Monthly Archives: July 2010

The CBO’s Misplaced Fear of a Looming Fiscal Crisis

Posted on July 29, 2010 by | 14 comments

By Eric Tymoigne

The Congressional Budget Office (CBO) has just released an 8-page brief titled “Federal Debt and the Risk of a Fiscal Crisis.” In it you will find all the traditional arguments regarding government deficits and debt: “unsustainability,” “crowding out”, bond rates rising to “unaffordable” levels because of fears that the Treasury would default or “monetize the debt,” the need to raise taxes to pay for interest servicing and government spending, the need “to restore investor’s confidence” by cutting government spending and raising taxes. This gives us an opportunity to go over those issues one more time.

  1. “growing budget deficits will cause debt to rise to unsupportable levels”

A government with a sovereign currency (i.e. one that creates its own currency by fiat, only issues securities denominated in its own currency and does not promise to convert its currency into a foreign currency under any condition) does not face any liquidity or solvency constraints. All spending and debt servicing is done by crediting the accounts of the bond holders (be they foreign or domestic) and a monetarily-sovereign government can do that at will by simply pushing a computer button to mark up the size of the bond holder’s account (see Bernanke attesting to this here).

In the US, financial market participants (forget about the hopelessly misguided international “credit ratings”) recognize this implicitly by not rating Treasuries and related government-entities bonds like Fannie and Freddie. They know that the US government will always pay because it faces no operational constraint when it comes to making payments denominated in a sovereign currency. It can, quite literally, afford to buy anything for sale in its own unit of account.


This, of course, as many of us have already stated, does not mean that the government should spend without restraint. It only means that it is incorrect to state that government will “run of out money” or “burden our grandchildren” with debt (which, after all, allows us to earn interest on a very safe security), arguments that are commonly used by those who wish to reduce government services. These arguments are not wholly without merit. That is, there may well be things that the government is currently doing that the private economy could or should be doing. But that is not the case being made by the CBO, the pundits or the politicians. They are focused on questions of “affordability” and “sustainability,” which have no place in the debate over the proper size and role for government (a debate we would prefer to have). So let us get to that debate by recognizing that there is no operational constraint – ever – for a monetarily sovereign government. Any financial commitments, be they for Social Security, Medicare, the war effort, etc., that come due today and into the infinite future can be made on time and in full. Of course, this means that there is no need for a lock box, a trust fund or any of other accounting gimmick, to help the government make payments in the future. We can simply recognize that every government payment is made through the general budget. Once this is understood, issues like Social Security, Medicare and other important problems can be analyzed properly: it is not a financial problem; it is a productivity/growth problem. Such an understanding would lead to very different policies than the one currently proposed by the CBO (see Randy’s post here).

  1. “A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers.”

First, this sentence seems to imply that government activities are unproductive (given that, following their logic, Treasury issuances “finance” government spending), which is simply wrong, just look around you in the street and your eyes will cross dozens of essential government services.

Second, the internal logic gets confusing for two reasons. One, if people are so afraid of a growing fiscal crisis, why would they buy more treasuries with their precious savings? Why not use their savings to buy bonds to fund “productive capital goods”? Using the CBO’s own logic, higher rates on government bonds would not help given that a “fiscal crisis” is expected and given that participants are supposed to allocate funds efficiently toward the most productive economic activity (and so not the government according to them). Second, we are told that “it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.” I will get back to what the government can do in that case, but you cannot get it both ways; either financial market participants buy more government securities or they don’t.

Third, this argument drives home the crowding-out effect. I am not going to go back to the old debates between Keynes and others on this, but the bottom line is that promoting thriftiness (increasing the propensity to save out of monetary income) depresses economic activity (because monetary profits and incomes go down) and so decreases willingness to invest (i.e. to increase production capacities). In addition, by spending, the government releases funds in the private sector that can be used to fund private economic activity; there is a crowding-in, not a crowding-out. This is not theory, this is what happens in practice, higher government spending injects reserves and cash in the system, which immediately places downward pressure on short-term rates unless the Fed compensates for it by selling securities and draining reserves (which is what the Fed does on a daily basis).

  1. “if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output.”

No, as noted many times here, all spending and servicing is done by crediting creditor’s account not by taxing (or issuing bonds). Taxes are not a funding source for monetarily-sovereign governments, they serve to reduce the purchasing power of the private sector so that more real resources can be allocated to the government without leading to inflation (again all this does not mean that the government should raise taxes and takeover the entire economy; it is just a plain statement of the effects of taxation). All interest payments on domestically-denominated government securities (we are talking about a monetarily-sovereign government) can be paid, and have been met, at all times, whatever the amount, whatever their size in the government budget.

  1. “a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.”

If the US Treasury cannot issue bonds at the rate it likes there is a very simple solution: do not issue them. This does not alter in any way its spending capacity given that the US federal government is a monetarily-sovereign government so bond issuances are not a source of funds for the government. Think of the Federal Reserve: does it need to borrow its own Federal Reserve notes to be able to spend? No, all spending is done by issuing more notes (or, more accurately, crediting more accounts) and if the Fed ever decided borrow its own notes by issuing Fed bonds to holders of Federal Reserve notes (a pretty weird idea), a failure of the auction would not alter its spending power. The Treasury uses the Fed as an accountant (or fiscal agent) for its own economic operations; the “independence” of the Fed in making monetary policy does not alter this fact.

