Tag Archives: Policy and Reform

The High Price of the President’s Council of Economic Advisors’ Failure to Read Akerlof & Romer

(Cross-posted from Benzinga.com)

By reviewing the annual reports (2005-2007) of President Bush’s Council of Economic Advisors (CEA) I learned that the Council had some interest in fraud, but no understanding of elite fraud and its implications for the economy.  The reports make sad reading.  They deny the developing crisis entirely and they do so for reasons that reflect badly on economics and economists. 

The CEA’s reports’ analysis of the developing fraud epidemics and crisis reveal critical weaknesses in theory, methodology, empiricism, candor, objectivity, and multi-disciplinarity.  Overwhelmingly, the reports ignored the developing crises and their causes.  Worse, as late as 2007, they denied – even after the bubble had popped – that there was a housing bubble.  When the nation and the President vitally needed a warning from its Council of Economic Advisors the CEA did not simply fail to warn, but actually advised that those who warned of a coming crisis were wrong. 

This column does not focus on the CEA’s claims that there was no housing bubble.  Like the National Association of Realtors’ top economist who became known to the trade press as “Baghdad Bob” (the mocking nickname journalists gave Saddam Hussein’s press flack after he denied U.S. troops were in Baghdad), the CEA’s specious bubble denial is an obvious embarrassment.  Their Japanese counterparts did far better in warning of the developing real estate bubble in the 1980s.  The collapse of the twin Japanese bubbles in 1990 and the resultant “lost decade” should have caused the CEA to recognize the gravity of the risk bubbles pose and importance of identifying them promptly.  Instead, the CEA gave in to the temptation to claim that the President’s brilliant policies had produced a wonderful economy.  The reality was that the economy was headed over the precipice.

The focus of this column is on the portion of the CEA’s annual report for 2006 that discussed the theory of financial intermediation and financial regulation.  Indeed, the column focuses on a small subset of the defects in those portions of the report.  I write to emphasize how a theory (“control fraud”) developed two decades ago by regulators, criminologists, and economists could have saved the CEA from analytical and policy errors with regard to financial crises and regulation and led it to identify the crisis and recommend effective measures to contain it.  The tragedy is that the CEA discussion of the theory of financial regulation embraces three of the most useful theoretical insights – adverse selection, lemon’s markets, and the centrality and criticality of sound underwriting to the survival of lending institutions.  These theories are interrelated and they are essential components of control fraud theory.  

Had the CEA understood the true import of these three economic theories it could have gotten the crisis right instead of making things worse.  White-collar criminologists and economists share these three theories (among others) and employ a (limited) “rational actor” model.  (Criminologists never made the mistake of assuming purely rational behavior.  Even neoclassical economists now generally acknowledge that behavioral economics research demonstrates that economic behavior can be irrational in important settings.)  In the 1980s and early 1990s, the efforts of a small group of criminologists, economists, and regulators to understand the causes of the developing S&L debacle led them to develop a synthetic theory that criminologists refer to as “control fraud theory.”  Unfortunately, the typical theoclassical economic treatment of these three theories, exemplified by the CEA’s 2006 report, ignores control fraud.  The result is that the 2006 CEA report misstated the predictions of each of the three theories that it discussed and concluded “no problem here.”  In reality, the three theories predicted that there were epidemics of accounting control fraud 
that were leading inevitably to a catastrophic crisis.

The context of the 2006 CEA report’s discussion of the three theories is a treatise on the theory of financial intermediation and its implications for financial regulation.  The treatise is over the top in its praise of the U.S. financial industry.  The CEA claimed that the U.S. financial deregulation gave its financial sector a “comparative advantage” over other nations.  The CEA cited the financial sector’s rapid growth in size and profits as proof of this comparative advantage and asserted that the financial sector’s rapid growth led to more rapid U.S. economic growth and increased financial stability.  The CEA’s theory of financial intermediation posited that banks exist to minimize the informational difficulties that beset lending and investment.  The CEA concluded that U.S. banks were growing rapidly because deregulation made them ever more efficient in minimizing these informational defects.

Adverse Selection
The CEA addressed three forms of informational defects that banks helped reduce.  The CEA began by discussing “adverse selection.”  Adverse selection was the key to understanding and preventing the developing crisis.  In the lending context, adverse selection arises when a lender’s policies selectively encourage lending to borrowers who pose greater credit risks that are unknown or underestimated by the lender.  Adverse selection can be one of the consequences of “asymmetrical information.”  (Adverse selection also poses a serious risk to honest insurance companies.) 

Because the lender does not know (and therefore is not compensated for) the full extent of the risk of default adverse selection produces a “negative expected value” for lenders.  In plain English, they lose money.  For a residential mortgage lender, adverse selection is fatal because the loans are so large and the loan proceeds are fully disbursed at closing.  It is essential to understand that adverse selection is not equivalent to credit risk.  A mortgage lender makes money by taking prudent credit risks.  Banks “underwrite” prospective borrowers and collateral in order to identify, understand, quantify, and price credit risk.  Prudent underwriting minimizes adverse selection.  Mortgage lenders that fail to underwrite create severe adverse selection and fail.  Honest home lenders would never gut their underwriting standards and create adverse selection.    

The existence of a secondary market does not change an honest home lender’s incentive to engage in prudent underwriting.  Neoclassical theory predicts that the ultra sophisticated investment banks that ran the secondary market would only purchase loans they had prudently underwritten.  A lender that failed to underwrite effectively would be unable to sell its loans in the secondary market.  Neoclassical theory also predicts that the secondary market would only purchase loans sold with guarantees against fraud.  The first prediction, of course, proved false but the second prediction was typically true.  All of the mortgage lenders that specialized in making large numbers of loans under conditions that maximized adverse selection failed even before the cost of the guarantees would have destroyed them because their “pipeline” losses exceeded their trivial (fictional) capital.       

The most severe form of adverse selection is fraud.  The ultimate form of adverse selection is accounting control fraud.  Any experienced banker or insurer knows that adverse selection can lead to fraud.  Fraud maximizes the asymmetry of information because the information provided to the victim contains data that are false and material.  The fraud makes the loan look far less risky than it really is. 

In 2006, MARI, the anti-fraud group of the Mortgage Bankers Association (MBA), reported to MBA members that “stated income” loans were an “open invitation to fraudsters” and that they deserved the term used behind closed doors in the industry, “liar’s loans,” because the incidence of fraud in liar’s loans was 90 percent.  The defining element of liar’s loans was the failure to conduct essential underwriting.  Moreover, fraudulent nonprime lenders typically simultaneously maximized adverse selection and created deniability by creating large networks of loan brokers to prepare the fraudulent loan applications. 

