Monthly Archives: July 2009

Washington Finally Proposes Real Help to Deal with Foreclosures

By L. Randall Wray

The Washington Post reported on Friday that Washington is finally considering meaningful steps to deal with the on-going foreclosure crisis. The article reports:

“A top Treasury Department official told a Senate panel yesterday that the government is considering a proposal to allow homeowners to stay in their home as renters after a foreclosure.”

The administration appears to be conceding that all of its proposals to date have been complete flops. The report goes on:

“Under the federal program known as Making Home Affordable, lenders are paid to lower borrowers’ mortgage payments. About 160,000 loans have been modified into lower-cost loans so far. The administration has said the federal effort has already been more successful than previous programs.”

That program was designed by the lenders, who wanted yet another government hand-out. But it was doomed to fail because mortgages that have been packaged into complex securities cannot be modified easily. If, instead, the government had directed aid to homeowners from the very beginning, it could have slowed the downward spiral of real estate markets. Reports yesterday put the number of foreclosures this year at another 2 million, with similar projections for next year. What is needed now is relief for the millions of families who have lost, or will soon lose, their homes.

Allowing families to stay on as renters after a foreclosure is a step in the right direction. However, the government should go further by following the plan put forward by Warren Mosler, as I summarized previously:

When banks begin to foreclose, the government would step in to purchase the property at the lower of market price or outstanding mortgage balance. Establishing market price in a glut is not simple, but it is not impossible. Mosler proposes that the federal government would rent homes back to the dispossessed owners (Dean Baker has a similar plan) for a specified period (perhaps two years) at fair market rent. At the end of that period, the government would sell the home, with the occupant having the right of first refusal to buy it. Reducing evictions by offering a rental alternative will help reduce the pain of foreclosure. It might also allow the process to speed up (with smaller losses for banks) since many families would choose to stay-on as renters, with the possibility that they could later buy their homes at more reasonable prices.

The Sector Financial Balances Model of Aggregate Demand

By Scott Fullwiler

Paul Krugman’s recent post indicates that perhaps those of us taking a stock-flow consistent approach to macroeconomics may be making some headway. My fellow blogger, Rob Parenteau, and another friend, Bill Mitchellboth describe many of the details of this approach and how they fit the graph posted by Krugman. Rob is correct to suggest this would be a much better framework for understanding macroeconomics than the traditional IS-LM model, which was highly flawed to begin. My purpose here is to build on both of these posts and demonstrate a few uses of the model (thus, those not familiar with this framework should read Rob’s and/or Bill’s posts first, probably).To begin, consider the graph in Krugman’s post below:

Continue reading

Employing Krugman’s Cross: Farewell, Mr. Hicks?

By Robert Parenteau

Paul Krugman’s July 15th blog post diagramming financial balances makes some important steps in revealing the analytical power of the financial balance approach to macroeconomics – something once understood by J.M Keynes and early Keynesians like Nicholas Kaldor, Abba Lerner, and Joan Robinson, but long since lost in the headlong rush over the past three decades of mainstream macroeconomics to become a special branch of microeconomics, which itself appears to have become a special branch of applied calculus in some sort of rather twisted physics envy. I suspect reading Minsky has helped Paul immeasurably in seeing these relationships, and I would urge him and others to go find some of Wynne Godley’s contributions (many of which are available online at the Levy Economics Institute) to a stock/flow coherent macroeconomics, and it may all become that much clearer.

The diagram Paul presented at first (reproduced below) threw me for a loop, but I believe I now see what he was doing, as the labeling did not initially make it clear, and perhaps by walking through Paul’s diagram, others can avoid my initial confusion.

The upward sloping line should be labeled the private sector financial balance (PSFB), and the downward sloping line should be labeled the government financial balance (GFB). Only the part of the PSFB schedule above the horizontal axis is in surplus, if this horizontal GDP axis crosses the vertical sectoral financial balance axis at zero. Similarly, only that part of the GFB schedule above the horizontal axis is in deficit. I believe Paul has defined the vertical axis such that the range above zero represents a rising PSFB, and at the same time, a falling GFB of the same absolute amount, but of opposite sign. Then the area below zero is a falling PSFB and a rising GFB. Above zero represents a private sector financial surplus and a government deficit, while below zero represents a private sector deficit and a government surplus.

Confusing at first, but this follows because Paul has simplified the analysis to two sectors, and sectoral financial balances must balance ex post for any accounting period. The range above zero representing a private sector surplus must also represent a government deficit (GFB must be of equal magnitude but opposite sign to the PSFB). This would seem consistent with Paul’s GFB schedule falling below zero as GDP increases, since a falling fiscal deficit would eventually give way to an increasing fiscal surplus as income increases if automatic stabilizers work as we believe they do (see previous post here). Similarly, the rising PSFB schedule is consistent with traditional Keynesian stability conditions, with saving increasing faster in income than investment does, although we should all keep in mind, as Minsky emphasized, that explosive growth dynamics (Minsky’s upward instability) can arise in economic expansions characterized by euphoric asset pricing. Hence, the last two US business cycle expansions have been characterized by a falling PSFB (that is, deficit spending by the household and business sectors combined), not a PSFB rising as income rises, but that can be accommodated in less simplified versions of Krugman’s cross.

Another way to see why this interpretation of the diagram must be correct is that when the PSFB schedule shifts up and to the left, representing a higher desired net private saving at each level of income, the new point of intersection with the GFB schedule would, for example represent a new short run equilibrium point where say a $250b net private saving position is met by a $250b fiscal deficit. Again, sectoral financial balance must balance ex post (as explained in prevoius posts here and here). If one sector is running a net saving or surplus position, the other sector must be dissaving or deficit spending. That is the tyranny of double entry book keeping – not high Keynesian theory.

If I now have the orientation of the diagram straight in my head (and this is the only way I can see that it makes sense), those who believe in fiscal rectitude may wish to notice two aspects of the world we live in. If you view a balanced fiscal budget as the ultimate and over riding goal, you can get there one of two ways from Paul’s second PSFB schedule (the higher line we seem to have shifted to, as asset prices and profitability have collapsed over the past year, thereby forcing lower private investment and driving saving out of private income flows higher).

To arrive at a fiscal balance, you can shift the GFB schedule down and to the left by jamming tax rates higher and lowering the government spending propensities out of tax revenue income until the GFB schedule intersects the PSFB schedule at the point where the PSFB schedule crosses the horizontal axis at the zero financial balance mark. Notice the level of income the economy is then operating at, and all of you who pay dues to the Concord Coalition, please consider whether existing private debt loads could actually be serviced at that lower level, since most private debt contracts are fixed nominal payment commitments. Think post Lehman bankruptcy, on steroids, and you might get a taste of what you are praying for with perpetually balanced fiscal budgets.