  1. “It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis.”

It is always possible that anything can happen, but what is the record? The record is that there is no relationship between the fiscal position of the US government and T-bond rates. Massive deficits in WWII went pari passu with record low interest rates on the whole Treasury yield curve. With the help of the central bank, the government made a point of keeping long-term rates on treasuries at about 2% for the entire war and beyond, despite massive deficits. There is a repetition of this story playing out right now, and Japan has been doing the same for more than a decade. Despite its mounting government debt, the yield on 10-year government bonds is not more than 2% as of July 2010. In the end, market rates tend to follow whatever the central bank does in terms of short-term rates, not what the fiscal position of the government is.

As we already stated on this blog before, a simple observation of how government finance operates shows that government spending injects reserves into the banking system (pressing down short-term interest rate), while the payment of taxes reduces/destroys reserves (pushing short-term rates up). The Fed has institutions that allow it to coordinate on a daily basis with the Treasury (they call each other every day) to make sure that all these government operations do not push the interest rate outside the Fed’s target range.

  1. “If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.”

That’s a repeat of the first question but with a bit of elaboration. The US government cannot default on its securities for financial reasons, it is perfectly solvent and liquid. (Sovereign governments can, as we have conceded on this blog, refuse to pay – e.g. Japan after the war – but that is because it was unwilling to repay, not because it was unable to pay.) Thus, despite Reinhart and Rogoff’s warnings, the credit history of the US government (and any monetarily-sovereign government) remains perfect. No government with a non-convertible, sovereign currency has ever bounced a check trying to make payment in its own unit of account.

The US government always pays by crediting the account of someone (i.e. “monetary creation”). If the creditor is a bank, this leads to higher reserves, if it is a non-bank institution it leads also to an increase in the money supply. It has been like this from day one of Treasury activities. It is not a choice the government can make (between increasing the money supply, taxing or issuing bonds); any spending must lead to a monetary creation; there is no alternative. Again taxes and bonds are not funding sources for the US federal government; however they have important functions. Taxes help to keep inflation in check (in addition to maintaining demand for the government’s monetary instruments). Bond sales allow the government to deficit spend without creating excessive volatility in the federal funds market. If financial market participants want more bonds, the Treasury issues more to keep bond rates high enough for its tastes; if financial market participants do not want more treasury bonds, the government does not issue to avoid raising rates. The US Treasury (and any monetarily sovereign government as long as they understand it) has total control over the rate it pays on its debts; whether the government understands this or not is another question. A monetarily sovereign government does not have to pay “market rates” in order to convince markets to hold its bonds. Indeed, it does not even have to issue securities if it does not want to. In the US, it is usually the financial institutions that beg the Treasury to issue more securities.

The recent episode of the “Supplementary Financing Program” is a very good illustration of that point. Financial market participants were crying for more Treasuries and the Fed could not keep pace. As a consequence the Treasury agreed to issue more Treasuries than expected to meet the demand and help the Fed drain reserves and thereby hit their interest rate target. According to the Federal Reserve Bank of New York (DOMESTIC OPEN MARKET OPERATIONS DURING 2008, page 28): “To help manage the balance sheet impact of the Federal Reserve’s liquidity initiatives, the Treasury announced the establishment of a temporary Supplementary Financing Program (SFP) on September 17. The program consists of a series of Treasury bills issued by Treasury, the proceeds of which are deposited in an account at the Federal Reserve, draining reserve balances from the banking sector.”

Now look how this was deformed by the Treasury (quite a few journalists and bloggers followed): “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.” No, Mr. Treasury, this was not done for funding purpose; it was done to drain reserves from the banking system. The Fed does not need any cash from the Treasury. The Fed is the monopoly supplier of cash.

A final point regarding inflation. Inflation is a potential issue, as we have always maintained. But, there is no automatic causation from the money supply to inflation (a point Paul Krugman appears to have forgotten). Inflationary pressures depend on the state of the economy (supply and demand-side factors). Most importantly, perhaps, it depends on people’s desire to hoard vs. spend cash. Even the massive deficits during WWII, when resources were fully employed, did not lead to a spiraling out of control of inflation. Finally, it is quite possible that causation actually runs the other way around – i.e. from inflation to the money supply – given the endogeneity of the money supply, but that’s a story for another day…


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Posted in Eric Tymoigne, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, Uncategorized, Unemployment

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RAB Capital’s Marshall Auerback on the CBO’s Report

Posted on July 28, 2010 by | 1 comment

Watch the latest video at video.foxbusiness.com

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Towards a Libertarian/Austrian Modern Money Theory

Posted on July 27, 2010 by | 31 comments

By L. Randall Wray

For reasons that I cannot fathom, the most vehement critics of Modern Money Theory (MMT) are the wingnut libertarians and Austrians (and, please, I use the term wingnut with some affection for our fellow fringe travellers). Any time there is an MMT post on this blog, or over at New Deal, Naked Capitalism, or the Huff, the comments are dominated by conspiracy theorists, haters of government, goldbugs, and victims of alien probings who are certain that MMT-ers are united in their effort to ramp up government until it consumes the entire economy. So let us try to mend fences.

