Daily Archives: March 22, 2010

Geithner and Greenspan do Standup

By William K. Black

My friends have to put up with my complaints that Brits think Americans are incapable of irony when, in reality, we are world class. Further proof of our preeminence in the irony department comes in the last five days from Geithner and Greenspan. The G2 are locked in a competition for droll humor. Today, in prepared remarks – he didn’t make some impromptu slip – he told Americans that when it comes to financial regulatory reform:

Listen less to those whose judgments brought us this crisis. Listen less to those who told us all they were the masters of noble financial innovation and sophisticated risk management.

Because I took his advice to heart I stopped reading his prepared remarks at that point and cannot report to you on the remainder of the regulatory advice given by an exemplar of “those whose judgments brought us this crisis.” The gentle reader will recall that Geithner testified to Congress that he had never been a regulator. True, but you’re not supposed to admit it. Your job statement required you to be a regulator and protect the public. Geithner’s advice means that we should all stop listening to Rubin, Summers, Greenspan, Bernanke, Gramm, Dodd, Patrick Parkinson (the Fed’s anti-supervisor), Dugan (OCC), Bowman (OTS), and Mary Shapiro (SEC). Thank you Mr. Geithner! Your advice is incredibly liberating.

Moreover, the Geithner corollary is that we should listen more to those that warned that war on regulation was producing an epidemic of fraud, a massive bubble, and an economic crisis. I trust that similar calls will be coming any minute to Ed Gray, Mike Patriarca, and our colleagues that led the successful reregulation of the S&L industry and prevented the S&L debacle from causing a recession (much less a Great Recession). Geithner’s novel idea that we should take our regulatory advice from regulators with a track record of success, courage, and integrity hasn’t been tried in over a decade.
Greenspan’s entry into the irony sweepstakes was a paper entitled “The Crisis” in which he purported to give advice about financial regulation. Seriously! The man that Charles Keating, the most infamous S&L fraud, used as a lobbyist to troll the Senate office buildings to recruit the infamous “Keating Five,” who wrote that Keating’s Lincoln Savings posed “no foreseeable risk of loss” (it turned to be the most expensive failure), and who praised the types of investments that Lincoln Savings’ (unlawfully) made that caused its catastrophic failure – all this before he became Fed Chairman – went on to become the leading anti-regulator that ignored copious warnings of the bubble and the “epidemic” of mortgage fraud to produce the environment that caused the Great Recession. Greenspan giving advice on regulation is standup at its finest.

Neoliberal Deficit Hysteria Strikes Again

ADVICE TO PRESIDENT OBAMA AND PRIME MINISTER BROWN: Tell the IMF, the European Commission, and the Ratings Agencies to Take a Hike

By L. Randall Wray and Yeva Nersisyan

In recent days, articles in Der Speigel, the NYTimes, and the AP have all highlighted Neoliberal commentary warning of the dangers of growing budget deficits in the wealthiest nations—specifically in the US and the UK.

Marco Evers, writing in Der Speigel helpfully argues that the UK’s deficit to GDP ratio (at 12.9%) is actually larger than the ratio of Greece (12.2%), which is already in crisis. According to the AP report, the European Commission has somberly warned London to tighten its budget–to bring its deficit down to 3% of GDP by 2014-15 as promised–through higher fees and taxes, as well as cuts that “will be more drastic than those under (former Prime Minister) Margaret Thatcher”, according to economist Carl Emmerson. It should be remembered that Thatcher oversaw the downsizing of the UK economy, moving it to second-rate status so far as economies go. (In 1980 the UK’s per capita income was 79% of that of the US; by 1985 it had fallen below half. It is now the third largest economy in Europe, and sixth in the world—but it ranks 21st on the Human Development Index.) Apparently the EC would like to see the UK reduced to a third-rate economy—perhaps as punishment for dealing with the global financial crisis in more reasonable manner than the EC has. According to PricewaterhouseCoopers’s calculations, to cut the budget deficit in half by 2014, spending in most areas will have to be cut by 10% per year beginning next year. The EU warns that these cuts will have to be made even in an economic climate that could be “distinctly less favorable” than the UK is now assuming. In other words, fiscal tightening should be undertaken even without economic recovery. That ought to bring the profligate Brits to their knees!