The second way to get to a fiscal balance is to encourage the PSFB schedule to shift down and to the right until it intersects the GFB schedule at the point at which it crosses the horizontal axis. That means increasing incentives for the private sector to invest more money at each income level and save less money at each income level. Given the residential housing stock overhang, and the need for households to save out of income flows if they cannot rely on serial asset bubbles to deliver the appropriate nominal net worth at retirement, that means ways must be found to encourage US businesses to pursue a higher reinvestment rate in the US, rather than borrowing money to buy back shares to boost stock prices or reinvesting abroad. Not easy, but not impossible either. Notice also that the second form of adjustment leaves you at a higher equilibrium income level, and the existing private debt to GDP ratio will stabilize, since there will be no additions to the private debt stock, as net private deficit spending is zero at the new income flow level.

Of course, this should all eventually be recast in dynamic terms. For example, income won’t grow unless the GFB is continually shifting up and to the right, or the PSFB is continually shifting down and to the right (or some combination of the two). There is also no obvious endogenous mechanism shifting the PSFB toward a position of full employment income over time, given the position of the GFB. Of course, in theory, policy could be geared such that given reasonable estimates of the likely position of the PSFB schedule, the GFB schedule could be shifted out (or less likely, in) to achieve the level of income associated with full employment. Alternatively, fiscal policy could be structured so the GFB schedule could be perfectly vertical at the full employment level of income, which in many ways is what an employer of last resort (ELR) driven fiscal policy attempts to do.

Finally, for those insistent that public and private debt to income ratios must be held fixed from here to eternity for whatever reason, then starting from Paul’s initial equilibrium, income growth could only be accomplished if the PSFB schedule could be encouraged to shift outward, and the GFB could be shifted in concert such that either the realized financial balances of both sectors were kept at zero, or there was some cycling between the two, such that periods of private sector financial deficits were followed by periods of government sector deficits of similar magnitude and duration.

The trade balance must also be brought back into the story, as a trade surplus is the only way both the GFB and the PSFB can maintain a net saving position at the same time (assuming for whatever reason that was a worthy goal), but at least it is a promising start at representing how sectoral financial balances are related, and it reveals many of the misconceptions that unnecessarily cloud the debate.

If the Krugman Cross does nothing more than provide a stepping stone away from the dead end trap of the Hicks/Harrod/Meade IS/LM diagram, then this is a useful initial contribution. Caught under the spell of IS/LM conventions, Paul and other New Keynesians have spilled far too much ink trying to devise ways of instituting negative real interest rates to get the economies out of a balance sheet driven recession. With policy rates near zero, this analysis has devolved into arguments about how best to increase inflation expectations or actual inflation in order to achieve a sufficiently negative real interest rate. From a practical point of view, the last thing households facing heavy debt servicing loads with falling wage and salary incomes need are rising consumer prices that drain their already reduced discretionary income. Households need higher money incomes, not higher consumer prices, expected or actual, to exit their current difficulties. Real interest rates are diversion from the real problem at hand in a balance sheet recession, which is how to get the economy to a point where money income levels can service most private debts. Krugman’s Cross makes it obvious – shift the GFB schedule in response to shifts in the PSFB schedule.

As always, we must be careful about sliding between the usual ex ante/ex post distinctions, as the income multiplier lies masked behind these interactions, as does the reconciliation of new liability issuance with portfolio preferences, among other balance sheet and asset price considerations that must be brought into play for a coherent stock/flow macroeconomics, of which Hick’s IS/LM approach was a pale shadow that concealed more than it revealed.

For example, the private sector may plan to net save more at any given expected income or GDP level, but unless some other sector net saves less or deficits spends more, private incomes will adjust downward, and the desired private net saving will be thwarted, paradox of thrift style. If Paul recalls his reading of Keynes’ General Theory (and he is to be applauded for being one of the few New Keynesians to actually read Keynes in the original), this is one of the reasons Keynes argues incomes adjust to close gaps between intended investment and planned saving. Interest rates do not equilibrate investment and saving – incomes do, in Keynes’ General Theory. Paul has taken a very large step in this direction with his financial balance diagram, which hopefully he will find more powerful than his IS/LM analytics which he employed in the case of the Japanese balance sheet recession.

Specifically, Paul refers to the need for net private saving being “absorbed” by the public deficit spending. That assumes the net private saving can exist without some other sector deficit spending at the same time, which is impossible. William Vickrey and James Tobin used to make a similar slip, with Vickrey arguing the private saving had to be recycled by public deficit spending (see Vickrey’s otherwise useful piece on 15 fundamental fallacies, linked at CFEPS here.

In Paul’s 2 sector model, unless the public sector spends more money than it takes in as tax receipts, the private sector cannot earn more money than it spends, no matter what its plans or intentions or ex ante designs. Net private saving is created, allowed, or constrained by the size of the public deficit. Net private saving cannot exist as anything more than a hope and a prayer unless some other sector is willing and able to deficit spend. Ex post, in a 2 sector model, as a matter of basic accounting, the net saving of one sector must be equal to the net deficit spending of the other. That is the short run accounting “equilibrium” or reality.

Moving beyond a simple 2 sector model to the world we actually inhabit, it is really as simple as this. The US household sector cannot net save in nominal terms (spend less money than it earns) unless some other sector (or combination of sectors) is willing and able to spend more money than it earns.

It can be the government, the business, or the foreign sector or some mix of the three that net deficit spends – take your choice. But keep in mind, of the three, a government with a sovereign currency (not convertible into fixed quantities of a commodity or another currency on demand) and no debt denominated in foreign currencies is the only one of those three that cannot go bankrupt and cannot default on its debt while continuously deficit spending – unless it chooses to default for some odd political reason.

The sooner we face this fundamental reality of contemporary monetary and economic arrangements, the better. It does not require swearing allegiance to high Keynesian theory – it is simply an accounting reality. Reject it, and you will also have to throw at least seven centuries of double entry book keeping out the window as well.

Since the US economy does appear to have entered a debt deflation spiral for the first time in a lifetime, and it does appears that the spiral has been contained for the moment by a reduction in the trade deficit and a surge in the fiscal deficit, it might be a good time for economists, investors, policy makers, and the general public to once and for all find some clarity on these questions regarding financial balances and the economy. Perhaps Paul’s simple back of the napkin diagram of financial balances takes us one step in that direction.