First, on one level, MMT is a description of the way a sovereign currency works. Love it or hate it, our sovereign government spends by crediting bank accounts. Over the past 20 years, MMT has investigated, analyzed, and documented the sordid operational details. We can lecture for hours on the balance sheet manipulations involving the Treasury, the Fed, the primary security dealers, the special depositories, and the regular private banks every time the Treasury buys a notepad from OfficeMax. We did the work, so you do not have to do it. And believe me, you do not want to do it. You can skip directly to the conclusion: “Yes, government spends by crediting bank accounts, taxes by debiting them, and sells bonds to provide an interest-earning substitute to low-earning reserves. Q.E.D.”

A few libertarians and Austrians now get this, although instead of thanking us for a job well done, they immediately attack us for explaining how things work. Now, why would they do that? Because they fear that if we tell policymakers and the general public how things work, democratic processes will inevitably blow up the government’s budget as everyone demands that wine flow freely through the nation’s drinking fountains whilst workers retire from government jobs at age 28 on generous pensions provided at the public trough. And off we go to Zimbabwe land, with hyperinflation that destroys the currency and sucks the precious body fluids from our economy.

Ok, understood. We fear inflation, too. That has always been our message, too. Indeed, “price stability” has always been one of the two key missions of UMKC’s Center for Full Employment and Price Stability (http://www.cfeps.org/). Maybe you do not like our proposed methods of battling inflation. Fine. Show us yours. I realize that many libertarians and Austrians believe that the only foolproof method for avoiding inflation is to go back to gold. Again, fine. But don’t criticize our labor “buffer stock” scheme for its political infeasibility! Going back to the gold standard is less likely than alien abduction. (Oh, sorry, no offence intended.) Anyway, we (also) do not want black helicopters flying around dropping bags of cash; and we (also) oppose government “pump-priming” demand stimulus—the libertarians and Austrians and even Milton Friedman are correct in their argument that this would generate inflation.

So it is true that there is a second level to MMT: we use our understanding of the way money works to bring rational analysis to government policy-making. Since involuntary default is, literally, impossible for a sovereign government, we quickly move beyond fears about government deficits and debt ratios and all the other nonsense that currently grips Washington. Can we “afford” full employment? Yes. Can we “afford” Social Security? Yes. Can we “afford” to put wine in all the drinking fountains? Yes. The problem IS NOT, CANNOT BE about affordability. It is about resources. Unemployment is easy: by definition, someone who is unemployed is available to hire. So government can put them to work. Social Security is a little more difficult: can we move enough resources to the aged (plus their dependents, and people with disabilities) so that they can enjoy a comfortable, American-style, life? On all reasonable projections of demographics and US ability to produce, the answer is yes. The projections could turn out to be wrong. But if they do, affordability still will not be the problem—it will be a resource problem. Finally, wine in drinking fountains? There probably is not enough fine wine, but we could probably fill all the drinking fountains with cheap French wine. Again, it is a resource problem and if we convert the American prairies to wine production we could probably even resolve that one.

Perhaps the most important policy pushed by most MMT-ers is the Job Guarantee/Employer of Last Resort proposal. This provides a federal-government funded job to anyone who wants to work, at a uniform, basic compensation (wages plus benefits). Our libertarian/Austrian fellow travelers seem to hate this program, again for unfathomable reasons. I suspect that they have misinterpreted this to be some kind of Big Government/Big Brother program based on a weird combination of force plus welfare. The claim is simultaneously that it “forces” everyone to work, and that it also pays everyone for not working. Actually, it is a purely voluntary program, only for those who want to work. Those who will not work cannot participate. Libertarians and Austrians ought to love it. It is not Big Brother. It is not even Big Government. The jobs do not have to be provided by government at all. No one has to take a job. It is consistent with, I think, the most cherished norms of freedom-loving libertarians and Austrians.

So to sum up:

1. MMT is consistent with any size of government. It can be a small libertarian government if you like. But it issues a sovereign floating currency. It supports the currency by imposing a tax payable in that currency.

2. Job Guarantee/Employer of Last Resort is also consistent with any size of government. If you want a big private sector and small government sector, keep taxes and government spending low. That frees up resources to be used by the big private sector. But you will need the JG/ELR to take up the labor resources the private sector cannot fully employ.

3. JG/ELR can be as decentralized as you want. I think there are massive incentive problems if you have federal government pay wages of for-profit firms. So I would have federal government pay the wages in the program but have the jobs actually created and managed by: not-for-profits, local government, maybe state government, maybe only as a final last resort the federal government. Argentina experimented with cooperatives and they looked to me to be highly successful.

4. The problem with a monetary economy (you can call it capitalism if you like) is that from inception imposition of taxes creates unemployment (those looking for money to pay taxes). We scale this up to our modern almost fully monetized economy (you need money just to eat, watch TV, play on cell phones, etc) and we get everyone looking for money (and not just to pay taxes). It is sheer folly to then force the private sector to solve the unemployment problem created by the government’s tax. The private sector alone will never (never has) provide full employment. ELR/JG is a logical and empirical necessity to support the private sector. It is a complement not a substitute for private sector employment.

