Monthly Archives: June 2011

Should European Nations Repudiate the Debt?

Posted on June 12, 2011 by | 9 comments

By L. Randall Wray

It is becoming increasingly clear that the global economy (at least in the West) is heading for a steep downturn. Almost all the US data coming out in recent days have been bad. The UK and Japan are in austerity mode, with predictable results. Worst of all is Euroland. It has imposed severe austerity—the modern day equivalent of Medieval blood-letting—on its periphery nations. These nations are loaded with debt. In the case of Ireland, which had been a model of a Neoliberal utopia, the government got into debt by taking over its banks’ debts. In an unfathomable act of charity, this was done only to save French and German banks—which held the unserviceable and unguaranteed Irish bank debt. In gratitude for Ireland’s equanimity, the EU imposed the equivalent of IMF sanctions on Ireland. The government is supposed to downsize and squeeze blood out of its population in order to reduce its debt load—which has thrown it into recession and reduced tax revenues. The worst thing you can do to a debtor is to force her to reduce her income. But that is exactly the Medieval medicine the EU prescribed for Ireland. The story with the other highly indebted euro nations is similar—if not in the causes of their particular debt disease, at least in the remedy prescribed.

There is now really no choice. The periphery nations must band together and go to the EU Parliament to present a unified voice. There are only three courses of action. The first is to abandon the euro, with each country adopting its own sovereign currency. For convenience, each could simply return to its pre-euro currency. All debts would be redenominated in its new (that is to say, old) currency. Each country would then adopt a package of stimulus policies to achieve growth with full employment. By returning to its own sovereign currency, no national government would have any problem servicing its debt. Each country could tell the ratings agencies to take a hike—if Moody’s et al are too stupid to recognize that a government operating with its own currency can always service its debt, each country could immediately pay off the debt in its own currency. All that really amounts to is crediting bank accounts with reserves and retiring the debt. As it reduces interest payments, that is actually a deflationary policy. However, any deflationary pressures can be offset by stimulative fiscal policy.

There is a downside to this policy. Holders of euro-denominated debt will be subject to redenomination in a new (old) currency. They will likely go to court in the EU to sue for recovery. This would lead to a long-drawn-out and nasty process that would at least buy time. I am not a lawyer and will not speculate on the likely results but I suspect that rulings will go against the “defaulters” and that sanctions will be imposed. Meanwhile, French and German banks will become insolvent, France and Germany will try to save them and will become exactly like Ireland—with huge and unserviceable government debts after they nationalize their private bank debt (ironically, in Germany’s case, its worst banks are already nationalized). Perhaps at that point they will join Ireland and the other formerly EMU nations in abandoning the euro. The last one out will need to shut off the lights. Say bye-bye to the euro. And hello to renewed hostility among European nations. We’ve been there before, with world war results.

The second approach is to stay on the euro but to default on euro-denominated debt. Now, in truth, there is nothing wrong with default by private sector debtors who are not insured by governments. Happens all the time. Debts owed to creditors are then pursued through bankruptcy courts. Ireland, however, decided to nationalize private debts of banksters. Unfortunately, sovereign default is not so simple. Yes, default by government on debt happens all the time, too. Remember Orange County? The problem is that creditors expect government to squeeze blood out of oranges (another Medieval technique) to pay off debt. In their otherwise awful book (This Time is Different), Carmen Reinhart and Kenneth Rogoff argue that when it comes to “sovereign” defaults, default is always in some sense voluntary. (It is noteworthy that they are unable to find a single case of a true sovereign default; that is to say, a default by a sovereign government on its own floating rate currency. So far as I can tell, every case of government default they identify has to do with a pegged exchange rate or currency board. But that is a topic for another day since the EMU countries essentially do have currency board arrangements.) Ireland could continue for some indeterminant period to let more blood out of its population. After all, the Irish are used to suffering. Perhaps with sufficient austerity, a modern equivalent to the potato famine could be reproduced. Young Irish are already emigrating in droves. Creditors could demand more Irish blood, until Ireland is completely depopulated. All that would be left would be the land—with foreclosure moving it to the portfolio of the French and German banks. No doubt they are drooling in anticipation. (Anyone who has ever been to Ireland can understand why.)

Defaulting whilst staying on the euro appears to me to include all the negative effects of leaving the euro but with none of the benefits. For example, Ireland and the other periphery nations would still be stuck with a vastly overvalued currency. At least if they abandoned the euro they could competitively devalue against German exporters. They will get sued in either case and rulings in EU courts will probably go against them. Perhaps it is best to leave the EMU and even the EU to protect their domestic economies if one is going to default.

The last option is to band together and to insist on EMU-wide reformation. Debts must be restructured and written-down. To be sure, default as well as leaving the EMU must be retained as a bargaining chip—but it should be “en mass”. And it should be made clear that the best option for both the indebted nations as well as the creditors is to come to mutually beneficial terms. European banks are, broadly, toast. Not only did they buy toxic US waste, but they also created plenty of their own. And they owe much of it to each other. Like the biggest US banks, they are “too big to fail”—which is to say that they are “systemically dangerous institutions” in Bill Black’s terminology. That means they must be “resolved”—downsized and closed, with assets and liabilities distributed to smaller institutions. Netting bad assets that banks owe to each other (within and across borders) would go a long way to downsizing exposures. (And banksters should be incarcerated. I suspect that the main reason that big banks are not closed is because governments know they will uncover massive go-to-jail fraud. It is not really that the banks are too big to fail but rather that they are too fraudulent to seize. If any honest examiner ever entered the doors of Goldman Sachs, for example, he could not leave with issuing thousands of subpoenas that would include the names of former, current and prospective future Treasury department officials.)

It is time to admit that the EMU was designed to fail. I have been arguing since the mid 1990s that the first serious financial crisis would bring it down. We are in that crisis. It is time to recognize that reality. The debts must be resolved and a new fiscal arrangement must be created. As I have argued many times, the EMU members are like US states, but without a Washington to help out in times of crisis. The chickens are here and they are roosting. We have come down to one viable choice—if the goal is to preserve European union. In addition to dealing with the debt, the EU must create a fiscal force similar in size to the US Treasury.

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MMP Blog 2: THE BASICS OF MACRO ACCOUNTING

Posted on June 12, 2011 by | 1 comment

By L. Randall Wray

In this blog we are going to begin to build the necessary foundation to understand modern money. Please bear with us. It may not be obvious, yet, why this is important. But you cannot possibly understand the debate about the government’s budget (and critique the deficit hysteria that has gripped our nation across the political spectrum from right to left) without understanding basic macro accounting. So, be patient and pay attention. No higher math or knowledge of intricate accounting rules will be required. This is simple, basic, stuff. It is a branch of logic. But it is extremely simple logic.

A note on terminology: a simple table at the bottom of this post will define some terms that will be used throughout this Primer. You might want to refer to it first, then come back and read the blog.

One’s financial asset is another’s financial liability. It is a fundamental principle of accounting that for every financial asset there is an equal and offsetting financial liability. The checking deposit is a household’s financial asset, offset by the bank’s liability (or IOU). A government or corporate bond is a household asset, but represents a liability of the issuer (either the government or the corporation). The household has some liabilities, too, including student loans, a home mortgage, or a car loan. These are held as assets by the creditor, which could be a bank or any of a number of types of financial institutions including pension funds, hedge funds, or insurance companies. A household’s net financial wealth is equal to the sum of all its financial assets (equal to its financial wealth) less the sum of its financial liabilities (all of the money-denominated IOUs it issued). If that is positive, it has positive net financial wealth.

Inside wealth vs outside wealth. It is often useful to distinguish among types of sectors in the economy. The most basic distinction is between the public sector (including all levels of government) and the private sector (including households and firms). If we were to take all of the privately-issued financial assets and liabilities, it is a matter of logic that the sum of financial assets must equal the sum of financial liabilities. In other words, net financial wealth would have to be zero if we consider only private sector IOUs. This is sometimes called “inside wealth” because it is “inside” the private sector. In order for the private sector to accumulate net financial wealth, it must be in the form of “outside wealth”, that is, financial claims on another sector. Given our basic division between the public sector and the private sector, the outside financial wealth takes the form of government IOUs. The private sector holds government currency (including coins and paper currency) as well as the full range of government bonds (short term bills, longer maturity bonds) as net financial assets, a portion of its positive net wealth.

A note on nonfinancial wealth (real assets). One’s financial asset is necessarily offset by another’s financial liability. In the aggregate, net financial wealth must equal zero. However, real assets represent one’s wealth that is not offset by another’s liability, hence, at the aggregate level net wealth equals the value of real (nonfinancial) assets. To be clear, you might have purchased an automobile by going into debt. Your financial liability (your car loan) is offset by the financial asset held by the auto loan company. Since those net to zero, what remains is the value of the real asset—the car. In most of the discussion that follows we will be concerned with financial assets and liabilities, but will keep in the back of our minds that the value of real assets provides net wealth at both the individual level and at the aggregate level. Once we subtract all financial liabilities from total assets (real and financial) we are left with nonfinancial (real) assets, or aggregate net worth.

Net private financial wealth equals public debt. Flows (of income or spending) accumulate to stocks. The private sector accumulation of net financial assets over the course of a year is made possible only because its spending is less than its income over that same period. In other words, it has been saving, enabling it to accumulate a stock of wealth in the form of financial assets. In our simple example with only a public sector and a private sector, these financial assets are government liabilities—government currency and government bonds. These government IOUs, in turn, can be accumulated only when the government spends more than it receives in the form of tax revenue. This is a government deficit, which is the flow of government spending less the flow of government tax revenue measured in the money of account over a given period (usually, a year). This deficit accumulates to a stock of government debt—equal to the private sector’s accumulation of financial wealth over the same period. A complete explanation of the process of government spending and taxing will be provided in the weeks and months to come. What is necessary to understand at this point is that the net financial assets held by the private sector are exactly equal to the net financial liabilities issued by the government in our two-sector example. If the government always runs a balanced budget, with its spending always equal to its tax revenue, the private sector’s net financial wealth will be zero. If the government runs continuous budget surpluses (spending is less than tax receipts), the private sector’s net financial wealth must be negative. In other words, the private sector will be indebted to the public sector.

We can formulate a resulting “dilemma”: in our two sector model it is impossible for both the public sector and the private sector to run surpluses. And if the public sector were to run surpluses, by identity the private sector would have to run deficits. If the public sector were to run sufficient surpluses to retire all its outstanding debt, by identity the private sector would run equivalent deficits, running down its net financial wealth until it reached zero.

Rest of world debts are domestic financial assets. Another useful division is to form three sectors: a domestic private sector, a domestic public sector, and a “rest of the world” sector that consists of foreign governments, firms, and households. In this case, it is possible for the domestic private sector to accumulate net claims on the rest of the world, even if the domestic public sector runs a balanced budget, with its spending over the period exactly equal to its tax revenue. The domestic sector’s accumulation of net financial assets is equal to the rest of the world’s issue of net financial liabilities. Finally, and more realistically, the domestic private sector can accumulate net financial wealth consisting of both domestic government liabilities as well as rest of world liabilities. It is possible for the domestic private sector to accumulate government debt (adding to its net financial wealth) while also issuing debt to the rest of the world (reducing its net financial wealth). In the next section we turn to a detailed discussion of sectoral balances.

