Monthly Archives: January 2012


In thecontext of today’s conventional wisdom about the dangers of budget deficits,Lerner’s views (examined last week) appear somewhat radical. What is surprisingis that they were not all that radical at the time. As everyone knows, MiltonFriedman was a conservative economist and a vocal critic of “big government”and of Keynesian economics. No one has more solid credentials on the topic ofconstraining both fiscal and monetary policy than Friedman. Yet, in 1948 hemade a proposal that was almost identical to Lerner’s functional finance views.On one hand, this demonstrates how far today’s debate has moved away from aclear understanding of the policy space available to a sovereign government,but also that Lerner’s ideas must have been “in the air”, so to speak, widelyshared by economists across the political spectrum. At the end of thissubsection we will also visit Paul Samuelson’s comment on this topic—whichprovides a cogent explanation for today’s confusion about fiscal and monetarypolicy. As Samuelson hints, the confusion was purposely created in order tomystify the subject.

Briefly,Milton Friedman’s 1948 article, “AMonetary and Fiscal Framework for Economic Stability” put forward aproposal according to which the government would run a balanced budget only atfull employment, with deficits in recession and surpluses in economic booms.There is little doubt that most economists in the early postwar period sharedFriedman’s views on that. But Friedman went further, almost all the way toLerner’s functional finance approach: all government spending would be paid forby issuing government money (currency and bank reserves); when taxes were paid,this money would be “destroyed” (just as you tear up your own IOU when it isreturned to you). Thus, budget deficits lead to net money creation. Surpluseswould lead to net reduction of money.

He thusproposed to combine monetary policy and fiscal policy, using the budget tocontrol monetary emission in a countercyclical manner. (He also would haveeliminated private money creation by banks through a 100% reserverequirement–an idea he had picked up from Irving Fisher and Herbert Simons inthe early 1930s–hence, there would be no “net” money creation byprivate banks. They would expand the supply of bank money only as theyaccumulated reserves of government-issued money. We will not address this partof the proposal.) This stands in stark contrast to later conventional views(such as those associated with the ISLM model taught in textbooks) that“dichotomized monetary and fiscal policy. Friedman, too, later argued that thecentral bank ought to control the money supply, delinking in his later work theconnection between fiscal policy and monetary policy. But at least in this 1948paper he clearly tied the two in a manner consistent with Lerner’s approach.

Friedmanbelieved his proposal results in strong counter-cyclical forces to helpstabilize the economy as monetary and fiscal policy operate with combinedforce: deficits and net money creation when unemployment exists; surpluses andnet money destruction when at full employment. Further, his plan forcountercyclical stimulus is rules-based, not based on discretionary policy—itwould operate automatically, quickly, and always at just the right level. As iswell known, he later became famous for his distrust of discretionary policy,arguing for “rules” rather than “authorities”. This 1948 paper provides a neatway of tying policy to rules that automatically stabilize output and employmentnear full employment.

We see thatFriedman’s “proposal” is actually quite close to a description of the waythings work in a sovereign nation. When government spends, it does so bycreating “high powered money” (HPM)–that is, by crediting bankreserves. When it taxes, it destroys HPM, debiting bank reserves. A deficitnecessarily leads to a net injection of reserves, that is, to what Friedmancalled money creation. Most have come to believe that government finances itsspending through taxes, and that deficits force the government to borrow backits own money so that it can spend. However, any close analysis of the balancesheet effects of fiscal operations shows that Friedman (and Lerner) had itabout right.

But if thatis so, why do we fail to maintain full employment? The problem is that theautomatic stabilizers are not sufficiently strong to offset fluctuations ofprivate demand. Below we will examine why that is the case.

Note thatFriedman would have had government deficits and, thus, net money emission solong as the economy operated below full employment. Again, that is quite closeto Lerner’s functional finance view, and as discussed above it was a commonview of economists in the early postwar period. But almost no respectableeconomist or politician will today go along with that on the belief it would beinflationary and/or would bust the budget. Such is the sorry state of economicseducation today. How did we get to this point? In last week’s blog, Samuelsonexplained that the belief that the government must balance its budget over sometimeframe a “religion”, a “superstition” that is necessary to scare thepopulation into behaving in a desired manner. Otherwise, voters might demandthat their elected officials spend too much, causing inflation. Thus, the viewthat balanced budgets are desirable has nothing to do with “affordability” andthe analogies between a household budget and a government budget are notcorrect. Rather, it is necessary to constrain government spending with the“myth” precisely because it does not really face a budget constraint.

A Budget Stance for Economic Stability. In Friedman’s proposal, the sizeof government would be determined by what the population wanted government toprovide. Tax rates would then be set in such a way so as to balance the budgetonly at full employment. Obviously that is consistent with Lerner’s approach—ifunemployment exists, government needs to spend more, without worrying aboutwhether that generates a budget deficit. Essentially, Friedman’s proposal is tohave the budget move countercyclically so that it will operate as an automaticstabilizer. And, indeed, that is how modern government budgets do operate:deficits increase in recessions and shrink in expansions. In robust expansions,budgets even move to surpluses (this happened in the US during theadministration of President Clinton). Yet, we usually observe that these swingsto deficits are not sufficiently large to keep the economy at full employment.The recommendations of Friedman and Lerner to operate the budget in a mannerthat maintains full employment are not followed. Why not? Because the automaticstabilizers are not sufficiently strong.