5. How can the belief that all ought to work, and contribute to society, rather than lay about and collect welfare be called socialism?

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

Posted on July 26, 2010 by | 3 comments


By L. Randall Wray

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

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

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

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

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

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

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

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Deficit Doves Meet the Deficit Owls

Posted on July 21, 2010 by | 6 comments


By Stephanie Kelton

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


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

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

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

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

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

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


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

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

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The Myths About Government Debt and Deficit as Told By Carmen Reinhart and Kenneth Rogoff

Posted on July 17, 2010 by | 25 comments

Yeva Nersisyan

In every culture there are a set of myths that are used to bring up future generations. In the US parents tell their children that if they don’t behave the bogeyman will get them. In many other countries it is a “Sack man” who carries naughty children away in a big sack. The myths are numerous and differ from culture to culture but the purpose is to get children to conform to the parental authority. As children trust their parents this is usually fairly easily accomplished. Although we would like to think that once we become adults we are not fed similar half-truths and outright lies, unfortunately it is not the case. One would think that as adults who have the capacity to reason and think critically we could spot those lies and myths. But what to do, if the people whose authority we trust, the so-called scientists and experts in the field are the ones feeding us the myths?

Major crises can be useful in helping people to rethink the way they once thought about the world. During the Great Depression, we abandoned the idea that free markets could work without government intervention. Gradually, as the postwar economy avoided major crises, precisely due to state intervention, people got comfortable thinking that the economy has become inherently stable and that state intervention is no longer necessary. Economists were at the forefront of propagating this myth. We were also led to believe that fiscal policy was neither useful nor necessary. But perhaps the biggest myth that we were all taught is that the government should balance its budget just like a household does, that persistent budget deficits are unsustainable and will lead to stagnant growth and even to sovereign defaults. Thanks to this myth, propagated by professional economists, with nearly 10% of the US labor force unemployed and another 7% underemployed, the public debate is now focused on the false issue of deficits and debt.

A case in point is a recent book by Carmen Reinhart and Kenneth Rogoff, “This Time is Different” that has become a bestseller, making them the ultimate authorities on the issues of debt, default and crises. It has been used by conservatives and progressives alike to argue for lowering government deficits and debt in the midst of the current Great Recession. The media as well as academia have fawned all over this book, to the point where one begs the question whether they have actually taken the pain (it is painful!) to read the book (see here for more on this). This is not particularly surprising, however, considering that orthodox economists don’t have a theory to explain the financial crisis (since their models always excluded the possibility of one). Hence they have been desperate to embrace the “analysis” found in the book just like a drowning person holds on to a straw. A most recent example of the fluff surrounding the book can be found in the NYT by the Economix section writer Catherine Rampell, a deficit hawk herself. Rampell suggests that the book somewhat makes up for the shortcomings of economists, that being the failure to foresee the current crisis. I decided to check out the publications of Reinhart and Rogoff prior to the crises with the hope to find papers that foresaw the current debacle. The closest Ken Rogoff got was to argue that global imbalances were unsustainable. Unless you believe that the current crisis was the result of global imbalances (a strange and flawed but not uncommon proposition) then Rogoff can safely be classified among those economists who were so blinded by their own models that failed to see what was going on under their noses. A similar story can be told about Reinhart.

Reinhart and Rogoff might be commended on the amount of work they have put into assembling the huge database (it covers eight centuries and sixty-six countries, although the focus of the book is crises and defaults since 1800). Rather than closely studying the details of particular crises to gain an understanding of causes and consequences in order to make more general statements, their method is to aggregate particular measures and ratios across countries and over the long sweep of history to obtain data presented in “simple tables and figures” to “open new vistas for policy analysis and research.” Indeed, their book is nothing more than a large database of questionable value. The authors argue in favor of empirical investigations rather than fancy models. I agree with that. But simply having a large amount of data without much meaningful explanation is not very useful. Economic analysis and theorizing doesn’t necessarily have to be mathematical. One can use the narrative approach to explain economic events. Indeed, the narrative approach is in some cases the only way to capture the complexity of the world around us. And while Rogoff and Reinhart have rejected the mathematical modeling, they haven’t offered an alternative in the form of a narrative either. They simply have failed to do much explaining at all.

The crux of the book is that each time people think that “this time is different”, that crises cannot occur anymore or that they happen to other people in other places. True. This is exactly what Hyman Minsky was arguing more than 40 years ago. Reinhart and Rogoff don’t really explain why this perception leads to crises. Minsky, on the other hand, had an analysis of investment and of position taking in assets which led him to conclude that when people get comfortable in the existing situation they tend to overextend their balance sheets and lower the cushions of safety, which inevitably leads to fragility. A fragile financial system is then subject to a crash like the one we experienced in 2007.

The book is mostly on crises driven by government debt. Rogoff and Reinhart claim to have identified 250 sovereign external defaults and 70 defaults on domestic public debt. The problem with their “analysis”, however, is that over the past 800 years (and even over the past two centuries that are the focus of the book), institutions, approaches to monetary and fiscal policy, and exchange rate regimes have changed. For example, before the Great Depression the US was on a Gold Standard, then there was the Bretton Woods regime and finally in the last 40 years the US dollar has been a non-convertible currency. From reading the book it seems that this is not important at all. In reality the monetary regime a country operates on has major implications for government solvency. Aggregating data over different monetary regimes and different countries cannot yield any meaningful conclusions about sovereign debt and crises. It is only useful if the goal is to merely validate one’s preconceived myth about government debt being similar to private debt.

