Monthly Archives: August 2011

Michael Hudson on the State and Local Budget Crisis

The State and Local Budget Crisis
The cost of the 2011 cutbacks in federal spending will fall most directly on consumers and retirees by scaling back Social Security, Medicare, Medicaid and social spending programs. The population also will suffer indirectly, by lower federal revenue sharing with U.S. states and cities. The following chart from the National Income and Product Accounts (NIPA, Table 3.3) shows how federal financial aid has helped cities shift the tax burden off real estate, although the main shift has been off property taxes onto income – and onto consumption (sales) taxes.


By L. Randall Wray

Last week I asserted that coins have never been a form of commodity money; rather they have always been the IOUs of the issuer. Essentially, a gold coin is just the state’s IOU that happens to have been stamped on gold. It is just a “token” of the state’s indebtedness—nothing but a record of that debt. The state must take back its IOU in payments made to itself. “Taxes drive money”—these “money things” are accepted because there are taxes “backing them up”, not because they have embodied gold. As promised, this week I will begin try to dispel the view that coins used to be commodity monies. Next week, we will finish up the discussion.

In this Primer I do not want to go deeply into economic history—we are more interested here with how money “works” today. However, that does not mean that history does not matter, nor should we ignore how our stories about the past affect how we view money today. For example, a common belief (accepted by most economists) is that money first took a commodity form. Our ancient ancestors had markets, but they relied on inconvenient barter until someone had the bright idea of choosing one commodity to act as a medium of exchange. At first it might have been pretty sea shells, but through some sort of evolutionary process, precious metals were chosen as a more efficient money commodity.

Obviously, metal had an intrinsic value—it was desired for other uses. (And if we take a Marxian labor theory of value, we can say metal had a labor value as it had to be mined and refined.) Whatever the case, that intrinsic value imparted value to coined metal. This helped to prevent inflation—that is, decline in the purchasing power of the metal coin in terms of other commodities—since the coin could always be melted and sold as bullion. There are then all sorts of stories about how government debased the value of the coins (by reducing precious metal content), causing inflation.

Later, government issued paper money (or base metal coins of very little intrinsic value) but promised to redeem this for the metal. Again, there are many stories about government defaulting on that. And then finally we end with today’s “fiat money”, with nothing “real” standing behind it. And that is how we get the Weimar Republics and the Zimbabwes—with nothing really backing the money it now is prone to causing hyperinflation as government prints up too much of it. Which leads us to the gold bug’s lament: if only we could go back to a “real” money standard: gold.

In this discussion, we cannot provide a detailed historical account to debunk the traditional stories about money’s history. Let us instead provide an overview of an alternative.

First we need to note that the money of account is many thousands of years old—at least four millennia old and probably much older. (The “modern” in “modern money theory” comes from Keynes’s claim that money has been state money for the past 4000 years “at least”.) We know this because we have, for example, the clay tablets of Mesopotamia that record values in money terms, along with price lists in that money of account.

We also know that money’s earliest origins are closely linked to debts and record-keeping, and that many of the words associated with money and debt have religious significance: debt, sin, repayment, redemption, “wiping the slate clean”, and Year of Jubilee. In the Aramaic language spoken by Christ, the word for “debt” is the same as the word for “sin”. The “Lord’s Prayer” that is normally interpreted to read “forgive us our trespasses” could be just as well translated as “our debts” or “our sins”—or as Margaret Atwood says, “our sinful debts”.*

Records of credits and debits were more akin to modern electronic entries—etched in clay rather than on computer tapes. And all early money units had names derived from measures of the principal grain foodstuff—how many bushels of barley equivalent were owed, owned, and paid. All of this is more consistent with the view of money as a unit of account, a representation of social value, and an IOU rather than as a commodity.

Or, as we MMTers say, money is a “token”, like the cloakroom “ticket” that can be redeemed for one’s coat at the end of the operatic performance.

Indeed, the “pawn” in pawnshop comes from the word for “pledge”, as in the collateral left, with a token IOU provided by the shop that is later “redeemed” for the item left. St. Nick is the patron saint of pawnshops (and, appropriately, for thieves), while “Old Nick” refers to the devil (hence, the red suit and chimney soot) to whom we pawn our souls. The Tenth Commandment’s prohibition on coveting thy neighbor’s wife (which goes on to include male or female slave, or ox, or donkey, or anything that belongs to your neighbor) has nothing to do with sex and adultery but rather with receiving them as pawns for debt. By contrast, Christ is known as “the Redeemer”—the “Sin Eater” who steps forward to pay the debts we cannot redeem, a much older tradition that lay behind the practice of human sacrifice to repay the gods.*

We all know Shakespeare’s admonition “neither a borrower nor a lender be”, as religion typically views both the “devil” creditor and the debtor who “sells his soul” by pawning his wife and kids into debt bondage as sinful—if not equally then at least simultaneously tainted, united in the awful bondage. Only “redemption” can free us from humanity’s debts owing to Eve’s original sin.

