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Wray explains the implications of exchange rate regimes for Modern Money Theory:

Floating vs fixed exchange rate regimes. The previous blogs were quite general and apply to all countries that use a domestic currency. It does not matter whether these currencies are pegged to a foreign currency or to a precious metal, or whether they are freely floating—the principles are the same. In this blog we will examine the implications of exchange regimes for our analysis.


Anti “MMT Types” Memes Migrate to Stage II

One of the famous statements attributed to Mahatma Gandhi is that opposition to new, powerful ideas goes through three stages.  First, they ignore you.  Then they attack you.  Then you win.  Modern Monetary Theory (MMT) has reached the second stage.  It has, on the same day, been attacked by Paul Krugman and John Carney (CNBC.com’s “senior editor”) in their unrelated columns. 

The attacks are particularly interesting because they share two characteristics.  They independently use the meme “MMT types” to disparage their opponents and they do not engage the accuracy of MMT theory.  The CNBC commentator dismisses MMT because he fears that if members of  Congress understood how monetary operations worked they would be tempted to support government programs.  The CNBC commentator has an intense ideological opposition to government programs, so he opposes MMT.  Note that he opposes MMT because it is substantively correct.  That is the oddest objection to a theory that I have seen presented.

CNBC’s hostility to MMT was predictable and its commentator was playing by modern journalistic rules with no pretense to academic objectivity.  Krugman’s disparaging dismissal of “MMT types” based on a straw man argument that he falsely ascribes to MMT is far more embarrassing because he is a globally prominent academic.

I am not an “MMT type.”  MMT is a macroeconomic theory.  I teach courses in microeconomics, law, regulation, finance, and criminology at the University of Missouri-Kansas City (and previously at the LBJ School of Public Affairs at the University of Texas at Austin).  I’m still trying to get past the first stage (being ignored) with Krugman.  He cited one of my columns favorably in his blog in which I recounted ECB President Trichet’s 2004 speech in Ireland urging new EU nations to use Ireland as their economic model.  My work explains how accounting control frauds drive our recurrent, intensifying crises and what policies create the criminogenic environments that produce fraud epidemics and hyper-inflate financial bubbles.  Criminological research findings would add considerable support and new insights to Krugman.  Scores of economists now cite our work, but Krugman still shares the characteristic reluctance of economists to use the “f” word (fraud) to describe frauds.    

UMKC’s economic department has a storied reputation going back over a half century.  It is one of the few remaining “heterodox” economics departments in America.  “Heterodox” is not a euphemism for Marxist and it is not an oxymoron describing a department filled with intellectual clones.  UMKC’s economics department is also cheerfully interdisciplinary.  They welcome the research insights of other fields such as criminology and law.  White-collar criminological theories about “control fraud” have shown far greater predictive strength than neoclassical and “modern finance” models.  White-collar criminologists falsified the efficient markets hypothesis 25 years before the hypothesis was created. 

As Jim Sturgeon, the chair of the economics department puts it: “UMKC, the place that got it right; and probably will again.”  I love Jim’s use of “probably.”  It is so wonderfully and appropriately Midwestern.  Our students are taught both the neoclassical canon and critiques of that canon.  The neoclassical model and “modern finance theory” have failed and are in their paradigmatic death throes.  Unfortunately, their dogmas will likely persist for decades and cause several more crises.  UMKC doctoral students have proven extremely successful in finding academic positions because of their broader training.  As heterodox economists, we are a tiny minority, but we punch way above our weight class.  (If you are interested in studying in an economics graduate program that is reality-based please contact us.)    
My closest colleagues at UMKC include Randy Wray and Stephanie Kelton and my closest colleague at U. Texas was Jamie Galbraith.  Wray is the nation’s leading MMT theorist.  (Bill Mitchell of the University of Newcastle and Wray are the best known academic developers of MMT.)  Wray was one of Minsky’s grad students and has continued to develop Minsky’s famous work on the paradox of financial stability leading to instability.  Jamie Galbraith has several specialties; including MMT.  Kelton is a younger colleague whose dissertation on government finance spawned two classic works on MMT, and the New Economics Perspectives blog — now a major player — was her creation.  I have been privileged to see each of these colleagues present on the subject of MMT in the U.S. and in several other nations and I have read Wray and Galbraith’s congressional testimony on MMT and read other academic and policy articles that they have authored. 

Mat Forstater is a colleague who is an active MMT scholar.  Mat runs our Center for Full Employment and Price Stability (CFEPS) and is particularly active in developing programs to use the government as the employer of last resort (ELR).  Warren Mosler, a hedge fund manager and leading MMT theorist, provided the primary funding for CFEPS and many of our grad students.    

Wray, Galbraith, Kelton, Forstater, and Mitchell are serious academics by anyone’s standards.  Mosler’s knowledge of actual monetary operations is legendary.  They present at major economic conferences, often as prominently featured speakers.  They are open to criticism and they engage in civilized dialogue with their critics.  One of the odd aspects of MMT is that none of the scholars who developed the theory likes the phrase “Modern Monetary Theory.”  Indeed, they do not like any of the three words in the term.  “Modern” is something of an internal joke among MMT theorists because Keynes observed that the state theory of money described events that arose over 4,000 years ago. 