A note on Automatic Stabilizers

What has so far prevented a deep depression in 2009? The answer, as Paul Krugman explained yesterday, are automatic stabilizers. Indeed, as Hyman Minsky emphasized more than 20 years ago in his book Stabilizing an Unstable Economy (1986), this feature of the federal government’s budget – i.e. the fact that it moves counter-cyclically in an automatic fashion – imparts a great stabilizing force to aggregate demand.

The figure below sheds light on the non-discretionary (i.e. automatic) nature of government deficits. In an economic downturn, tax receipts automatically fall, and government expenditures automatically rise, resulting, automatically, in budget deficits. (net govt saving = right hand scale)

Source: Bureau of Economic Analysis (BEA)

The components of government spending that rise automatically are called ‘transfer payments’, that include unemployment compensation, Medicaid, grants-in-aid to state and local government, etc.
With these forms of payment increasing and tax receipts declining due to falling economic activity, the federal budget moves automatically into deficit.

Source: Bureau of Economic Analysis (BEA)

So far the stimulus package was not what saved the US economy. The budget projections show that 24% of the total cost of the stimulus package will occur in fiscal year 2009 (which means $198 billion) and 47% of it occurring in fiscal year 2010.

“The ARRA is estimated in the budget to cost $825.4 billion over the next 10 years. These costs are split between $600.0 billion in increased outlays and $225.4 billion in reduced receipts. Although the cost of the ARRA is spread over 10 years, the budget projections show 24 percent of the total cost occurring in fiscal year 2009 and 47 percent of the total cost occurring in fiscal year 2010…The budget estimates that receipts will be reduced $77.4 billion in fiscal year 2009 and $152.3 billion in fiscal year 2010 primarily because of the tax provisions of ARRA… The budget estimates that outlays will be increased about $120.2 billion for fiscal year 2009 and $237.8 billion for fiscal year 2010 because of the spending and investment provisions of the ARRA.”

As noted in previous posts (here, here, and here), government deficits, themselves, perform an important stabilizing function, because they allow the private sector to net save. Given that during a recession there is a sharp increase in uncertainty and insecurity, the private sector desires to spend less than its income which translates into a rising personal saving rate. In the current recession, the forecast is that the personal saving rate will reach 10% in 2009 and that jump to 14-16% by 2010. Such large decline in consumption means falling sales, production and further declines in GDP. As noted above, to meet the private sector rising saving desire the government should run bigger deficits to prevent a deflationary spiral.

Source: Jan Hatzius, Goldman Sachs

As Minsky emphasized, the problem, during the Great Depression, was that the government sector was too small relative to the rest of the economy; it couldn’t fill the demand gap and allow the private sector to save as much as it desired. In the absence of large enough automatic stabilizers to offset swings in private spending, GDP contracted to the point where desired net nominal saving equaled actual net nominal saving. Note that in second half of the last century, given the private sector’s desire to have positive net nominal saving, the US government normally ran budget deficits.

As Wray pointed out, “Since WWII we have had the longest depression-free period in the nation’s history. However, we have had nine recessions, each of which was preceded by a reduction of deficits relative to GDP.” This directly results from the impact of large swings in the federal government’s budget.

Automatic stabilizers work by putting a floor under aggregate demand, preventing a deflationary spiral, but they also put ceilings in place, as rapid economic growth translates into rising tax revenues which destroy income and temper the expansion. The impact of large automatic stabilizers explains why we can have a deep recession but not a Great Depression. As Wray noted:

“With one brief exception, the federal government has been in debt every year since 1776. In January 1835, for the first and only time in U.S. history, the public debt was retired, and a budget surplus was maintained for the next two years in order to accumulate what Treasury Secretary Levi Woodbury called “a fund to meet future deficits.” In 1837 the economy collapsed into a deep depression that drove the budget into deficit, and the federal government has been in debt ever since. Since 1776 there have been six periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. (Thayer 1996) The United States has also experienced six periods of depression. The depressions began in 1819, 1837, 1857, 1873, 1893, and 1929. Every significant reduction of the outstanding debt has been followed by a depression, and every depression has been preceded by significant debt reduction. Further, every budget surplus has been followed, usually sooner rather than later, by renewed deficits. However, correlation—even where perfect—never proves causation. Is there any reason to suspect that government surpluses are harmful?”

Gift-Wrapping the White House for the GOP

by Stephanie Kelton

It looks like Christmas has come early for one of President Obama’s most vocal critics. Rush Limbaugh said he hoped the president would fail, and the GOP is doing everything it can to make sure he does. The party stands united in its opposition to a (much-needed) ramping up of the federal stimulus effort. And, at the moment, the president is playing right into their hands.

Sen. Jon Kyl, R-Ariz., has called the $787 billion stimulus effort a “flop,” adding:

“The reality is, it hasn’t helped yet. . . Only about 6.8 percent of the money has actually been spent. What I propose is, after you complete the contracts that are already committed, the things that are in the pipeline, stop it.”

In other words, he thinks the stimulus isn’t working because the government isn’t spending the money FAST enough. And, with the lion’s share of the spending about to kick in, he wants to scrap the entire effort, just to make sure it won’t work.

The only thing more disappointing than hoping the president – any president – will fail is actively working to keep millions of Americans unemployed in order to score political points in the coming election. But that’s exactly what’s happening, and the president may be painting himself into a losing corner.

President Obama has insisted that: (1) the stimulus is working as planned; (2) a second stimulus is not needed; and (3) he will cut the deficit in half by the end of his first term.

If he sticks to his guns, I believe he will dig his own political grave (not to mention prolonging the agony for millions of Americans). He cannot have it both ways. He cannot reverse the effects of the worst economic downturn since the Great Depression and do it on a shoestring.

That isn’t to imply that $787 billion is chump change, but it pales in comparison to the losses that have already been borne by homeowners, businesses and investors. As Dean Baker recently pointed out, annual consumption is down about $700 billion (due to the loss of roughly $16 trillion in real estate and stock market wealth). Add to that “a reduction in annual rates of construction of about $450 billion” and a decline of “approximately $200 billion” in demand due to losses in the non-residential sector, and Baker says we’re looking at an annual loss of about $1,350 billion. And we’re trying to offset it with $300 billion or so (the annual stimulus) in spending by the federal government! It’s like using an umbrella to stop an avalanche. It won’t work.

But it gets worse, because Baker’s figures don’t account for the void that has been created by state and local governments, where expenditures have fallen by more than $64 billion in the last two quarters alone. And, with virtually every state bracing for even bigger cuts next year, we could easily lose another $100 billion or so in fiscal 2010. Then, of course, there’s the multiplier, which has been hard at work, exacerbating the magnitude of these cuts and costing us untold trillions in lost GDP.