The percentage of nonprime loans made without prudent underwriting is not known with precision because there were no official definitions of stated income, alt-a, or liar’s loans.  Subprime and liar’s loans were not mutually exclusive.  By the time the CEA wrote its 2006 report roughly half of the loans lenders termed “subprime” were also liar’s loans.  Credit Suisse’s March 12, 2007 study (“Mortgage Liquidity du Jour: Underestimated No More”) presented data estimates that roughly 30% of all mortgage loans made in 2006 were liar’s loans.  That frequency produces an annual mortgage fraud incidence of well over one million.  The FBI had put the entire nation on alert about the developing “epidemic” of mortgage fraud in its September 2004 House testimony.  The FBI predicted that the fraud epidemic would cause a financial “crisis” unless the epidemic was contained.  In 2006, no one believed that the epidemic was being contained. 
What everyone, including the CEA, knew in 2006 was that mortgage underwriting standards for nonprime loans were in freefall while other “layered risk” characteristics were multiplying.  This meant that nonprime lenders were dramatically increasing adverse selection while making loans that were ever more vulnerable to losses from adverse selection.  Everyone, including the CEA, knew that the only reason this could occur was the rapid growth of the three “de’s” – deregulation, desupervision, and de facto decriminalization.  Everyone, including the CEA, knew that no one was forcing the nonprime lenders to make liar’s loans.  That should have led the CEA to ask why the senior officers controlling nonprime lenders were deliberately causing the lenders to make loans that created intense adverse selection, endemic fraud, massive (longer-term) losses, and the failure of the lender.  That behavior makes no sense under the theory of financial intermediation advanced by the CEA.  No honest lender CEO would engage in that pattern of behavior.  The nonprime lender CEOs’ behavior only makes sense if they are engaged in accounting control fraud.  The recipe for maximizing fictional accounting income has four ingredients and adverse selection optimizes the first two (rapid growth through making very poor quality loans at premium yields).      
Unfortunately, the CEA’s 2006 report was devoid of any real analytics or facts related to adverse selection.  Indeed, the report’s entire discussion of financial institutions is bizarre because it is not simply removed from any factual context but based on factual assumptions that were contrary to reality and becoming ever more contrary to reality in 2006.  The discussion is a surreal theoretical exercise based on unstated factual assumptions that are the opposite of reality.  The (inevitable) result of its unstated assumptions is the worst possible financial regulatory policy advice that the CEA could give in 2006 – everything is wonderful because our financial intermediaries prevent adverse selection.  The CEA wrote to warn us of the dangers of excessive financial regulation at a time when financial regulation had been eviscerated.
The CEA’s discussion of adverse selection ignored the risk of fraud during what the FBI had aptly termed a fraud “epidemic.”  Instead, it premised its concern on managers of high quality projects being unwilling to seek commercial loans from banks because banks charged excessive interest rates for even high quality projects because of their inability to differentiate bad and high quality business projects.  In reality, interest rates on commercial loans were exceptionally low – even for poor quality business projects.  The CEA’s discussion of adverse selection was premised on an alternate universe.
Lemon Markets
The CEA discussed lemon markets in conjunction with its discussion of adverse selection.  A lemon market reaches its nadir when bad quality products drive good quality products out of the marketplace.  Control fraud theory agrees that lemon market and adverse selection are interrelated theories and provide the keys to understanding why control frauds cause such devastating injury.  George Akerlof was awarded the Nobel Prize in Economics in 2001 for his 1970 article on markets for lemons, which was a pioneering article on fraud and asymmetrical information.  As I have explained, fraud produces the epitome of adverse selection and control fraud is the ultimate form of fraud.  The examples Akerlof provided of sales of goods that posed lemon problems were anti-customer control frauds.
The CEA does not mention Akerlof in its discussion of lemon markets.  This was deeply unfortunate, for it reinforced the CEA’s failure to discuss the epidemic of control fraud by nonprime lenders.  The CEA also failed to explain one of Akerlof’s most important theoretical contributions in his 1970 article, the “Gresham’s” dynamic.  Akerlof used Gresham’s law (bad money drives good money out of circulation in hyperinflation) as a metaphor to explain why market forces became perverse in the presence of asymmetrical information.  The anti-customer control fraud that sells an inferior good through the claim that it is a high quality good gains a large cost advantage over its honest competitors.  If they are driven into bankruptcy or emulate the fraudulent practices good quality goods – and honest sellers – will be driven from the marketplaces by competition.  This happened recently in the Chinese infant formula market, where honest manufacturers were driven out of the market, six infants were killed, and over 300,000 were hospitalized.  The perverse effects of extreme executive compensation largely driven by short-term reported earnings have now created a perverse Gresham’s dynamic in many firms, particularly in the finance industry.  The CEA did not mention the perverse incentives produced by control fraud and modern executive compensation and why markets make the environment even more criminogenic rather than restraining fraud.  Implicitly, however, the CEA recognized that there was some perverse market dynamic that could drive lemon markets to their nadir where “only the worst-quality” good would be sold. 
The CEA compounded its error of not discussing Akerlof’s 1970 analysis of control fraud and the Gresham’s dynamic by failing to address George Akerlof and Paul Romer’s 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Their 1993 article analyzed accounting control frauds.  The CEA’s discussion of financial intermediaries also included a discussion of “moral hazard.”  As with its discussion of adverse selection, the CEA’s discussion of moral hazard implicitly excluded all fraud.  There is no theoretical basis for this exclusion.  Economics (and reality) has long recognized that moral hazard can lead to excessive risk or fraud.  Fraud is often a superior strategy (in terms of expected value – not morality).  As Akerlof & Romer stressed, accounting control fraud is a “sure thing” (1993: 5).  “Gambling for resurrection” is a near sure thing, but in the opposite direction.  The economic theory of how the insolvent or failing bank’s owners maximize the value of their “option” predicts that they will engage in such extraordinary risk that their gamble will nearly always fail. 
But Akerlof & Romer endorsed another point that S&L regulators and criminologists stressed – the manner in which S&Ls purportedly engaged in honest gambling due to moral hazard made no sense for a rational (honest) actor.  Please read their explanation with particular care for its obvious application to our ongoing crisis should be glaring.
“The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending:  maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.*  Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem.  They were right (1993: 4).”
Akerlof & Romer went on to explain that accounting control frauds optimize fictional income by making loans with a negative expected value and by deliberately seeking out borrowers with poor reputations (1993: 17).  Their logic relies implicitly on the deliberate creation of adverse selection by the lender and the creation of a Gresham’s dynamic both among borrowers and those that aid and abet the CEO’s frauds, e.g., the appraisers when they inflate appraisals.

There is no good explanation for why the CEA would cite the Akerlof’s famous theory on lemon markets yet ignore the FBI’s 2004 warning, the experience of the S&L debacle (and the public administration literature on the successful regulatory fight against the control frauds), the Enron era accounting control frauds, Akerlof & Romer’s theory of accounting control fraud, and criminology’s theory of control fraud.  The basic fraud mechanisms had so many parallels that one is forced to the conclusion that the CEA and its staff never read the most important modern economic article on bank failures.  Akerlof & Romer explicitly noted that accounting fraud created perverse “lemon” projects (1993: 29).  It is bizarre that the CEA wrote in 2006 for the express purpose of opposing essential financial regulation and thought that the best way to make its case was to cite theories most closely associated with George Akerlof while ignoring his application of those theories to financial regulation and his research findings on the reality of accounting control fraud.  Note that Akerlof & Romer were writing about precisely the point the CEA was discussing – the role of banks with respect to information asymmetries.  Worse, Akerlof & Romer’s point was that one could not assume that banks acted to reduce information asymmetries because banks engaged in accounting control fraud did the opposite.  Akerlof & Romer also explained how accounting control frauds caused Texas real estate bubbles to hyper-inflate.  If there was one economics article the CEA needed to read carefully it was Akerlof & Romer.  Akerlof was a Nobel Prize winner well before the CEA wrote its 2006 annual report.   
But the CEA could have learned the same vital facts about fraud and financial crises had it read the criminology literature, the regulatory literature on the S&L debacle, or the public administration literature.  The CEA had experienced recently the Enron-era accounting control frauds and the S&L debacle was relatively recent.  The CEA’s failure to even consider the role of fraud in financial crises, particularly after the FBI’s stark warning in 2004, was unconscionable.  Akerlof & Romer went out of their way to warn economists of the dangers of control fraud.
“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself (1993: 60).”
My criminology colleagues and I sent the same warnings, as did the S&L regulators and public administration scholars.  The FBI sent an explicit warning.  None of us were able to get through to the Clinton, Bush, or Obama administrations.  They have all ignored the epidemic of accounting control fraud that hyper-inflated the real estate bubbles and drove the financial crisis.    
The Necessity and Centrality of Effective Underwriting
The CEA report continues its triumphal “just so” story approach to financial services by explaining how banks develop expertise in evaluating credit risk and use collateral as a means of inducing borrowers to “truthfully” rather than “strategically” release information on the true value of the real estate to the lender.  By 2006, the nonprime industry was notorious for deliberately inflating appraisal values so that it could make more and larger fraudulent loans.  Surveys of appraisers showed widespread efforts by lenders and their agents to coerce appraisers to inflate valuations.  No honest lender would ever coerce an appraiser to inflate a collateral valuation.  Only lenders and their agents can engage in widespread appraisal fraud.  Appraisal fraud is a “marker” of accounting control fraud.  The “strategic” behavior with regard to appraisers was by fraudulent lenders and their agents.  It relied on endemic, deliberate deceit.  Appraisal fraud is particularly egregious in residential home lending because it can lead borrowers to overpay for their home and to fail to understand the risks of purchasing a home. 
The greatest analytical defect in this section of the CEA report, however, is its false dichotomy between economic efficiency and financial regulation.  The CEA was on to something important.  A well run banking system does reduce adverse selection and make markets less inefficient.  A well run banking system does so by engaging in expert underwriting of significant loans such as home loans.  A bank that does not engage in expert underwriting poses a grave danger.  At best, it is incompetent.  Far more dangerously, it is often engaged in accounting control fraud.  A regulation that requires a lender to engage in prudent underwriting imposes no costs on honest banks and it saves society from vast amounts of damage.  When the regulatory agencies gutted the underwriting rules by turning them into guidelines they set us on the road to the Great Recession.  Effective financial regulation begins with mandating prudent underwriting.  Rules mandating prudent underwriting make financial markets far more efficient and stable by blocking the perverse Gresham’s dynamic that otherwise can create a criminogenic environment.  
The CEA was correct in explaining that the raison d’être of financial intermediaries is the provision of exemplary underwriting.  It is, of course, significantly insane that the CEA would implicitly assume in 2006, contrary to known facts, that nonprime lenders, the investment banks packaging CDOs, and the rating agencies were prospering because they were engaged in exemplary underwriting.  The CEA, in the two most important reports it issued in modern times (2005 and 2006), got the developing financial crisis and regulatory policy as wrong as it is possible to get something wrong. 
No economist should be allowed to graduate from a doctoral program without reading Akerlof & Romer.  It would also be salutary to expose any doctoral candidate interested in finance or regulation to the relevant work of criminologists and public administration scholars.  Collectively, our work on control fraud has shown great predictive strength while neoclassical economic work (both macro and micro) and “modern finance” have suffered repeated, abject predictive failures. 