To build in sufficient countercyclical swingsto move the economy back to full employment requires two conditions. First,government spending and tax revenues must be strongly cyclical–spending needsto be countercyclical (increasing in a downturn), and taxes pro-cyclical(falling in a downturn). One way to make spending automatically countercyclicalis to have a generous social safety net so that transfer spending (onunemployment compensation and social assistance) increases sharply in adownturn. Alternatively, or additionally, tax revenues also need to be tied toeconomic performance–progressive income or sales taxes that movecountercyclically.

Second,government needs to be relatively large. Hyman Minsky (1986) used to say thatgovernment needs to be about the same size as overall investment spending–orat least, swings of the government’s budget have got to be as big as investmentswings, moving in the opposite direction. (This is based on the belief thatinvestment is the most volatile component of GDP. This includes residentialreal estate investment, which is an important driver of the business cycle inthe US. The idea is that government spending needs to swing sufficiently and inthe opposite direction to investment in order to keep national income andoutput relatively stable; that, in turn will keep consumption relativelystable.) According to Minsky, government was far too small in the 1930s tostabilize the economy–even during the height of the New Deal, the federalgovernment was only 10% of GDP. Today, all major OECD nations probably have agovernment that is big enough, although some developing countries probably havea government that is too small by this measure. Based on current realities, itlooks like the national government should range from the US low of less than20% of GDP to a high of 50% in France. The countries at the low end of therange need more automatic fluctuation built into the budget than those with abigger government.

Looking tothe decade of the 1960s in the US, one sees that it was more-or-less consistentwith Friedman’s proposal and with Lerner’s functional finance approach. Federalgovernment spending averaged around 18-20% of GDP, and deficits averaged $4 or$5 billion a year, except for 1968 when they temporarily increased to $25billion–but for the decade, deficits ran well under 1% of GDP on average. Wecould quibble about whether the US was at full employment in the 1960s, but itwas certainly closer to full employment during that decade than it was afterthe early 1970s. From the early 1970s until the boom of the 1990s during thepresidency of Bill Clinton, the budget was too tight relative to therecommendations of Friedman and Lerner. How do we know? Because unemploymentwas chronically too high—even in expansions it never got down to 1960s levels.

Note thatthis was not because government spending fell much, or because taxes wereraised. Indeed, the deficit tended to be much higher after the early 1970s (thehigh unemployment period) than it was during the 1960s (the low unemploymentperiod).

What went wrong? Briefly, the problem could be attributed tothe evolution of the international position of the US that led to a chroniccurrent account deficit. The US emerged from WWII in a dominant position—notonly was the dollar in high demand, but so were US exports—needed bywar-ravaged Europe and Japan. The US had a trade surplus, and lent Dollars tothe rest of the world to buy its output. That added to US demand and—from ouraccounting identities—kept our budget deficits small and let our private sectorrun surpluses (save).

Recall thatthe international monetary system (Bretton Woods) was based on a dollar-goldstandard, with exchange rates fixed to the Dollar and the Dollar convertible togold. By the early 1970s, the US was running a trade deficit and foreignholders were exchanging excess dollars for gold. To make a long story short,the US abandoned gold, the Bretton Woods system collapsed, and most developedcountries floated. The dollar fell in value (helping to generate inflationpressures in the US as imports, especially oil, got more expensive), and the USfound it harder to compete in international markets (Japan and Europe hadlargely recovered and were producing for their own markets—and even for the USconsumer). The current account deficit turned negative—more or lesspermanently–during the administration of President Reagan. As we know from ourmacro identities, that deficit would have to be offset by a growing budgetdeficit—which had to be large enough to offset both the current account as wellas the US domestic sector surplus (saving of households and firms). By the endof the 1980s, Congress and the new president (George Bush) agreed to try toreign-in deficit spending. Hence, an already too-small budget deficit (giventhe current account deficit and the desire of the domestic private sector torun surpluses, demand was too low to eliminate unemployment) was constrainedfurther by the Gramm-Rudman Amendment that promised to work toward a budgetbalance.

The economysuffered from weak growth and relatively high unemployment over most of thisperiod. Then, suddenly, economic growth picked up speed during the Clintonadministration; indeed it grew so fast that it produced a budget surplus (astax revenues boomed) that lasted for nearly three years (the first sustainedsurplus since 1929!). President Clinton actually predicted at the time that thebudget surplus would continue for at least 15 more years, and that alloutstanding Federal government debt would be retired (for the first time since1837).

Note thatthis was not accomplished by reversing the current account deficit—whichactually grew. How could the US run a current account deficit and a government budget surplus? Only byrunning a sustained private sector deficit. Indeed, from 1996 until 2007 the USprivate sector ran a budget deficit every year except during the recession ofthe early 2000s. At times, the domestic private sector deficit reached 6% ofGDP (meaning that for every Dollar of US national income, the private sectorspent $1.06. With such a large “flow” deficit, the stock of private sector debt grewrapidly—both in nominal terms and as a ratio to GDP. By 2007, total US debtreached five times GDP (versus three times GDP in 1929 on the verge of theGreat Depression). This huge debt implied a big debt burden—the portion ofincome that had to be devoted to servicing debt. When the economy collapsed in2007, a private sector surplus finally returned (the turn-around from private deficitsto private surpluses amounted to 8% of GDP—a huge reversal that removedapproximately $1 trillion of spending from the economy)—and the governmentbudget deficit grew rapidly to 10% of GDP. Even as the private sector cut downits spending, it was forced to default on debts run up since the Clintonperiod. A wave of bankruptcies and home foreclosures resulted that drove theeconomy into a deep recession and financial crisis that spread around theworld.