But the president seems convinced that $787 billion will do the trick – at least according to his definition of the trick. You see, the Obama administration has not set the bar very high, and this seems to be why the president believes the stimulus has “worked as intended.” As he explained, it “wasn’t designed to restore the economy to full health on its own, but to provide the boost necessary to stop the free fall.” And this is why even bad news – e.g. 565,000 people filing first time jobless claims – can be interpreted as an indication that the stimulus is working as intended. (Recall that this was the smallest number since January 2009.)

Indeed, the president’s top economic advisors have always been careful to use the words “create or save” when describing the objective of the stimulus plan. And this means that net job creation isn’t the goal. The economy can continue to lose jobs faster than it creates them, and the policy will be described as “working” because the stimulus money helped at least some workers keep their jobs.

So the stimulus may be working “as intended,” but I don’t think the president can rely on semantics to carry him to victory in 2012. 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. I have outlined my twelve-step recovery program, and others on this blog have put forward similar ideas. A payroll tax holiday that cuts FICA contributions to zero will provide immediate relief to millions of working families and their employers, boosting take-home pay as well as business profits. An additional $1,000 per capita will help ease the on-going budget crisis so that states can avoid further cuts to education and social services. A job-guarantee program, modeled on the WPA, will provide useful work and retraining opportunities for the many Americans who will not find jobs even after the economy recovers. Investing in our nation’s infrastructure – roads, bridges, transmission lines, etc. – will address years of neglect and improve the safety and security of all Americans.

These are the kinds of tangibles the American people will think about when they decide for themselves whether the stimulus was a success. At the end of the day, President Obama must cut loose the deficit bogy and abandon any date-specific goal for cutting the deficit in half. It is his Achilles heel. Let the deficit (and the debt) go where it will. With a sufficiently flexible fiscal response, GDP will explode, tax receipts will pour in, and the dreaded debt-to-GDP ratio will drop like a rock.

Why Negative Nominal Interest Rates Miss the Point, Part II—Understanding the Excess Reserve Tax

By Scott Fullwiler

My previous post critiquing Scott Sumner’s (and others’) proposal for negative nominal interest rates brought a most welcome response from Prof. Sumner in the comments section. The comments section has a character limit that I’m sure to go over in response to his response, however; hence this post. The core of my reply and critique here is twofold: first, Sumner misunderstands the Fed’s monetary operations, particularly the details of reserve accounting (that is, the dynamics of changes to the Fed’s balance sheet); and second, the proposal assumes the textbook money multiplier when in fact this doesn’t apply to the U.S. or any other nation not operating under a fixed exchange rate policy such as a gold standard or currency board.

Sumner’s original proposal, as he notes in the comments, can be found here. The basics of the proposal are that the Fed would set a modestly negative rate to be paid on bank excess reserves (ERs; he has discussed rates -2% and -4% on his blog); given this penalty, banks would then be encouraged via the monetarist “excess cash balance” mechanism, as he describes it (i.e., the money multiplier) to create deposits that would thereby transform these ERs into required reserves that would not be subject to the penalty. The problem the proposal supposedly solves is that banks are “sitting” on their excess balances (currently around $700 billion) and need an incentive to “move [ERs] into cash in circulation.”

Turning to reserve accounting, consider Sumner’s comment on my original post:”The proposal would not drive interbank loan rates significantly negative, as banks could always exchange ERs for T-bills. And T-bill yields could not go significantly negative because non-bank holders of T-bills can always hold cash.”
As a small aside, I’m puzzled why he would think my critique centered on the interbank rate or T-Bill rate, as my critique was instead directed at the “excess cash balance” mechanism or money multiplier; that these rates might turn negative is not necessarily problematic in my opinion, but that’s what will happen, so I noted as much. But I digress.

Sumner’s statement “banks could always exchange ERs for T-bills” misses an important point . . . namely because this transaction would not extinguish the reserve balances, but rather move them to the (in the case of a non-bank seller) seller’s bank. So, let’s assume that the seller’s bank had no undesired ERs prior to the sale. Now, after the sale, it DOES have undesired ERs (while, yes, the non-bank seller can now hold deposits or CDs or whatever).

The fundamental point here is that ONLY changes to the Fed’s balance sheet can change the aggregate quantity of reserve balances held by banks. In other words, the Fed is the MONOPOLY supplier of net reserve balances to the banking system. This is not an opinion or a theory, but rather a FACT of double-entry reserve accounting . . . aggregate reserve balances are on the liability side of the Fed’s balance sheet, only a change somewhere else on the Fed’s balance sheet can alter them. And the T-bill purchase Sumner describes does not involve the Fed’s balance sheet.

In fact, the only way a T-bill purchase would extinguish reserve balances as Sumner proposes is if the purchase is done at auction (from his quote, clearly not what he was intending), which would in fact be a roundabout way of having the Fed simply add balances to the Treasury’s account (again, I’ll assume he wasn’t intending this with his proposal).

So, if we have an aggregate banking system with some undesired excess balances, the banks individually can trade these among themselves however they want (fed funds market, T-bill transactions, repos, and so forth), but the undesired excess simply moves from bank to bank, never going away. It’s well established in the academic literature on the fed funds market that this brings the fed funds rate down toward the level paid to banks on reserve balances (which Sumner’s wants negative). Hopefully it’s clear, though, that my criticism in this case is not and was not about the fact that the interbank rate would fall, but rather about the inherent misunderstanding of reserve accounting in the proposal (and, alas, in Sumner’s comment above).Very briefly to his point on T-bill rates, any individual bank will purchase T-bills at yields higher than its marginal return on ERs at the Fed. These purchases move those reserves to other member banks, which then do the same, thereby driving T-bill rates down to or even below the Fed funds rate. Furthermore, negative T-bill rates have for technical reasons in fact been a common occurrence in both Japan and the U.S.

For a little more detail, consider Sumner’s following comment from his original proposal: “We also know that banks hold very low levels of ERs any time the opportunity cost (in terms of the T-bill alternative) is even modestly positive. Thus in the summer of 2008 when the target rate was only 2%, ERs were still very low.”
Wrong. Banks DESIRE to hold low levels of ERs when the opportunity cost is even modestly positive. But they will by definition in the aggregate hold as many as the Fed leaves circulating, since the Fed is the monopoly supplier of aggregate reserve balances. Prior to September 2008, the Fed ACCOMMODATED banks’ desire to hold low levels of ERs by draining any additional balances via reverse repos and such—a process that had become very complicated starting in August 2007 (but that’s a long story in itself). Virtually every other central bank does the same under normal circumstances.