Basics of sectoral accounting, relations to stock and flow concepts. Let us continue with our division of the economy into three sectors: a domestic private sector (households and firms), a domestic government sector (including local, state or province, and national governments), and a foreign sector (the rest of the world, including households, firms, and governments). Each of these sectors can be treated as if it had an income flow and a spending flow over the accounting period, which we will take to be a year. There is no reason for any individual sector to balance its income and spending flows each year. If it spends less than its income, this is called a budget surplus for the year; if it spends more than its income, this is called a budget deficit for the year; a balanced budget indicates that income equalled spending over the year.

From the discussion above, it will be clear that a budget surplus is the same thing as a saving flow and leads to net accumulation of financial assets. By the same token, a budget deficit reduces net financial wealth. The sector that runs a deficit must either use its financial assets that had been accumulated in previous years (when surpluses were run), or must issue new IOUs to offset its deficits. In common parlance, we say that it “pays for” its deficit spending by exchanging its assets for spendable bank deposits (called “dis-saving”), or it issues debt (“borrows”) to obtain spendable bank deposits. Once it runs out of accumulated assets, it has no choice but to increase its indebtedness every year that it runs a deficit budget. On the other hand, a sector that runs a budget surplus will be accumulating net financial assets. This surplus will take the form of financial claims on at least one of the other sectors.

Another note on real assets. A question arises: what if one uses savings (a budget surplus) to purchase real assets rather than to accumulate net financial assets? In that case, the financial assets are simply passed along to someone else. For example, if you spend less than your income, you can accumulate deposits in your checking account. If you decide you do not want to hold your savings in the form of a checking deposit, you can write a check to purchase—say—a painting, an antique car, a stamp collection, real estate, a machine, or even a business firm. You convert a financial asset into a real asset. However, the seller has made the opposite transaction and now holds the financial asset. The point is that if the private sector taken as a whole runs a budget surplus, someone will be accumulating net financial assets (claims on another sector), although activities within the private sector can shift those net financial assets from one “pocket” to another.

Conclusion: One sector’s deficit equals another’s surplus. All of this brings us to the important accounting principle that if we sum the deficits run by one or more sectors, this must equal the surpluses run by the other sector(s). Following the pioneering work by Wynne Godley, we can state this principle in the form of a simple identity:

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0

For example, let us assume that the foreign sector runs a balanced budget (in the identity above, the foreign balance equals zero). Let us further assume that the domestic private sector’s income is $100 billion while its spending is equal to $90 billion, for a budget surplus of $10 billion over the year. Then, by identity, the domestic government sector’s budget deficit for the year is equal to $10 billion. From the discussion above, we know that the domestic private sector will accumulate $10 billion of net financial wealth during the year, consisting of $10 billion of domestic government sector liabilities.

As another example, assume that the foreign sector spends less than its income, with a budget surplus of $20 billion. At the same time, the domestic government sector also spends less than its income, running a budget surplus of $10 billion. From our accounting identity, we know that over the same period the domestic private sector must have run a budget deficit equal to $30 billion ($20 billion plus $10 billion). At the same time, its net financial wealth will have fallen by $30 billion as it sold assets and issued debt. Meanwhile, the domestic government sector will have increased its net financial wealth by $10 billion (reducing its outstanding debt or increasing its claims on the other sectors), and the foreign sector will have increased its net financial position by $20 billion (also reducing its outstanding debt or increasing its claims on the other sectors).

It is apparent that if one sector is going to run a budget surplus, at least one other sector must run a budget deficit. In terms of stock variables, in order for one sector to accumulate net financial wealth, at least one other sector must increase its indebtedness by the same amount. It is impossible for all sectors to accumulate net financial wealth by running budget surpluses. We can formulate another “dilemma”: if one of three sectors is to run a surplus, at least one of the others must run a deficit.

No matter how hard we might try, we cannot all run surpluses. It is a lot like those children at Lake Wobegone who are supposedly above average. For every kid above average there must be one below average. And, for every deficit there must be a surplus.

Notes on Terms. Throughout this primer we will adopt the following definitions and conventions:

The word “money” will refer to a general, representative unit of account. We will not use the word to apply to any specific “thing”—ie a coin or central bank note.

Money “things” will be identified specifically: a coin, a bank note, a demand deposit. Some of these can be touched (paper notes), others are electronic entries on balance sheets (demand deposits, bank reserves). So, “money things” is simply short-hand for “money denominated IOUs”.

A specific national money of account will be designated with a capital letter: US Dollar, Japanese Yen, Chinese Yuan, UK Pound, EMU Euro.

The word currency is used to indicate coins, notes, and reserves issued by government (both by the treasury and the central bank). When designating a specific treasury or its bonds, the word will be capitalized: US Treasury; US Treasuries.

Net financial assets are equal to total financial assets less total financial liabilities. This is not the same as net wealth (or net worth) because it ignores real assets.

An IOU (I owe you) is a financial debt, liability, or obligation to pay, denominated in a money of account. It is a financial asset of the holder. There can be physical evidence of the IOU (for example, written on paper, stamped on coin) or it can be recorded electronically (for example, on a bank balance sheet).

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MMP Blog 2: THE BASICS OF MACRO ACCOUNTING

Posted on June 12, 2011 by | 75 comments

By L. Randall Wray

In this blog we are going to begin to build the necessary foundation to understand modern money. Please bear with us. It may not be obvious, yet, why this is important. But you cannot possibly understand the debate about the government’s budget (and critique the deficit hysteria that has gripped our nation across the political spectrum from right to left) without understanding basic macro accounting. So, be patient and pay attention. No higher math or knowledge of intricate accounting rules will be required. This is simple, basic, stuff. It is a branch of logic. But it is extremely simple logic.

A note on terminology: a simple table at the bottom of this post will define some terms that will be used throughout this Primer. You might want to refer to it first, then come back and read the blog.

One’s financial asset is another’s financial liability. It is a fundamental principle of accounting that for every financial asset there is an equal and offsetting financial liability. The checking deposit is a household’s financial asset, offset by the bank’s liability (or IOU). A government or corporate bond is a household asset, but represents a liability of the issuer (either the government or the corporation). The household has some liabilities, too, including student loans, a home mortgage, or a car loan. These are held as assets by the creditor, which could be a bank or any of a number of types of financial institutions including pension funds, hedge funds, or insurance companies. A household’s net financial wealth is equal to the sum of all its financial assets (equal to its financial wealth) less the sum of its financial liabilities (all of the money-denominated IOUs it issued). If that is positive, it has positive net financial wealth.

Inside wealth vs outside wealth. It is often useful to distinguish among types of sectors in the economy. The most basic distinction is between the public sector (including all levels of government) and the private sector (including households and firms). If we were to take all of the privately-issued financial assets and liabilities, it is a matter of logic that the sum of financial assets must equal the sum of financial liabilities. In other words, net financial wealth would have to be zero if we consider only private sector IOUs. This is sometimes called “inside wealth” because it is “inside” the private sector. In order for the private sector to accumulate net financial wealth, it must be in the form of “outside wealth”, that is, financial claims on another sector. Given our basic division between the public sector and the private sector, the outside financial wealth takes the form of government IOUs. The private sector holds government currency (including coins and paper currency) as well as the full range of government bonds (short term bills, longer maturity bonds) as net financial assets, a portion of its positive net wealth.

A note on nonfinancial wealth (real assets). One’s financial asset is necessarily offset by another’s financial liability. In the aggregate, net financial wealth must equal zero. However, real assets represent one’s wealth that is not offset by another’s liability, hence, at the aggregate level net wealth equals the value of real (nonfinancial) assets. To be clear, you might have purchased an automobile by going into debt. Your financial liability (your car loan) is offset by the financial asset held by the auto loan company. Since those net to zero, what remains is the value of the real asset—the car. In most of the discussion that follows we will be concerned with financial assets and liabilities, but will keep in the back of our minds that the value of real assets provides net wealth at both the individual level and at the aggregate level. Once we subtract all financial liabilities from total assets (real and financial) we are left with nonfinancial (real) assets, or aggregate net worth.

Net private financial wealth equals public debt. Flows (of income or spending) accumulate to stocks. The private sector accumulation of net financial assets over the course of a year is made possible only because its spending is less than its income over that same period. In other words, it has been saving, enabling it to accumulate a stock of wealth in the form of financial assets. In our simple example with only a public sector and a private sector, these financial assets are government liabilities—government currency and government bonds. These government IOUs, in turn, can be accumulated only when the government spends more than it receives in the form of tax revenue. This is a government deficit, which is the flow of government spending less the flow of government tax revenue measured in the money of account over a given period (usually, a year). This deficit accumulates to a stock of government debt—equal to the private sector’s accumulation of financial wealth over the same period. A complete explanation of the process of government spending and taxing will be provided in the weeks and months to come. What is necessary to understand at this point is that the net financial assets held by the private sector are exactly equal to the net financial liabilities issued by the government in our two-sector example. If the government always runs a balanced budget, with its spending always equal to its tax revenue, the private sector’s net financial wealth will be zero. If the government runs continuous budget surpluses (spending is less than tax receipts), the private sector’s net financial wealth must be negative. In other words, the private sector will be indebted to the public sector.

We can formulate a resulting “dilemma”: in our two sector model it is impossible for both the public sector and the private sector to run surpluses. And if the public sector were to run surpluses, by identity the private sector would have to run deficits. If the public sector were to run sufficient surpluses to retire all its outstanding debt, by identity the private sector would run equivalent deficits, running down its net financial wealth until it reached zero.

Rest of world debts are domestic financial assets. Another useful division is to form three sectors: a domestic private sector, a domestic public sector, and a “rest of the world” sector that consists of foreign governments, firms, and households. In this case, it is possible for the domestic private sector to accumulate net claims on the rest of the world, even if the domestic public sector runs a balanced budget, with its spending over the period exactly equal to its tax revenue. The domestic sector’s accumulation of net financial assets is equal to the rest of the world’s issue of net financial liabilities. Finally, and more realistically, the domestic private sector can accumulate net financial wealth consisting of both domestic government liabilities as well as rest of world liabilities. It is possible for the domestic private sector to accumulate government debt (adding to its net financial wealth) while also issuing debt to the rest of the world (reducing its net financial wealth). In the next section we turn to a detailed discussion of sectoral balances.

Basics of sectoral accounting, relations to stock and flow concepts. Let us continue with our division of the economy into three sectors: a domestic private sector (households and firms), a domestic government sector (including local, state or province, and national governments), and a foreign sector (the rest of the world, including households, firms, and governments). Each of these sectors can be treated as if it had an income flow and a spending flow over the accounting period, which we will take to be a year. There is no reason for any individual sector to balance its income and spending flows each year. If it spends less than its income, this is called a budget surplus for the year; if it spends more than its income, this is called a budget deficit for the year; a balanced budget indicates that income equalled spending over the year.