Next week: a budget stance to promote growth.

Bill Black Chats with Dylan Ratigan: Firedoglake Book Salon This Afternoon

Don’t miss William K. Black on today’s Firedoglake book salon.  Professor Black will be chatting with Dylan Ratigan about his new book, Greedy Bastards:  How We Can Stop Corporate Communists, Banksters, and Other Vampires from Sucking America Dry.  The chat begins at 5:00 p.m. (EST).  Click here to watch the chat.

In the meantime, you can read Professor Black’s review of Dylan’s book below.

Dylan Ratigan is well positioned to author a book,designed to be an enjoyable and informative read by normal humans, on theongoing financial crisis.  He is the wunderkind who became Global Managing Editor for Corporate Finance ofBloomberg, the premier news service that specializes in finance, at anexceptionally young age.  He was at CNBCwhile that network was hyping the housing bubble as a non-bubble offeringfantastic investment opportunities.

Now an anchor forMSNBC, Ratigan is a fierce critic of prominent politicians in both parties forwhat he views as their destructive policies and slavish efforts to aid thewealthiest and most politically powerful at the expense of the best interestsof America and its people.  He ispassionate about these subjects and far less predictable than many of his peersbecause he is not a political partisan.      

In finance, the most important question is why wesuffer recurrent, intensifying financial crises.  That question is really two questions.  Answering it requires that we determine whatcauses our crises and why we fail to learn from these crises, but instead makethe incentive structure ever more perverse after each crisis.  Anyone from a finance background is likely toconclude that perverse incentives cause financial crises, so I was surprised byRatigan’s choice of book title (“Greedy Bastards”).  I think that greed is unlikelyto have changed greatly over the last quarter century in which the U.S. hassuffered three recurrent, intensifying financial crises. 

Idon’t call people bastards, even the self-made ones, because my mother reactedpoorly to Speaker Wright referring to me as the “red-headed SOB.” Ratigan’s view on these points turns out to be similar to mine.  He arguesthat the issue is not greed, but perverse incentives.  When CEOs haveincentives adverse to the public and their customers they tend to act on thoseincentives and harm the public and their customers.  This observation isone of those essential points so often overlooked by writers about this crisis. A CEOs’ principal function is creating, monitoring, and adjusting thecorporation’s incentive structures.  There is a massive businessliterature on this function and CEOs uniformly believe that incentivestructures for officers and employees are critical in shaping their behavior.
There is only one (disingenuous)exception to this rule – when officers and employees act criminally because theCEO has created perverse incentive structures.  Suddenly, the CEO isshocked that his officers and employees acted criminally in response to theCEO’s incentive structures that encourage criminal conduct.  Ratiganfocuses on precisely this exception.  Anyone that has had the misfortuneto listen to compulsory business ethics training by his or her employer willhave learned that the key is the “tone at the top” set by the CEO.  True,but that always ends the discussion.  No employee is going to be trainedby his employer as to what to do when the tone at the top set by the CEO ispro-fraud.
As Ratigan demonstrates,our most elite financial CEOs typically created and maintained grotesquelyperverse incentive structures that encouraged their officers and employees aswell as “independent” professionals to act criminally in a manner that harmedcustomers, the public, and shareholders – but made the controlling officerswealthy.  Is there any CEO of a lender incapable of understanding that whenthe loan officers and brokers’ compensation depends on volume and yield – notquality – the result will be catastrophic?  Is there any CEO of a lenderincapable of understanding that if the loan brokers’ fees depend as well on thereported debt-to-income and loan-to-value ratios and the broker ispermitted to make liar’s loans the result will be that the brokers will engagein endemic, severe inflation of the borrowers’ incomes and their homes’appraised values?  Is there any reader that doubts that the CEOs intendedto produce precisely what their perverse incentives were certain toproduce?  A CEO cannot send a memo to 50,000 loan brokers instructing themto inflate appraisals and use liar’s loans to inflate the borrowers incomes’but he can, and does, send the same message through his compensationsystem.  Each of these perverse incentives produces precisely the resultthat the CEOs expected and desired. 
Ratigan gets right twoof the essentials to understanding why we suffer recurrent, intensifyingfinancial crises.  First, cheating has become the dominant strategy infinance.  Second, cheating is dominant because finance CEOs create suchintensely perverse incentives that fraud becomes endemic.  The BusinessRoundtable (the largest100 U.S. corporations), had to react to the Enron erafrauds.  It chose as its spokesperson a CEO who embodied the best ofAmerican big business.  This was the response he gave to Business Week whentheir reporter asked why so many top corporations engaged in accounting controlfraud:
“Don’t just say: “If you hit this revenuenumber, your bonus is going to be this.” It sets up an incentive that’soverwhelming. You wave enough money in front of people, and good people will dobad things.”
How did the CEO knowabout the “overwhelming” effect of creating incentives so perverse that theywould routinely cause “good people [to] do bad things”?  He knew becausehe directed and administered such a perverse compensation system.  An SECcomplaint would soon identify that compensation system as driving accountingcontrol fraud at his firm.  His name was Franklin Raines, CEO of FannieMae.
What Ratigan does in this book that differs soimportantly, and accurately, from nearly every other account of the crisis by aprominent writer is to say in plain English that our most elite financialinstitutions caused the crisis, that they did so because their controllingofficers caused them to cheat, and that the senior officers cheated their ownshareholders for the purpose of becoming wealthy. 