After September 2008, circumstances were not normal, as the Fed (in its view, at least) no longer had enough purchased assets to sell or repo to drain any undesired ERs created via its various standing facilities. Consequently, while banks individually actually may have DESIRED to hold lower levels of ERs (though their desired quantity was admittedly increased above normal given substantial concerns about counterparty risks), in the aggregate, they had no choice but to hold a larger quantity (again, though, the Fed’s repeated flubs with instituting payment on reserve balances kept the fed funds rate well below the target and thereby minimized any opportunity cost that might have existed).

I don’t want to dwell on this particular point too much, as it moves a bit too far ahead given that, for Sumner’s proposal, at issue isn’t the aggregate quantity of reserve balances but rather how to transform the ERs to required reserves. But clarity on reserve accounting in monetary operations is absolutely essential, as we’ll see again below.

As for transforming the ERs to required reserves, Sumner writes in his original post that “from a monetarist excess cash balance perspective, the problem is the hoarding of ERs by banks.” So, now quoting from his comments on my post, his excess reserve tax proposal is intended “to move ERs into cash in circulation . . . [as it] . . . relies on the monetarist ‘excess cash balance’ mechanism.” From his original post, “a penalty rate on ERs of say 4% should bring ERs down to extremely low levels.”

That is, penalizing banks for holding ERs is proposed in order to encourage banks to create more deposits, thus raising reserve requirements and lowering the relative quantity of ERs among existing reserve balances.

This is the money multiplier framework, which is inapplicable to the US monetary system, as noted above. So what this errant view does is cause Sumner to get the problem wrong.

To see why, consider a bank with no ERs at all. Suppose a credit worthy customer comes through the door and wants a loan and the bank deems the loan profitable. Does the bank have the operational ability to create the loan? In EVERY country not operating under a fixed exchange rate system such as a gold standard or a currency board, the answer is YES. As I have explained in previous posts (here and here), if the bank ends up short on its reserve requirements, it incurs an overdraft automatically from the Fed at a stated penalty rate as a matter of accounting. In practice, this wouldn’t actually occur for at least 2.5 weeks given lagged reserve accounting in the US, by which time the bank’s liquidity manager would have raised any required funds via any number of sources, but that’s not really the point.

The point is that the reserve requirement can only impose a “cost” penalty on the bank, not constrain it from lending. Further, in the aggregate, central banks act to avoid such additional costs which would cause the interbank rate to trade above the central bank’s target rate by ACCOMMODATING the banking system’s demands for balances to meet reserve requirements before such overdrafts occur. They do this out of necessity since leaving banks in the aggregate short of meeting requirements would mean that deficient banks would bid the interbank rate up as they tried to entice other banks to lend, pushing the rate up above the central bank’s target until it reached the central bank’s stated penalty for a reserve deficiency. At this point, banks would be theoretically indifferent between borrowing from another bank and simply incurring the overdraft at the same rate.

Now consider a bank with substantial ERs. Does it have any more operational ability to create a loan than the bank in the previous example? Certainly not, as the bank in the previous example has NO operational limits to its abilities to lend–it will obtain any necessary reserves from other banks and the central bank will provide more to the aggregate system should that be necessary to achieve its target rate.

The only instance in which the previous bank might change its plans is where a central bank does not accommodate its interest rate target but instead provides the overdraft at a penalty to a deficient bank. But all this would do is raise the interest rate the bank would be willing to lend at (since its own costs would have risen via the penalty). So, again, the bank would not be constrained by reserve availability. It just means that infinite funds would still be available but at a higher interest rate. Again, this has not been the practice of modern central banks (even for the Fed during its so-called “monetarist experiment”).

As an aside, let’s state this another way. That is, a central bank that attempts to target the quantity of aggregate reserve balances such that it forces individual banks to meet reserve requirements via overdrafts at a penalty is NOT targeting directly the quantity of reserve balances but rather setting a de facto target at its stated penalty rate. As Warren Mosler says, central bank operations are ALWAYS about price, not quantity, as a matter of institutional structure.

Now assume that the excess reserve tax is imposed on the bank holding the ERs. Does this make it more likely to lend? Given that the ERs don’t give it any more ability to create a loan in the first place, unless the tax somehow gets the bank to lower its lending standards (not necessarily the best idea given the current status of banks), the answer is clearly NO.

What the tax DOES do is encourage the bank to get rid of its ERs by lending in the interbank market. But because only changes to the Fed’s balance sheet can alter the aggregate quantity of reserve balances (as I said, reserve accounting would be shown to be important yet again), lending in the interbank market can only shift existing balances from bank to bank. If the aggregate banking system is left holding undesired excess balances that the Fed does not drain, the fed funds rate is bid down, at the limit to the rate paid to banks for holding ERs, which because of the excess reserve tax has been set below zero.

Again, the fact that the fed funds rate has fallen isn’t the point. The point is that the money multiplier, or “excess cash balance” mechanism is NOT applicable to our monetary system.

In my previous post, I pointed out that another of this tax’s effects would be to reduce bank profits for those left holding the ERs. Sumner’s counter was this: “Another mistake is to assume it would hurt bank profits. It could, but need not if the Fed doesn’t want it to. They could simply pay positive interest on RRs to offset the negative interest on ERs. All this is explained in this post”

In his original post, he gives as an initial example an excess reserve tax of 4% and payment on required reserves of 4%.

But again, the bank with no ERs has the same ability to create a loan as the bank with ERs. So, to stimulate lending, the only thing the ER tax can possibly do is encourage banks left holding the undesired ERs (assuming they aren’t drained by the Fed) to lower lending standards below those of banks without ERs in the hope that more would-be borrowers come though their doors.

All the evidence from volumes of empirical research on bank reserve behavior is very clear—banks don’t make an “asset allocation” decision between ERs at below market rates (lots of experience in the real world with these, as it’s been the normal state of affairs) and lending to willing, creditworthy borrowers. The two are unrelated as explained above (or at least mostly explained . . . one could be a great deal more technical about payment settlement-related motives for holding ERs and how this is also unrelated to lending), though the excess reserve tax tries to make them related by forcing banks in the aggregate to hold undesired balances, imposing a tax if they don’t create loans/deposits, and then paying them to make more loans/deposits.

So, again, the banks left holding the ERs would see their profits fall.

Banks could in fact avoid the excess reserve tax and receive the interest payment on required reserves by making NO loans at all if they instead found ways to incentivize, entice, or even force customers currently holding non-reserveable liabilities (savings, CDs, money market accounts) to shift these to reserveable liabilities (deposits). In fact, rather than lending, this sort of reclassification of existing balances is probably the outcome of the excess reserve tax plus payment for required reserves.