Every financial regulatory agency should have a “chief criminologist.”  The financial regulatory agencies are civil law enforcement entities whose primary responsibility is to limit control fraud, but they virtually never have anyone in authority with expertise in identifying, investigating, and sanctioning control frauds.

* Black (1993b) forcefully makes this point.

Time to panic? You Betcha.

By Stephanie Kelton

Earlier this week, President Obama talked about the weakening state of the economy, telling us that he’s not worried about a double-dip recession and that the nation should “not panic.” It’s hard to imagine a more alarming assessment at this juncture.

The recovery is faltering. Our economy is growing at annual rate of just 1.8 percent. Manufacturing just grew at its slowest pace in 20 months. More than 44 million Americans – one in seven – rely on food stamps. Employers hired only 54,000 new workers in May, the lowest number in eight months. Jobless claims increased to 427,000 in the week ended June 4. The unemployment rate rose to 9.1 percent. Nearly half of all unemployed Americans have been without work for more than 6 months. About 25% of all teenagers who are looking for work are unemployed. Eight-and-a-half million Americans are underemployed – i.e. working part-time because their hours have been cut or because they can’t find full-time work. There are, on average, 4.6 unemployed people for every 1 job opening. And even if all the open positions were filled, there would still be 10.7 million people looking for work.

The Case-Shiller index shows that the housing market has already double-dipped.

And, because of the huge shadow inventory of yet-to-be-foreclosed homes, Robert Shiller, a co-creator of the index, thinks home prices could easily fall another 15-25% before bottoming out. If he’s right – and I suspect he is – this spells the end of the recovery. As prices continue to decline they create hidden losses elsewhere in the economy, hurting not just homeowners but the financial institutions that hold their mortgages. The list goes on and on.

These are not, as Obama said, “headwinds” that will slow the pace of our recovery. They are gale force winds that will push millions of families into poverty and thousands of business into bankruptcy.

There is a way out, but it seems unlikely that Congress and the White House will work together to do what’s necessary to turn things around.  Why?  Because a recent poll shows that 59 percent of the public disapproves of the president’s handling of the economy.  And Republicans smell blood.  They know that since WWII no president has been re-elected with unemployment above 7.2 percent, so they see Harry Hard Luck and Sally Sob Story as their best chance at reclaiming the White House in 2012.  It’s a victory the Republicans have been masterfully engineering since February 2009, when they succeeded in restricting the size and scope of the American Recovery and Reinvestment Act (ARRA).
Some of us saw this coming.  For example, Jamie Galbraith and Robert Reich warned, on a panel I organized in January 2009, that the stimulus package needed to be at least $1.3 trillion in order to create the conditions for a sustainable recovery.  Anything shy of that, they worried, would fail to sufficiently improve the economy, making Keynesian economics the subject of ridicule and scorn.
But it’s easy to see why the $787 billion package we ended up with didn’t do the trick.  Remember that the stimulus didn’t take effect all at once – it was spread out over a three-year period.  And while the left hand of the federal government was trying to rev up the economy with increased spending, the right hand of the private sector (together with state and local governments) was dutifully stomping on the breaks.  Just consider the fact that bank lending declined by $587 billion in 2009 alone – the biggest one-year drop since the 1940s.  That’s a $587 billion hole that businesses and households created just as the stimulus was rolling out the first $200 billion or so.  ARRA was the right medicine, but it was administered in the wrong dosage, and this became clear within months of its passage.

In July 2009, I wrote a post entitled, “Gift-Wrapping the White House for the GOP.” In it, I said:

“If President Obama wants a second term, he must join the growing chorus of voices calling for another stimulus and press forward with an ambitious program to create jobs and halt the foreclosure crisis.”

Two years later, both crises are still with us, and the election is just around the corner.
Meanwhile, a new Washington Post-ABC News poll shows former Massachusetts Governor Mitt Romney with a slight edge in a hypothetical race against President Obama, and Howard Dean is warning that without a marked improvement in the economy, even Sarah Palin could clobber Obama in 2012.
To avoid this, President Obama must get his economics right.  Unfortunately, he’s too busy fanning the flames of the phony debt crisis and complaining that the discouraging data is hampering the recovery because it “affects consumer confidence, and it affects business confidence.” But here’s the thing – the recovery isn’t going to be driven by a change in our mentality.  It’s going to be driven by a change in our reality.
So here’s what he needs to do – stop talking about the deficit.  It has always been his Achilles’ heel.  The US is not broke and cannot go bankrupt.  Let go of that myth, and deliver one of those jaw-dropping, awe-inspiring speeches of yesteryear.  Tell the American people that he’s calling on the Republicans to help him enact the most sweeping tax relief since Ronald Reagan was in office — a full payroll tax holiday for every employee and every employer in the nation.  Tell us that you understand that sales create jobs, and income creates sales.  Tell us that families and small businesses don’t have enough income to dig us out of the ditch we’re still in.  Tell us that you will not withhold a dime from our paychecks until cash registers across the nation are chiming and unemployment has fallen below 5 percent.  Tell us before it’s too late.