Not to be outdone, the IMF’s John Lipsky (deputy managing director) “offered a grim prognosis for the world’s wealthiest nations, which are at a level of indebtedness not seen since the aftermath of World War II.” Even if fiscal stimulus is ended, he warned, debt ratios on average will rise to 110% by 2014. “Maintaining public debt at postcrisis levels could reduce potential growth in advanced economies by as much as half a percentage point annually.” And to reduce debt ratios appreciably will require an 8 percentage point swing, from structural deficits of 4% of GDP to surpluses of 4% annually by 2010. Note that in the case of the US, this would be equivalent to a reduction of national income by more than a trillion dollars. In other words, the Neoliberal doctors at the IMF recommend lots of pain.

Finally, Moody’s warned that the US and UK have moved closer to credit downgrades, negatively impacting their ability to borrow at favorable interest rates. Presumably, they can look to Greece and Portugal for lessons on the folly of ignoring the warnings of Neoliberal credit raters. Moody’s also warned that these nations cannot rely on growth alone to work their way out of debt. They will “require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.” Moody’s repeated the assertion that the UK is relying on overly rosy economic forecasts—tax receipts will be lower than anticipated, hence the pain that Brown must inflict on his economy is higher—presumably high enough to provoke the kind of civil unrest we now see in Greece.

It is very hard to avoid the conclusion that the Neoliberals at the EU (which seems to act on these matters as a front for the Bundesbank), the IMF, and the ratings agencies are trying to do to the UK and US what they already did to Greece. A real conspiracy theorist might even wonder whether they are trying to succeed where the Third Reich could not—destruction of the US and UK economies in a bid to annihilate the nations themselves. Obviously, that is not a view we suggest. But if one were to adopt it, it could be noted that Neoliberals in Germany have been picking off its neighbors one-by-one, first Greece, then Portugal and Spain, then on to Italy and finally France. (here) These Neoliberals use a combination of mercantilism—trade surpluses that suck demand and jobs out of its fellow EU nations—and then “market discipline” that punishes any nation that tries to fill resulting demand gaps with government spending. (here) However, a more charitable interpretation is that it is the Teutonic Calvinism that guides EU prognostication on government deficits: today’s “excesses” must surely impose a tradeoff in the form of tomorrow’s costs. But when the EC begins to criticize UK and US policy, that is certainly a step that goes too far—even if it is simply due to muddled thought rather than to a nefarious agenda.

The ratings agencies are another matter altogether. These blessed every kind of Wall Street excess with triple A ratings. They never saw a NINJA loan they did not love. Yet, they are engaged in an ugly form of deficit terrorism, attacking one country after another, downgrading debt, raising interest rates and causing budget deficits to rise, which then pushes up credit default swap prices and triggers further downgrades. Ratings agencies serve no public purpose. They are thoroughly incompetent, and probably irredeemably fraudulent. They should be shut down, investigated, and prosecuted.

President Obama and PM Brown should “just say no” to the attempted intervention by these fundamentally misguided deficit hawks into their economic and political affairs. Not only would fiscal tightening now or even within the next several years be a monumental mistake, the notion that continued deficits threaten our economies is unsound. In the remainder of this piece we will briefly explain why. What these Neoliberals do not understand is that the UK and US operate with sovereign currencies—that is both of these nations issue their own non-convertible (floating exchange rate) currencies. For this reason the comparison with any nation that uses the Euro (such as Greece), or with a nation that pegs to precious metals or foreign currencies is invalid. In other words, there is no question of solvency or sustainability of deficits for the US and UK. Sovereign debt of these nations never carries default risk and hence cannot be rated below triple A.

Further, budget deficits are largely endogenously determined by economic performance, so that even if the US and UK adopted the Neoliberal recommendations, the budgetary outcome is not discretionary—indeed, tight fiscal policy would probably increase budget deficits by killing nascent economic recovery. Again, this would not raise any questions about solvency, but it certainly would impose unnecessary pain and sacrifice on the populations of the countries. Since we find it very difficult to believe that the ratings agencies, the IMF and the EU do not understand this, it is equally hard to avoid the conclusion that their policy recommendations are designed to subvert the economies of the US and UK. To what end we can only wonder.