From the discussion above, it will be clear that a budget surplus is the same thing as a saving flow and leads to net accumulation of financial assets. By the same token, a budget deficit reduces net financial wealth. The sector that runs a deficit must either use its financial assets that had been accumulated in previous years (when surpluses were run), or must issue new IOUs to offset its deficits. In common parlance, we say that it “pays for” its deficit spending by exchanging its assets for spendable bank deposits (called “dis-saving”), or it issues debt (“borrows”) to obtain spendable bank deposits. Once it runs out of accumulated assets, it has no choice but to increase its indebtedness every year that it runs a deficit budget. On the other hand, a sector that runs a budget surplus will be accumulating net financial assets. This surplus will take the form of financial claims on at least one of the other sectors.

Another note on real assets. A question arises: what if one uses savings (a budget surplus) to purchase real assets rather than to accumulate net financial assets? In that case, the financial assets are simply passed along to someone else. For example, if you spend less than your income, you can accumulate deposits in your checking account. If you decide you do not want to hold your savings in the form of a checking deposit, you can write a check to purchase—say—a painting, an antique car, a stamp collection, real estate, a machine, or even a business firm. You convert a financial asset into a real asset. However, the seller has made the opposite transaction and now holds the financial asset. The point is that if the private sector taken as a whole runs a budget surplus, someone will be accumulating net financial assets (claims on another sector), although activities within the private sector can shift those net financial assets from one “pocket” to another.

Conclusion: One sector’s deficit equals another’s surplus. All of this brings us to the important accounting principle that if we sum the deficits run by one or more sectors, this must equal the surpluses run by the other sector(s). Following the pioneering work by Wynne Godley, we can state this principle in the form of a simple identity:

Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0

For example, let us assume that the foreign sector runs a balanced budget (in the identity above, the foreign balance equals zero). Let us further assume that the domestic private sector’s income is $100 billion while its spending is equal to $90 billion, for a budget surplus of $10 billion over the year. Then, by identity, the domestic government sector’s budget deficit for the year is equal to $10 billion. From the discussion above, we know that the domestic private sector will accumulate $10 billion of net financial wealth during the year, consisting of $10 billion of domestic government sector liabilities.

As another example, assume that the foreign sector spends less than its income, with a budget surplus of $20 billion. At the same time, the domestic government sector also spends less than its income, running a budget surplus of $10 billion. From our accounting identity, we know that over the same period the domestic private sector must have run a budget deficit equal to $30 billion ($20 billion plus $10 billion). At the same time, its net financial wealth will have fallen by $30 billion as it sold assets and issued debt. Meanwhile, the domestic government sector will have increased its net financial wealth by $10 billion (reducing its outstanding debt or increasing its claims on the other sectors), and the foreign sector will have increased its net financial position by $20 billion (also reducing its outstanding debt or increasing its claims on the other sectors).

It is apparent that if one sector is going to run a budget surplus, at least one other sector must run a budget deficit. In terms of stock variables, in order for one sector to accumulate net financial wealth, at least one other sector must increase its indebtedness by the same amount. It is impossible for all sectors to accumulate net financial wealth by running budget surpluses. We can formulate another “dilemma”: if one of three sectors is to run a surplus, at least one of the others must run a deficit.

No matter how hard we might try, we cannot all run surpluses. It is a lot like those children at Lake Wobegone who are supposedly above average. For every kid above average there must be one below average. And, for every deficit there must be a surplus.

Notes on Terms. Throughout this primer we will adopt the following definitions and conventions:

The word “money” will refer to a general, representative unit of account. We will not use the word to apply to any specific “thing”—ie a coin or central bank note.

Money “things” will be identified specifically: a coin, a bank note, a demand deposit. Some of these can be touched (paper notes), others are electronic entries on balance sheets (demand deposits, bank reserves). So, “money things” is simply short-hand for “money denominated IOUs”.

A specific national money of account will be designated with a capital letter: US Dollar, Japanese Yen, Chinese Yuan, UK Pound, EMU Euro.

The word currency is used to indicate coins, notes, and reserves issued by government (both by the treasury and the central bank). When designating a specific treasury or its bonds, the word will be capitalized: US Treasury; US Treasuries.

Net financial assets are equal to total financial assets less total financial liabilities. This is not the same as net wealth (or net worth) because it ignores real assets.

An IOU (I owe you) is a financial debt, liability, or obligation to pay, denominated in a money of account. It is a financial asset of the holder. There can be physical evidence of the IOU (for example, written on paper, stamped on coin) or it can be recorded electronically (for example, on a bank balance sheet).

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Control Fraud and the Irish Banking Crisis

Posted on June 11, 2011 by | 3 comments

By William K. Black

This is part of a continuing series of articles on the European crises of the core and periphery. This column focuses on the causes of Ireland’s banking crisis. It begins by discussing what we know about modern financial crises in the West.

The leading cause of catastrophic bank failures has long been senior insider fraud. James Pierce, The Future of Banking (1991). Modern criminologists refer to these crimes as “control frauds.” The person(s) controlling seemingly legitimate entities use them as “weapons” to defraud creditors and shareholders. Financial control frauds’ “weapon of choice” is accounting. The officers who control lenders simultaneously optimize reported (albeit fictional) firm income, their personal compensation, and real losses through a four-part recipe.

  1. Grow extremely rapidly by
  2. Making poor quality loans at premium yields while employing
  3. Extreme leverage and
  4. Providing grossly inadequate provisions for losses for the inevitable losses

This recipe produces guaranteed, record reported income in the near term. In the words of George Akerlof and Paul Romer in their famous 1993 article – Looting: the Economic Underworld of Bankruptcy for Profit – accounting fraud is a “sure thing.” Even if the firm fails (“bankruptcy”) – which is no longer a sure thing given the bailouts of systemically dangerous institutions (SDIs) the CEO walks away wealthy (the “profit” part of the title). The use of “underworld” also demonstrates that Akerlof & Romer understood how important it was that the bank appears to be legitimate in order to aid the CEO’s “looting.”

Lenders engaged in accounting control frauds will tend to cluster in the most criminogenic environments. The most criminogenic environments have these characteristics

  1. Non-regulation, deregulation, desupervision, and/or de facto decriminalization
  2. Assets that lack easily verifiable market values
  3. The opportunity for rapid growth
  4. Extreme executive compensation based on short-term reported income
  5. Easy entry, and an
  6. Expanding bubble in the asset category that lacks easily verifiable market values

Individual accounting control frauds are exceptionally dangerous. The recipe makes them an engine that destroys wealth at prodigious rates. Control frauds cause greater financial losses than all other forms of property crime – combined. A single large accounting control fraud can cause losses so large that it renders a deposit insurance fund insolvent and causes a crisis. This happened in Maryland and Ohio “thrift and loans” in the mid-1980s. The failure of a single accounting control fraud in each state caused the collapse of the entire privately insured thrift and loan system in each state.

Accounting control frauds are also criminogenic. I will only discuss two ways in which these frauds are criminogenic and mention a third way in passing. The first concept is the “Gresham’s dynamic.” In this context, that term refers to a perverse dynamic in which those that cheat gain a competitive advantage over their honest rivals. This twists “competition” and “private market discipline” into perverse forces that can drive honest firms and professionals from the market place. There are three primary variants of Gresham’s dynamics that are criminogenic. Accounting control frauds’ record reported profits and their leaders’ extreme compensation inherently create Gresham’s dynamics with respect to rival firms and senior officers. The CEOs who lead accounting control frauds can intentionally create Gresham’s dynamics among their employees, customers, and agents in order to suborn them into becoming fraud allies. Accounting control frauds that are lenders can also create an undesired Gresham’s dynamics among third parties. The fraud recipe requires them to render their underwriting ineffective and to suborn their internal and external “controls.”

The second criminogenic aspect of accounting control frauds is that it can hyper-inflate asset bubbles. This is easier to do in smaller economies such as Ireland and Iceland, but the current crisis has shown that epidemics of accounting control fraud can hyper-inflate bubbles even in the world’s largest economy.

The third criminogenic aspect is that accounting control frauds can cause crippling “systems capacity” problems that make it less likely that the regulators and prosecutors will respond effectively to the frauds. I will discuss this third aspect in greater detail in future essays.

Gresham’s dynamics and control fraud

Economists have known for over 40 years about the role of control fraud in producing perverse Gresham’s dynamics.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” George Akerlof (1970).

I’m writing this in Dublin, so it is fitting to give credit to the insights of an Irish genius whose views on the same subject predate Akerlof’s, for they were published in 1726 while he was in Dublin.

The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honestly hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.

Swift, J. Gulliver’s Travels, London, Penguin (1967) p. 94. See Levi, M. The Royal Commission on Criminal Justice. The Investigation, Prosecution, and Trial of Serious Fraud. Research Study No. 14, London, HMSO (1993) p. 7.

Swift’s words should be etched on every building housing a financial regulator. The regulatory cops on the beat’s principal function is to reduce this Gresham’s dynamic and help honest firms prosper by stopping the frauds.

Akerlof wrote about Gresham’ Law in his famous article on markets for “lemons,” which led to the award of the Nobel Prize in Economics in 2001. As the language he used makes clear (“dishonest,” “cheated,” and “legitimate”), he was describing what criminologists now refer to as a “control fraud.” The seemingly legitimate firm gains a competitive advantage over honest rivals by defrauding the consumer about the quality of the goods. That is an example of anti-customer control fraud. If a dishonest used car dealer takes advantage of his superior information about the quality of the car (“asymmetrical information”) to purchase defective cars (“lemons”) for a low price and sells them as purported high quality cars for the market price for high quality cars he will have a substantial competitive advantage over any honest rival. Market forces will tend to drive the honest competitors out of the market.

Accounting control fraud, by contrast, does not create a competitive advantage. The recipe for a lender, for example, is a recipe for losing massive amounts of money. The rational, legitimate bank under any neoclassical model would be overjoyed to see its competitors committing suicide by making massive amounts of bad loans. Where then does the Gresham’s dynamic arise for accounting control frauds? The answer is executive compensation and survival. It is now common for executives to “earn” exceptional compensation if they report that the firm has “earned” exceptional income. In a reasonably competitive market it is the rare CEO and CFO who should be able to obtain highly supra-normal profits in any particular year. However, the fraud recipe produces guaranteed, record reported firm income in the short-term. Once accounting control frauds begin to operate in an industry their senior officers will receive extraordinary compensation. Honest CFOs, overwhelmingly, should fail to attain supra-normal profits in any particular year. That means that their bonus, their peers’ bonuses, and their CEO’s bonuses will be far lower than they could be, and often far less than the dishonest executives receive. The honest CFO has a direct financial incentive in terms of his own compensation to adopt the fraud recipe that is making his rival’s wealthy. More importantly, the honest CFO will fear that his CEO will fire him if he cannot match the accounting control frauds’ record reported income. The CEO that fails to match the reported record profits of his fraudulent rivals does not simply lose millions of dollars in compensation; he may also lose his job through a takeover (or, more rarely, through a board of directors revolt). Modern executive compensation causes accounting control fraud to produce an inherent, powerful Gresham’s dynamic among other firms in the same industry.