The Perfect Fiscal Storm: Causes, Consequences, Solutions

Approximately a decade ago I wrote a paper with a similar title, announcing that forces were aligned to produce the perfect fiscal storm. What I was talking about was a budget crisis at the state and local government levels. I had recognized that the economy of the time was in a bubble, driven by what I perceived to be unsustainable deficit spending by the private sector—which had been spending more than its income since 1996. As we now know, I called it too soon—the private sector continued to spend more than its income until 2006. The economy then crashed—a casualty of the excesses. What I had not understood a decade ago was just how depraved Wall Street had become. It kept the debt bubble going through all sorts of lender fraud; we are now living with the aftermath.
Still, it is worthwhile to return to the “Goldilocks” period to see why economists and policymakers still get it wrong. As I noted in that earlier paper:
It is ironic that on June 29, 1999 the Wall Street Journal ran two long articles, one boasting that government surpluses would wipe out the national debt and add to national saving—and the other scratching its head wondering why private saving had gone negative. The caption to a graph showing personal saving and government deficits/surpluses proclaimed “As the government saves, people spend”. Almost no one at the time (or since!) recognized the necessary relation between these two that is implied by aggregate balance sheets. Since the economic slowdown that began at the end of 2000, the government balance sheet has reversed toward a deficit that reached 3.5% of GDP last quarter, while the private sector’s financial balance improved to a deficit of 1% of GDP. So long as the balance of payments deficit remains in the four-to-five percent of GDP range, a private sector surplus cannot be achieved until the federal budget’s deficit rises beyond 5% of GDP (as we’ll see in a moment, state and local government will continue to run aggregate surpluses, increasing the size of the necessary federal deficit). [I]n recession the private sector normally runs a surplus of at least 3% of GDP; given our trade deficit, this implies the federal budget deficit will rise to 7% or more if a deep recession is in store. At that point, the Wall Street Journal will no doubt chastise: “As the people save, the government spends”, calling for a tighter fiscal stance to increase national saving!

Turning to the international sphere, it should be noted that US Goldilocks growth was not unique in its character. [P]ublic sector balances in most of the OECD nations tightened considerably in the past decade–at least in part due to attempts to tighten budgets in line with the Washington Consensus (and for Euroland, in line with the dictates of Maastricht criteria). (Japan, of course, stands out as the glaring exception—it ran large budget surpluses at the end of the 1980s before collapsing into a prolonged recession that wiped out government revenue and resulted in a government deficit of nearly 9% of GDP.) Tighter public balances implied deterioration of private sector balances. Except for the case of nations that could run trade surpluses, the tighter fiscal stances around the world necessarily implied more fragile private sector balances. Indeed, Canada, the UK and Australia all achieved private sector deficits at some point near the beginning of the new millennium.

As we now know, my short-term projections were not too bad, but the medium-term projections were off. The Bush deficit did grow to 5% of GDP, helping the economy to recover. But then the private sector moved right back to huge deficits as lender fraud fueled a real estate boom as well as a consumption boom (financed by home equity loans). See the following chart (thanks to Scott Fullwiler):

This chart shows the “mirror image”: a government deficit from 1980 through to the Goldilocks years is the mirror image of the domestic private sector’s surplus plus our current account deficit (shown as a positive number because it reflects a positive capital account balance). During the Clinton years as the government budget moved to surplus, it was the private sector’s deficit that was the mirror image to the budget surplus plus the current account deficit. This mirror image is what the Wall Street Journal had failed to recognize—and what almost no one except MMT-ers and the Levy Economic Institute’s researchers understand. After the financial collapse, the domestic private sector moved sharply to a large surplus (which is what it normally does in recession), the current account deficit fell (as consumers bought fewer imports), and the budget deficit grew mostly because tax revenue collapsed as domestic sales and employment fell.  

Unfortunately, just as policymakers learned the wrong lessons from the Clinton administration budget surpluses—thinking that the federal budget surpluses were great while they actually were just the flip side to the private sector’s deficit spending—they are now learning the wrong lessons from this crash. They’ve managed to convince themselves that it is all caused by government sector profligacy. Especially, spending on public sector workers.

For example, Wisconsin Governor Walker’s attack on workers has been taken on the pretext that state employee wages and pensions have driven the budget into deficit. We all know that is ridiculous. The reality is simple: Wall Street crashed the economy, crashed state revenues, and crashed workers’ pensions. Washington responded with a massive bail-out for Wall Street—perhaps $25 trillion worth. It gave a mere pittance to “Main Street” in its $1 trillion stimulus package. Since the recession manufactured on Wall Street cost the economy a lot more than that, Main Street is not on the road to recovery. No one is projecting that jobs will return for many more years. It is delusional to believe that economic recovery can really get underway until we have added 8 million jobs.

In other words, the fiscal storm that killed state budgets is the same fiscal storm that created federal budget deficits. You cannot lose about 8% of GDP (due to spending cuts by households, firms and governments) and over 8 million jobs without negatively impacting government budgets. Tax revenue has collapsed at an historic pace. State governments really do need to balance their budgets, and they really do need tax revenue to finance their spending or to service debt. The federal government, as the sovereign issuer of the currency is in a different situation. I will not go through the MMT approach to sovereign currency spending as all readers here are familiar with that. My point is that states really are facing a funding crisis. The federal government does not face a solvency constraint and it can always afford to buy anything for sale in dollars. Still, as we all know, Washington Beltway insiders have manufactured a fake budget crisis to serve political ends.

State spending cuts (or tax increases) will not restore their budgets. Just take a look at the results of austerity in Greece or the UK. Budget-cutting in a downturn does not reduce deficits significantly. The reason is obvious: austerity slows the economy and reduces tax revenue. Art Laffer’s supply siders were onto something, although they mostly got it the wrong way around. Yes, a booming economy will generate a movement toward balanced government budgets. They thought that tax cuts are always the answer to everything—cut tax rates and you get more tax revenue. I would not say that that never works, but it didn’t when Presidents Reagan and Bush tried it. However, if we get the Laffer Curve the right way around, we can use it to explain why austerity in a downturn just makes budget deficits worse.
In truth, state budgets will not recover before the economy recovers. And state austerity will just make the economy worse. So, as a Thatcher might say: TINA: there is no alternative–to federal government stimulus, that is. I realize that goes against the deficit hysteria in Washington. But it is the truth.
What kind of stimulus makes the most sense? I think we need another trillion dollars, minimum. This can be split equally between aid to the states and extension of the payroll tax holiday. The federal government should provide $500 billion in block grants to the states, on a per capita basis. On the condition that they stop attacking state workers. The funds would be used to replace lost tax revenue—to cover operating expenses (and where possible, to actually increase spending on priority projects). This program would continue until economic growth and job creation reaches established thresholds. Let us say 10 million more jobs or a measured unemployment rate of 4%.

The payroll tax holiday would also be expanded, with a moratorium on taxes for both workers and employers until those thresholds are reached. Why penalize job creation with an employment-killing payroll tax? Reward firms for providing jobs by giving them tax relief. Let workers keep more of their hard-earned pay. This is the quickest and best way to give significant tax relief to most Americans. In addition, we need to stop the attacks on unemployment compensation. To be sure, jobs should always be favored over unemployment compensation—but until we get the jobs we must extend the unemployment benefits. Cutting benefits will just prevent the jobs from coming back.

These measures are only a first step. We still have a lot of damage to repair—damage caused by Wall Street’s excesses. And we will need to reign-in and prosecute the fraudsters, otherwise they will blow up the economy again. Actually, they are already trying to do that—creating yet another commodities market speculative bubble. It is looking an awful lot like 2006 all over again. However this time, we are down by 8 million jobs and trillions of dollars of household wealth. Wall Street is bubbling up even as the economy as a whole is in the trenches. This bubble will not last long. It is going to crash. That will expose the huge accounting holes in the bank balance sheets. Wall Street will want another 25 trillion dollar bail out. This time, we’ve got to follow Nancy’s dictum: just say no.