Ratigan shows that theself-described “productive class” is actually a group dominated by “greedybastards” who win by cheating.  As GeorgeAkerlof and Paul Romer said in their famous 1993 article (“Looting: theEconomic Underworld of Bankruptcy for Profit”), accounting fraud is a “surething.”  Ratigan shows that while lootingbegins with accounting fraud it ends with tax fraud, political domination andscandal by the wealthy frauds, and crony capitalism.  Indeed, Ratigan shows how far we have fallensince 1993.  Fraudulent CEOs who controlsystemically dangerous institutions (SDIs) can now become wealthy by looting,cause the SDI to become insolvent, get bailed out by their political lackeys,resume looting, pay virtually no federal income tax, and do so with nearlycomplete immunity from prosecution.  Heshows that rather than being “productive”, the greedy bastards are destroyingAmerica’s middle and working classes, hollowing out our economy, and destroyingwealth and employment. 

Marshall Auerback discusses the Euro on the Lang and O’Leary Exchange.  Watch it here.

Bill Moyers Essay: Occupying a Cause

The first episode of Bill Moyers’ new TV, Moyers & Company, features our own William K. Black and the Occupy Wall Street movement.  Click here for local listings.


A Federally-Funded Jobs Program? Lessons from the WPA

By John Henry

In the current debates surrounding various jobguarantee programs (in association with the Chartalistor Modern Money perspectives), it might prove helpful to review some aspects ofthe Works Progress Administration (renamed in 1939 as Work ProjectsAdministration).  While the WPA was not a“job guarantee” program, it nevertheless points to a number of issues that areunder current discussion, including those of the nature of the projectsundertaken, impact on the larger economy, concerns surrounding bureaucraticimpediments, etc.  Let’s begin with an introductory statement pertainingto the political and economic orientation of Franklin Delano Roosevelt (and hisAdministration).
Roosevelt was nota progressive. He ran on a balanced budget platform, and initially attempted tofulfill his campaign promise of reducing the federal budget by slashingmilitary spending from $752 million in 1932 to $531 million in 1934, includinga 40% reduction in spending for veteran’s benefits which eliminated thepensions of half-a-million veterans and widows and reduced the benefits forthose remaining on the rolls. As well, federal spending on research andeducation was slashed and salaries of federal employees were reduced. Suchprograms were reversed after 1935. And one might recall that Rooseveltattempted to return to a balanced budget program in 1937, just as the economyappeared to be slowly recovering. The result was a renewed depression thatbegan in the fall of that year and ran through 1938.

Responses to Blog #31: Functional Finance

All: thanks to some for attempts to come up with some realworld JG jobs suggestions in answer to my challenge last week. We will move onto the JG after dealing with a few more issues related to JG. Keep thinking! Ialso saw that Neil has done a good job around the blogosphere defending JG.Keep it up!

We are more than half-way through the MMP. My responses toquestions/comments are going to become more focused. In part because manyquestions concern issues we already covered, or those we will cover. But moreimportantly, I’ve put a lot of work to the side to do the Primer over the past6+months and now must catch up with a variety of other work and deadlines. So,the Primer will continue, maybe with fewer side issues, but my responses willbe more focused on those questions/comments that respond to the current week’sblog.

So just a few responses today.

Q1: I thought it was the MMT position that adjustments tothe interest rate are not and cannot be matters of open market purchases, whichare only used defensively to maintain the target rate.  Instead, the Fedchanges interest rates by announcing the new rate (it’s unclear to me what theactual threat is for the rate to change) or paying IOR at the target rate(unless this is the threat???).

A: That is pretty much what the blog says and what Lernerthought. If banks are short reserves, they drive fed funds rate (in US) abovetarget, Fed buys bonds (OMP), provides reserves, increases the ratio ofreserves/bonds. Just like Lerner (and I) said. On the other hand, when Fedannounces new interest rate target (say, increase from 1% to 2%) it does notneed to change Res/Bonds ratio at all since it is likely banks have the ratiothey want and the demand for reserves is not interest elastic. So I thinkyou’ve confused two different things—using bond sales/purchases to satisfyprivate sector demands for high powered money (to hit a rate target), versusannouncing a new interest rate target (which normally does not require any openmarket sales or purchases).

Q2: What is the government budget constraint?

A: OK this is the idea that even sovereign currency-issuinggovernment is subject to a spending constraint. I’m sure BillyBlog has writtenon this. It came to life in the late 1960s—government is like a household andmust “finance” its spending: taxes, borrowing, or (unlike households) printingmoney. But that is false. Government spends through keystrokes. Yes it canself-impose budget constraints (ie in the US we pass a budget and we alsoimpose a debt limit). But this is nothing like a household, that faces a marketimposed constraint.

Q3: What drove inflation?

A: This is not the time for that. We already talked abouthyperinflation and a bit about CPI inflation. We might return to it againlater; and note that the JG is a price stabilizer. We can have full employmentwithout stoking inflation pressure—a topic for later.

Q4: Can the Euro nations create net financial assets?