For instance, banks would probably cease all operations related to moving customer deposits into retail sweep accounts previously intended to avoid reserve requirements. This alone would reclassify about $600 billion or so in money market accounts as deposits and create somewhere around $50 billion in reserve requirements. As banks continued to “encourage” deposit accounts over non-reserveable accounts to reflect their own incentive to convert excess balances to required balances, still more balances could be reclassified.

So again, like the currency tax, we just get a reclassification of existing balances . . . this time toward deposits rather than away from them as the currency tax would do. Also like the currency tax, then, we don’t get any more spending and we therefore don’t get more aggregate demand. In other words, just as my spending plans didn’t change as I moved away from deposits to avoid Buiter’s proposed tax on transaction balances in the previous post, my spending plans also don’t change as I move toward transaction balances to avoid banks’ newly imposed disincentives for holding savings-type of accounts resulting from the mix of excess reserve tax/reserve requirement incentive they are facing.

A better way to increase aggregate demand than going to all these disruptive extremes that can only work if they reduce lending standards or reduce savings desires would be to raise household incomes and business profits directly and thereby increase both consumption and the likelihood loans can be paid back. I suggested a payroll tax holiday as one way to do this . . .this and other complementary proposals have been repeatedly discussed by L. Randall Wray, Stephanie Kelton, and Pavlina Tcherneva on this blog (and Warren Mosler and Mike Norman have done the same on theirs).

In closing, I ended the previous post by writing “unfortunately, those recommending penalties on currency, deposits, or reserves don’t fully understand monetary operations given that their basic framework is inapplicable to a modern monetary system such as ours.” Given that my conclusions here—that the excess reserve tax is based upon a lack of understanding of monetary operations (and reserve accounting in particular) and the inapplicable money multiplier—are much the same, there is no reason to alter that initial assessment.

Can Better Risk Management Techniques Prevent “It” From Happening Again?

by Eric Tymoigne

The risk-management approach to financial regulation has been around for a long time and it has failed consistently. It has not only failed to promote safer economic decisions and prevent the emergence of crises, but it has also failed to provide a relevant protection against major financial problems. Since at least 1864, with the imposition of capital adequacy ratios on national banks, regulators have tried to establish adequate buffers against expected and unexpected financial losses. Over time, the calculation of those buffers (liquidity, loan provisions, capital equity, etc.) has been refined, and Basel II was supposed to provide the latest improvements in this area. The current crisis has already made Basel II obsolete and many economists have noted the importance of accounting for liquidity issues in addition to loss issues.

Recent reports (e.g., CRMPG, BIS, IMCB, FSF, and the Department of the Treasury) have suggested that risk management can be improved by accounting for systemic risk and liquidity risk, and by making capital adequacy ratios more countercyclical. In addition, improvements were suggested in terms of reinforcing the role of risk officers in the governance of companies and in terms of remuneration methods.

Two of the major drawbacks of these proposals are that, first, like all previous risk-management policies, they do not deal with the core cause of financial instability and, second, they aim at being the least “intrusive,” which gives them only a very indirect impact on the management of financial stability.

Regarding the latter point, the philosophy of the past and current regulatory approaches has been to let individuals take whatever risk they find appropriate given market signals. Regulation is just there to tweak costs and returns in order to give an incentive to make “prudent” decisions as defined by arbitrary ratios of capital and liquidity (as well as by insurance premiums). As a consequence, as long as financial institutions meet the regulatory ratios, they are assumed to be safe and prudently managed, no matter how risky their asset positions and funding methods are. In addition, financial institutions can self-righteously complain further supervisory scrutiny if they meet their capital requirements, which greatly limits the effectiveness of supervision. All this is rather a permissive approach to financial regulation that is highly reluctant to forbid unsustainable financial practices. This is all the more so that economic agents are willing, and are forced by market mechanisms, to use those financial practices to improve their economic situations (unfortunately without consideration for the long-term indirect consequences of their choices).

Regarding the former point, the core cause of systemic financial crisis is the growing use of Ponzi finance over enduring periods of economic expansion. Ponzi finance means that the servicing of a given amount of debts requires the growing use of refinancing operations and/or liquidation of assets at rising prices. Ponzi funding methods are usually associated with crooks like Madoff, but the most devastating Ponzi processes are those that involve legal economic activities that are at the core of the economic growth process. Consumer finance for the past twenty years and the mortgage booms of the past ten years were Ponzi processes that involved honest and creditworthy borrowers who just wanted to improve their standard of living; lenders were more than eager to promote this trend to maintain their profitability and competitiveness, which was seen as a proud achievement of American free enterprise. Thus several Ponzi processes were at play and they all were used “judiciously” to maintain economic growth and business activities.

The problem with the type of Ponzi processes that we have experienced, is that, no matter how sophisticated and well informed financial players are, and no matter how efficient financial markets are, it always fails; and when it does, no buffer, no matter how high it is, can protect against the collapse. Pyramid Ponzi processes cannot be “risk managed.”

To better prevent the emergence of Ponzi processes an emphasis should be put on cash flows (rather than accounting profit) and on how economic entities plan to meet their financial commitments. Rather than asking, “Will you pay on time?” to determine creditworthiness, a more relevant question would be, “How will you pay on time?” And rising collateral price and access to refinancing channels should not be used to determine the expected capacity to repay of a borrower. Collateral liquidation (and so price) would only be used as a defensive means to protect banks against unexpected default, rather than as an offensive means to grow market shares and lending volumes. Ponzi processes should be eliminated or discouraged, no matter how good (or necessary) they appear for the competitiveness and (short-term) improvement of standards of living.

All financial institutions should be regulated, and the restructuring of the financial system should be based on promoting hedge financing of economic activities. By focusing on the financial practices of financial institutions, strong financial stability will be promoted and economic growth will proceed on more solid grounds (albeit probably at a slower pace).

Do banks need more capital?

By William K. Black (via New Deal 2.0)

Five Unasked Questions About the Stress Tests

1. Why will these (weak) stress tests lead to more realistic evaluations than the (far tougher) stress tests that Congress mandated for Fannie Mae and Freddie Mac?
Congress mandated a purportedly “stringent” stress test for Fannie Mae and Freddie Mac over a decade ago. It required them to have adequate capital to withstand the simultaneous onslaught of severe credit, interest rate and operational risks that continued for 10 years. The current Treasury test concentrates solely on credit risk and assumes it ends after two years. How well did the far more stringent Fannie and Freddie stress tests work? In August 2008, Freddie reported that “even [our] most severe stress tests [show] losses … less than $5 billion.” It failed in September. Actual losses: 20 to 40 times greater.