Fannie and Freddie’s Confused Futures

By William K. Black

(cross-posted with Benzinga.com)

A few days after the Obama administration released its vague concepts for the future of Fannie and Freddie it issued budget estimates for Fannie and Freddie’s losses premised on the continued existence, indeed, expansion of Fannie and Freddie. The administration assumed that the cost of resolving Fannie and Freddie would drop by roughly one-half – by 2021. The predicted reduction in losses appears to come not from improvement in Fannie and Freddie’s bad assets, but rather from profits on Fannie and Freddie’s overall operations. These profits stem from Fannie and Freddie, which are now publicly-owned, being able to borrow funds at or near the governmental rate. That price advantage makes it impossible for any private entity to compete with them in the secondary market. This purported reduction in the cost to the public of resolving Fannie and Freddie’s failures is not really an economic savings – unless one ignores the implicit cost of issuing government debt to fund Fannie and Freddie. The nominal accounting savings, however, will be exceptionally attractive to politicians. Administration officials will have an overpowering desire to claim that their brilliance cut Fannie and Freddie’s costs in half. Collectively, this will provide powerful incentives to continue Fannie and Freddie as a huge governmental enterprise.
We need to understand why Fannie and Freddie became massively insolvent. It wasn’t because they were governmental, but because they were private. It is simple to run Fannie and Freddie in a safe and sound fashion. Fannie created the concept of prime loans and prime loans have exceptionally low credit risk. Fannie and Freddie can easily spot any degradation in credit quality by reviewing samples of the loans insisting on full underwriting. Fannie and Freddie can minimize interest rate risk by creating and selling MBS and hedging the pipeline risk. When Fannie and Freddie were governmental 25 years ago they did not deliberately take excessive risks. They did not understand how to hedge in a fully effective fashion, but we have learned a great deal in 25 years about how to hedge pipeline risk.

The risks to Fannie and Freddie are governmental, not financial. The government could decide to do extremely destructive things to Fannie and Freddie.

The risks to a privatized Fannie and Freddie (by whatever name) are even greater. If the existing systemically dangerous institutions (SDIs) became private label securitizers they would have all the perverse risks that come from modern executive compensation. They would pose a systemic risk if they were to fail – which is why regardless of how much the government promised not to bail them out no one would believe it. That is why they would be GSEs regardless of their official designation. The more they are perceived as GSEs the greater the political risk that Congress will demand dangerous actions from the private label securitizers.

It is not clear why the administration believes that securitization of mortgages is necessary or even desirable. Portfolio home lenders will face prepayment and interest rate risk, but those risks are simply transferred, not removed, by securitization. Given what we have learned from the crisis, the assumption that securitization leads to an efficient distribution appears baseless. Some banks will doubtless fail if interest rates increase sharply and remain high for many months, but hedging and macroeconomic policy can greatly reduce the failure rate among banks.

The first step, however, should be to make the existing disaster that is Fannie and Freddie fully transparent. We need to investigate fully what went wrong. If Fannie and Freddie put all their information on the web we could bring the wisdom of the masses to bear and determine the truth. There is no reason why Fannie and Freddie should have broad proprietary secrets.

Women Want Jobs, not Handouts

By Pavlina Tcherneva

(via New Deal 2.0 where it first appeared)

When the White House released its report on the economic security of America’s women, it proposed to improve their well-being with the standard fare of economic policies, usually prescribed for just about any type of problem that ails the job market: more training and education, more tax incentives, and more income support. These prescriptions are already part of the Recovery Act, which for two years has produced dismal economic results. Is more of the same what we need when it comes to improving women’s economic opportunities?

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While Labor Unions celebrate Anti-Austerity Day in Europe, European Neoliberals raise the ante: Governments must Lower Wages or Suffer Financial Blackmail

By Michael Hudson

Most of the press has described Europe’s labor demonstrations and strikes on Wednesday in terms of the familiar exercise by transport employees irritating travelers with work slowdowns, and large throngs letting off steam by setting fires. But the story goes much deeper than merely a reaction against unemployment and economic recession. At issue are proposals to drastically change the laws and structure of how European society will function for the next generation. If the anti-labor forces succeed, they will break up Europe, destroy the internal market, and render that continent a backwater. This is how serious the financial coup d’etat has become. And it is going to get much worse – quickly. As John Monks, head of the European Trade Union Confederation, put it: “This is the start of the fight, not the end.”
Spain has received most of the attention, thanks to its ten-million strong turnout – reportedly half the entire labor force. Holding its first general strike since 2002, Spanish labor protested against its socialist government using the bank crisis (stemming from bad real estate loans and negative mortgage equity, not high labor costs) as an opportunity to change the laws to enable companies and government bodies to fire workers at will, and to scale back their pensions and public social spending in order to pay the banks more. Portugal is doing the same, and it looks like Ireland will follow suit – all this in the countries whose banks have been the most irresponsible lenders. The bankers are demanding that they rebuild their loan reserves at labor’s expense, just as in President Obama’s program here in the United States but without the sanctimonious pretenses.
The problem is Europe-wide and indeed centered in the European Union capital in Brussels, where fifty to a hundred thousand workers gathered to protest the proposed transformation of social rules. Yet on the same day, the European Commission (EC) outlined a full-fledged war against labor. It is the most anti-labor campaign since the 1930s – even more extreme than the Third World austerity plans imposed by the IMF and World Bank in times past.