A sovereign government that operates on a non-convertible currency regime spends by issuing its own currency and as it’s the monopoly issuer of that currency, there are no financial constraints on its ability to spend. See here, here and here for more. It doesn’t need to tax or issue bonds to spend. It makes any payments that come due, including interest rate payments on its “debt” and payments of principal by crediting bank accounts meaning that operationally they are not constrained on how much they can spend. Governments operating with a non-convertible fiat currency cannot be forced to default on sovereign debt. They can choose to do so but that’s ultimately a political decision, not an economic/operational one. As far as I can tell Rogoff and Reinhart haven’t identified a single case of government default on domestic-currency denominated debt with a floating exchange rate system.

The need to balance the budget over some time period determined by the movements of celestial objects is a myth. When a country operates on a fiat monetary regime, debt and deficit limits and even bond issues for that matter are self-imposed, i.e. there are no financial constraints inherent in the fiat system that exist under a gold-standard or fixed exchange rate regime. But that superstition is seen as necessary because if everyone realizes that government is not actually financially constrained then it might spend “out of control” taking too large a percent of the nation’s resources. See here for more.

When the Great Depression hit governments didn’t know how to counteract the crisis, to solve the problem of unemployment. Further they were constrained by the Gold Standard (which the U.S. finally abandoned in 1933). Today we know exactly what to do to solve the issue of underutilization of labor resources. But unfortunately we are constrained by myths. I wonder what the economists, who propagate these myths, would say if they were in the ranks of the unemployed. Would they say that Congress should not extend unemployment benefits because it will further contribute to the deficit? Would they say that more stimulus is unsustainable? I suggest we leave them unemployed for a while. They will have more free time to do some Modern Monetary Theory reading and more “economic incentives” (i.e. lack of income to support themselves and their families) to rethink their position. Professional economists are a major impediment on the way to using our economic system for the benefit of us all. And Reinhart and Rogoff are no exception.


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Goldman Vampire Squid Gets Bitch Slapped: JP Morgan Bitch Slaps the Dow; and Geithner Tries to Bitch Slap Elizabeth Warren

Posted on July 15, 2010 by | 14 comments

By L. Randall Wray

Ok here were three pieces of news today. First, Goldman Sachs was fined $550 Million for duping customers. We do not need to recap the charges in detail. Goldman helped hedge fund manager John Paulson pick toxic waste sure to go bad for collateralized debt obligations (CDOs) that Goldman would sell to its own patsy clients. Goldman and Paulson then bet against the clients. Since Paulson had picked “assets” guaranteed to go bad, it was a sure bet that Paulson and Goldman would win and that Goldman’s clients would lose. Oh, and by the way, although Goldman let Paulson meet the patsies, Goldman never told the patsies that Paulson arranged the deals and would win when they failed. Business as usual on Wall Street. In the SEC’s settlement, Goldman agreed that this was “incomplete information”—ie the patsies might have liked to know that Goldman and Paulson worked together to ensure the bets were rigged and the patsies would lose. Duh. For Goldman it was a tiny slap on the wrist—it still controls the Obama administration, with its moles, Timmy Geithner and Larry Summers still in charge of fiscal policy, thus prepared to funnel whatever money is necessary to prop up their firm—and the fine amounts to just 14 days of Goldman’s earnings. Time to celebrate—which Goldman did, as its stock rallied on the news that it had been found to have screwed its customers. Is there a better reason to party?

Round two. JP Morgan announced that its profits rose by 76%. Funny thing is that in all banking categories, JP Morgan’s results were horrendous: it lost deposits, it made fewer loans, and even its fees fell by 68%. So how could a bank manage to profit on such dismal results? Well in the old days it was called window dressing—banks would move one little chunk of gold among themselves to show that they were credit worthy. In Morgan’s case, the profits supposedly came from “trading”. In reality they mostly came from reducing “loan loss reserves”. In other words, Morgan decided it had set aside too many reserves against all the bad loans it made over the past decade. After all, borrowers will almost certainly start to make payments on all their debt over the next few months and years, won’t they? Sure, homeowners are massively underwater, and losing their jobs, and cutting back spending, but recovery is just around the corner. Right. Looks like 1933 all over again.

Ok, bitch slapping number three. Our favorite Timmy has weighed in on Elizabeth Warren. Lest readers need any reminder, Warren is the lone sensible voice within the Obama administration. There is, with no exaggeration at all, no other administration official who deserves her or his job more than Warren does. If—and this is a big if—the US survives the current crisis, there is no one who deserves more accolades than Warren. Heck, half the men (and perhaps the same percent of women) in the country have already proposed marriage to her. Yet, Timmy Geithner (let me repeat that: Timmy! Geithner!) the most incompetent and conflicted public official since “heck-uv-a-job” Brownie has dared to oppose Ms. Warren to lead the new Consumer Financial Protection Bureau.