2. Where else were stress tests used?
Stress tests were used for the Rating Agencies, IndyMac, and AIG. The Rating Agencies’ stress tests gave AAA ratings to toxic waste. Actual losses: more than an order of magnitude greater than those predicted by the stress tests. IndyMac sold over $200 billion of “liar’s loans.” Actual losses: 160 times greater than its tests. AIG (2007): “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions.” AIG (2008): “Using a severe stress test … losses could go as high as $900 million.” Actual losses: 200 times greater.

3. When did Geithner begin to claim that stress tests were the keys to safe operation?
As president of the Federal Reserve Bank of New York, in a speech in 2004, he first praised stress tests. He was the principal regulator of many of the largest bank holding companies in the U.S. Every large bank has long used stress tests – and Geithner’s Federal Reserve examiners reviewed their stress tests. The big banks’ stress tests on nonprime loans and derivatives failed, and the Federal Reserve examiners consistently failed to understand the failures.

4. How can you conduct a stress test without reviewing the bad mortgage assets’ (missing) underlying loan files?
A Standard & Poor’s (S&P) memorandum recently unearthed reveals the sad truth about how non-prime collateralized debt obligations (CDOs) were purchased, pooled, rated and sold: ”Any request for loan level tapes is TOTALLY UNREASONABLE!!!. … Most investors don’t have it and can’t provide it. … we MUST produce a credit estimate. … It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.” The email message is from a senior S&P manager to the professional rater. The word “investors” means the entity that created the CDOs. One cannot evaluate loan quality or losses accurately without reviewing a significant sample of the underlying loan files. The banks and the regulators virtually never do this. They did not do this during the stress tests. They do not even have access to the files that they need to review.

5. How can you ignore fraud losses during an “epidemic” of mortgage fraud?
The FBI began testifying publicly in September 2004 about the “epidemic” of mortgage fraud. It has also stated that lending insiders participated in 80 percent of mortgage fraud losses. The presence of massive fraud losses means primarily produced by lenders makes it absurd to rely (as Treasury did in its stress tests) on the lenders’ loss evaluations. Stress tests produce fictional results that massively understate real losses and produce complacency.

BerkShares, Buckaroos, and Bear Dollars: What Makes a Local Currency Tick?

by L. Randall Wray

Some commentators have argued that the proposed California “warrants” are similar to local currencies (see, e.g., Mark Thoma). In this piece I discuss experiments with local currencies and continue my argument that if California were to accept its own “warrants” in payment to itself, it could turn these into a functioning currency free of the defects of local currencies.

Interest in local currencies has soared in recent years, with nearly 100 U.S. communities experimenting with them. While proponents offer a variety of arguments in favor of local currencies, they share three common themes. First, there is concern that the use of a national, monopoly, currency creates a variety of economic, social, and environmental problems. Second, local currencies are said to improve regional communities, again across several dimensions including economic, social, political and environmental spheres. Third, many proponents want to reduce the power of national government, recognizing a relation between the monopoly of currency issue and centralization. They believe that decentralized money would shift power back to the communities.

At the same time, critics object that most local currency experiments quickly fail. Even the successful ones never displace local use of the national currency to any significant degree. Local currencies are inconvenient and appear to go against the prevailing tide of use of credit and debit cards rather than cash. Retailers must keep two sets of books, and many limit acceptance of local currencies to some kinds or amounts of purchases. Sales taxes must be paid in the national currency, so retailers must either collect taxes in the national currency, or pay taxes for the customers. In some cases, local currencies are accepted at a discount—with either the retailer or the customer bearing the cost. When the discount is borne by the retailer, businesses with low margins are reluctant to accept local currencies. Finally, in a national, and global, economy, most production and sales involve economic activities that are geographically dispersed–making it unlikely that local currencies can ever play much of a role.

The BerkShares program grew out of previous local currency systems used in the region. Local banks maintain a primary (currency exchange) market for BerkShares, selling and buying them for $0.90. Local merchants agree to accept BerkShares one-to-one against the dollar, effectively providing a ten percent discounted price. (This is because a customer can obtain one BerkShare for only ninety cents, purchasing an item priced at a dollar.) Merchants redeem excess BerkShares at participating banks at the fixed rate of one BerkShare equals ninety cents. Banks hold 100% dollar reserves against BerkShares issued, and absorb the cost of operating the exchange. Local consumers (and tourists) have a strong incentive to use BerkShares to take advantage of the ten percent discount; merchants have an incentive to accept them only if their sales increase sufficiently to offset the lost revenue due to the discount. This discount is treated as a business expense, much like a coupon or discounted sales price. There are now over 300 merchants participating and over 1.5 million BerkShares have been put into circulation.

A decade ago, the University of Missouri-Kansas City (UMKC) created a local currency, the Buckaroo (derived from slang for the dollar, “buck”, and from the University’s kangaroo mascot), with two purposes in mind: to teach students how a national currency “works”, and to provide community service to the Kansas City area. Most college students today are used to community service requirements, so the second objective could have been met by requiring that each student complete five service hours for every course. With 10,000 students enrolled in three courses each, 150,000 community service hours would be performed each semester—thereby accomplishing many of the community objectives identified above. However, we decided to provide more flexibility while enhancing the educational experience, so we created the Buckaroo. We provide to each community service organization as many Buckaroos it desires, stipulating that the provider pay only 1 Buckaroo per hour of labor.

Of course, on the first day of class when we tell students that they can earn Buckaroos by working at local charities, they invariably ask “but why do I want Buckaroos?”. The answer is that each student faces a 5 Buckaroo tax, which must be paid before the student can pass. Students are free to beg, borrow, earn, or exchange dollars (or any other valuables) to obtain the required Buckaroos. The vast majority of them choose to work with local community service providers to earn their Buckaroos. Many students work extra hours to earn more Buckaroos than required to pay their taxes. They accumulate savings in the form of Buckaroos, which they are able to exchange for dollars, or to purchase goods and services from fellow students.

We have a “Treasurer” who keeps track of “spending” (Buckaroos spent into circulation by community organizations) and “tax receipts” (collected by professors). It is instructive to note that the Treasury has run a budget deficit every semester since the program’s inception, as students earn more buckaroos than necessary to pay taxes, saving some for future use (or souvenirs) or losing them. We also take informal surveys to gauge the Buckaroo-dollar exchange rate, which varies over the semester (the Buckaroo strengthens at the end as desperate procrastinators realize they need to pay their tax). Over the decade, the Buckaroo appreciated considerably against the dollar, rising from a range of $5-$10 per Buckaroo to the current $10-$20—presumably reflecting the rising nominal dollar reservation wage of students. However, the Buckaroo’s purchasing power has remained absolutely constant at one hour of student labor per Buckaroo. If we allowed community service providers to pay 2 Buckaroos per hour, the value of the currency would immediately fall by half in terms of labor—and it would probably depreciate against the dollar. However, as the monopoly supplier of the currency, we can fix its purchasing power in terms of the only thing we buy—student labor.