The EC is using the mortgage banking crisis – and the needless prohibition against central banks monetizing public budget deficits – as an opportunity to fine governments and even drive them bankrupt if they do not agree roll back salaries. Governments are told to borrow at interest from the banks, rather than raising revenue by taxing them as they did for half a century following the end of World War II. Governments unable to raise the money to pay the interest must close down their social programs. And if this shrinks the economy – and hence, government tax revenues – even more, the government must reduce social spending yet further.
From Brussels to Latvia, neoliberal planners have expressed the hope that lower public-sector salaries will spread to the private sector. The aim is to roll back wage levels by 30 percent or more, to depression levels, on the pretense that this will “leave more surplus” available to pay in debt service. It will do no such thing, of course. It is a purely vicious attempt to reverse Europe’s Progressive Era social democratic reforms achieved over the past century. Europe is to be turned into a banana republic by taxing labor – not finance, insurance or real estate (FIRE). Governments are to impose heavier employment and sales taxes while cutting back pensions and other public spending.
“Join the fight against labor, or we will destroy you,” the EC is telling governments. This requires dictatorship, and the European Central Bank (ECB) has taken over this power from elected government. Its “independence” from political control is celebrated as the “hallmark of democracy” by today’s new financial oligarchy. This deceptive newspeak evokes Plato’s view that oligarchy is simply the political stage following democracy. The new power elite’s next step in this eternal political triangle is to make itself hereditary – by abolishing estate taxes, for starters – so as to turn itself into an aristocracy.
It is a very old game indeed. So it is time to put aside the economics of Adam Smith, John Stuart Mill and the Progressive Era, to forget Marx and even Keynes. Europe is ushering in an era of totalitarian neoliberal rule. This is what Wednesday’s strikes and demonstrations were about. Europe’s class war is back in business – with a vengeance!
This is economic suicide, but the EU is demanding that Euro-zone governments keep their budget deficits below 3% of GDP, and their total debt below 60%. On Wednesday the EU passed a law to fine governments up to 0.2% of GDP for not “fixing” their budget deficits by imposing such fiscal austerity. Nations that borrow to engage in countercyclical “Keynesian-style” spending that raises their public debt beyond 60% of GDP will have to reduce the excess by 5% each year, or suffer harsh punishment.[1] The European Commission (EC) will fine euro-area states that do not obey its neoliberal recommendations – ostensibly to “correct” budget imbalances.
The reality is that every neoliberal “cure” only makes matters worse. But rather than seeing rising wage levels and living standards as being a precondition for higher labor productivity, the EU commission will “monitor” labor costs on the assumption that rising wages impair competitiveness rather than raise it. If euro members cannot depreciate their currencies, then they must fight labor – but not tax real estate, finance or other rentier sectors, not regulate monopolies, and not provide public services that can be privatized at much higher costs. Privatization is not deemed to impair competitiveness – only rising wages, regardless of productivity considerations.
The financial privatization and credit-creation monopoly that governments have relinquished to banks is now to really pay off – at the price of breaking up Europe. Unlike central banks elsewhere in the world, the charter of the European Central Bank (ECB, independent from democratic politics, not from control by its commercial bank members) forbids it to monetize government debt. Governments must borrow from banks, which are create interest-bearing debt on their own keyboards rather than having their national bank do it without cost.
The unelected members of the European Central Bank have taken over planning power from elected governments. Beholden to its financial constituency, the ECB has convinced the EU commission to back the new oligarchic power grab. This destructive policy has been tested above all in the Baltics, using them as guinea pigs to see how far labor can be depressed before it fights back. Latvia gave free reign to neoliberal policies by imposing flat taxes of 51% and higher on labor, while real estate is virtually untaxed. Public-sector wages have been reduced by 30%, prompting labor of working age (20 to 35 year-olds) to emigrate in droves. This of course is contributing to the plunge in real estate prices and tax revenue. Lifespans for men are shortening, disease rates are rising, and the internal market is shrinking, and so is Europe’s population – as it did in the 1930s, when the “population problem” was a plunge in fertility and birth rates (above all in France). That is what happens in a depression.
Iceland’s looting by its bankers came first, but the big news was Greece. When that nation entered its current fiscal crisis as a result of not collecting taxes on the wealthy, European Union officials recommended that it emulate Latvia, which remains the poster child for neoliberal devastation. The basic theory is that inasmuch as members of the euro cannot devalue their currency, they must resort to “internal devaluation”: slashing wages, pensions and social spending. So as Europe enters recession it is following precisely the opposite of Keynesian policy. It is reducing wages, ostensibly to “free” more income available to pay the enormous debts that Europeans have taken on to buy their homes and pay for schooling (hitherto provided freely in many countries such as Latvia’s Stockholm School of Economics), transportation and other public services. Manly such services have been privatized and subsequently raised their rates drastically. The privatizers justify this by pointing to the enormously bloated financial fees they had to pay their bankers and underwriters in order to get the credit to buy the infrastructure that was being sold off by governments.
So Europe is committing economic, demographic and fiscal suicide. Trying to “solve” the problem neoliberal style only makes things worse. Latvia’s public-sector workers, for example, have seen their wages cut by 30 percent over the past year, and its central bankers have told me that they are seeking further cuts, in the hope that this will lower wages in the private sector as well, just as neoliberals in other European countries hope, as noted above.
About 10,000 Latvians attended protest meetings in the small town of Daugavilpils alone as part of the “Journey into the Crisis.” In Latvia’s capital city, Riga, yesterday’s Action Day saw the usual stoppage of transportation and an accompanying honk concert for 10 minutes at 1 PM to let the public know that something was happening. Six independent trade unions and the Harmony Center organized a protest meeting in Riga’s Esplanade Park that drew 700 to 800 demonstrators, relatively large for so small a city. Another union protest saw about half that number gather at the Cabinet of Ministers where Latvia’s austerity program has been planned and carried out.
What is happening most importantly is the national parliamentary elections this Saturday (October 2). The leading coalition, Harmony Center, is pledged to enact an alternative tax and economic policy to the neoliberal policies that have reduced labor’s wages and workplace standards so sharply over the past decade. A few days earlier a bus tour drove journalists to the most visible victims – schools and hospitals that had been closed down, government buildings whose employees had seen their salaries slashed and the workforce downsized.
These demonstrations seem to have gained voter sympathy for the more militant unions, headed by the hundred individual unions belonging to the Independent Trade Union Association. The other union group – the Free Trade Unions (LBAS) lost face by acquiescing in June 2009 to the government’s proposed 10% pension cuts (and indeed, 70% for working pensioners). Latvia’s constitutional court was sufficiently independent to overrule these drastic cuts last December. And if the government does indeed change this Saturday, the conflict between the Neoliberal Revolution and the past few centuries of classical progressive reform will be made clear.
In sum, the Neoliberal Revolution seeks to achieve in Europe what the United States has achieved since real wages stopped rising in 1979: doubling the share of wealth enjoyed by the richest 1%. This involves reducing the middle class to poverty, breaking union power, and destroying the internal market as a precondition.
All this is being blamed on “Mr. Market” – presumably inexorable forces beyond politics, purely “objective,” a political power grab. But is not really “the market” that is promoting this destructive economic austerity. Latvia’s Harmony Center program shows that there is a much easier way to cut the cost of labor in half than by reducing its wages: Simply shift the tax burden off labor onto real estate and monopolies (especially privatized infrastructure). This will leave less of the economic surplus to be capitalized into bank loans, lowering the price of housing accordingly (the major factor in labor’s cost of living), as well as the price of public services. (Owners of monopoly utility services would be prevented from factoring interest charges into their cost of doing business. The idea is to encourage them to take returns on equity. Whether or not they borrow is a business decision of theirs, not one that governments should subsidize.) The tax deductibility of interest will be repealed – there is nothing intrinsically “market dictated” by this fiscal subsidy for debt leveraging. This program may be reviewed at rtfl.lv, the Renew Task Force Latvia website.
No doubt many post-Soviet economies will find themselves obliged to withdraw from the euro area rather than see a flight of labor and capital. They remain the most extreme example of the Neoliberal Experiment to see how far a population can have its living standards slashed before it rebels.
But so far the neoliberals are fully in control of the bureaucracy, and they are reviving Margaret Thatcher’s slogan, TINA: There Is No Alternative. But there is an alternative, of course. In the small Baltic economies, pro-labor parties are pressing for the government to shift the tax burden off employees and consumers back onto property and financial wealth. Bad debts beyond the reasonable ability to pay must be scaled back. It may be necessary to let the banks go under (they are mainly Swedish), even if this means withdrawing from the Euro. The choice is between who will be destroyed: the banks, or labor?
European politicians now view this as being truly a fight to the death. This is the ideology that has replaced social democracy.

[1] Matthew Dalton, “EU Proposes Fines for Budget Breaches,” Wall Street Journal, September 29, 2010.

The Wingnuts go after Fannie and Freddie

By L. Randall Wray

In recent weeks the wingnut right wing ideologues have made a lot of headway in their goal of gutting Social Security. Well-funded by hedge fund manager Pete Peterson as well as right wing Washington think tanks, they have promoted the preposterous notion that our wealthy and productive economy cannot afford to take care of our elders. Now they have turned their sights on Fannie and Freddie. They argue that it is time to cut Uncle Sam out of the home mortgage market. Just as he has no role to play in providing decent pensions to our retired population, he should not help make homeownership affordable for most Americans. “Free markets” can do it all so much better than Uncle Sam can do.

Give me a break. These are the same bozos that are promoting home foreclosure and happily cheering the biggest transfer of wealth to Wall Street that the US has ever seen. Without Fannie and Freddie there would be no home financing or refinancing going on right now. Oh, right, free markets did such a good job with the subprime mortgage market, creating a global financial crisis that rivals the Great Crash of 1929. Hey, let’s reward them by getting government out of the mortgage markets so that Pete Peterson can run the whole shebang for the benefit of Wall Street. That, of course, is the real goal. Wall Street wants to get back to predatory lending as quickly as possible, and hates the competition from a newly missioned Fannie and Freddie—which have turned away from the practices that assisted rapacious private lenders from 2004 to 2008. Better close them down because Wall Street hates competition.

And, yes, let’s reduce Social Security benefits and raise payroll taxes, squeezing our seniors so that they have no choice but to let Pete Peterson charge them exorbitant fees to manage their miniscule life savings. Government is running out of keystrokes and won’t be able to afford to credit retiree bank accounts fifty years from now. Better slash Social Security now.

Ain’t it all just so convenient for the Pete Petersons of the world? Shift the blame, no matter how ridiculous the claims. Our current problems are caused by runaway Fannie and Freddie and Social Security—providing safety nets that our homeowners and seniors abused, taking advantage of poor little defenseless Goldmans and Morgans and Citibanks. That was the cause of the crisis! If we had just had more free market abuse of consumers, everything would have just been fine. Besides, government is broke. We’ve got to tighten the purse strings. Running out of cash, you know. No more keystrokes to credit bank accounts.