Mr. Lipsky is certainly not alone in arguing that high debt levels will be detrimental for economic growth. A new and influential study by Kenneth Rogoff and Carmen Reinhart, heavily publicized by the media, purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically—by at least one percentage point. But the findings reported in Rogoff and Reinhart cannot be applied to the situation of the US or to the case of many other nations today—those that are not pegging their currency to gold or any other currency. Indeed, the Rogoff and Reinhart study is fatally flawed precisely because it does not recognize the difference between sovereign debt—debt of a national government that issues its own nonconvertible currency—and private debt or the debt issued by nonsovereign government that pegs its currency to precious metal or foreign currency (or Euro nations that adopt the euro).

Governments across the world have inflicted so many self-imposed constraints on public spending that the relatively simple operational realities behind public spending have been obscured. Most people tend to think that a balanced budget, be it for a household or a government, is a good thing, failing to make a distinction between a currency issuer and a currency user. Indeed, one of the most common analogies used by politicians and the media is the claim that a government is like a household: the household cannot continue to spend more than its income, so neither can the government. See here for more on the differences between a household and a government. Yet that comparison is completely fallacious. Most importantly, households do not have the power to levy taxes, and to give a name to—and issue–the currency that those taxes are paid in. Rather, households are users of the currency issued by the sovereign government. Here the same distinction applies to firms, which are also users of the currency.
Operationally the sovereign government spends by crediting bank deposits (and simultaneously crediting the reserves of those banks) at its own central bank, in the case of the US, the Federal Reserve Bank. No household (or firm) is able to spend by crediting bank deposits and reserves, or by issuing currency. Households and firms can spend by going into debt if some entity will lend to them, which is something the national, sovereign government in no case requires when using its own currency. Unlike private debtors it can always make payments, including debt service payments, simply by changing numbers on its own spread sheet at its own central bank. This is a key to understanding why perpetual budget deficits are “sustainable” in the conventional sense of that term because government can always make any payments it desires on a timely basis.

A government that issues its currency that is not backed by any metal or pegged to another currency is not constrained in its ability to spend by the possibility that holders of dollars might ‘cash them in’ for gold, for example, as is the case with a gold standard. With a non-convertible sovereign currency, a government doesn’t need tax and bond revenues to protect its gold reserves—because it does not use gold reserves! While all governments today spend by crediting bank accounts and tax by debiting bank accounts, with convertible currencies budget deficits risk the loss of reserves, while with non-convertible sovereign currencies there is no such risk.

If we take the US as an example, its budget deficits add to the total of the outstanding stock of outstanding US Treasury securities, bank balances in their reserve accounts at the Federal Reserve Bank, and/or cash in circulation, together on a dollar for dollar basis. Treasury Securities are functionally nothing more than ‘time deposits’ at the Fed, held in what are called ‘securities accounts’ at the Fed. They are often measured relative to the size of GDP, as are the annual federal deficits, to help scale the nominal numbers to provide perspective. (Note this is often NOT done by those who try to scare the population with talk of “tens of trillions of dollars of unfunded entitlements” due to retirements of the babyboomers, rather than show those numbers as a % of future GDP.)

Figure 1 shows federal government debt since 1943.

Note that during WWII the government’s deficit (which reached 25% of GDP) raised the publicly held debt ratio above 100%– much higher than the ratio expected to be achieved by 2015 (just under 73%). Further, in spite of the warnings issued in the Reinhart and Rogoff study, US growth in the postwar period was robust— in fact it was the golden age of US economic growth. Ironically, this is even acknowledged in the report by the IMF’s Lipsky—who noted that the average ratio of government debt to GDP in the advanced countries will reach the postwar 1950 peak of somewhat more than 75%. Again, misfortune did not befall those big government spenders after WWII. Actually, debt ratios came down over the postwar period as relatively robust growth grew the denominator (GDP) relative to the numerator (government debt).

Indeed, robust growth reduces budget deficits by raising tax revenue and reducing certain kinds of government spending such as unemployment compensation. That was exactly the US experience in the postwar period. The budget deficit is highly counter-cyclical, and will come down automatically when the economy recovers.