MMT is a rich theory in that it is built from diverse supporting strands pursued independently that were eventually woven together to form a far stronger intellectual fabric.  The heart of MMT is not a “theory.”  It is a description of reality as opposed to an idealized theory with simplifying assumptions.  It turns out that the description of monetary operations we were taught in conventional macro courses is inaccurate in several important areas.  MMT theorists cite the statements of central bankers (even Alan Greenspan) that demonstrate that their actual operations accord with MMT’s description of those operations.  If Krugman believes that the heart of MMT – the description of actual monetary operations – is incorrect he should explain what he believes is incorrect.  He has never suggested that MMT’s description is inaccurate.  MMT has found increasing popularity among financial market participants precisely because they know that it is an accurate description of actual monetary operations. 

MMT is also woven with strands drawn from research of monetary and macroeconomic history.  One component of this historical research has refuted the conventional “just so” story of the creation of monetary systems.  MMT shows the closeness of the relationship between the sovereign and the monetary system.  MMT research shows that it was normal for the U.S. government to be in deficit and normal for the U.S. government to be in debt.  These deficits have not led to hyperinflation in the United States.  Historical research shows that the age of the gold standard was not a golden era.  The gold standard caused recurrent crises in many nations.  MMT research shows that when President Roosevelt listened to his conventional economic advisors in 1937 and attempted to balance the budget the result was to throw the U.S. back into the depths of the Great Depression.  MMT research has shown that the extremely uncommon periods in which the U.S. runs a material budget surplus are typically followed quickly by serious recessions.  Wray, Galbraith, and Kelton are appropriately cautious in concluding that this historical pattern demonstrates that the surpluses caused the recessions.  They do, however, offer a credible explanation of why budget surpluses could lead to recessions.  Again, if Krugman has specific disagreements with these findings about monetary and macroeconomic history my colleagues will be delighted to discuss the merits.  As we will see, Krugman is one of the scholars whose historical research has confirmed and extended these findings.  

The leading MMT scholars have been among the strongest spokespersons predicting that the proposed U.S. stimulus program would prove far too small and explaining why the budget deficit is a consequence of Great Recession, why vigorous counter-cyclical fiscal policies are essential to our recovery, why austerity would worsen the recession and increase budget deficits, why our focus needs to be on restoring full employment (the MMT scholars are strong supporters of government ELR programs), and why these policies are not inflationary in the current circumstances.  Krugman acknowledges that he agrees with each of these conclusions.             
Regular readers of comments will notice a continual stream of criticism from MMT (modern monetary theory) types, who insist that deficits are never a problem as long as you have your own currency. I really don’t want to get into that fight right now, because for the time being the MMT people and yours truly are on the same side of the policy debate. Right now it really doesn’t matter at all whether the United States issues zero-interest short-term debt or simply prints zero-interest dollar bills, and concern about crowding out is just bad economics.

Krugman agrees that the MMT scholars are correct except as to one matter: “MMT … types … insist that deficits are never a problem as long as you have your own currency.”  That is a straw man argument.  I can personally attest that Wray, Galbraith, and Kelton do not argue that “deficits are never a problem.”  MMT explains the economic circumstances in which “deficits are … a problem.”  I am unaware of any MMT scholar who asserts that “deficits are never a problem” for a nation with a sovereign currency.  It is not uncommon for academics to misunderstand an academic literature that they have not read.  I invite Krugman to read the academic MMT literature and critique it substantively.

Three aspects of Krugman’s dismissal of “MMT types” strike me as unworthy of him.  The term “MMT types” is deliberately ad hominem.  Using the term to belittle and dismiss scholars such as Wray, Galbraith, and Kelton is unwarranted and diminishes Krugman. 

The “stream of criticism” of Krugman from supporters of MMT is largely driven by his repeated straw man assertions that MMT predicts that “deficits are never a problem as long as you have your own currency.”  Krugman then attacks the straw man he created by arguing that that because deficits mattered in France after World War I (one of the subjects of his dissertation) he has refuted MMT’s (non) prediction that deficits never matter.  MMT supporters have repeatedly explained to Krugman that MMT does not predict that “deficits are never a problem as long as you have your own currency.”  Wray, Galbraith, and Kelton have emphasized that MMT predicts the circumstances in which deficits can cause problems.  World War I was fought largely on French soil, destroying and allocating real resources to the imperative of national defense.  France went off, then on, then off the gold standard.  Yes, France followed policies, in dreadful circumstances, that sometimes produced serious financial instability – as MMT would predict. 

Making a dismissive straw man assertion once is a common error.  Ascribing the same straw man assertion to “MMT types” after he had been warned repeatedly that his assertion was false evinces a serious flaw.

The final aspect of Krugman’s response that is so disturbing is his claim that he is the victim of “harass[ment]” by “MMTers.”