A: I already discussed this. Domestically, yes, in the sensethat claims on the Greek government are net financial assets for thenongovernment sector. But I do take the point that ultimately Greece (etc) areusers of the currency so it all depends on the ECB to create true NFA for thesystem as a whole. (or the US which can create NFA in dollars for Eurolandersto hold)

FDR’s Second Bill of Rights: An Unrealized Dream

By Stephanie Kelton

Sixty-eight years ago today, Franklin Delano Roosevelt laid out what he referred to as a “Second Bill of Rights” in his State of the Union address to Congress.  Those of us who’ve been part of the MMT movement for well over a decade have worked tirelessly to advance an understanding of the way modern monetary systems operate so that we might one day replace suffering with opportunity and a minimum standard of economic security for all.  
Roosevelt’s Second Bill of Rights
“This Republic had its beginning, and grew to its presentstrength, under the protection of certain inalienable political rights—amongthem the right of free speech, free press, free worship, trial by jury, freedomfrom unreasonable searches and seizures. They were our rights to life andliberty.
As our Nation has grown in size and stature, however—as ourindustrial economy expanded—these political rights proved inadequate to assureus equality in the pursuit of happiness.
We have come to a clear realization of the fact that trueindividual freedom cannot exist without economic security and independence.”Necessitous men are not free men.” People who are hungry and out ofa job are the stuff of which dictatorships are made.
In our day these economic truths have become accepted asself-evident. We have accepted, so to speak, a second Bill of Rights underwhich a new basis of security and prosperity can be established for allregardless of station, race, or creed.
Among these are:
The right to a useful and remunerative job in theindustries or shops or farms or mines of the Nation;
The right to earn enough to provide adequate food andclothing and recreation;
The right of every farmer to raise and sell hisproducts at a return, which will give him and his family a decent living;
The right of every businessman, large and small, totrade in an atmosphere of freedom from unfair competition and dominationby monopolies at home or abroad;
The right of every family to a decent home;
The right to adequate medical care and theopportunity to achieve and enjoy good health;
The right to adequate protection from the economicfears of old age, sickness, accident, and unemployment;
The right to a good education.
All of these rights spell security. And after this war iswon we must be prepared to move forward, in the implementation of these rights,to new goals of human happiness and well-being. ”

Greenspan’s Laissez Fairy Tale

By William K. Black
(Cross-posted from

We continue to witness remarkable developments inthe intersection of the related fields of economics, finance, ethics, law, andregulation.  Each of these five fieldsignores a sixth related field – white-collar criminology.  The six fields share a renewed interest intrust.  The key questions are why wetrust (some) others, when that trust is well-placed, and when that trust isharmful.  Only white-collarcriminologists study and write extensively about the last question.  The primary answer that the five fields giveto the first question is reputation.  Thefive fields almost invariably see reputation as positive and singular.  This is dangerously naïve.  Criminals often find it desirable to developmultiple, complex reputations and the best way for many CEOs to develop asterling reputation is to lead a control fraud.  Those are subjects for futurecolumns.

This column focuses on theoclassical economics’ useof reputation as “trump” to overcome what would otherwise be fatal flaws intheir theories and policies.  FrankEasterbrook and Daniel Fischel, the leading theoclassical “law and economics”theorists in corporate law, use reputation in this manner to explain why seniorcorporate officers’ conflicts of interest pose no material problem.  The most dangerous believer in the trump,however, was Alan Greenspan.  Hisstandard commencement speech while Fed Chairman was an ode to reputation as thecharacteristic that made possible trust and free markets.  I’ve drawn on excerpts from one example, his May15, 2005 talk at Wharton

I find Greenspan’s odes to reputation as theantidote to fraud to be historically inaccurate and internally inconsistent intheir logic.  Here, I ignore his factualerrors and focus on his logical consistency.    

“The principles governing business behavior are an essential support to voluntary exchange, the defining characteristic of free markets. Voluntary exchange, in turn, implies trust in the word of those with whom we do business.

Trust as the necessary condition for commerce was particularly evident in freewheeling nineteenth-century America, where reputation became a valued asset. Throughout much of that century, laissez-faire reigned in the United States as elsewhere, and caveat emptor was the prevailing prescription for guarding against wide-open trading practices. In such an environment, a reputation for honest dealing, which many feared was in short supply, was particularly valued. Even those inclined to be less than scrupulous in their personal dealings had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business.

To be sure, the history of world business, then and now, is strewn with Fisks, Goulds, Ponzis and numerous others treading on, or over, the edge of legality. But, despite their prominence, they were a distinct minority. If the situation had been otherwise, late nineteenth- and early twentieth-century America would never have realized so high a standard of living.
* * *
Over the past half-century, societies have chosen to embrace the protections of myriad government financial regulations and implied certifications of integrity as a supplement to, if not a substitute for, business reputation. Most observers believe that the world is better off as a consequence of these governmental protections. Accordingly, the market value of trust, so prominent in the 1800s, seemed by the 1990s to have become less necessary. But recent corporate scandals in the United States and elsewhere have clearly shown that the plethora of laws and regulations of the past century have not eliminated the less-savory side of human behavior. We should not be surprised then to see a re-emergence of the value placed by markets on trust and personal reputation in business practice. After the revelations of recent corporate malfeasance, the market punished the stock and bond prices of those corporations whose behaviors had cast doubt on the reliability of their reputations. There may be no better antidote for business and financial transgression. But in the wake of the scandals, the Congress clearly signaled that more was needed.