The CEOs that lead accounting control frauds also create deliberate Gresham’s dynamics in order to aid their frauds. Fraudulent CEOs seek to suborn their colleagues, customers, agents, “controls,” and “independent” professionals in order to make them fraud allies. They do so through the full gamut of psychological and material rewards. This produces “echo” epidemics of fraud in these other contexts. I have written about these echo epidemics extensively so I will only provide a few examples here. If a CEO bases his loan officers’ compensation on loan volume, not quality, then dishonest loan officers will become far better compensated. If a CEO simultaneously debases underwriting and internal controls this perverse incentive and result will be greatly increased. If the CEO causes the bank to make liar’s loans and creates a compensation system for loan brokers that increases with (1) loan volume, (2) lower debt-to-income ratios, and (3) lower loan-to-value (LTV) ratios (to name only three common characteristics) then the loan brokers will produce fraudulent loan applications with grossly inflated “stated” incomes and fraudulent inflated appraisals (which is also done by creating a Gresham’s dynamic in the hiring and compensation of appraisers). If the CEO “shops” for compliant audit partners and credit rating agencies then the CEO will generate a Gresham’s dynamic that will permit him to suborn purported “controls” and obtain their “blessing” for grossly inflated market values. The fraudulent CEO finds these controls’ reputation valuable in committing accounting fraud. The CEO can use a similar perverse incentive to induce many borrowers to knowingly file false loan applications. An honest banker would not create such Gresham’s dynamics because it would harm the bank. Collectively, the fraudulent CEOs at hundreds of nonprime lenders deliberately generated these perverse incentives in order to maximize the four-part recipe for fraudulent reported income. This was guaranteed to make them wealthy – quickly. It also guaranteed massive losses to the firms, the customers, and the government.

Collectively, the primary and echo epidemics of accounting control fraud produced staggering amounts of fraud. The incidence of fraud in liar’s loans in reported studies is 90% and above. By 2006, one-half of loans called subprime were also liar’s loans. Collectively, nonprime loans in the U.S. were enormous under any estimate (though the estimates vary seriously).

The third form of Gresham’s dynamic is not desired even by fraudulent CEOs. When a dog lies down with fleas it comes up with fleas. Firms engaged in accounting control fraud have grossly deficient underwriting and controls and, over time, they increasingly select for the officers and employees who are willing to deliberately make and approve bad loans. The best bankers leave. Without strong underwriting and controls to restrain them, the worst bankers are increasingly tempted to engage in fraud for their own account (instead of the CEO’s).

Control fraud and bubbles

Accounting control frauds are particularly well designed to cause bubbles to hyper-inflate. First, the recipe’s initial ingredient is extreme growth.

Second, control frauds can sustain that extreme growth for a considerable time period. A business strategy that depends on extreme growth through making high quality loans is inherently limited, particularly in a reasonably competitive, mature market. An individual firm that seeks to grow extremely rapidly by making good loans would have to “buy market share” by reducing its yield. Its competitors would match its lower interest rates. The end result would be that lenders’ income would fall. Even if a firm could grow extremely rapidly by making good loans, a lending industry could not do so. (This is known in logic as the “fallacy of composition.”) The industry could grow by making good loans at roughly the rate of GDP growth – far less than is required to hyper-inflate a bubble.

This is why the second ingredient in the fraud recipe is so important. There are tens of millions of potential home owners who cannot afford to buy a home. A lender can grow rapidly and charge these unceditworthy borrowers a premium yield. Better yet, many lenders can follow this same strategy. Best of all, as more lenders follow the fraud recipe it works even better to make the CEO wealthy. The faster the growth in lending, the faster and greater the bubble hyper-inflates. This allows the lenders to refinance the bad loans and delay loss recognition for years. The saying in the industry is “a rolling loan gathers no loss.” (Lenders also structured loans to be negative amortizing in order to delay the inevitable defaults.) Every year the fraud continued could add millions of dollars to the CEO’s wealth.

Third, as I explained above, accounting control frauds will tend to cluster, particularly if entry is relatively easy, in particular asset categories, industries, and regions that are most criminogenic. This clustering makes accounting control fraud more likely to hyper-inflate a bubble.

Fourth, because they are frauds, lenders will often continue to grow rapidly even into the teeth of a glut. This makes them particularly important in sustaining the life of bubbles.

Fifth, some kinds of assets are exceptionally good at hyper-inflating bubbles. The U.S. experienced simultaneous bubbles in residential and commercial real estate (CRE), but the residential bubble caused far greater losses because it was the largest bubble in history and because liar’s loans were such an ideal fraud mechanism. Even the U.S. anti-regulators would have balked at making CRE loans without any meaningful underwriting. CRE loans pose unique dangers in causing CRE bubbles to hyper-inflate. (CRE bubbles and residential real estate bubbles can interact because they may both compete for the same land.) Single family dwellings have some potential restraints because one can estimate demand for housing reasonably well. CRE has few restraints. It is frequently speculative (it is not preleased to prospective tenants). CRE loans can be massive. If the bubble hyper-inflates the initial large CRE borrowers will report few losses and record profits from any sales. The bank can then lend exceptional amounts of money to the successful developers on the basis of their appreciating real estate. Concentrations of credit can become extraordinary.

Sixth, bubbles are much easier to hyper-inflate in smaller nations. The Irish real estate bubble is typically described as over twice the (relative) size as the U.S. Spain’s real estate bubble is off the charts even though its economy is far larger than Ireland’s. The nonprime sector, which was endemically fraudulent, was capable of hyper-inflating the largest bubble (in absolute terms) in history in the world’s largest economy. The effect was to right-shift the demand curve for housing – for a time – by lending to those who would often be unable to repay their loans so that they could buy homes at prices greatly inflated by a bubble.

(For estimates of the size of the nonprime market see William Poole, Reputation and the Non-prime Mortgage Market (July 20, 2007) (available on line at the FRB of St. Louis). Note that the issue is not the absolute number of nonprime loans but the additional loan volume represented by nonprime loans made as the bubble hyper-inflated. Nonprime loans increasingly became the marginal loan.)

The role of an epidemic of accounting control fraud in hyper-inflating a regional CRE bubble in the Southwest during the S&L debacle is explained in Akerlof & Romer (1993), the report of the National Commission on Financial Institution Reform, Recovery and Enforcement (1993), and The Best Way to Rob a Bank is to Own One (Black, W. 2005)

The Nyberg Report about Ireland

The central points of the preceding discussion are that if a nation suffers a series of catastrophic banking failures the single most likely explanation for them is accounting control fraud; particularly if the crisis involves a hyper-inflated bubble. Naturally, when Ireland decided to investigate the causes of its crisis it hired a non-investigator and instructed him not to investigate whether the leading cause of catastrophic bank failures and hyper-inflated bubbles had occurred. Here is how Mr. Nyberg explained the matter:

“The mandate of the Commission did not include investigating possible criminal activities of institutions or their staff, for which there are other, more appropriate channels. Under the Act, evidence received by the Commission may not be used in any criminal or other legal proceedings.” (Nyberg 2011: 11)

“The Commission has not investigated any issues already under investigation elsewhere. Instead, the Commission used its limited time and resources to investigate, as its Terms of Reference specified, why the Irish financial crisis occurred.” (Nyberg 2011: 11)

Yes, you read it correctly. Because he was barred from investigating fraud (which was outside his expertise), he investigated “why the Irish financial crisis occurred.” He knew, of course, without investigation or expertise in detecting fraud, that the crisis did not occur because of insider fraud even though insider fraud is the most common cause of such crises. Nyberg’s report is the third report Ireland has paid for (at a cost of hundreds of thousands of dollars). It contains no essential new facts not already known from the prior reports – because it did not conduct any real investigation. It reads like a defense lawyer’s brief for the senior management of the failed Irish banks. Ireland paid Nyberg large amounts of money to make it far harder to prosecute or even sue the CEOs that destroyed the Irish economy. This is significantly insane.

So, what did cause the crisis according to Nyberg? Even Nyberg admits he has no coherent explanation. The next two sentences epitomize his report:

“Even with the benefit of hindsight, it is difficult to understand the precise reasons for a great number of the decisions made. However, it would appear that they generally were made more because of bad judgment than bad faith.” (Nyberg 2011: 11)

Got it? Nyberg can’t explain the CEOs’ decisions. But not to worry, for “it would appear” that they “generally” were made “more” “because of bad judgment than bad faith.” Here’s why this cloud of vagueness matters. If the managers acted in bad faith they will be at least liable for the damages in a civil or administrative action and quite possibly criminally liable. The damages the managers caused are so massive relative to their assets that it almost certainly does not matter whether they “generally” caused injury through bad judgment. The times they did act in bad faith would subject them to greater civil liability than their assets. It also doesn’t much matter that “more” of the damage they did was due to bad judgment than bad faith. A mixture of bad faith and bad judgment would subject them to crushing civil liability and criminal prosecution. So, for all the money it spent, Ireland deserved to be told where Nyberg found that the officers acted in bad faith so that it could guide the process to hold them appropriately accountable.

“Indeed, a fair number of decision-makers appear to have followed personal investment policies that show their confidence in the policies followed by “their” institution at the time. Such faith usually produced large personal, financial and reputational losses.” (Nyberg 2011: 11)

This is too vague and likely (it’s so vague it’s impossible to be certain) evidences a failure to understand accounting control fraud. “A fair number of decision-makers” is a doubly vague phrase and it is illogical as an argument. What’s a “fair number?” Which “decision-makers” acted in this manner? The fact that some decision-makers lost money on some unspecified investment does not indicate that the others had the same views (assuming those views somehow negated intent). More basically, it is common for accounting control frauds to suffer losses. They are not geniuses. I quote Nyberg below about how “easy” it was for the officers to maximize their personal compensation by making bad loans. No one knows when a bubble will collapse, so the officers controlling fraudulent lenders often stay in investments too long and suffer personal losses. Those losses do not negate a criminal intent.

Nyberg on Compensation

How would a real investigation that had expertise look at the facts Nyberg found?

“The [compensation] models, as operated by the covered banks in Ireland, lacked effective modifiers for risk. Therefore rapid loan asset growth was extensively and significantly rewarded at executive and other senior levels in most banks, and to a lesser extent among staff where profit sharing and/or share ownership schemes existed.” (Nyberg 2011: 30)

What can we infer from these facts? The controlling officials at the worst Irish banks paid themselves, their senior officers, and even their staff largely on the basis of loan volume – irrespective of the soundness of the loans. This is suicidal for a mortgage lender because it creates intense, perverse incentives to make bad loans. It leads to extremely rapid growth through making increasingly bad loans. This produces severe “adverse selection.” Adverse selection in these lending fields produces a negative expected value of lending – the lender will lose money and fail. Nyberg has established that the banks followed the first two ingredients of the recipe for maximizing short-term (fictional) reported accounting income – and the controlling officers’ compensation.

“Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector. On the other hand, most banks also included performance factors in their models other than financial growth.” (2011: 30)

Focus on the word “intended.” This is a characteristic flaw of Nyberg’s report. The bonus targets were not “intended to be demanding” much less “through the pursuit of sound policies.” Nyberg provides nothing in his report that supports his claim that senior managers “intended” to create a “demanding” hurdle before they could receive exceptional compensation. Similarly, he provides no support for the claim that the senior managers “intended” to assure “sound policies” by creating a compensation system that was certain to produce unsound policies, consistently produced unsound policies, was known by the senior managers to produce unsound policies, and was repeatedly modified to encourage ever more unsound policies. Nyberg’s report repeatedly refutes his claims. Nyberg never identifies the mythical, unidentified senior people who he purports had such an intent. The real factual takeaway is that the officers and staff could, respectively, get wealthy and well-off “easily” by following the first two ingredients of the recipe that maximizes fictional bank income and real compensation.

“Rewards of CEOs reached levels, at least in some cases, that must have appeared remarkable to staff and public alike. It is notable, that proportionate to size, the CEOs of Anglo and INBS received by far the highest remuneration of all the covered bank leaders.” (Nyberg 2011: 30)

No, the compensation the CEOs caused “their” banks to pay them as “rewards” for making exceptionally bad loans that were destroying the banks and Ireland’s economy did not “appear” “remarkable” – they were remarkable. Recall that Nyberg concedes that the managers “easily” obtained remarkable compensation not through any skill but rather through making loans without regard to risk. Making loans with acute, expert regard to risk is the core skill of a lender. Why would it ever make sense to pay CEOs remarkable compensation for making bad loans chosen by the CEO because they maximized his wealth? Nyberg provides this chart of CEO compensation.

The recipe was a “sure thing” for the controlling managers. They made sure that they could “easily” and quickly become wealthy. Nyberg finds a Gresham’s dynamic, but offers a naïve view of how it operates because he uncritically accepts the self-serving claims of “bank management and boards.”

“Bank management and boards in some of the other covered banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in particular, they would face loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect.” (Nyberg 2011: v)

Anglo was not “profitable” during the bubble while it was making loans without regard to their risk. It was creating net liabilities (losing money) when it lent – it simply was not recognizing the reality. Anglo was destroying itself. The other managers may have had some fears of a hostile takeover, but the Nyberg report shows that they were driven primarily by their desire to maximize their personal compensation. Nyberg seems to credit the claim of “a number of bankers” that compensation did not drive managers’ decisions.

“Nevertheless, it was claimed by a number of bankers that management and staff were not motivated by compensation alone. Most would compete, it was claimed, as they had during the previous period of lower compensation, on the basis of natural competitiveness and professional pride.” (Nyberg 2011: 31)

This passage is wondrously incoherent. No one thinks humans are “motivated by compensation alone.” Ego, status, and prestige, for example, are often powerful motivators, but this increases the criminogenic nature of perverse compensation for extreme compensation is often the entrée in the modern world to increased status. “Natural competitiveness” almost certainly compounded these perverse incentives as individuals, particularly males, competed to be the top producers of disastrously bad loans that were destroying Ireland. The top producers got paid the most and had higher status. What “professional pride?” Nyberg’s report shows the opposite – the perverse compensation had its typical effect in destroying bank professionalism and integrity.

“Over time, managers known for strict credit and risk management were replaced; there is no indication, however, that this was as a result of any policy to actively encourage risk-taking though it may have had that effect.” (Nyberg: v)

“In addition, there were some indications that prudential concerns voiced within the operational part of certain banks may have been discouraged. Early warning signs generated lower down in the organisation may in some cases not have reached management or the board. If so, the pressure for conformity in the banks has proven to be quite expensive.” (Nyberg: v)

“The few that admitted to feeling any degree of concern at the change of strategy often added that consistent opposition would probably have meant formal or informal sanctioning.” (Nyberg 2011: v)

Nyberg has described the Gresham’s dynamic characteristic of control frauds, but suicidal for an honest bank. The best people are forced out. Those that remain go along with the CEOs dictates. Consider the first quotation, another Nyberg classic. Anybody known for effective underwriting was “replaced.” We’ll return to Nyberg’s claim that there was “no indication” this was designed to encourage making bad loans and his use of “risk-taking” as a euphemism.

Now we add the second quotation. Could we make a report any more vague and useless? “There were some indication that prudential concerns voiced within the operational part of certain banks may have been discouraged.” Nyberg has just written that those who rejected bad loans were “replaced.” That “discouraged” voicing operational concerns. We’ll return to the remainder of that quotation.

The third quotation completes the inevitable result of replacing those who refuse to make the bad loans. “Few” would even admit years later that they felt even “concern” about making loans without regard to risk (again, this is suicidal for mortgage lenders). Even those few said nothing because they believed opposition to the CEO’s plan would lead to them being “sanction[ed].” Once more, Nyberg has described the kind of criminogenic environment that the CEO generates to create “echo” fraud epidemics throughout the organization.

We can now complete the discussion of the first quotation. Here it is again:

“Over time, managers known for strict credit and risk management were replaced; there is no indication, however, that this was as a result of any policy to actively encourage risk-taking though it may have had that effect.” (Nyberg: v)

What would it take before Nyberg can find an “indication?” Does he expect that senior managers are going to tell him that they “replaced” Sean for the purpose of “actively encourage[ing] risk-taking?” They got rid of people who rejected bad loans. They “discouraged” people from raising prudential concerns. The staff feared that it would be “sanctioned” if it raised concerns and this Gresham’s dynamic was so effective that “few” of the remaining staff would even admit to having any concern about a suicidal lending policy.

More fundamentally, none of this – on the facts found by Nyberg – has anything to do with “risk-taking” as we conventionally use that term in finance and economics. Akerlof & Romer agree with us (criminologists) – accounting control fraud is a “sure thing.” The massive executive compensation it creates is a “sure thing.” The supposedly exceptional bank “income” or loan volume necessary to maximize one’s bonus is typically “easily” met by making loans without regard to creditworthiness. The accounting fraud strategy that relies on making loans without regard to creditworthiness is also suicidal. “Risk-taking” at banks involves exactly the opposite behavior. Underwriting is the process of identifying, pricing, and managing bank lending risk. Underwriting is what Nyberg found that the Irish bank CEOs eviscerated.

Nyberg eagerness to offer apologies for the controlling managers is displayed again in the second quotation.

“In addition, there were some indications that prudential concerns voiced within the operational part of certain banks may have been discouraged. Early warning signs generated lower down in the organisation may in some cases not have reached management or the board. If so, the pressure for conformity in the banks has proven to be quite expensive.” (Nyberg: v)

I focus here on the last two sentences. The implicit premise of these sentences is that “management or the board” would have listed to “prudential concerns” from the staff about management’s policy of lending without regard to creditworthiness in order to maximize management’s compensation. Nyberg presents nothing that would support this implicit premise. His report disproves the premise. It was “management” that created the loan policy. It was “management” that “replaced” the officers and staff who opposed the policy. The “few” staffers left that even had a “concern” about the suicidal policy kept their mouths shut because they were afraid of being “sanctioned” by management. No one was better positioned than “the board and management” to know that creating a compensation system that rewarded making mortgage loans regardless of creditworthiness was suicidal. We have understood adverse selection in banking for hundreds of years. No junior staffer needed to tell the board and management that the compensation and lending policies were suicidal for the bank and fabulous for management. If more staffers had said no to the bad loans then the management would have “replaced” more staffers until the Gresham’s dynamic was all-encompassing at the staff level.

Nyberg conclusion about the perverse role of compensation brings out yet another apology for senior management.

“Financial incentives were unlikely to have been the major cause of the crisis. However, given their scale, such incentives must have contributed to the rapid expansion of bank lending.” (2011: 31)

His own report refutes his apology. Nyberg actually finds that the financial incentives were (1) perverse, (2) exceptionally lucrative to the controlling officers, and (3) decisive in determining the conduct that destroyed the banks and Ireland’s economy.

“Occasionally, management and boards clearly mandated changes to credit criteria. However, in most banks, changes just steadily evolved to enable earnings growth targets to be met by increased lending.” (Nyberg 2011: 34)

Nyberg found that compensation drove the banks’ “credit criteria.” In plain English, that means that the banks made continually worse loans it new were less likely to be repaid in order to maximize the officers’ compensation. Nyberg found that the banks’ controlling officers chose their personal compensation over the quality of bank loans. Nyberg uses a lot of jargon, but he concedes the essential nature of underwriting standards.

“The core principles, values and requirements governing the provision of credit are contained in a bank’s credit policy document which must, as a regulatory requirement, be approved at least annually by a bank’s board. The policy defines the risk appetite acceptable to the bank and appropriate for the markets in which the bank operates….”

“The purpose of such a credit policy is to set out clearly, particularly for lenders and risk officers, the bank’s approach to lending and the types and levels of exposures to counterparties that the board is willing to accept.” (2011: 31)

In this passage, however, Nyberg resorts to clear writing.

“The associated risks appeared relevant to management and boards only to the extent that growth targets were not seriously compromised.” (Nyberg 2011: 49)

Nyberg finds that the banks’ credit policies were fictions – fictions that repeatedly yielded to the necessity of maximizing the officers’ compensation.

“[A]ll of the covered banks regularly and materially deviated from their formal policies in order to facilitate rapid and significant property lending growth. In some banks, credit policies were revised to accommodate exceptions, to be followed by further exceptions to this new policy, thereby continuing the cycle.”

One of the predictions that flows from the recipe for maximizing fictional short-term accounting income is that over time loan quality is likely to deteriorate as lending is expanded to increasingly less creditworthy borrowers. Nyberg found that this happened.

“As all banks had effectively adopted high-growth strategies (IL&P less so), the aggregate increase in credit available could not be fully absorbed by good quality loan demand in Ireland. Banks had two options to remedy this; diversify their lending into other markets or relax lending standards.” (Nyberg 2011: 34)

“[S]ubstantial numbers of new loans were made in Ireland. By implication, credit standards fell. The lowering of standards manifested itself as both a reduction in minimum accepted credit criteria and (more subtly) as an increase in accepted customer and property leverage.” (Nyberg 2011: 34)

Note that Nyberg also found that the Irish banks could not grow extremely rapidly by making good quality loans. They found, consistent with the predictions of control fraud theory, that the banks moved to increasingly poor quality loans at premium yields.

Nyberg then finds that the banks violated both their own underwriting limits and banking rules. He confirms a common criminological insight – the continued violation of the law leads to “neutralization” that diminishes any perceived immorality.

“The resulting asset growth meant that internal lending limits (both sector and large exposure limits) were exceeded. Regulatory sector limits in some banks were also exceeded, both prior to and during the Period. Gradually, as such excesses became more frequent, they were viewed with less seriousness.” (Nyberg 2011: 34)

Nyberg found related facts consistent with the predictions of control fraud theory. First, accounting control frauds often continue to lend and seek to grow rapidly into the teeth of a glut because they are quasi-Ponzi schemes. Second, it is far easier to grow by making bad loans than good loans. This is one of two places in the report that he uses the word “easily” to explain that the four-part recipe was a “sure thing” – guaranteed to maximize the CEO’s compensation.