How about a reality check? Fannie and Freddie made no subprime loans. Indeed, they originated no loans at all. Yes, they offered insurance on privately originated mortgages, and yes, they lowered their standards. This has been carefully studied, and all analysts have reached the conclusion that Fannie and Freddie got into trouble because they catered to “free” market demands that they either insure the kinds of toxic mortgages markets wanted to provide or that they become irrelevant. The free markets wanted to do Liar loans and NINJA loans, making loans that borrowers could never service. The old fuddy duddies Fannie and Freddie would never have agreed to guarantee this trash, so they were partially privatized, with big gun, high paid CEOs hired. And just like magic, they started behaving like a Goldman or a Countrywide—maximizing CEO pay while damning the firms. Yes, that is the free market solution and my colleague Bill Black calls it control fraud. Fannie became a control fraud, just like all the big boy private financial institutions. Peterson’s solution? Promote control frauds by freeing markets.

The thing that the wingnuts cannot explain is why Fannie and Freddie—which had a history that goes back to the mid 1960s – did not encounter significant problems until they were directed by Congress to replicate a market-oriented strategy. And the wingnuts cannot explain why defaults on home mortgages were so rare until the “free markets” took over the mortgage sector. Heck, Fannie and Freddie even survived the savings and loan fiasco of the 1980s, when thrifts were “freed” to pursue free market maximization that resulted in suicide for the whole industry. It was only after 2004 when Fannie and Freddie were directed to cater to control frauds like Countrywide that they got into trouble.

Make no mistake. The wingnuts are likely to win these battles. President Obama will not put up a fight—he’s already bought the Peterson story, hook, line and sinker. Social Security is a done deal. It is going to be “reformed”. That is, it will be handed over to Pete Peterson, who will manage it right down the rat hole where all the private pensions are going. Wall Street will gamble away all the funds, whilst enriching itself with management fees. And Fannie and Freddie will be shut down so that Wall Street will have free reign in the housing market. Homeownership rates will plummet. Predatory mortgages will be the rule. Wealth will trickle up. Democratic Party coffers will be replenished. Obama will declare Social Security and Fannie and Freddie to be reformed—just like the healthcare system.

The only possible hope is that financial markets completely collapse in the next three to four months. That would discredit Pete Peterson and the wingnuts at his think tanks. It would make it possible to stop the right wing stampede and the collective amnesia about the last three years—that is, about the global financial crisis caused by free market wingnuts. Resumption of the crisis could discredit the crazy troglodyte thinking promoted at Chicago and Washington think tanks.

What is the free market path to homeownership? A subprime crisis.

What is the free market path to private pensions? Across the board collapse of commodities, real estate, and equities markets.

What is the free market alternative to Social Security? An impoverished elderly population.

What is the free market alternative to Medicare? High priced health insurance that most elderly people cannot afford.

Not to worry, all these reductions of government interference into the finely oiled free market machine will help to enrich Pete Peterson and the other funders of the wingnut think tanks.

Ok, how about a politically feasible alternative? We all know that Pete Peterson’s well-funded effort has convinced most policy makers that the federal government has run out of money, so cannot afford costly Social Security or government guarantees of mortgages. Any federal spending must be offset by tax hikes or spending cuts. Pete Peterson’s minions are fond of “infinite horizon” calculations that show that “government entitlements” will lead to shortfalls of tens of trillions of dollars. It is all nonsense, but it guides all policy making.

So here is a proposal consistent with such calculations. Let us raise Social Security benefits today to help seniors through the current depression. Let’s have a payroll tax holiday—stop collecting the taxes from employers and employees to put more pay into the hands of workers and to reduce the costs of employing them. Let us provide debt relief to homeowners so that they can keep their homes. Let us create a jobs program to put 12 million people back to work (the number of jobs created by New Deal programs).

To please the deficit hysteria crowd we will need to offset all of this spending. So let us propose that beginning in 2050 all seniors above age 65 will be ground to produce soylent green burgers, with a proviso that implementation can be postponed by majority vote of the population annually from 2050 on. For budgetary purposes, the future savings to Social Security and Medicare can be counted today, eliminating Peterson’s infinite horizon unfunded entitlements. Voters in 2050 and thereafter can decide whether they want those burgers—year-by-year so that infinite horizon forecasts will remain favorable. Each year voters will decide whether they want to eat seniors or feed them for one more year.

Personally, I don’t eat mammals, but I won’t be voting in 2050. Now, reptiles are an entirely different matter, and only discretion prevents me from naming a few that could be candidates for reptilian burgers. Bloodsucking vampire squid cakes, anyone?

Heck, no matter what we do today, it will be voters in 2050 that will decide the fate of seniors in 2050. That is what scares the Beetlejuice out of Pete Peterson—he’s afraid that American compassion and reason will triumph, hence the scaremongering to convince voters that retiring babyboomers expecting government to credit their bank accounts using keystrokes represents the biggest threat facing America today. And that is why the wingnuts think it is so important to start cutting benefits and raising payroll taxes today—to eliminate America’s most popular government program so that no one will have any alternative to Wall Street management of pensions. Yes it is unimaginatively silly—the agenda of simpletons who have no understanding of balance sheets or of sovereign currencies or of anything else that is important to the issues of Social Security or government guarantees of home mortgages. Unfortunately, these are the most dangerous kind of simpleton—with billions of dollars to throw around to get their way.

Remember Thatcher’s motto: TINA = there is no alternative to free markets. The wingnuts have learned these lessons well. Remove any alternative to Wall Street’s complete control over all aspects of life. Then TINA will be true.

I do not want to be accused of being unfair to wingnuts. There is certainly room for debate on the necessity of reforming Social Security and government guarantees of mortgages (and student loans, and small business loans, and farm loans, and veteran’s loans). One can coherently—even if repugnantly—argue that government should play no role in helping to provide seniors with a decent living standard. Declaring that any senior who is not sufficiently lucky, industrious, and foresighted to provide for her own retirement ought to live out a miserable old age is an opinion that deserves to be debated. But declaring that government simply cannot afford current law Social Security benefits it just plain ignorant—it is a position that deserves no attention. Siding with Wall Street against government protection of homeowners might be an unpopular position but it is, again, worthy of debate. Yet claiming that Fannie and Freddie as originally constituted would have contributed in an important way to the global financial crisis does not merit consideration. It is not even worthy of Fox News. It is beyond stupid. It is an outright misrepresentation of the facts.


By L. Randall Wray

Outgoing Senator Dodd just weighed in on the possibility that Elizabeth Warren might get the top spot heading the new Bureau of Consumer Financial Protection at the Federal Reserve:

“What you don’t need to have is an eight-month battle for who the director or the head or chairperson of this new consumer financial protection bureau will be,” Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee, said in an interview on Bloomberg Television’s “Conversations with Judy Woodruff,” to be broadcast today.
Let us get this straight. Dodd has been a shill for Wall Street for years. He has never seen a fight against Wall Street worth fighting. He is retiring. Why would anyone care what he thinks about Warren?

Let us get this straight. Warren created the proposal to create a consumer financial protection act and agency to enforce it. She has been the driving force behind it. No one is better qualified to lead it. Any other appointment would confirm that the Obama administration is not serious about reform.

Dodd is pushing Sheila Bair, head of the FDIC. She is a fine person. She says she does not want the job. I haven’t met her, but she is no Elizabeth Warren.