The Sarbanes-Oxley Act of 2002 appropriately places the explicit responsibility for certification of the soundness of accounting and disclosure procedures on the chief executive officer, who holds most of the decisionmaking power in the modern corporation. Merely certifying that generally accepted accounting principles were being followed is no longer enough. Even full adherence to those principles, given some of the imaginative accounting of recent years, has proved inadequate. I am surprised that the Sarbanes-Oxley Act, so rapidly developed and enacted, has functioned as well as it has. It will doubtless be fine-tuned as experience with the act’s details points the way.

It seems clear that, if the CEO chooses, he or she can, by example and through oversight, induce corporate colleagues and outside auditors to behave ethically. Companies run by people with high ethical standards arguably do not need detailed rules on how to act in the long-run interest of shareholders and, presumably, themselves. But, regrettably, human beings come as we are–some with enviable standards, and others who continually seek to cut corners.

I do not deny that many appear to have succeeded in a material way by cutting corners and manipulating associates, both in their professional and in their personal lives. But material success is possible in this world, and far more satisfying, when it comes without exploiting others. The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake.
* * *
Our system works fundamentally on trust and individual fair dealing. We need only look around today’s world to realize how valuable these traits are and the consequences of their absence. While we have achieved much as a nation in this regard, more remains to be done.”

Greenspan appears to have relied on the trump ofreputation as the basis for causing the Fed to oppose financial regulationgenerally and at least five specific examples of proposed or existingregulation designed to deal with conflicts of interest.  He supported the repeal of the Glass-SteagallAct despite the conflict of interest inherent in combining commercial andinvestment banking.  He supported thepassage of the Commodities Futures Modernization Act of 2000 despite agencyconflicts between managers and owners of firms purchasing and selling creditdefault swaps (CDS).  He opposed usingthe Fed’s unique statutory authority under HOEPA (1994) to regulate banfraudulent liar’s loans by entities not regulated by the Federalgovernment.  He opposed efforts to cleanup outside auditors’ conflict of interest in serving as auditor and consultantto clients.  He opposed efforts to cleanup the acute agency conflicts of interest caused by modern executivecompensation.  He opposed taking aneffective response to the large banks acting on their perverse conflicts ofinterest to aid and abet Enron’s SPV frauds. 

Greenspan’shypothesis: reputation trumps perverse incentives

Greenspan’s overall anti-regulatory hypothesis seemsto be that laissez faire led tosubstantial control fraud, which gave business actors a strong incentive toavoid being defrauded.  This caused themto care a great deal about reputation, which successfully prevented fraud.  Indeed, the frauds “had to adhere to a more ethicalstandard in their market transactions, or they risked being driven out ofbusiness.” 

The mostobvious logic problem with this hypothesis is why laissez faire led to substantial control fraud.  Here is his key sentence, discussing businesslife under laissez faire:  “In such an environment, a reputation forhonest dealing, which many feared was in short supply, was particularly valued.”  How could “many” American business peopleoperating under laissez faire fearthat reputations for honest dealing were “in short supply” among theircounterparts?  Under Greenspan’s logicreputations for honest dealing should have been omnipresent among Americanbusiness people during laissez faire.  Greenspan assures us that under laissez faire even frauds “had to adhereto a more ethical standard in their market transactions, or they risked beingdriven out of business.”  If this istrue, then the “many” who “fear[ed]” that “a reputation for honest dealing “wasin short supply” must have been irrational. Reputations for honest dealing should have been virtually universalunder Greenspan’s logic. 

Markets make the Mensch                        

Greenspanasserted that unethical CEOs who act like scum in their personal lives engagedin a daily “Road to Damascus” conversion whenever they worked.  Greenspan concedes that CEOs dominatecorporations and that a honest CEO will prevent any material corporate fraud (“ifthe CEO chooses, he or she can, by example and through oversight, inducecorporate colleagues and outside auditors to behave ethically”).  In short, Greenspan asserts (contrary to AdamSmith’s warnings) that there is no serious “agency” problem caused by theseparation of ownership and control in corporations.  Markets force CEOs to act as if they werehonest because a good reputation is essential to the CEO.  The CEO, in turn, is able to ensure thatsubordinates act ethically.  ButGreenspan then contradicts his logic again, despairing that:  “regrettably, human beings come as weare–some with enviable standards, and others who continually seek to cutcorners.”  Greenspan has just assertedthat humans do not “come as we are”to business.  Markets force us to behaveas if we are moral regardless of our actual morality.  When we are in our business mode we are atour patriarchal Grandfather’s house on our best behavior in constant fear ofarousing his ire.        

Greenspan claimed that we were inthe midst of a renewal of CEO honesty – in 2005

InSeptember 2004, the FBI warned that there was an “epidemic” of mortgage fraudand predicted that it would cause a financial “crisis” if it were notcontained.  The fraud epidemic grewmassively, and I have shown why we know that it was overwhelmingly lenders whoput the lies in liar’s loans – at a rate of roughly a million fraudulentmortgages annually at the time that Greenspan gave his talk at Wharton inmid-2005. 

“We should not be surprised then to see a re-emergence ofthe value placed by markets on trust and personal reputation in businesspractice. After the revelations of recent corporate malfeasance, the marketpunished the stock and bond prices of those corporations whose behaviors hadcast doubt on the reliability of their reputations. There may be no betterantidote for business and financial transgression.”