“The demand for Development Finance was so strong over the Period that bank and individual growth targets were easily met from this sector. Both of the bigger banks continued to lend into the more speculative parts of the property market well into 2008, even though demand for residential property (a major end-user) had begun to decline by the end of 2006.” (Nyberg 2011: 35-36)

Nyberg also found, consistent with control fraud theory, that the Irish banks were major contributors to the hyper-inflation of the Irish real estate bubbles.

“Thus, banks accumulated large portfolios of increasingly risky loan assets in the property development sector. This was the riskiest but also (temporarily) the easiest and quickest route to achieve profit growth.” “Credit, in turn, drove property prices higher and the value of property offered as collateral by households, investors and developers also.” (Nyberg 2011: 50)

Nyberg found the clustering aspect of accounting control fraud that helps cause bubbles to hyper-inflate.

“High profit growth was the primary strategic focus of the covered banks…. Since the potential for high growth (in assets) and resultant profitability in Ireland were to be found primarily in the property market, bank lending became increasingly concentrated there.” (Nyberg 2011: 49)

Nyberg concedes that the controlling officers could only believe that their lending policies were not suicidal if they adopted an irrational belief contrary to everything we know about finance. The CEO simply had to believe that:

“As long as there was confidence that prices would always increase and exit finance was available, an upward spiral of lending and property price increases was maintained.” (Nyberg 2011: 50)

Yes, if prices always increase then banks might survive making bad loans. Making bad loans would still be irrational, however, for an honest lender because they could still make more money by making good loans.

The third ingredient in the four-part recipe is extreme leverage. Nyberg is very weak on this point. His findings demonstrate that several of the Irish banks were massively insolvent for years while they continued to grow rapidly by making bad loans. When equity is negative, leverage ceases to be a meaningful ratio.

Nyberg is particularly damaging on the fourth ingredient – grossly inadequate loss reserves. The view he takes of international accounting standards would create a perfect crime. Nyberg is disturbed about that result, but he does not understand that if he is right he is describing a monstrous loophole that most of the bank CEOs in the world can use to loot “their” banks with impunity.

“In the benign economic environment before 2007, the banks reduced their loan loss provisions, reported higher profits and gained additional lending capacity. The banks could no longer make more prudent through-the-cycle general provisions, or anticipate future losses in their loan books, particularly in relation to (secured) property lending in a rising property market.” (Nyberg 2011: 42)

A record financial bubble that misallocates billions of dollars of credit and assets and causes a severe economic crisis is not “benign.” The Irish bubble stalled in 2006. The Irish banks that Nyberg studied would not have made “more prudent ‘through-the-cycle’ general [loss] provisions” absent changes in the international accounting rules. Nyberg is again displaying his apologist for management instinct. Elsewhere, Nyberg, refutes Nyberg. Note that he found that not establishing loss reserves increased the banks’ reported profits and its ability to grow. That meant it increased the top managers’ compensation. Indeed, as I will explain, had the banks complied with the principles underlying the international accounting standards the banks would have had to report that they were insolvent and the controlling officers would have lost their jobs and incomes.

“The higher reported profits also enabled increased dividend and remuneration distributions during the Period. All of this led to reduced provisioning buffers….”

“From 2005 the banks’ profits, capital and lending capacity were enhanced by lower loan loss provisioning while the benign economic conditions continued. (Nyberg: 55)

“As a consequence of not making this level of loan loss provisions [1.2% of loans], increased accounting profits effectively provided additional capital of up to €3.5bn to the covered banks. This, in turn, increased their capacity to lend by over €30bn.” (Nyberg 2011: 43)

Again, failing to provide remotely adequate ALLL did not provide “additional capital” to the Irish banks. It created (fictional) increased reported income and capital to the banks, which led to larger compensation to the officers and increased bank growth and leverage. None of this should have been permitted under a “principles-based” international accounting standard – particularly when the banks were engaged in the unprincipled exploitation of an accounting standard designed to create another variant of the abuse the international accounting standard was designed to prevent.

International accounting rules were promoted largely on the basis of their asserted superiority over generally accepted accounting principles (GAAP) and their principal asserted advantage was that they were principles-based. The idea was that the effort to specify and forbid every possible abuse (which was supposedly GAAP’s approach) invariably lead to unmanageable audit standards that could always be evaded. Principles-based audit standards would be far more concise and better prevent abuses because the auditors would be responsible for adhering to those principles rather than pursuing arcane, technical evasions of GAAP. One of the differences between GAAP and the international accounting standards was the treatment of allowances for loan and lease losses (ALLL). The Financial Accounting Standards Board (FASB) and the international standards setting bodies shared a concern about “cookie jar reserves.” A common abuse was to use improperly the ALLL allowances as a reserve that could be called on whenever needed to “make the number” and ensure that the firm’s stock price (and the senior executives’ compensation) not be reduced. The SEC filed a complaint asserting, for example, that Freddie Mac’s engaged in securities fraud by hiding gains in good years through inappropriately increasing its ALLL account and reducing the ALLL allowance in bad years sufficiently to make the analysts’ quarterly predicted earnings per share forecast.

GAAP revised the ALLL provision through a principles-based approach designed to prevent two abuses – cookie jar reserves and the fourth ingredient of the accounting control fraud recipe. The specific language of the international accounting standards provision dealing with allowances for loan losses did not discuss explicitly the second form of accounting fraud. Instead, it aimed to kill “cookie jar reserves” as an intolerable abuse. The purpose of the rule was to prevent the officers controlling a firm from manipulating the allowance for losses for the purpose of inflating the share price and the officers’ compensation. Nyberg, without discussion of any alternative interpretation that would actually accord with the anti-fraud principle underlying the international rule, asserts that it must be interpreted to facilitate accounting control fraud. He then asserts that this rule is the reason the Irish banks have inadequate allowances for losses.

“As the global crisis developed from mid-2007, the banks were constrained by these incurred-loss rules from making more prudent loan-loss provisions earlier, and the auditors were restricted from insisting on such earlier provisioning.” (Nyberg: 55)

“The composite provisioning level for the covered banks at end 2000 was 1.2% of loans…. If this 1.2% provisioning level had been applied at the 2007 year end by the covered banks, aggregate provisions would have increased by approximately €3.5bn (i.e. from the €1.8bn actual to €5.3bn).” (Nyberg 2011: 43)

“[T]he incurred-loss model [IAS 39] also restricted the banks’ ability to report early provisions for likely future loan losses as the crisis developed from 2007 onwards.” (Nyberg 2011: 42-43)

Nyberg’s interpretation would create the perfect insider bank fraud – throughout most of the world. It would destroy the anti-fraud principle underlying the international accounting standard he cites. There are three key, related lessons to be learned from his argument. One, the international accounting standards setting bodies should promptly and authoritatively reject his interpretation of IAS 39. Two, alternatively, if the bodies adopt the principle that IAS 39 should be interpreted to defeat its underlying anti-fraud principle, then they should change the rule on an emergency basis. Three, in any event, Nyberg’s story of a poor little management and Big 4 audit firm trying to do the right thing about allowances for loan losses but being stymied by IAS 39 is a fantasy and Nyberg’s apologies for the managers are beyond embarrassing.

I leave to the reader the reason a principles-based accounting system should be interpreted in a manner that supports rather than defeats the underlying anti-fraud purpose of the rule. But what if the accountants or the international accounting standards setting boards choose to defeat the anti-fraud purpose of the rule? That would create the perfect fraud. Some numbers may help. Recall that Nyberg’s fundamental factual finding is that the banks lent without regard to risk whenever considering risk conflicted with the imperative to maximize the controlling officers’ compensation. That is the heart of accounting control fraud. Assume that Bank A subject to the international accounting standards grows exceptionally rapidly, while employing extreme leverage, by lending to states and localities at 15% with a term of 30 years. Assume that the 15% yield embodies 3% less than an appropriate yield premium for the risk of lending to states and localities because of their current financial distress. Bank A only lends to states and localities with relatively good credit, so defaults are unlikely to become large in the near term. Assume that Bank A can borrow at 3% and has general and administrative expenses of 2%. Statistically, Bank A loses money with every loan it makes under this program. The appropriate allowance for loan losses, under GAAP, would be over 15%. If Bank A established the appropriate allowances for losses on these loans it would be admitting that it was losing money on the loans. Under the international accounting rules (assuming they are interpreted to defeat the allowance for loan loss provisions’ purpose), the allowance would be close to zero in the early years because Bank A would experience very few losses. The combination of the extreme nominal yield (15%), the delay in losses, and the virtually nonexistent allowance for loan losses, produces exceptional reported income – even though in economic substance Bank A is losing money when it makes the loans. With modern executive compensation, Bank A’s controlling officers have a “sure thing” – they will receive exceptional compensation and quickly become wealthy. Bank A will eventually fail, but the CEO will walk away rich and with legal impunity from any claim for securities fraud. The internal accounting rules, if so interpreted, will create a perfect crime – one that Nyberg aptly called “easy.” It takes no great skill to make bad loans.

Recall what even Nyberg admits in his specific factual findings (though rarely his conclusions) was actually going on at these Irish banks. They loaned without regard to risk in order to maximize the controlling officers’ compensation. The amount and degree of bad loans they made grew over time and became staggering. Losses at the worst Irish banks are roughly 60% of total (fictional) assets. The banks typically continued to lend into a bubble they knew had collapsed over a year earlier to people they knew were uncreditworthy. (They made the loans largely to cronies and borrowers they knew could not repay the loans because they were massively insolvent given the collapse of the bubble. They made the new loans largely to give those uncreditworthy borrowers cash to delay defaults on their prior loans.) The ALLL that Anglo would have needed to avoid recognizing additional losses was not 1.2% — it was 60%.

Nyberg completes his fantasy about the banks’ managers with this epic claim:

“In the competitive market, many property loans were made at margins of less than 1% per annum. A composite year end provisioning level at the 2000 level of 1.2% might have caused the banks to reconsider the amount of low margin property lending and might have led to more appropriate pricing for risk.” (Nyberg 2011: 43)

Ireland’s banks did not operate in a “competitive market.” Yes, there was some competition for borrowers, but in a real market none of the banks would have competing to see who could make the largest money-losing loans. If the Irish banks made “many” property loans at margins of less that 1% then we need to have another discussion. Banks that make “many” property loans at margins of less than 1% fail even if they make exceptionally safe loans. The Irish banks were making loans sure to fail.

“The demand for Development Finance was so strong over the Period that bank and individual growth targets were easily met from this sector. Both of the bigger banks continued to lend into the more speculative parts of the property market well into 2008, even though demand for residential property (a major end-user) had begun to decline by the end of 2006.” (Nyberg 2011: 35-36)

Elsewhere, Nyberg aptly refers to CRE lending as the “riskiest” lending. He found that it got progressively worse before 2007 – much worse. He found, as I have just cited, that the banks went heavily into the “speculative parts of the property market well into 2008” well after the bubble collapsed. Speculative CRE is exceptionally risky – when done (1) in a favorable economic environment, (2) with superb underwriting, (3) with careful limits on concentrations within sectors and in terms of loans to one borrower, (4) and to borrowers who are successful and not in financial distress, while (5) avoiding any conflicts of interest such as insider loans or loans to cronies. The Irish banks were zero for five on these characteristics.