Now, all of this is remote right now. And notice too that France in the 1920s stabilized with debt of 140 percent of GDP — far higher than the numbers that are supposed to terrify us now. So none of this is relevant to the current policy debate.
But since the MMTers seem to have decided to harass those of us who want stronger action now but think there really is a long-run fiscal issue, I needed to put this out there.

This passage is odd on several different levels.  He asserts that MMT predicts that deficits never matters.  MMT supporters point out to him that he has erred – MMT theory predicts the circumstances in which deficits can cause severe problems.  Krugman does not respond: “thank you, I am delighted to learn that MMT does not make such a prediction.”  Instead, Krugman repeats the straw man assertion that he knows to be false.  He gets called on it – again.  He now plays the victim card: “MMTers … harass” him when he writes about MMT.  Critiques of what we write are valuable, particularly when we commit error.  There is nothing better for an academic than being saved from error by a commenter’s correction.  Krugman is both a journalist and a scholar, so he should take special joy in receiving vigorous critiques from readers of his New York Times column. 

The passage is also bizarre with regard to the substance of this argument about MMT.  Recall what I have explained about MMT scholars’ historical findings.  While MMT theory explains why severe deficits could indeed cause problems, historical research shows that nations with sovereign currencies are far less vulnerable to deficit levels than the deficit hawks assert should “terrify us.”  Deficit hawks’ primary strategy is to create what criminology and sociology call a “moral panic” (think “Reefer Madness”, the “crisis” of “illegal immigrants”, and the plague of “voter fraud” led by ACORN).  As the term implies, the goal is to moralize the issue and generate a panic that makes immediate action imperative to save the Republic.  Anyone who opposes immediate action is immoral and disloyal to the Republic.  Government deficits are generally not a “moral” matter.  Governments are not like private households.  Deficits are “just business.”  They may be good for the economy or bad for the economy.  Given the roughly 25 million Americans who want to be fully employed and cannot find such jobs, it would be far easier to craft a moral argument in favor of a larger federal budget deficit during the current economic crisis than a moral case for consigning millions more to unemployment – which is what “balancing the budget” would do.  MMT scholars are the “owls” in the debate between the deficit hawks and doves (Krugman is a dove).  MMT scholars seek to alert the public to the deliberate generation of a moral panic.  President Obama has appointed (think Simpson-Bowles) leaders of the campaign to create a moral panic.  Krugman has decried this, but he seems to believe that we have an inherent budgetary (as opposed to cost containment) crisis in health care.  I will respond to the roots of the rise in health care costs in a later column.  Hint:  I will often cite Krugman.     
Krugman’s historical research into France’s deficits for his dissertation is part of the academic literature supporting MMT.  He found that France “stabilized” “with debt of 140 percent of GDP – far higher than the numbers that are supposed to terrify us now.”  An MMT theorist could not have said it better.  The nature and magnitude of the deficit can cause a problem, but the deficit hawks and the deficit doves are both allowing current U.S. deficits that are far lower than France ran to “terrify us now.”  Like Krugman, in his dissertation, Wray, Galbraith, and Kelton’s research findings refute the claim that the current U.S. deficits are too large and should terrify us.  Once one strips away Krugman’s straw man misconception about MMT (“deficits are never a problem”) one is left with Krugman agreeing entirely with MMT scholars on substance with regard to current policies.  I believe that he would also agree with me that the hawks are deliberately generating a moral panic for political and ideological purposes and that it is essential that economists fight this panic and show that the policies its proponents advocate would be disastrous for the nation.  Indeed, I believe that Krugman would agree that this has been the thrust of dozens of his columns. 

Now, if I could only find him a way to get him to read the research on accounting control fraud…. 


*Bill Black is an Associate Professor of Economics and Law at UMKC.  He is a former senior financial regulator, a white-collar criminologist, and the author of The Best Way to Rob a Bank is to Own One.  

Interview with Randy Wray, Regarding the Next Crisis (Part 2)

(cross-posted with Mecpoc.org)
The following is Part Two of an interview with Randy Wray on the Global Crisis and the extent of the possibility of another crisis. It was conducted by students Inigo Garcia, Fahd Arnouk, and James Jasper, at Franklin College Switzerland for Mecpoc. (4 May 2011)

Mecpoc: In your writings, you argue that losing the monetary and fiscal independence that currency sovereignty gives would prevent a country from pursuing certain policies such as full employment. How big of a problem is the fact that the countries that are part of the Economic and Monetary Union in Europe are no longer sovereign? Is this really going to affect the future of the European Union? Is there a way out of it?
Randy Wray (RW): As early as 1996, I was writing on the EU, and stating that this is a system designed to fail. The system will fail. The fundamental problem is that the countries are not sovereign and that they have adopted foreign currencies. The ECB always has the ability to create euros, but it is prohibited from buying the government debt of each individual country, and so you couldn’t use the normal procedure used in any sovereign country where the central bank either directly buys sovereign debt or it has an arrangement, like we do in the United States, where the Treasury first sells the debt to a private bank and then the Fed buys it from a private bank. So it is just a little more round about, but it has exactly the same impact of creating dollar reserves as well as deposits in the Treasury’s account that it can use for fiscal policy.