Again, myemphasis here is on Greenspan’s logic. It does not follow that because “the market punished the stock and bondprices of those corporations” that collapsed because they were looted by theirCEOs this served as the best “antidote” to prevent future accounting controlfrauds.  George Akerlof and Paul Romerpublished their famous article in 1993 (“Looting: the Economic Underworld ofBankruptcy for Profit”).  Indeed, GeorgeAkerlof received the Nobel Prize in economics in 2001.  Greenspan was Charles Keating’s principaleconomic expert and had seen him loot Lincoln Savings in the late 1980s.  Accounting control frauds are funded by stockand bond sales.  The markets fundaccounting control frauds, and they do so massively even when the CEO islooting the firm and causing losses principally to the shareholders andcreditors.  The CEO walks away wealthyfrom the husk of the failed corporation. Almost everyone agrees that leverage is one of the great causes oflosses in our recurrent, intensifying financial crises here and abroad.  Debt drives leverage.  Debt is supposed to provide the “privatemarket discipline” that prevents accounting control fraud, and reputation issupposed to be the piston that adds immense power to this great brake.  But accounting control fraud, as Akerlof& Romer (and we criminologists) emphasize is a “sure thing” – it producesrecord (albeit fictional) profits in the near-term.  When there are epidemics of accountingcontrol fraud, bubbles hyper-inflate. The combined result is that loss recognition is hidden byrefinancing.  Reporting record profitsand minor losses via accounting control fraud is the surest means for a CEO togrow wealthy and develop a strong reputation. Creditors rush to lend to corporations reporting stellar results, whichis what produces the extraordinary leverage. Far from acting as an “antidote” to accounting control fraud, reputationhelps explain why private market discipline becomes an oxymoron.  Reputation is the great booster shot aidingand encouraging accounting control fraud. 

In anyanalogous context we would consider Greenspan’s “antidote” claim to be faciallyinsane.  If the head of the public healthservice announced proudly that the service had triumphed because, while onemillion Americans had died of an epidemic of cholera, the death rate had beenso severe and rapid that the epidemic had burned out, we would consider him tobe delusional and heartless.  The deathof the pathogen’s host (us) does not constitute a triumph over cholera.  It also does not leave the survivors who werenot exposed to the pathogen with additional antibodies that will prevent futureepidemics. 

“Texas Triumphs”

In an article I wrote in 2003 during the unfolding Enron-era frauds I calledsimilar claims by prominent Texas politicians that Enron’s failure representeda triumph of capitalism “Texas triumphs.” 

I distinguished Texas triumphs from Pyrrhic victories.  The origin of that phrase comes from King Pyrrhus’ (of Epirus in Greece) victory over theRomans in 279 BC at the battle of Asculum in Apulia (on the Eastern side of theItalian peninsula).  The Roman legionswere elite and outnumbered Pyrrhus’ forces (which had many mercenaries).  Nevertheless, he twice defeated the Romanforces, inflicting significantly greater casualties on their forces.  After the battle of Asculum he responded tocongratulations by remarking that one more such victory would undo him.  He was a great commander who defeated highlycompetent opponents defending their own lands. 

Only theoclassical economists could call thefailure of our most elite firms that were looted by their CEOs a triumph ofcapitalism.  I wrote: 

“MartinWolf repeated the well-worn claim that Enron’s failure demonstratescapitalism’s virtues in 2003.  It is aview most famously stated by Larry Lindsey, a member of George W. Bush’s first(failed) economic team, when he saidin January 2002 that Enron’s failure was “a tribute to American capitalism.” Thethen treasury secretary, Paul O’Neill, wasn’t to be outdone. He insistedEnron’s failure proved “the genius of capitalism.””

Our family’s rule that it isimpossible to compete with unintentional self-parody remains intact.   Adiscipline (economics) that counts massive looting by the CEOs of elite controlfrauds as its greatest triumphs desperately needs an intervention.  None of these control fraud failures (andthat includes Fannie and Freddie) involves valiant efforts by economists toprevent the looting.  The theoclassicalfailures to prevent control fraud did not occur because the economists stroveto prevent the looting but were defeated by impossible odds.  Theoclassical economists were theanti-regulatory architects of the criminogenic environments that produce ourepidemics of control fraud.  They are theelite frauds’ most valuable allies.        

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

Real Financial Regulators Love Prosecutions of Fraudulent Bank CEOs

By William K. Black

The New YorkTimes published a column by its leading financial experts, GretchenMorgenson and Louise Story, on November 22, 2011 which contains a spectacularcharge against the Obama administration’s financial regulatory leaders.  I have waited for the rebuttal, but it is nowclear that the administration does not contest the charge.

The specific example that prompted the NYT article (“Financial Finger-PointingTurns to Regulators”) was a civil action against a former executive ofIndyMac.  IndyMac was supposed to beregulated by the Office of Thrift Supervision (OTS).  OTS was the worst of the federal financialregulators – which is a large statement. It was so bad that the Dodd-Frank Act killed it.  I used to work for OTS. One of the things Idid to make myself unemployable during the S&L debacle was to testifybefore Congress against the head of our agency, Danny Wall, and our head ofsupervision, Darrell Dochow.  Wall resignedin disgrace and Dochow was demoted and sent back to run the obscure office hehad once run in Seattle.
Continue reading

MMP Blog #31: FUNCTIONAL FINANCE: Monetary and Fiscal Policy for Sovereign Currencies

By L. Randall Wray

This weekwe begin a new topic: functional finance. This will occupy us for the nextseveral blogs. Today we will lay out Abba Lerner’s approach to policy. In the1940s he came up with what he called the functional finance approach to policy.In one of those amazing historical coincidences, Lerner happened to teach atUMKC when he published one of his most famous papers, laying out the approach.Maybe there is something special in the air in Kansas City?