Conclusion: How can we ensure a currency’s use?

The Buckaroo is a “tax driven” currency: students demand Buckaroos to pay taxes so that they might pass their courses. The US dollar is also tax driven: the US government imposes taxes in dollars and will attach income or property to enforce the liability. It spends dollars into circulation, through its purchases and social spending; it also can lend them into circulation. The purpose of the Buckaroo tax is to move “private” resources (student labor) to the “public” sector (of community service providers)—as is the case with all tax systems. UMKC created the Buckaroo to facilitate that public purpose. In the case of tax driven currency, so long as the tax is enforceable there is a guaranteed demand for the currency at least as great as the total tax liability. And, as the Buckaroo program shows, actual demand will exceed the tax liability because there is a desire to earn and hoard extras. We can envision continued expansion of the program, with local student hang-outs accepting Buckaroos for cappuccinos while paying a Buckaroo wage premium to student baristas (being careful not to run afoul of IRS and minimum wage laws!). In that case, the demand for Buckaroos would expand, fueled by use beyond taxes and payment for community service work—just as the dollar is used outside transactions with the government.

The dollar and the Buckaroo are not unique; indeed it could be argued that tax driven currencies have been the rule, not the exception, throughout recorded history. However, we do not need to debate such a controversial claim—all we need to do is to understand that a tax is sufficient to create a demand for a currency.

As discussed, most local currencies have failed (of the 82 created between 1991 and 2004, only 17 remained by 2004). Those that succeeded shared some combination of the following characteristics: an exchange rate pegged to a strong national currency by a trusted institution; substantial supplies of unemployed or underemployed workers; businesses operating below capacity; and a strong community spirit, led by liberal, middle class residents. These characteristics are not always easy to replicate nor are they necessarily desirable. If the goal is to displace the national monopoly currency, linking the local currency to it appears inconsistent—especially if one fears national government policy is inflating away the value of the nation’s currency. If unemployed workers and excess capacity are required to keep the local currency strong, then success at building a sustainable region might threaten the currency.

Could tax driven local currencies work? In Argentina as the financial crisis deepened after 2000, local governments began to issue “Patacones” (bonds with interest) as local currencies, paying workers and suppliers, and accepting them in tax payment. Utility companies began to accept them—knowing they could pay part of their taxes with them–and acceptance spread even to international corporations such as MacDonald’s. A local government could help to stimulate circulation of BerkShares by accepting them in tax payment. Firms and households with local tax liabilities would be encouraged to accept BerkShares. Local government could pay part of its bills using the local currency. Finally, so long as there are always jobs available for anyone desiring to work for BerkShares, an increase in the demand for the local currency would always generate more employment.

As Marshall Auerback, Warren Mosler, and I have been arguing, California can turn its warrants into sovereign currency by agreeing to accept them in payments to the state. Note that we ARE NOT arguing that California should make them “legal tender, payable for all debts public and private”—this is something it cannot do.

As a stopgap measure, this will ensure a demand for the state’s IOUs. Each individual vendor, contractor, or even state employee will accept the state’s new warrants up to the individual’s expected tax liability. Eventually the warrants will also be accepted by retail establishments and others who also have liabilities to the state of California—meaning that the state could (eventually) issue a number of warrants equal to the total of all such obligations owed to the state, on an annual basis.

The next step is to issue these IOUs at zero interest. The taxes, fees, and liens will be sufficient to generate a demand without promising interest. Currency is simply an IOU that does not pay interest—it is “current”. As I suggested before, the state can also accept its own “currency” in payment of fees and tuition paid to state institutions of higher learning—further increasing demand.

Unlike other local currencies around the country—such as the BerkShare in Massachusetts, the new California currency would then be “tax driven”, thus sustainable. In other words, it would be a sovereign currency backed by the state’s ability to impose taxes.

Some Want the Whole Truth about What Went Wrong

There is a movement afoot to instruct Congress to conduct a proper inquiry into the cause(s) of the economic and financial crisis. Here is some background on the initiative, which appears on the Huffington Post:

“Legal chicanery and pitch darkness were the banker’s stoutest allies.”

– from Wall Street Under Oath, 1936, the memoir of Ferdinand Pecora

In 1933, Ferdinand Pecora – lead counsel for the Senate Banking and Currency Committee inquiry – led an investigation into the causes of economic collapse that preceded the Great Depression. His unrelenting investigation provided the evidentiary basis for legislation that restored market integrity and rebuilt public confidence in the financial markets and the banking system. For 45 years – until many of the New Deal protections were removed by de-regulation and insufficient supervision – these laws formed the basis of an economic structure that created prosperity and withstood crisis.

By taking lessons from the original commission in its design and execution, the recently established Financial Crisis Inquiry Commission (FCIC) can ensure that it provides the insights necessary to understand what caused the crisis and, in so doing, to protect the nation from future collapses.

Please join us in signing this letter that encourages the new “Pecora” Commission to pursue rigorously the truth.

Dear Members of the Financial Crisis Inquiry Commission,

In this moment of great economic turmoil, there is a simple but critical question that we must ask and answer together as a nation:

What caused the crisis?

We, the undersigned, call on you to fulfill the responsibilities of your position by joining together in non-partisan cooperation to investigate the origins of the financial crisis in ways that lead to a full understanding of the institutions, people and practices that are responsible for our economic collapse.

In particular, we encourage the adoption of three guidelines that history has taught us are essential to an effective inquiry:

– Appoint a single investigator. This individual must have a proven record of exposing fraudulent elites and institutions, and must provide a professional, non-political spirit to the investigation.

– Afford no special treatment. No one is off-limits or gets special protection in the investigation.

– Provide the tools to do the job. The investigator must be given ample budget and time, full subpoena authority, and the ability to hire and fire staff.

These principles were applied in the 1930s when Congress launched a formal inquiry into the causes of the Great Depression. That commission – led by Ferdinand Pecora – was willing to reach into the highest levels of Wall Street and finance to determine the causes of the economic collapse of 1929. The courage with which the commission greeted its task – and the revelations that courage ensured – inspired the sweeping banking and financial reforms that were the bedrock of our financial system for decades.

Building a new financial foundation requires us to begin on solid ground – the truth. It is only by illuminating the mistakes of the past that we will be able to meet the great challenges of the future.

Thank you for your consideration, and for your willingness to take on this historic challenge.