The ECB was prohibited to this, so you always had a constraint on the individual countries that they can only get euros by borrowing or exporting, but you cannot all be exporters. So some countries will be the exporters and some are the importers, and in net, this does not create euros. You could borrow euros from another country—for example from the net exporting countries, so that relieves the constraint a bit by not being completely constrained to exports. But that just means that if you are a net importer, you are going to be increasing your debts, external debts, to other European countries and eventually you are going to have to adjust your trade, or you are going to get shut-off, downgraded. It couldn’t last.

Then, the crisis hits, and the ECB starts providing loans in euros and creates new ways to finance individual country’s foreign debt–trying to prevent default or even worse downgrades of the debt, which the market wouldn’t buy either.

Is there a way out? Sure. And it is not hard at all to come up with solutions that are economically viable. One would be that you just allow the ECB to provide funding for individual countries, and they could do it directly. The ECB can start buying government debt, or they can do it indirectly by proving loans of reserves to central banks or private banks so that they can buy the debt.
Another is that you do it through fiscal policy, and that would be to increase the size of the budget of the European Parliament. Right now they have a budget of less than 1 percent of GDP for Europe versus our Congress that has over 20 percent of U.S. GDP to play with. And in the US they redistribute it among the states, so we have fiscal transfers to the poor states. If the European Parliament had a budget of 15 percent of GDP it probably would be enough to solve all the financial problems in Europe. With 15 percent of GDP they can target Greece, Portugal, Ireland, and so on by providing fiscal transfers to them. That would solve the problem.
Either one of those. But politically I don’t think either of these is possible, that is the problem.

Mecpoc: Neither options are politically feasible under the existing rules of the Euro zone, correct?

RW: Correct, you would have to change the constitution to do it through the ECB, so that is the problem. I don’t think it is a secret: the ECB is completely run by Germany. And Germany would never allow the ECB to do this, and for the other one there is an even less political possibility because probably every country in Europe would be against it. Why? Because they still want to be independent, they want to have independent fiscal policy. It is not likely that they are going to give that much power to the European Parliament, so that is the problem.
Mecpoc: It took a Civil War in the United States…
RW: Yes, and from the beginning we always had more power in Washington than you have given. And it took the Civil War, but it also took the Great Depression—during which the Federal government budget grew from 3% of GDP toward the current 20% (of course it hit 50% in WWII).
Mecpoc: Let’s look at the problem of Spain, for example, where unemployment is over 20 percent. How can a country with those levels of unemployment have a future in terms of economic well being within the European Union? Portugal and Greece are smaller economies, but would the measures you just talked about be sufficient to solve the “Spanish problem?”
RW: No there is no future with such high unemployment. And it probably will get worse. If Spain were the only country that had problems then there would be some hope. But Spain isn’t the only one, so there are only a few strong economies in Europe. The strongest, Germany, relies on exporting, so it is a mercantilist country, and mercantilist countries impoverish other countries. But failure of the other countries will kill Germany too, so it is self-defeating even for Germany. The problem is that Spain can compete only by becoming much poorer than it is. So this would work, but the problem is that you have many other countries that will pursue the same strategy. They are going to become poor at least as fast as Spain does, so that won’t work.
Mecpoc: German exporters impoverish the other countries financially, but they impoverish themselves by exporting the real goods.
RW: That is true! And they always have to watch out. Let’s say that their workers are the most productive and the best trained, but at some relative wage German manufacturers would rather be located in Spain. So if you get Spanish wages low enough, German wages have to come down. So that is why it won’t work. And the Germans are willing to use austerity in Germany if they have to in order to keep their trade advantage, so there is no possible solution.
Mecpoc: And what role do you see China playing in all of this? Is China the same type of mercantilist as Germany?
RW: I think they are in a much different situation because Germany is a rich country already highly developed. China was a very poor country and still has relative poverty for the majority of the population compared to European living standards. I wouldn’t say that what China is doing is illegitimate at all; they are following a normal development path. The normal development path is that for a while you export, and there are some reasons why they do that.

One is that if they don’t have to produce products that compete in world markets, they don’t have any competitive reason to produce good products. So they learn how to produce good products by competingthey have to export high quality commodities produced to world standards. Also, a lot of Chinese exports are very low value added. Much of the high value production is done outside China, and then sent to China. It is pretty misleading to say that Chinese are taking away manufacturing jobs as for the most part it is not true. They are adding a little bit at the end of the production process and learning something about producing high quality goods, so that they can produce some for their domestic population. Maybe not all, but most countries follow that same development path.

At some point, China does have to switch over. I have been to China talking to Chinese, and I think they universally recognize that. They are rapidly increasing consumption domestically, and they will move to much higher domestic consumption and much lower investment and exports as a percent of total GDP. And they are doing it: living standards are rising extremely fast in China and you can’t do that without having consumption.