No one was holding a gun to the heads of the Irish banks. There’s no reason why an honest bank would have made “many” property loans at margins below 1% to pristine credits in great economic times. The actual CRE developers they were lending to in 2008 would have required margins of well over 60% (60% is the average loss on the portfolio). No one prevented the officers controlling the worst Irish banks, if they felt constrained by the international accounting rules, from increasing their capital, selling their worst loans, reducing their dividends, or reducing their compensation. They could have disclosed to shareholders the enormous risk they were taking in making suicidal loans with virtually no ALLL. Their outside auditors could have demanded that they make such disclosures.)

Assume that Anglo was borrowing at 5%, had general and administrative expenses of 2%, and its ALLL was 0.3%. It made property loans at 8%. Its gross (before taxes) margin was 0.7%. At that margin, it could not survive even tiny levels of delinquencies and defaults, but it was making loans that would almost invariably default and suffer catastrophic losses.

Does Nyberg seriously think that if the ALLL had been 1.2% (v. 0.3%) the bank managers would have stopped making loans with 60% losses? The loans were insane for any honest bank – they were supremely rational for any accounting control fraud. Nyberg’s factual findings make an clear case for likely accounting control fraud. We can answer his confusion:

“Even with the benefit of hindsight, it is difficult to understand the precise reasons for a great number of the decisions made. However, it would appear that they generally were made more because of bad judgment than bad faith.” (Nyberg 2011: 11)

The facts that Nyberg found show that they were likely decisions of the most profound bad faith. His facts show that the people controlling Ireland’s worst banks chose to maximize their personal compensation at the expense of the bank, the Irish government, and the Irish people. If the reader frees himself from Nyberg’s unstated and crippling assumptions – fraud cannot drive financial crises and CEOs cannot be frauds (indeed they can’t even be bad chaps) – then the Irish bank managers’ specific behaviors that he describes are understandable.

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MMT Explained to Mums

Posted on June 11, 2011 by | 41 comments

By Paolo Rossi Barnard

Intro.

The post that follows poses as an example of how the huge complexities of MMT and its political and historical contexts could be divulged to the ordinary folks out there. We named it “MMT explained to mums”, precisely for that reason. This effort is of no small importance, since we at NEP recognize that without a growing popular support for our vision of how economies should be run, we may never gather enough steam to push MMT through the barriers of Power Politics. The actual writer of this post is Italian journalist and MMT supporter Paolo Rossi Barnard. Of course this is not definitive, and we invite both our bloggers and our readers to make comments and contributions to this essential communication effort. We all know that millions of people and families out there are needlessly suffering right now for the insanity of the present economic dogmas. They must be told that there is a life saving, job saving, even nation saving alternative to the present system; it’s called MMT and it’s authoritative, but it’s being denied to them by a tiny elite of power brokers. Ordinary folks must at least know this, because, as Noam Chomsky once remarked, “When people know of injustice, sooner or later they organize to stop it. They always did.”

MMT Explained to Mums

This could change your welfare and your kids’ like nothing before. It concerns what government could have really done for you with jobs, housing, income, schooling, health. It tells you why it never did, and how you could turn things around. It’s tremendously important today for all of us, the ordinary folks.
We are not wasting your time with ludicrous theories. What follows is authoritative, it was born of high academic research. We made it simple for you to read.

One more thing: we are not politicians, we are neither the Left nor the Right. We just believe that folks should be told what’s really wrong with the economy, which means their livelihood. Truth works with the American people.

Ask yourself: What’s the government for?

The obvious answer is to run the country, ok. Anything else? Yes, government should be there first and foremost to look after its people as youths, then workers and then seniors by providing good schooling, good jobs and good welfare whenever people lack them for any reason.This is what government ought to really be about.

Does the government do it?

No. We still have rampant unemployment, underemployment, poor health care for millions and lack of good education for scores of kids and many other ills.
Could the government do it? Can it afford it?

Yes, easily, we’ll explain why.

So, why has the government never done it?

Because private corporations, big banks and the extremely wealthy knew that if government used its monetary powers (the US dollar) to look after us, the people, they would have lost. Lost what? The bigger slice of national wealth with its privileges, and also millions of insecure workers as cheap labor for their profits. Finally, they would have lost control over politics. So they organized a web of lobbies, big media, and above all a host of economic ideas that took over government and stopped it from spending for us. This way they increased their slice of the pie, but they also prevented the pie from growing, kind of they killed the goose that lays the golden eggs, and so the general US wealth pie in the end got even smaller. It’s been happening for the last 40 years. This is no conspiracy, it’s simply the reality of Power Politics in America and elsewhere, too. We are saying to you: unemployment and lack of welfare need not have existed at all in modern America. They were used as a policy tool to prevent citizens from controlling too large a share of the national wealth and political power with the help of their government. Just think: if the majority of us are stuck in a life-long struggle for subsistence, we can’t even begin to think of ruling or controlling anything. We become class B citizens, we don’t count. We don’t count at all. Do you understand now why the powerful always told us that Big Government is bad? Sure, it’s bad for them.

Here’s what government could have done instead, what it could still do.

First, the government could employ at a living salary every single American out of work, and all those working on minimum wages. It has all the money in the world to do so, because our government owns the US dollar and it can pay any wage anywhere it wants to (simple explanation below). You may ask: wouldn’t this add to big national debt? No, not at all, simply because a larger and better paid American workforce would create a lot of new production, new infrastructure, new investment and new services, that is, more American wealth in its pockets and into the government’s coffers. It’s a government expenditure that would end up largely paying for itself and benefiting all. No need for panic about big debt.

Second, government could pay for adequate welfare for all Americans, that is to say universal health coverage, good schooling, social care for the needy and the elderly, and good pension schemes. Again, there would be no big debt in D.C., because it would again make us all better workers, better students, less needy seniors. In a nutshell: we would be an even more competitive nation that creates wealth instead of wasting it on immense social problems. And a society where a sense of common security substitutes pain and fear, which means less social ills, less family disintegration, less crime.

Sounds good, right? But does the government really have all these dollars to spend on us?

A very simple answer. Ask yourself: who gives the US government its dollars? Is it us? Can we citizens print dollars? No. Can businesses print dollars? No. Can banks print dollars? No. Citizens, businesses and banks can only use already existing dollars. Don’t be fooled: when you read of a business having made a fortune, all that’s happened in reality is that a mass of already existing dollars has simply shifted from lots of places or pockets into that business’ coffers. In some cases new dollars are created by private people, but they are always offset by some sort of equally private debt somewhere, so again no net money has come into existence. And when our government sells its bonds and someone buys them, the same applies: already existing dollars move from one place to another. So, who is it that creates new net dollars then? Only our government can. It does it at the Treasury and at the Fed. Think of it this way: government creates dollars by putting its signatures to pieces of paper (notes/bonds) or to electronic money transfers. Can it ever run out of its own signatures? Does it need to borrow them from someone else? Does it need to tax people to get back those signatures that it can just create? No, of course not. So to recap: government creates US dollars anew, never has to borrow them, cannot run out of them, doesn’t need to tax anyone to get them. And so it can use its dollars to do anything it wants, like employ all of us, educate all of us, treat all of us, look after all of us. And don’t forget: this form of government expense ends up largely paying for itself, because of the virtuous circle of new net national wealth it creates. And this requires no super taxes at all. Actually, it all works precisely in this way if the government gives us more dollars than it takes away through taxation. It also beats inflation thanks to all the new things that will be produced and as long as the government stops increasing its spending (plus dollar creation) as we get full employment.

So, you may ask: then what’s all this frenzy about national debt and the deficit?

Debt and deficits are the normal way to run an economy, they have always existed in American history and have never made us broke. Panic about them is largely a ploy concocted by the corporate elites, their economists and their big media. Remember: they had to prevent government and its citizens from acquiring too large a slice of the national wealth. So, among other things, they worked out a brilliant catch phrase: the government’s budget works just like your family’s, so to be ok the government has to earn more than it spends and never spend more than it earns. They said that just as your family debt is bad news, so is government’s. They turned this into mainstream economics through their people sitting as professors in all major universities and often as government top advisers. Sounds reasonable, right? Yes it does, so much so that we all fell for it and the government started worrying so much about debt and the deficit that it stopped the deficit spending that would have made us all live better. And the consequences were disastrous. But wait: do you remember that government creates its own dollars at will? Can any family in America do that? Of course not, period. So how can government and families have the same budget rules? Your family debt has to be repaid by you finding dollars somewhere else, usually through hard work. You don’t grow greenbacks in your garden. And if you fail to find them then you are in big trouble. So yes, you ought to be very careful about debts and deficits. None of this ever applies to the government, because as we said to get dollars it has to turn only to ITSELF and creates them out of thin air at the Treasury and the Fed. Think: if you could just create the dollars you need to pay back your debts, would you ever worry about debts and deficits? Ok, you got it. That’s precisely why all this frenzy about US government debt and deficit is just a plain lie, concocted by the corporate elite to achieve their goals. And look: the richest America we have ever known, that is, the American Dream emerging from World War II, had massive deficits and yet we became a world Super Power that spilled its wealth all over Europe as well. So much for this deficit hysteria. In fact it has been created to allow the conservatives to eliminate those social programs that benefit average Americans. You must understand that this is not a Republican vs Democrat issue – both sides have teamed up to cut programs that help you in order to favor their fat cat Wall Street friends, who think they’ll be better off if you are poorer and unemployed.

In conlcusion.

Do you realize what you have just read? Yes, unemployment and underemployment need not exist in our country. Yes, universal welfare is possible. And yes, all this would come out of government deficit spending with no problem whatsoever. Actually, in the long run it would even make America richer. Think of all the suffering that the present system creates instead, today spreading to millions of decent families all over the country. And what for? Just to ensure that some tiny super wealthy elite could control the majority of our common wealth. Outrageous.

Here’s what you can do to claim back what ought to be yours. Anyone can.

First, we can provide simple to understand primers to further explain to you why the above is truly possible, and we’ll give you all the authoritative academic sources for it in case you want them. Then the immediate thing for you to do is to challenge your Representative with a simple letter and/or email to tell him/her “My family and I are for Full Employment, Price Stability and for Good Deficits for the people, as proposed by senior economists here (NEP url). Do discuss them in Congress, it’s vital for us ordinary Americans. Otherwise you can forget our vote”.

So to recap: Americans and American families were made to suffer needlessly for decades out of greed of the few and out of ignorance of politicians, and things are getting worse by the day. It’s time to stop them. Let’s get the government to do its proper job.

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How Would You Reinvent Capitalism?

Posted on June 11, 2011 by | 2 comments

The Nation put this question to a panel of sixteen activists and economic thinkers. Our own Randy Wray shared his ideas for remaking capitalism into a more stable and equitable system.