Actually I agree with Timmy. Elizabeth Warren ought to be gunning for Timmy’s job. Fire Geithner. Now. Elizabeth Warren for Treasury Secretary! And in 2012, Warren for President. We should settle for no less. And Obama clearly does not want that job, anyway. Sorry folks, the audacity of hope can only carry us so far. Time for a new face in the White House. Elizabeth is our man, or woman.

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Latvia’s Third Option: Neither Devaluation nor Austerity, but Tax Restructuring

Posted on July 7, 2010 by | 7 comments

By Michael Hudson

As Europe’s banking crisis deepens, Greece’s and Spain’s fiscal crisis spreads throughout Europe and the US economy stalls, most discussions of how to stabilize national finances assume that only two options are available: “internal devaluation” – shrinking the economy by cutting public spending; or outright devaluation of the currency (for countries that have not yet joined the euro, such as Eastern Europe).

The Baltics and other countries have rejected currency depreciation on the ground that it would delay EU membership. But as most debts are denominated in euros – and owed mainly to foreign banks or their local branches – devaluation would cause a sharp jump in debt service, causing even more defaults and negative equity in real estate. Devaluation also would raise the price of energy and other essential imports, aggravating the economic squeeze.

Sovereign governments of course can re-denominate all debts in domestic currency by abolishing the “foreign currency” clause, much as President Roosevelt abolished the “gold clause” in U.S. bank contracts in 1933. This would pass the bad-loan problem on to the Swedish, Austrian and other foreign banks that have made the loans now going bad. But most government leaders find currency devaluation so unthinkable that, at first glance, there seems to be only one alternative: an austerity program of fiscal cutbacks.
The EU, IMF and major banks are telling governments to run budget surpluses by cutting back pension and social security programs, health care, education and other social spending. Central banks are to reinforce austerity by reducing credit. Wages and prices are assumed to fall proportionally, enabling shrinking economies to “earn their way out of debt” by squeezing out a trade surplus to earn the euros to carry the enormous mortgage debts that fueled the post-2002 property bubble, and the new central bank debt taken on to support the exchange rate.
The Baltic States have adopted the most extreme monetary and fiscal austerity program. Government spending cutbacks and deflationary monetary policies have shrunk the GDP by more than 20% over the past two years in Lithuania and Latvia. Wage levels in Latvia’s public sector have fallen by 30%, and the central bank has expressed hope that the wage squeeze will continue and lower private-sector wages as well.
The problem is that austerity prompts strikes and slowdowns, which shrinks the domestic market and investment. Unemployment spreads and wages fall. This leads tax receipts to plunge, because Latvia’s tax system falls almost entirely on employment. Half of the employers’ wage bill goes to pay the exorbitant set of flat taxes amounting to over 51%, while a VAT tax absorbs another 7% of disposable personal income. Yet the central bank trumpets the wage decline as a success – and would like even further shrinkage!
Property prices have plunged too, by as much as 70%. Mortgage arrears have soared to over 25 percent, and defaults are rising. Downtown Riga and the Baltic beach suburb of Jurmala are filled with vacancies and “for sale” signs. Falling prices lock mortgage-burdened owners into their properties. Meanwhile, the virtual absence of a property tax (a merely nominal rate in practice of about 0.1%) has enabled speculators to leave prime properties unrented.
About 90% of Latvian mortgage debts are in euros, and most are owed to Swedish banks or their local branches. A few years ago, bank regulators urged banks to shift away from collateral-based lending (where the property backed the loan) to “income-based” lending. Banks were encouraged to insist that as many family members as possible co-sign the loans – children and parents, even uncles and aunts. This enables banks to attach the salaries of all co-signing parties.
The next step is to foreclose on the property. Bank regulators are concerned only with maintaining bank solvency (mainly for a foreign-owned banking system) not with the overall economy. Their model is Estonia which combined stable finances with 15% economic shrinkage in 2009, and was rewarded by last month’s promise of entry into Euroland.
The result is that instead of running the banking system for the economy, Latvia and other post-Soviet economies are managing their economies to maintain bank solvency – as if the indebted population is really expected to spend the rest of their lives paying off the deep negative equity left in the wake of bad loans.
This is causing such havoc that some business owners are emigrating to escape their debts. The newspaper Diena recently published an article about a woman of modest means in the mid-sized Latvian town of Jelgava. After taking out a 40,000 lat ($65,000) mortgage she lost her job. The bank refused to renegotiate and auctioned off her property for just 7,500 lats, leaving her still owing 30,000 for the shortfall, to be paid out of future income.

Mortgage lending to fuel the property bubble has been financing the trade deficit – but now has stopped
Until the property bubble burst two years ago, euro-mortgage lending provided the foreign exchange to cover Latvia’s trade deficit. The central bank is now borrowing from the EU an IMF, on the condition that the loan will be used only to back the currency as a cushion. This seems self-defeating, because monetary deflation will cause financial distress, aggravating the bad-debt crisis and spurring financial outflows.