The second reason why they did it is that they saw what happened in the other Asian countries. If you don’t have huge dollar reserves, you get attacked. So they wanted to accumulate a lot of dollar reserves to make sure that they can control their currency. That brings in the US charge that they are currency manipulators, and again, I think that is extremely unfair. Most countries, almost all countries, pegged their currencies until Bretton Woods fell apart, so how can you blame a country for pegging their currency when you did it too? Within Europe, all of the nations in the EMU have pegged currencies. And many Asian countries peg their currencies to the dollar, so what China is doing is not unusual at all. It is very common even today and it was almost universal a few decades ago. Why are they doing it? Because this is consistent with trying to develop your export market as you develop. To secure stable development you try to maintain the value of your currency.

China is not likely to open up its capital markets, as they saw what happened to Asian and Latin American countries with open capital markets. As a result, they are probably not going to do it. And the financial crisis only confirmed what they believed, so they are thankful that they didn’t allow this to go on. So the pegged exchange rate is reasonably easy for them to maintain, and it is going to be very hard for anyone to attack them. They’ve got capital controls and they have huge dollar reserves. They won’t use their dollar reserves for a long time. They probably will become net importers in a reasonably short amount of time as they increase domestic consumption, so they need the dollar reserves for a while.

Mecpoc: Can China however be viewed as an efficient economic system given its political corruption and the amount of bad loans that exist? While China is developing very successfully as you mentioned, are these factors, such as the political corruption, going to prevent China from continuing their development path? If so, what can they do to prevent them?
RW: I think the concept of efficiency is overused and almost always wrong. I don’t think that out in the real world where you have unemployed or underemployed resources, the notion of efficiency applies. I think that is irrelevant. It only matters once you reach full employment of all resources—then it is legitimate to worry about using them more efficiently.

Regarding the banks, on conventional accounting, they are massively insolvent. Does it make any difference? No, it makes absolutely no difference. They are completely stable, there will be no financial crisis in China. Why? Because banks will be backed up by the government. The government uses the banks as a fiscal tool, it has nothing to do with normal banking. It is a fiscal tool so that the Chinese government doesn’t have a budget deficit. So what the banks do—and they are mostly government banks–is to make loans that they know are going to be bad, but it doesn’t matter, because it is spending, it is not really lending. The finance is mostly public infrastructure and universities, so it is achieving a public purpose I wouldargue that is efficient. All you have to do is go to China and look at the trains, at the universities which are like cities. That is where the bad loans are, the bad loans are paying to build magnificent universities. So what?

They could have just allocated the funds and built a university. We should look at this as fiscal spending. The debt will be written off, and the buildings will remain.

Now, there is a legacy of bad loans to the state-owned enterprises, which were uncompetitive so when China opened up there was no way that these state-owned enterprises were going to compete with modern manufacturing. They’ve got all of those loans on the books, but many of those were closed, and gradually all of these are going to be closed down, and you are going to be stuck with bad loans. But again, that is not a problem– the government is going to bail the banks out.

There could be one danger, and that is the real estate boom. They have a huge real estate boom, maybe it is a bubble. The equity is pretty high so it is not like they are borrowing 100 percent, they are borrowing 60 percent. The homeowners have a lot of equity and for the most part they are living in the homes. The prices are probably going to come down but they can drop a lot before the people get in trouble. The Chinese in those situations in cities have secure financial positions as they have relative high income and very low costs. A college professor in a major city in China lives much better than a college professor in a major city in the United States; their standard of living is much higher. It is hard to believe, but it is true. They make $400 a month but they have few expenses, and $400 goes a long way in China.

Mecpoc: Since you discussed corruption in China, would you mind making one last comment on frauds and corruption in Wall Street?
RW: It is very much worse. The worst corruption in the world is on Wall Street. People talk about the corruption in Latin America or Africa or China, but it is nothing compared to what is going on. The biggest scandal in human history without any question at all; the whole thing is fraud, everything they do is fraud.

Yes there is corruption in China, and the further you get away from Beijing the worse it is, but the corruption, at least what I hear when I talk to Chinese, comes from the fact that the government owns the land and local governments sell the land to get the revenue. That is a major source of finance for local governments, from the sale of land to developers. Whenever developers play a big role, there is always corruption. That is true in the United States too–the whole savings and loans crisis was caused by developers and the link between developers and politicians. Because then you favor a particular developer, so they have massive corruption whenever developers and politicians get together.

But what is the purpose of it? It is to get the land developed, largely homes, and then to provide financing to the local government (from the sale of the land), and so they are favoring individual developers who become massively rich, but comparing that to Goldman Sachs, the consequences of the corruption is completely different. Think about it: the fraud perpetrated by Wall Street is kicking millions of Americans out of their homes, destroying financial wealth, jobs, families, and neighborhoods. The relatively minor corruption in China is generating economic development, building homes and putting people into them.

Mecpoc: Thank you for your time Dr. Wray.

L. Randall Wray interviewed by Ian Masters on KPFK FM-90.7 – Los Angeles

L. Randall Wray was interviewed by Ian Masters on KPFK FM-90.7 – Los Angeles. Click here to listen to the full interview. You can also listen to the full program.

Background Briefing with Ian Masters:

Economist Randall Wray joins us for a macro-economic analysis of adverse economic trends at home and abroad amid dire predictions of a double-dip recession in the U.S. and defaults in Europe. We will try to connect the dots to see if we are indeed at a Smoot-Hawley moment where the Congress, instead of reversing economic decline, has accelerated it.