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Time to panic? You Betcha.

Posted on June 9, 2011 by | 33 comments

By Stephanie Kelton

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

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

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

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

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

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

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

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

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

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The Sector Financial Balances Model of Aggregate Demand and Austerity

Posted on June 9, 2011 by | 10 comments

By Scott Fullwiler

As Stephanie Kelton has recently published two excellent pieces explaining the sector balances in the context of government “belt tightening” (see here and here), a logical next step is to present this in the sector financial balances model of aggregate demand. This post will only briefly review that model before applying it to austerity policies; those desiring more complete background can find it here, and a printable version here. Posts by several others describing various aspects of the model are also linked to therein.

Continue reading →

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MMP BLOG #1 RESPONSES

Posted on June 8, 2011 by | 24 comments

By L. Randall Wray

We thank commentators for mentioning some of the many people who are helping to spread the word about MMT to the world, both through blogs and out there in the real world through their many contacts. We especially thank Cullen Roche (Pragcap.com), Selise at FDL, and Paolo Rossi Barnard (a reporter and documentary film maker in Italy) who were mentioned in comments this week. Paolo is right: we have to get beyond academics, beyond policymakers, and even beyond the blogosphere. Many of you out there are much better connected and more knowledgeable about these things than we are. We need your help. We need your advice. What we will do is to use NEP as a resource for networking–with other MMT blogs but also with communities. We ask for your thoughts: what is the best way (other than blogs and comments) to organize efforts to spread the word to the “real world”. We need You-tube videos and animated cartoons that can go viral; we need those of you with Twitter followers to ‘tweet’ about us; we need presentations before community groups; we need documentaries; and we need letters to the editor and op-eds in newspapers across the nation. Money also helps! (We’ll be adding a Donate button and seeking grant support soon.) Please send your thoughts.

Now on to some of the comments.

There were a couple of comments urging us to be sure to demonstrate that modern money “works” as we say it does. OK, we will do that over the coming year. But look at it this way. “Modern money” is 4000 years old, “at least”, according to Keynes. A 4000 year history shows that it “works”. Of course that depends on what you mean by “works”. But if you don’t want to define that too narrowly, I think you’d have to define modern money as a “success”–we’ve increased lifespans, improved quality of life, sent men to the moon, created literature and art–all while operating with modern money. That said, most people do not understand how the actual real world monetary system “works”. And that is why they think we are describing a new monetary regime. We are not. We are explaining how our monetary system actually works. No myths, no religion, no magic.

As I said in the Intro (Blog 1) this Primer WILL NOT present and critique the orthodox, mainstream approach. It is already in every economics textbook. It is the basis of all the conventional wisdom about the operation of the monetary system. It is wrong. But it is irrelevant to the purpose of this Primer—which is to explicate how things really work.

Now that is going to keep things largely at the theoretical level, at a general level that can be applied to specific circumstances. The USA is NOT Turkey. Both have modern money systems. But if the focus is too much on the operations in one nation, it will be hard to see how the points made apply to others. The regular pages of NEP (and Billy Blog, and many other MMT blogs) apply MMT to specific issues.

Here are some responses to more specific comments. Please remember that we will be covering such areas in detail over the next year.

(i) Where is the evidence that an economy will quantity expand rather than price expand when stimulated?

It’s always a risk, as with most any policy, that there could be a round of price increases after a fiscal stimulus, due to the institutional structure (i.e. bottlenecks) and level of aggregate demand (i.e. full employment of plant or labor). The key is to provide stimulus when it is needed, and to formulate and direct the stimulus in a manner that is least likely to cause price increases. As will be seen, we do not favor “pump priming”, old-style, Keynesian aggregate demand stimulus in most situations. We prefer targeted policy. A case in point is the job guarantee/employer of last resort program, which sets a fixed wage to COUNTER the fact that bottlenecks exist in many markets and as an alternative to traditional Keynesian pump priming precisely because of problems associated with bottlenecks.

(ii) Where is the evidence that the floating rate exchange mechanism gives you the degree of freedom required to allow MMT to work?

As discussed above, MMT explains how things really do “work” in the real world. Floating exchange rates offer more fiscal and monetary policy space. This will be explained in detail in coming months. Indeed, as discussed in the introduction, a major purpose of this Primer is to deal with the range of exchange rate regimes.

Finally, a (longish) note on comments and on this project more generally.

We hope that those who engage with us on this Primer are here because they want to learn and to help improve MMT through the creation of this Primer. We will not argue with those who want to reject it. Yes, there are alternative explanations of the operation of the monetary system. No one has to accept ours. As Paul Davidson always says, channeling Keynes, you cannot convict your opponent of error—you must convince her. People are convinced in different ways. At least one commentator says that she/he will not be convinced with theory. I have found that some people are convinced very quickly—when they are introduced to MMT they say it is like putting on a new pair of glasses. Suddenly the world becomes clear to them. Paolo Barnard (who commented) and I had many long telephone conversations. He grasped the implications immediately (and he discussed them in his comment)—he did not need the details, he was convinced by the conclusion. We then filled-in the details over the past year. Many others do not like the conclusions. They do not come on board until they’ve got all the details. Some are skeptical of “pure logic”—to them the “three balances” looks highly suspicious (why would deficits and surpluses have to balance? Why can’t we all run surpluses all the time?). Still others jump immediately to Zimbabwe hyperinflation—using their understanding of some real world event. They’ve got to be brought beyond their fears before they are open to understanding MMT. There is no “one size fits all”.

Civility. Education. That is what we are aiming for on the MMP. If you want to throw “flames” please post them to the main site.

The claim that none of the NEP people has explained MMT simply is perplexing to me. Read Stephanie’s posts, the model of clarity. In any case, that is the purpose of this MMP—to start with the basics and to build up gradually to MMT. Wait a year. If after the next 52 posts you are still convinced that the best MMT explanation can be found elsewhere, so be it.

Ditto the claim that no MMT people at NEP care anything about fraud and criminal activity. My goodness. Ask our colleague Bill Black who has spent the most time studying and exposing bankster foreclosure fraud and the role played by MERS (Hint 1: it ain’t Bill. Hint 2: surf HuffPost). Look, Michael Hudson and Bill Black are fellow travelers, working in a parallel world to our MMT world. To be sure, it is a non-Euclidean world in which parallel lines intersect. Yet, they cover some issues that are different from MMT concerns. We are thrilled, literally, that some readers find their ideas important, maybe even more important than MMT. That is why they are frequent contributors to NEP on other topics including control fraud and super imperialism. Inequality? Unemployment? Job guarantee? Poverty? Incarceration? Banker fraud? We’ve been writing about these issues, too, for decades—long before NEP, before blogs, before widespread use of the internet.

The argument that NEP folks are just academics that never pay any attention to “real folks”? Look, Stephanie, Bill and I speak to hundreds of groups per year. I cannot recall ever turning down an invitation to speak unless it conflicted with another talk—in which case I worked out an alternative date. I speak at local Perkins coffee shops. I go to old folk’s homes. I teach MMT to atheists. For heaven’s sake, Stephanie ran for public office—as a Democrat—against all odds, in Kansas! She knocked on thousands of doors. She kissed thousands of babies, and hugged hundreds of thousands of flag waving dads. Warren ran for Senate as a TeaParty Democrat, before crowds of well-armed nuts who hoped to get a glimpse of Sara Palin. (Try pushing MMT and ELR before that crowd!) We speak ALL THE TIME to nonacademic groups. The idea that we chose an easy academic path to Nobel prizes and global academic acclaim cannot be farther from the truth. Only those outside academics could possibly be fooled. You really need to see our day planners before you criticize us for lack of involvement.

Admittedly, our success could be criticized as spotty. Both Stephanie and Warren lost their elections. But all of you, every single one of you reading this blog (as well as Billy Blog) is here because we—a half dozen of us—created Modern Money Theory from the beginning. Us Pointy-Headed Academics (with a somewhat less-pointy-headed hedge fund manager). We welcome, with open arms, all the new MMT-ers. We admit our failures. No, we are not the best writers. We are not the best performers. We are not the best framers of the message. In many ways we are technically, socially, and politically inept. For the past 2 decades we used to meet once a year to count how many MMT-ers there were in the world. It took a dozen years to get beyond the fingers on one hand. We celebrated when we had to bring in the second hand and some toes to do the count. I suppose that is a measure of our incompetence. Maybe some of you could have developed and spread the ideas much more quickly than we did. We wish you would have joined up a lot earlier! We’ve had our years wandering around the wilderness.

But we learned to be thick-skinned. We’ve been called every name in the book, from Nazi to Pinko Commie. We could not be deterred. And now you are here. We won. At least, we interested somewhere around 3000 of you enough to bring you to this site (on day one of the MMP). We are glad you are with us. We want you to help us to continue to develop the theory, the message, and the strategy to get these ideas out. We are glad to pass the torch. Indeed, we must pass the torch.

So to conclude: This is a joint project. We are trying to create a primer of MMT. The project will take a year. You are a contributor, not a critic. On Mondays there will be a blog to explain a piece of the theory (to be precise, it is at most 1/52nd of the Primer). You tell us where it is unclear or just plain wrong. If you can explain it better than we can, go for it. We’ll do our best to correct the mistakes and clarify the message in the Thursday response. Of course, until we near the end, there will be a lot that still needs to be covered. Indeed, even at the end of our journey—June 2012—we might find that the Primer still has a long way to go, in which case we will continue. Maybe the journey will never end. That will depend, to a large degree, on you and your commitment to the process.

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Tim Pawlenty Blurs the Distinction Between an Entrepreneur and a Rentier

Posted on June 8, 2011 by | 5 comments

By Marshall Auerback

In a private email exchange, Michael Lind of the New America Foundation drew my attention to a recent speech by Republican Presidential candidate Tim Pawlenty. Like those of us who blog on this site, Pawlenty thinks we need to cut taxes.  But, as Jon Ward at HuffPost argued, Pawlenty’s justification for tax relief “took him into unusual — and scatological — rhetorical territory.” 


Pawlenty said that about five percent of the population belongs to the entrepreneurial class and that “if that five percent become six, seven percent, we’ve got a very bright future. And if that five percent becomes four, three, two or one percent, we’re in deep doo doo. We are in deep crap.”


He’s given away the Rentier mindset.  He talks about “entrepreneurs” but he’s really talking about rentiers.

About 10 percent of the US population is self-employed, the majority of them lawn mowers and such.  Clearly Pawlenty’s tax cuts aren’t aimed at expanding the group of self-employed lawn mowers by one or two percent of the population. He’s talking about expanding the richest few percent.

He’s talking about capitalists, not entrepreneurs.  There’s a certain overlap, but most capitalists are not entrepreneurs and vice versa.  Most capitalists are passive investors in businesses they know nothing about and most entrepreneurs are unable to fund their businesses without borrowing. 

The rentier right wants to blur this distinction, so 2-year-old Junior Moneybags, whose trust fund is earning money while he barfs on the family maid, is an “entrepreneur.”

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