Lerner’s Functional Finance Approach. Lerner posed two principles:

First Principle: if domestic income is too low, governmentneeds to spend more. Unemployment is sufficient evidence of this condition, soif there is unemployment it means government spending is too low.

Second Principle: if the domestic interest rate is too high, itmeans government needs to provide more “money”, mostly in the form of bankreserves.

The idea ispretty simple. A government that issues its own currency has the fiscal andmonetary policy space to spend enough to get the economy to full employment andto set its interest rate target where it wants. (We will address exchange rateregimes later; a fixed exchange rate system requires a modification to thisclaim.) For a sovereign nation, “affordability” is not an issue—it spends bycrediting bank accounts with its own IOUs, something it can never run out of.If there is unemployed labor, government can always afford to hire it—and by definition,unemployed labor is willing to work for money.

Lernerrealized that this does not mean government should spend as if the “sky is thelimit”—runaway spending would be inflationary (and, as discussed many times inthe MMP, it does not presume that government spending won’t affect the exchangerate). When Lerner first formulated the functional finance approach (in theearly 1940s), inflation was not a major concern—the US had recently livedthrough deflation in the GreatDepression. However, over time, inflation became a serious concern, and Lernerproposed a form of wage and price controls to constrain inflation that hebelieved would result as the economy nears full employment. Whether or not thatwould be an effective and desired way of attenuating inflation pressures is notour concern here. The point is that Lerner was only arguing that governmentshould use its spending power with a view to moving the economy toward fullemployment—while recognizing that it might have to adopt measures to fight inflation.

Lernerrejected the notion of “sound finance”—that is the belief that government oughtto run its finances as if it were like a household or a firm. He could see noreason for the government to try to balance its budget annually, over thecourse of a business cycle, or ever. For Lerner, “sound” finance (budgetbalancing) was not “functional”—it did not help to achieve the public purpose(including, for example, full employment). If the budget were occasionallybalanced, so be it; but if it never balanced, that would be fine too. He alsorejected any attempt to keep a budget deficit below any specific ratio to GDP,as well as any arbitrary debt to GDP ratio. The “correct” deficit would be theone that achieves full employment.

Similarlythe “correct” debt ratio would be the one consistent with achieving the desiredinterest rate target. This follows from his second principle: if governmentissues too much debt, it has by the same token issued too few bank reserves andcash. The solution is for the treasury and central bank to stop selling bonds,and, indeed, for the central bank to engage in open market purchases (buyingtreasuries by crediting the selling banks with reserves). That will allow theovernight rate to fall as banks obtain more reserves and the public gets morecash.

Essentially,the second principle just says that government ought to let the banks,households, and firms achieve the portfolio balance between “money” (reservesand cash) and bonds desired. It follows that government bond sales are notreally a “borrowing” operation required to let the government deficit spend.Rather, bond sales are really part of monetary policy, designed to help thecentral bank to hit its interest rate target. All of that is consistent withthe modern money view advanced previously.

Functional Finance versus Superstition. The functional finance approach ofLerner was mostly forgotten by the 1970s. Indeed, it was replaced in academiawith something known as the “government budget constraint”. The idea is also simple:a government’s spending is constrained by its tax revenue, its ability toborrow (sell bonds) and “printing money”. In this view, government reallyspends its tax revenue and borrows money from markets in order to finance ashortfall of tax revenue. If all else fails, it can run the printing presses,but most economists abhor this activity because it is believed to be highlyinflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’s experience, or in moderntimes, Zimbabwe—as a cautionary tale against “financing” spending throughprinting 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 using government’sown IOUs; banks use government’s own IOUs to buy bonds from government.

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 theUS—is far more confused. For example, President Obama frequently assertedthroughout 2010 that the US government was “running out of money”—like ahousehold that had spent all the money it had saved in a cookie jar.

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

In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:
                “I think there is anelement of truth in the view that the superstition that the budget must bebalanced at all times [is necessary]. Once it is debunked [that] takes away oneof the bulwarks that every society must have against expenditure                 out of control. There must bediscipline in the allocation of resources or you will have anarchistic chaosand inefficiency. And one of the functions of old fashioned religion was toscare 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 you havedone” and James Buchanan argues in those terms. I have to say that I seemerit 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 (andmany other nations) really did face inflationary pressures from the late 1960suntil the 1990s (at least periodically). Those who believed the inflationresulted from too much government spending helped to fuel the creation of thebalanced budget “religion” to fight the inflation. The problem is that whatstarted as something recognized by economists and policymakers to be a “myth”came to be believed as the truth. An incorrect understanding was developed.

Originallythe myth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation and endangering the dollarpeg to gold. But like many useful myths, this one eventually became a harmfulmyth—an example of what John Kenneth Galbraith called an “innocent fraud”, anunwarranted belief that prevents proper behaviour. Sovereign governments beganto believe that the really could not “afford” to undertake desired policy, onthe belief they might become insolvent. Ironically, in the midst of the worsteconomic crisis since the Great Depression of the 1930s, President Obamarepeatedly claimed that the US government had “run out of money”—that it couldnot afford to undertake policy that most believed to be desired. Asunemployment rose to nearly 10%, the government was paralysed—it could notadopt the policy that Lerner advocated: spend enough to return the economy towardfull 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$600 billion 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.

Next week, we’ll show that some Kansas City airmight have drifted northeast to the bastion of free market economics: theUniversity of Chicago