William K. Black interviewed by Ian Masters on KPFK FM-90.7 – Los Angeles

William K. Black was interviewed by Ian Masters on KPFK FM-90.7 – Los Angeles. Click here to listen to the full interview. You can also listen to the full program.

Background Briefing with Ian Masters:

We begin by discussing the continued uncertainty about financial stability in the Eurozone, and the European Central Bank’s ability to weather the accumulating debt burden of Greece, Ireland, Portugal, Spain and Italy. William K. Black, the former litigation director of the Federal Home Loan Bank Board, who investigated the Savings and Loan disaster of the 1980’s, joins us to assess the exposure of German banks and how much they are hiding bad loans.

Pavlina Tcherneva on KPFK FM-90.7 – Los Angeles

Pavlina Tcherneva was interviewed by Ian Masters on KPFK FM-90.7 – Los Angeles. To listen to the interview click here.

Background Briefing with Ian Masters:

“we look into the state of economic literacy in the United States following the debt-ceiling debacle and the S&P debt-rating agency’s repudiation of the deal that has set off financial tremors around the globe. Research scholar at the Levy Economics Institute, Pavlina Tcherneva joins us to see if any lessons were learned from a brazen act of stupidity that has the nation’s self-inflicted financial wound getting worse as those responsible blame everyone but themselves.”

More Bad Beer From S&Ps David Beers

By Marshall Auerback

Like the horrible aftertaste that comes from throwing up the contents of one’s stomach after a night of binge drinking, the ratings agencies have reared their ugly heads again. David Beers, head of S&P’s government debt rating unit, announced Friday night that S&P has downgraded the U.S. credit rating for the first time, from AAA to AA. It’s a sham: S&P’s whole analytical framework reflects ignorance about modern money. If the US government, Treasury, and the Federal Reserve, capitulate to this outrageous act of economic extortion, it will effectively be sanctioning a beer hall putsch by the rentier class. 

Justifying its decision, Standard and Poor said “political brinkmanship” in the debate over the debt had made the U.S. government’s ability to manage its finances “less stable, less effective and less predictable.” It said the bipartisan agreement reached this week to find at least $2.1 trillion in budget savings “fell short” of what was necessary to tame the nation’s debt over time and predicted that leaders would not be likely to achieve more savings in the future.

“It’s always possible the rating will come back, but we don’t think it’s coming back anytime soon,” said Beers.

Of course, the response from Treasury was equally inane:

“A judgment flawed by a $2 trillion error speaks for itself,” a Treasury spokesman said last Friday.
$2 trillion, $4 trillion, who cares if the S&P is math-challenged?  It’s irrelevant!  The notion that the US can arbitrarily summon up the ability to register $4 trillion in “savings” demanded by Standard & Poor as the price for upholding America’s AAA rating is nonsensical, as it ignores the impact that the withdrawal of income will have on the overall economy and, by extension, the size of the government deficits that the ratings agencies regularly decry. An ex post outcome is never guaranteed by an ex ante action undertaken by government.  In other words, it’s not a number that can be controlled by the actions of political hacks in DC, so it’s truly pointless debating whether S&P screwed up on its calculations or not. And in their ideological zeal to demonize public debt and budget deficits, all of the ratings agencies are by definition relying on more private sector debt to drive growth, given that this is the only way to replace the government spending withdrawn. How did that work out for us in the last decade?

Treasury would have been on stronger ground if it had simply pointed out the sterling historic track record of the ratings agencies. Recall how well the S&P (along with Moody’s and Fitch) covered themselves with glory during the housing bubble, rating toxic subprime junk as AAA rated paper. Not only were the agencies politically corrupted by virtue of their incestuous ties to Wall Street, but criminally incompetent as well.  Yves Smith of Naked Capitalism gives a perfect illustration of the latter:

The biggest proof of criminal incompetence was their downgrades of RMBS versus CDOs made pretty much entirely of the same RMBS. They started downgrading RMBS en masse in July 2007. They didn’t start marking down CDOs until six month later, and the process took another six months. Yet it should have been impossible to downgrade the RMBS and not the CDOs at the same time. The downgrades were based on the failures of the underlying loans. You can’t have it show up in one product and not the other.

And S&P continues to screw up MBS ratings in the wake of heightened scrutiny (see here).
Credit ratings are based on ability to pay and willingness to pay.  And, as Alan Greenspan explained in 1997, a sovereign issuer always has the ability to pay:

[A] government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit.  

Whether it chooses to make those payments is another matter.  But that’s a matter of politics, not economics. 

To be fair to Mr. Beers, his agency did specifically cite the political brinkmanship of a number of US Congressmen, who seemed far too inclined to contemplate the option of default as a means of securing greater spending cuts on the part of the US government. But that wasn’t the full story. S&P placed particular emphasis on the size of the cuts, implicitly suggesting that larger cuts would have superseded the political questions. That’s intellectual dishonesty at its worst.

