two years at firms supplying services to Apple, 137employees were seriously injured after cleaning iPad screens with n-hexane, atoxic chemical that can cause nerve damage and paralysis; over a dozen workershave committed suicide or fell or jumped from buildings in a manner thatsuggests a suicide attempt; and in two separate blasts caused by dust frompolishing iPad cases, four were killed and 77 injured.”
“Apple found that 62 percent of the 229 facilitiesit inspected were not in compliance with the company’s maximum 60-hour workpolicy; 13 percent did not have adequate protections for juvenile workers; and32 percent had problems with the management of hazardous waste.

One supplier was caught dumping wastewater at anearby farm. Another had a total lack of safety measures, creating “unsafeworking conditions,” the report found. Five facilities employed underageworkers.

The company in the past had refused to divulge itsfull supplier list even as it became standard practice for multinationalcorporations to do so after the public outcry in the 1990s over labor problemsat Nike factories in developing countries.

Apple’s change of heart follows a highly publicizedstring of factory worker suicides in 2010 and deadly explosions in two Chinesefactories in 2011.”



The WSJ emphasized this chillingfinding:


“The report also found 24 facilities conducted pregnancytests and 56 didn’t have procedures to prevent discrimination against pregnantworkers. Apple said that at its direction, the suppliers have stoppeddiscriminatory screenings for medical conditions or pregnancy.”



The article does not make this point explicitly, but these firms conductthese tests in order to unlawfully coerce their pregnant employees to haveundesired abortions in order to obtain and keep their jobs.

ForeignAnti-employee Control Fraud harms U.S. Workers

These frauds take place abroad, but they harm employees in the U.S.  Mitt Romney explains that Bain had to slashwages and pensions to save firms located in the U.S. who had to meetcompetition from foreign anti-employee control frauds.  The damage from foreign anti-employee controlfrauds drives the domestic attack on U.S. manufacturing wages.  Bad ethics increasingly drive good ethics outof the markets and manufacturing jobs out of the U.S. and into morefraud-friendly nations. 


A final caution is in order because each of the major articles on the Applereport failed to mention it.  CEOs whoare willing to routinely defraud their workers and expose them to grave threatsto their health are exceptionally likely to commit other forms of controlfraud. 



Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.


Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives. 


 Follow him on Twitter: @WilliamKBlack