We know that Dodd does not take consumer protection seriously. He has been in the back pocket of rapacious lenders so long that his views have no credibility. He is the problem, not the solution. That is why he is leaving “public service”. He knows he has no chance to win an election in the aftermath of a crisis he helped to create.
Warren, by contrast, has been a tireless defender of consumers. She knows all the “tricks and traps” that credit card issuers put into the complex contracts that—literally—no law school grad could wade through. She forcefully argues that it makes no sense that we protect consumers from faulty toasters but let Wall Street steal their home and their life savings. She knows that Wall Street bought and paid for the 2005 Bankruptcy “Reform” Act written by the credit industry to screw the last dime out of overburdened homeowners—exactly on the cusp of the collapse. She knows that states (with the help of the Supreme Court) have raised the maximum permitted interest rate from a “measly” 36% in 1965 to a median of 398% in 2007. Yes, read that again—it is not a mistake, it is a disgrace.
Warren knows that financial products are only subject to contract law—based on the notion that both parties are fully informed. And are “equals” in the contract. Yep, right—you, dear reader, are equal to the team of vampire blood sucking squids at Goldman Sachs dead set on taking away your home. What, you do not have a good corporate lawyer looking over your mortgage contract? Sucker!
Other consumer products are subject to tort law—you can sue manufacturers for injury. Imagine if you bought a lawn tractor, with 37 pages of disclaimers, and buried deep inside in incomprehensible language the contract said that due to shoddy manufacturing practices, the blade is liable to occasionally fly off and take off your leg, but if it does that, we are not liable. That is exactly what your credit card contract says.
It ain’t right. Warren knows that. She wants to protect consumers of financial products—which, arguably are far more important today than are toasters that occasionally short and burn your toast.
If you are not convinced that she is the right person for the job, please read her excellent essay: “Redesigning regulation: a case study from the consumer market”, in Government and Markets, toward a new theory of regulation, edited by Edward Balleisen and David Moss, Cambridge University Press, 2010, based on a paper she gave back in 2008.

May the Biggest Loser Win: Euroland’s Race to the Bottom

By L. Randall Wray

As part of the EU/IMF plan to resolve Greece’s debt crisis and to make its  economy more competitive, the government announced a couple of weeks ago plans to revamp labor relations laws and social security entitlements. The minimum monthly wage for new entrants into the labor market will be decreased from 700 euros to 560 euros, and workers will be required to have 40 years of employment to receive a full pension (which has also been subject to significant reductions). And companies would face far fewer restrictions with regard to layoffs and layofff compensations–which have been cut in half. The strategy is obvious: Greece wants to win the race to the bottom in the Eurozone, that is, to win competitive advantage by having the region’s lowest and meanest living standards. That, of course, will now be an even tougher race to win, with the recent entry of Estonia into the Eurozone.

Even in the best of times, this would be a dangerous strategy. Given that all members of the Eurozone have removed trade and capital barriers and adopted a common currency, there is no possibility of gaining advantage through the normal methods of currency devaluation or by tacking tariffs onto imports. This means that trade surpluses can be achieved only by lowering costs and increasing labor productivity. Costs are cut by slashing wages and benefits; productivity is increased by working employees harder—downsizing the labor force, longer hours, shorter vacations, and postponed retirement. But every nation will adopt the same strategy. Matters are made worse by the deep global crisis. Markets for exports are depressed and tourism is down. Meanwhile, governments are cutting spending—especially in those areas that could actually help increase productivity and enhance competitiveness: public infrastructure investment and education. Lower wages and retail sales, and a smaller workforce result in collapsing government tax revenue—fueling a vicious cycle of spending cuts but falling tax revenue so that budget deficits cannot be reduced.
To be sure, Greece has had its problems. Its labor costs have grown significantly over the past decade, much faster than those of Germany and other Eurozone nations. But the notion that workers in Greece have been enjoying the fruits of an overly generous welfare state is belied by the facts. (See here) In reality, the Greeks have one of the lowest per capita incomes in Europe (21,100), much lower than the Eurozone 12 (27,600) or the German level (29,400). Further, the Greek social safety nets might seem generous by US standards but are modest by European standards. On average, for 1998-2007 Greece spent only 3530 per capita on social protection benefits–slightly less than Spain’s spending and only 700 more than Portugal’s, which has one of the lowest levels in all of the Eurozone. By contrast, Germany and France spent more than double the Greek level, while the original Eurozone 12 level averaged 6251.78. Even Ireland, which has one of the most neoliberal economies in the euro area, spent more on social protection than the supposedly profligate Greeks.

Greece is also supposed to suffer from inefficiency and cronyism in its government—so its administrative costs should be higher than those of more disciplined governments such as the German and French. But this is obviously not the case as the table below demonstrates. Even spending on pensions, which is the main target of the neoliberals, is lower than in other European countries.

Table 2 shows total social spending of select Eurozone countries as a per cent of GDP. Through 2005, Greece’s spending lagged behind that of all euro countries except for Ireland, and was below the OECD average. Note also that in spite of all the commentary on early retirement in Greece, its spending on old age programs was in line with the spending in Germany and France.

Greece has one of the most unequal distributions of income in Europe, and a very high level of poverty, as the following table shows. Again, the evidence is not consistent with the picture presented in the media of an overly generous welfare state.

The proposed cuts will simply widen the gap between living standards in Greece versus those in the wealthiest Eurozone nations.

This is a race to the bottom that can only be won by the biggest loser. It is bizarre that the EU and the IMF are promoting such a contest since it is completely inconsistent with the longer-run strategy of convergence across Euroland. Indeed, it will ultimately destroy the union.

Deficit Doves Meet the Deficit Owls

By Stephanie Kelton

On July 19, The Daily Beast published a piece by Harold Evans, Joseph Stiglitz, Alan Blinder, Robert Reich and others, urging greater fiscal stimulus in the short-term and renewed fiscal discipline over the medium- and longer-term horizon. A number of bloggers on this site were asked to support their deficit-dove petition. We declined, and so did the three wise owls who wrote the following statement, which first appeared at New Deal 2.0.  

The following is a reprint of a response by Paul Davidson, James K. Galbraith and Lord Robert Skidelsky (Deficit Owls) First published at New Deal 2.0

“We three were each asked to sign the letter organized by Sir Harold Evans and now co-signed by many of our friends, including Joseph Stiglitz, Robert Reich, Laura Tyson, Derek Shearer, Alan Blinder and Richard Parker. We support the central objective of the letter — a full employment policy now, based on sharply expanded public effort. Yet we each, separately, declined to sign it.

Our reservations centered on one sentence, namely, “We recognize the necessity of a program to cut the mid-and long-term federal deficit…” Since we do not agree with this statement, we could not sign the letter. Why do we disagree with this statement? The answer is that apart from the effects of unemployment itself the United States does not in fact face a serious deficit problem over the next generation, and for this reason there is no “necessity [for] a program to cut the mid-and long-term deficit.”

On the contrary: If unemployment can be cured, the deficits we presently face will necessarily shrink. This is the universal experience of rapid economic growth: tax revenues rise, public welfare spending falls, and the budget moves toward balance. There is indeed no other experience in modern peacetime American history, most recently in the late 1990s when the budget went into surplus as full employment was reached.

We agree that health care costs are an important issue. But health care is a burden faced by both the public and private sectors, and cost control is a job for health policy, not budget policy. Cutting the public element in health care – Medicare, especially – in response to the health care cost problem is just a way of invidiously targeting the elderly who are covered by that program. We oppose this.

The long-term deficit scare story plays into the hands of those who will argue, very soon, for cuts in Social Security as though these were necessary for economic reasons. In fact, Social Security is a highly successful program which (along with Medicare) maintains our entire elderly population out of poverty and helps to stabilize the macroeconomy. It is a transfer program and indefinitely sustainable as it is.

We call on fellow economists to reconsider their casual willingness to concede to an unfounded hysteria over supposed long-term deficits, and to concentrate instead on solving the vast problems we presently face. It would be tragic if the Evans letter and similar efforts – whose basic purpose we strongly support – led to acquiescence in Social Security and Medicare cuts that impoverish America’s elderly just a few years from now.”

James K. Galbraith is a Professor at The University of Texas at Austin and author of “The Predator State.”

Lord Robert Skidelsky is the author, most recently, of “Keynes: The Return of the Master.”Paul Davidson is the Editor of the Journal of Post Keynesian Economics and author of “The Keynes Solution.”