Here are a few questions the S&P ought to have considered before it issued its debt downgrade:
Is government spending so high that it is competing with private sector spending plans? Certainly not – substantial amounts of plant and equipment remain idle, unemployment remains at depression like levels, and there is ample capacity for firms to expand if they want to do so. Businesses, however, are constrained by inadequate demand for their output, a phenomenon which would become even worse if the US were to follow the prescribed level of cuts advocated by S&P to retain its AAA rating with these economic blackmailers.  That is a real cost (and it also drives those “horrible” government deficits higher, as tax revenues plunge and social welfare expenditures via the automatic stabilizers rise).

Is government issuing so much debt that it is causing interest rates to skyrocket? Not in the slightest. Rates have actually gone NEGATIVE in term yields under 12 months over the past few weeks (so much for the notion that the end of QE2 would drive rates sky-high).  We have a deflation problem, not inflation. Widespread austerity of the sort now advocated by the S&P is destroying economic growth and the claims by politicians and economists that we would enjoy a “fiscal contraction expansion” if only the government stopped “crowding out” the private sector are now being revealed as bogus propaganda.   And the political dysfunction that Mr. Beers describes could have easily been avoided through a number of options, which would not have left the country in the hands of irrational deficit terrorists.  As Joe Firestone notes:

Treasury can cease issuing long-term bonds, and sell only three-month bonds. Three-month bond interest rates are generally controlled by overnight rates for bank reserves, and overnight rates can be driven down to near zero by flooding the banks with excess reserves. That’s basically how the Japanese keep their bond interest rates near zero, and that’s how we can do the same.

Firestone is right: A sovereign government like the US only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward whatever rate the central bank offers to pay commercial banks for excess overnight reserves.

Even with our existing legal constraints (predicated on a now non-existent gold standard system in which we are forced to sell bonds before Treasury spends), Treasury/Fed have other tools to counteract the alleged effect of this downgrade.  Mr. Bernanke can simply call up the NY Fed and gives Mr. Dudley instructions to buy all the 10-year UST on offer to keep the US 10 year at, say 2.5%. It is an open market operation, which the Fed performs all the time. And the banks cannot lend out these reserves, so it’s not inflationary (see here for more explanation). Then, as Rob Parenteau and I have noted before, every time some so-called “bond market vigilante” tries to push it above 2.5% by shorting Treasuries, the Fed can slam their face into the concrete by having the open market desk buy the hell out of UST until the 10 year yield is back to 2.5%. Burn Fido enough times, yank his chain enough times, and like the Dog Whisperer, he gets it and stops.

Think this can’t be done if the ratings agencies downgrade the US?

Japan is a perfect illustration of how little these downgrades impact borrowing rates for a sovereign government (thanks to Bill Mitchell):  In November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody’s Investors Service began the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. The next major Moody’s downgrade occurred on September 8, 2000.

Then, in December 2001, Moody’s further downgraded the Japan Governments yen-denominated bond rating to Aa3 from Aa2. On May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana, Chile and Hungary.  This at a time when the Japanese economy was then almost 1,000 times the size of Botswana’s, had the world’s largest foreign reserves, $446 billion; the world’s largest domestic savings, $11.4 trillion; and about $1 trillion in overseas investments.

In a statement at the time, Moody’s said that its decision “reflects the conclusion that the Japanese government’s current and anticipated economic policies will be insufficient to prevent continued deterioration in Japan’s domestic debt position … Japan’s general government indebtedness, however measured, will approach levels unprecedented in the postwar era in the developed world, and as such Japan will be entering ‘uncharted territory’.”

“Uncharted territory” – well, the last time anybody looked, the Japanese government was still comfortably issuing 10-year government debt at around 1%. That Japan’s debt is largely domestically held is irrelevant: the denomination of the debt, NOT the debt holder is the key consideration. 
There are only two sectors to issue bonds to, the domestic private and international. US and Japan are on opposite ends of the spectrum, with the US issuing a lot to the latter (though still more domestically in fact), and Japan issuing a lot to the former. The interesting thing is that this hasn’t mattered at all in the determination of rates–the key difference affecting relative interest rates between the US/Japan and, say, the periphery countries of the euro zone, has been the nature of the monetary system–the US/Japan are currency issuers under flexible foreign exchange, whilst the member states of the European Monetary Union are not.  As Scott Fullwiler indicated to me in a recent email exchange, “For the former, rates follow monetary policy; for the latter, rates follow markets’ perceptions of default risk. This is why for the former credit rating downgrades are complete monetary non-events, like QE. Note further that if the int’l sector were to stop buying US debt, this just means that the US trade balance improves and the breakdown of government debt sales starts to look more like Japan’s.”

To argue otherwise is to ignore the actual causation of the transaction, which is that China exports something to the US in exchange for dollars, and then that money goes into their checking account at the Federal Reserve. It’s called a reserve account because it’s the Federal Reserve, and they give it a fancy name. But in reality it is a checking account, just like you or I use. Now China has 3 choices with what they can do with the money in their checking account. They could spend it and buy real assets in the US, which would be great for our economy, or they can put it into another currency (say, euros), in which case the dollar declines, which enhances our export position, or they can put it in another account at the Federal Reserve called a Treasury security, which is nothing more than a savings account. In other words, the bond purchase, if it occurs, comes at the end of the transaction and actually ‘funds’ nothing.