The claim made by Moody’s that growth will not reduce debt ratios does not square with the facts of historical experience and must rely on the twin assumptions that growth in the future will be sluggish and that government spending will grow relative to GDP. However, such an outcome is inconsistent: if government spending grows fast it raises GDP growth and hence tax revenues, reducing the budget deficit. This is precisely what has happened in the US over the entire postwar period. It is only when government spending lags behind GDP growth by a considerable amount that it slows growth of GDP and tax revenues, causing the budget deficit to grow. What Rogoff and Reinhart do not sufficiently account for is the “reverse causation”: slow growth generates budget deficits. This goes a long way toward explaining the correlation they find between slow growth and deficits: as economists teach, correlation does not prove causation!

Actually, there are always two ways to achieve the same budget deficit ratio: the ugly (Japanese) way and the virtuous way. If fiscal policy remains chronically too tight even in recession, economic growth is destroyed, tax revenues plummet, and a deficit opens up. So far, that is—unfortunately—the US path in this recession, a path already well-worn by two decades of Japanese experiments with belt-tightening. The alternative (let us call it the Chinese example) is that a downturn is met with an aggressive and appropriately-sized discretionary response. In that case, growth is quickly restored, tax revenue begins to grow, and the budget deficit is reduced.

We emphasize that the deficit outcome is of no consequence for a sovereign nation. What is important is that the “ugly” Neoliberal path means chronically insufficient demand, high unemployment, and lots of suffering. The virtuous path—which is always available to a sovereign government—means less loss of output and employment, and relatively rapid resumption of economic growth. So it is not the deficit outcome that matters, rather it is the real suffering imposed by slow growth that results when fiscal policy is too tight.

In conclusion, the Neoliberal agenda would impose the ugly path on the US and UK. President Obama and Prime Minister Brown should tell the Neoliberals to take a hike.

“The Hyperinflation Hyperventalists”

By Rob Parenteau**

After a two day blogging slugfest on fiscal deficits, I find that the question of hyperinflation now demands an answer. And here it is: fiscal deficit spending may be a necessary condition of hyperinflation, but it is hardly a sufficient condition.

Think this is yet another rant against the “deficit errorists?” Think again. Paul Krugman treated this question in his March 18th New York Times column:

Hyperinflation is actually a quite well understood phenomenon, and its causes aren’t especially controversial among economists. It’s basically about revenue: when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage – revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.

Krugman locates the source of hyperinflation in what is termed the “monetization” of fiscal deficit spending. He then attributes its perpetuation to shifts in the liquidity preferences of people — that is, the share of their portfolio that households and firms wish to hold in cash or cash like investment instruments (think Treasury bills, or money market mutual funds, for example). Krugman’s logic means that even the liberal wing, or the saltwater contingent, of the economics world has a touch of deficit errorism. We would invite Paul to take a closer look at the UBS research on public debt to GDP ratios and inflation first released last summer, reprinted in a FT Alphaville note, and discussed on Naked Capitalism. The story of inflation and fiscal deficits is more ambiguous, or at least more complex than the deficit errorists would have you believe.

Coincidentally, an investment manager friend forwarded me a letter that Ebullio Capital Management* allegedly sent to its clients after February’s investment results, which took them down nearly 96% for the year – virtually wiping out their stellar gains of the prior two years. The letter reveals that Ebullio was so ebullient about the possibility (inevitability?) of hyperinflation emerging from recent policy excesses that they bet the ranch on hyperinflation plays in the commodity corner of the investing world (metals), and lost big time. While we still have questions as to whether this is a spoof or not, there are undoubtedly people sitting around in gold wondering whether the old yellow dog is going to get up and bark again anytime soon. Although hyperinflation hyperventilation has been catching on in recent months, especially amongst the deficit errorists, gold has been dead money since late November 2009.