Can governments that promote such policies be re-elected to office? In Latvia and other East European economies, political parties are developing a Third Option as an alternative to devaluation, economic shrinkage and declining living standards.
This Third Option is to reform the tax system. It starts with the fact that Latvia’s bloated 50%+ tax package on employment means that take-home wages are less than half of what employers pay. Latvia has the worst remunerated northern European labor, yet it is proportionally the highest-cost to employers. And to make matters worse, real estate taxes are only a fraction of 1%. This has been a major factor fueling the real estate bubble. Untaxed land value is paid to banks, which in turn lend their mortgage receipts out to bid up property prices all the more – while obliging the government to tax labor and sales, raising the cost of labor and the price of goods and services. A similar high flat tax on labor and little property tax has plagued the entire post-Soviet block ever since 1991.
The good news is that this malformed tax system leaves substantial room to shift employment taxes onto the “free lunch” revenue comprised of the land’s rental value, monopoly rents and financial wealth. At present, this revenue is left “free” of taxation – only to be pledged to banks.
Latvia’s economy can be made more competitive simply by freeing it from the twin burden of heavily taxed wages and housing prices inflated by easy euro-credit. It has a wide margin to reduce the cost of labor to employers by 50 percent, without reducing take-home wages. A tax shift off labor onto the land’s rental value would lower the cost of employment without squeezing living standards – and without endangering government finances.
Lowering taxes on wages would reduce the cost of employment without squeezing take-home pay and living standards. Raising taxes on property, meanwhile, would leave less value to be capitalized into bank loans, thus guarding against future indebtedness.
This was the policy that underlay Hong Kong’s economic rise – the example that Latvian leaders hope to emulate as a banking service entrepot and international technology center (as Latvia was in pre-1991 Soviet times). Hong Kong promoted its economic takeoff by relying mainly on collecting the land’s rental value, enabling it to minimize employment taxes (presently only 15%).
Shifting the burden of tax from labour onto land would therefore hold down the price of housing and commercial space, because rental value that is taxed will no longer will be recycled into new mortgages.
The tax shift also can bring down property prices, because rental value that is taxed no longer will be available for banks to capitalize into mortgage loans. Housing in debt-leveraged economies such as the United States and Britain typically absorbs 40 percent of family budgets. Reducing this proportion to 20 percent – the typical rate in Germany’s much less indebted economy, where lending has been more responsible – could enable wage receipts to be spent on goods and services rather than as mortgage debt service. It thus would provide further scope for wage moderation without lowering living standards. This means that Latvians and other Eastern European countries do not need to sacrifice the economy on a cross of euro-debts and suffer from currency devaluation or austerity programs.
Shifting the tax off employees onto the land would cut the cost of living for Latvians, by holding down the price of housing and commercial space. The economic rent – income without any corresponding cost of production – would be paid to the government as the tax base rather than being “free” to be pledged to banks to be capitalized into mortgage loans. Property prices are determined by how much banks will lend, so taxing the land’s rental value (but not legitimate returns on building and capital improvements) would reduce the capitalization rate, holding down property prices.
In sum, the problem with monetary deflation (“internal devaluation”) is that it leaves the existing dysfunctional tax structures in place. The main issue in Eastern Europe and beyond over the coming years will be whether economies can free themselves from the twin burden of heavily taxed wages and inflated housing prices, while avoiding an overdose of needless austerity. The tax structure needs to be changed – along the lines that most countries in the West expected to see a century ago.
The aim should be to make the economy more competitive by minimizing the cost of living and doing business. The Third Option serves to bring property and monopoly prices in line with necessary costs of production. Taxing away “empty” pricing in excess of cost-value – economic rent – was part of the “original” liberalism of Adam Smith and John Stuart Mill, and indeed of classical economists from the French Physiocrats down through Progressive Era reformers.
The national parliamentary elections scheduled for this October will be fought largely over the Latvia Renewed economic development program, sponsored by Harmony Center the coalition of left-wing parties. At the latter’s annual meeting on May 29-30, party leaders moved to start preparations to translate the above alternative into law and drawing up a land-value map of Latvia.

*Michael Hudson is Chief Economist of the Reform Task Force Latvia, http://www.rtfl.lv, commissioned by the Harmony Center coalition.

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Why Dean Baker has Gone off the Rails on Social Security

Posted on July 2, 2010 by | 20 comments

By Stephanie Kelton

Some of the members of the president’s National Commission on Fiscal Responsibility and Reform are using the trumped-up crisis in Social Security to push their decades-in-the-making agenda of privatization. For example, Andy Stern, one of the commission’s key members, wants to see the system transformed from one that guarantees a minimum standard of living to the elderly, their dependents and the disabled into one that leaves them (in whole or in part) dependent on the vagaries of the market.

Asked to comment on Stern’s privatization proposal, Dean Baker recently said:

“I don’t think it’s necessarily a bad idea …. If he’s talking about getting money out of the trust fund for that purpose, I could live with it. You’d get a higher return now that stocks are falling.”

To defend his position, Baker pointed out that the Trust Fund, which consists almost entirely of non-marketable government securities, is only earning about three percent but that “it would be reasonable to assume a six or seven point return” on funds invested in the stock market. Hmm . . .

Seven is greater than three. You can’t argue with that. That is, unless you look more closely at what privatization would actually entail.