Economist Warren Mosler has noted on numerous occasions that China and others buy US Treasury securities primarily to support the dollar versus their own currencies, and thereby drive exports to the US, and not because they are looking for safe investments per se. That is, it’s a consequence of their drive for ‘competitiveness’ and their desire to net save in US dollars. It takes two to tango. And with no Treasury securities China would be forced to buy state debt, corporate debt, euro debt (say, Greek bonds?), equities, etc. which is highly problematic for them for a variety of reasons.

A final question for Mr. Beers: Is government spending so high that the dollar is crashing in international exchange markets? No. Certainly the dollar has its ups and downs — we’ve got a floating exchange rate and it is supposed to go up and down.   So let’s assume that our dollar falls because China no longer wishes to net save in greenbacks. In fact, this has been occurring over the past several months and the bond market has gone up during this period.  If this were to go on long enough, the ultimate impact would be that our external balances improve significantly (as does the likely desire of foreigners to accumulate cheap US assets via FDI), because our exports increase, which means the current account deficit goes down and less bonds are available for China to ‘fund’ us”.

Now that’s not the way I would go as a growth strategy, as it entails a “race to the bottom” as far as wages go.  Moreover, if budget deficits are not allowed to grow large enough to enable private domestic agents reduce their overall debt levels, then the economy will remain mired in its stagnant state. With austerity being pursued everywhere it is a fool’s hope to think that net exports are going to swing enough to save the day. But from a straight sectoral balances point of view, IF we did export more, these increased exports would mitigate the ability of countries like Japan or China to net save in our currency.  By definition, this would also correspondingly reduce their holdings in US Treasuries.

Floating rates float. This is not synonymous with economic and financial degeneracy, as our economic moralists, or the gold bugs seem to imply. Over the past 10 years, the Australian dollar has fluctuated between 50 cents to $1.08 against the greenback.  The last time I looked Australia was still surviving and thriving. One can also consider the more extreme case of Russia in 1998, during which its entire financial system imploded and the ruble lost two thirds of its external value against the dollar.  Yet the currency itself did not “evaporate” and the ruble remains Russia’s currency unit of account today.

It is questionable how much of this deficit austerianism is ideological and how much is really a misunderstanding (an “innocent fraud” in the words of John Kenneth Galbraith). Governments around the world have been led to believe that they need to issue bonds and collect taxes to finance government spending, and that good policies should be judged by their ability to enforce fiscal austerity. Mainstream economists and ratings agencies such as S&P have guided policymakers into imposing artificial constraints on fiscal policy and government finances, such as issuing bonds when running deficits, debt ceilings, forbidding the central bank to directly buy treasury debt, allowing the markets to set interest rates on government bonds, etc.  While last Friday’s downgrade per se probably won’t do much, if anything, to interest rates, growth, and employment, ratings agencies like the S&P reinforce the current deflationary state of affairs because their perverse rating actions simply reinforce efforts for further substantial deficit reduction and a balanced budget amendment. Ironically, if the siren songs of “sound finance” are followed, we will get exactly the outcome now predicted by the likes of Michelle Bachmann:  the US WILL become like Greece.

Paul McCulley on Bloomberg on Minsky, Liquidity Traps, Euro, and Fiscal Policy

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Why Won’t Progressives Act Like Progressives?

By Stephanie Kelton

Paul Krugman just addressed a plea from Cullen Roche, who implored him to throw his considerable weight behind a proposal for a payroll tax cut to help bolster the fledging recovery.  Krugman doesn’t really take a position for or against the proposal but instead suggests that it is DOA because the GOP doesn’t support it. Well WTF?

Is this really what it’s come to?  Experts in the field — even those with a Nobel Prize — can’t stand up for what they believe in unless they consider it politically feasible? An extension of the payroll tax cut — or, far better, a full payroll tax holiday (a 0% withholding for employers and employees) should have been a key component of the stimulus from the beginning.  But the deficit doves (the most high-profile progressives out there) never supported it.  Had they advocated such a policy, there’s a good chance the economy would be on sound footing by now.  But they did not, and impatient voters delivered the House to the GOP.  Now Social Security — along with Medicare and Medicaid — will be sacrificed at the alter of the deficit hawks.

Many of us called for a full (0% deduction) payroll tax holiday (employer AND employee) more than 2 years ago, but the beltway “progressives” all fought against it, preferring instead to accept the conservative frame that these programs face long-term solvency problems that can be “fixed” by chipping away at the very programs they claim to be defending.

I agreed (here) with Professor Krugman’s point about the politics of a payroll tax  — Republicans will do whatever they can to prevent the economy from improving before Nov. 2012. But it is the President’s job to call them out — publicly — and make them explain why they are opposed to reducing/eliminating this regressive (and anti-business) tax.

Oh, and S&P just downgraded the US.  BFD.