What gives? As a piece I wrote in the July issue of The Richebacher Letter explains, hyperinflation requires extreme conditions not just on the demand side, but on the supply side as well. A month after the Richebacher piece, Bill Mitchell published a similar conclusion. To summarize our findings: on the demand side, in order for household spending power to keep up with rising prices, household nominal incomes or credit access must be ratcheted up in synch with price hikes. Otherwise, the price hikes will not stick. Households will have to pull back less-essential spending areas to afford the same quantity of goods in essential items. So your gas, home heating oil, health care, or food bill goes up, and you cut back on your restaurant and entertainment spending, unless your paycheck also increases, or you can tap more credit. That is why hyperinflation episodes need more than just deficit spending. It is true, as Marshall Auerback and I explained in a recent New Deal 2.0 post, that fiscal deficits increase the net cash flow for the household sector as a whole. But we also usually observe some sort of escalator clauses or cost of living adjustment mechanisms built into wage contracts that allow this ratcheting up of household income pari passu with the inflation hikes. Take that element away — and it is a recurring theme in historical episodes of hyperinflation — and households cannot keep up with hyperinflation. The higher prices cannot get validated by higher consumer spending. The hyperinflation flares out.

Beyond this demand side component, which is scarcely to be found in the US wage contracts these days (although we must mention it is built into some government benefit programs like social security), there is the supply side issue. Productive capacity must be closed or abandoned in order for the hyperinflation to really rip. There is a built-in dynamic that encourages this. As the hyperinflation gets recognized, entrepreneurs eventually figure out that they would be much better off speculating in commodities (like Ebullio), buying farmland, chasing gold and other precious metals, or more generally, repositioning their portfolios and reinvesting their profits in tangible assets with relatively fixed supplies. That is, goods that are fairly nonreproducible become stores of value, as it is their prices that tend to rise most swiftly, since higher prices cannot, by definition, elicit any new supplies. Hence, those of you who lived through the ‘70s (and still remember what you were doing) will recall high net worth households were busy hoarding ancient Chinese ceramics while the middle class was chasing residential real estate, and the stock market basically went sideways.

In the case of the Weimar Republic following WWI, and Zimbabwe most recently, remember that war (civil or international), has an impeccable way of destroying productive capacity in a nation, or rerouting it to the production of war material. In the Weimar episode, the final back-breaking run up in hyperinflation accompanied the occupation by the French of the Ruhr Valley, which held a fair concentration of German production facilities. In solidarity with the workers who struck those plants in response, the Weimar Republic continued to pay the workers through fiscal measures. Cut production, but continue income flows, and you have the recipe for the kind of unresolved distributional conflict that often lies at the heart of the inflation process. Mainstream economics and popular lore refuse to see this.

Suffice it to say that hyperinflation takes a very special set of conditions. It is not, contra Paul Krugman, all about fiscal deficits, nor is it only about fiscal deficits. That is why we do not see hyperinflation breaking out all over the place on any given day, despite the fact the governments have to first create the money that you and I use to pay taxes or buy Treasury bonds (because even though we “make” money, we cannot create it, without risking a spell in jail for counterfeiting). Know your history. Try not to pass out with the hyperventilating hyperinflationistas: they are a particularly virulent wing of the deficit errorists, and they may simply leave you in a state similar to the one alleged to have been experienced by Ebullio Capital Management’s clients.

P.S. I have a piece called “On Fiscal Correctness and Animal Sacrifices” appearing on several blogs that formed the basis for the March 2010 Richebacher Letter. It is crucial that this piece get into the hands of Paul Krugman. If anyone knows how to get to him, I would be much obliged. His July 15th, 2009 NY Times diagram, which I call the Krugman Curve, has planted a seed that he would benefit greatly from watering. I believe it would help him escape the trap of continually returning to the manipulation of real interests rates (now requiring that he advocate central banks push a credible plan to deliver higher inflation in perpetuity, since policy rates are near the zero nominal bound in many places) as the holy grail for all countries operating below potential output. Time for him to exit from the IS/LM straight jacket, which even Sir John Hicks, one of its fathers, had his sincere doubts about, as well as the intertemporal utility maximization straight jacket of his more orthodox contemporaries. He knows how to do it…he just does not know it yet, which is why this paper needs to get in his hands, and soon, before the deficit errorists claim him as one of their own.

* You can go to Ebullio’s website, but unfortunately, authorization is required to see their performance, their track record, and their client letters.

**This article originally appeared on new deal 2.0