Since President Obama’s deficit commission hasn’t proposed anything concrete (yet) – i.e. we don’t know how much of the current system they want to privatize – let’s go ahead and use George W. Bush’s privatization proposal, simply for purposes of demonstration.

In 2005, President Bush pushed for partial privation of Social Security, which would have allowed workers under the age of 55 to divert up to 4 percent of their current payroll tax contribution into their own retirement accounts. Workers who decided to participate would then depend upon benefits from two sources: (1) the (now lower) guaranteed benefit they would continue to receive from Social Security and (2) the market benefit that would accrue in the form of gains in their personal account. Clearly, the more an individual diverts into private accounts, the less they would receive in the form of a guaranteed benefit, and, hence, the more they will rely upon gains in financial markets.

Here’s the way a Senior Administration Official sold the Bush plan in 2005:

“The way that the election is put before the individual in a personal account structure of this type is that in return for the opportunity to get the benefits from the personal account, the person foregoes a certain amount of benefits from the traditional system.

Now, the way that election is structured, the person comes out ahead if their personal account exceeds a 3 percent real rate of return, which is the rate of return that the trust fund bonds receive. So, basically, the net effect on an individual’s benefits would be zero if his personal account earned a 3 percent real rate of return. To the extent that his personal account gets a higher rate of return, his net benefit would increase as a consequence of making that decision . . . .

. . . the specific trade-off that you’re making in opting for a personal account is based on your decision that you
think you can beat the 3 percent real rate of return.”

So that’s the privatization pitch: privatization offers better prospects for growth and, ultimately, a more comfortable retirement. This is especially true in the case of younger workers, because they can get in early and experience the magic of compound interest. This, apparently, is where Dean Baker is coming from.

It’s a choice that seems to make sense for those who expect their personal account to earn a rate of return that exceeds the rate of return earned on Treasury bonds (held in the Trust Fund). But is it really such a no-brainer? Let’s look more closely at the implications of diverting withholdings into personal accounts.

Investing in a personal account means foregoing a portion of the guaranteed benefits that would have been received under the traditional system. Advocates of privatization see no harm in this, since earnings on personal savings accounts should more than offset the foregone benefits. Chart 1 on page 13 of this essay provides a diagrammatic description of the role of personal savings accounts in offsetting guaranteed benefit reductions.

It works like this. When a worker agrees to establish a personal account he is effectively asking the government to lend him part of his Social Security tax so that he can invest it in the stock market. The government would monitor these loans and investments by establishing parallel accounts, a ‘notional account’ (to keep track of the loan) and a ‘personal account’ (to keep track of the investment). This means that diverted payroll contributions would be double-counted, and each account would be credited, over time, with interest – the notional account would accumulate interest at the rate of return on Treasury bonds, and the personal account would accumulate interest at the nominal portfolio rate of return, less annual fees.

To make the argument concrete, consider a highly simplified example. Suppose an individual’s notional account would equal $100,000 at retirement. If this person’s life expectancy at retirement is 20 years and the annuity draws zero interest and comes at zero administrative costs (simplifying assumptions), the annuity on this account would be $5,000. This sum – known as the “clawback” – would be deducted from the defined benefit amount, to arrive at the “benefit after clawback.” If the defined benefit (calculated using an inflation-index) would have otherwise been $12,000 per year, it will now be $7,000. Now, if the poverty-level of income is $16,000, this individual’s personal account will need to be sufficiently large (well above $100,000) to allow an additional (lifetime) benefit of $9,000 per year through annuitization.

As time goes on, the size of the clawback would grow, relative to the benefit, because the clawback would be proportional to wages, whereas the defined benefit would be fixed in real terms (i.e. indexed to prices). This would make workers increasingly dependent on the annuitized value of their personal accounts. Moreover, workers will have to pay a fee – to financial firms – to annuitize their individual accounts, a cost that could absorb as much as 10 to 20 percent of their savings, as Dean Baker showed when he was an outspoken critic of privatization in 2005.

With the size of the after-clawback benefit projected to decrease over time, it is likely that the whole private account will need to be annuitized. And, unless the stock market performs incredibly well, there is a good chance that the annuitized value of the private account will be insufficient to sustain many Americans in retirement.

The groups who are most vulnerable to this kind of shortfall are women and minorities, who make up a disproportionate share of America’s low-wage workers. This has been emphasized by Diana Zuckerman, president of the National Research Center for Women and Families, who argued that “[w]omen depend more on Social Security than men do, because women are less likely to have their own private pensions when they retire.” And, even when they do have pensions, Zuckerman said, “their pension checks are, on average, half as large as men’s are.” This means that our nation’s low-wage workers are particularly vulnerable because they are less likely to have other forms of saving, pensions, etc., to supplement Social Security in retirement.

So here we are again, this time with a Democratic president and a deficit commission stacked with conservatives posing the same question the Bush administration asked in 2005: Do you want your money in a Trust Fund that earns a 3 percent real return, or would you prefer to invest it in a personal account that might yield nearly 7 percent after inflation? Using this simple argument, people like Andy Stern will try to persuade Americans that the answer is fairly obvious.

For the sake of millions of Americans who are able to avoid the anguish of poverty only because of the benefits they receive under the current system, I hope Dean Baker will return to his roots and lead the progressive charge to preserve Social Security as we know it.

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