Of course, for most of humanity today, it is the original sin/debt to the tax collector, rather than to Old Nick, that we cannot escape. The Devil kept the first account book, carefully noting the purchased souls and only death could “wipe the slate clean” as “death pays all debts”. Now we’ve got our tax collector, who like death is the only certain thing in life. In between the two, we had the clay tablets of Mesopotamia recording debits and credits in the Temple’s and then the Palace’s money of account for the first few millennia after money was invented as a universal measure of our multiple and heterogeneous sins.

The first coins were created thousands of years later, in the greater Greek region (so far as we know, in Lydia in the 7th century BC). And in spite of all that has been written about coins, they have rarely been more than a very small proportion of the “money things” involved in finance and debt payment. For most of European history, for example, tally sticks, bills of exchange, and “bar tabs” (again, the reference to “wiping the slate clean” is revealing—something that might not be done for a year or two at the pub, where the alewife kept the accounts) did most of that work.

Indeed, until very recent times, most payments made to the Crown in England were in the form of tally sticks (the King’s own IOU, recorded in the form of notches in hazelwood)—whose use was only discontinued well into the 19th century (with a catastrophic result: the Exchequer had them thrown into the stoves with such zest that Parliament was burnt to the ground by those devilish tax collectors!) In most realms, the quantity of coin was so small that it could be (and was) frequently called in to be melted for re-coinage.

(If you think about it, calling in all the coins to melt them for re-coinage would be a very strange and pointless activity if coins were already valued by embodied metal!)

So what were coins and why did they contain precious metal? To be sure, we do not know. Money’s history is “lost in the mists of time when the ice was melting…when the weather was delightful and the mind free to be fertile of new ideas—in the islands of the Hesperides or Atlantis or some Eden of Central Asia” as Keynes put it. We have to speculate.

One hypothesis about early Greece (the mother of both democracy and coinage—almost certainly the two are linked in some manner) is that the elites had nearly monopolized precious metal, which was important in their social circles tied together by “hierarchical gift exchange”. They were above the agora (market place) and hostile to the rising polis (democratic city-state government). According to Classical scholar Leslie Kurke, the polis first minted coin to be used in the agora to “represent the state’s assertion of its ultimate authority to constitute and regulate value in all the spheres in which general-purpose money operated… Thus state-issued coinage as a universal equivalent, like the civic agora in which it circulated, symbolized the merger in a single token or site of many different domains of value, all under the final authority of the city.”** The use of precious metals was a conscious thumbing-of-the-nose against the elite who placed great ceremonial value on precious metal. By coining their precious metal, for use in the agora’s houses of prostitution by mere common citizens, the polis sullied the elite’s hierarchical gift exchange—appropriating precious metal, and with its stamp asserting its ultimate authority.

As the polis used coins for its own payments and insisted on payment in coin, it inserted its sovereignty into retail trade in the agora. At the same time, the agora and its use of coined money subverted hierarchies of gift exchange, just as a shift to taxes and regular payments to city officials (as well as severe penalties levied on officials who accepted gifts) challenged the “natural” order that relied on gifts and favors. As Kurke argues, since coins are nothing more than tokens of the city’s authority, they could have been produced from any material. However, because the aristocrats measured a man’s worth by the quantity and quality of the precious metal he had accumulated, the polis was required to mint high quality coins, unvarying in fineness. (Note that gold is called the noble metal because it remains the same through time, like the king; coined metal needed to be similarly unvarying.) The citizens of the polis by their association with high quality, uniform, coin (and in the literary texts of the time, the citizen’s “mettle” was tested by the quality of the coin issued by his city) gained equal status; by providing a standard measure of value, coinage rendered labor comparable and in this sense coinage was an egalitarian innovation.

From that time forward, coins commonly contained precious metal. Rome carried on the tradition, and Kurke’s thesis is consistent with the statement of St. Augustine, who declared that just as people are Christ’s coins, the precious metal coins of Rome represent a visualization of imperial power—inexorably doing the emperor’s bidding just as the reverent do Christ’s.*** Note, again, the link between money and religion.

OK, that gets us to Roman times. Next week we examine coinage from Rome through to modern times.

*Payback: debt and the shadow side of wealth, by Margaret Atwood, Anansi 2008.
**Coins, Bodies, Games, and Gold, by Leslie Kurke, Princeton University Press, Princeton, New Jersey, 1999; xxi, 385; paper $29.95 (ISBN 0-691-00736-5), cloth $65.00 (ISBN 0-691-01731-X).
***If anyone knows the source for St. Augustine’s comparison of people to coins, please provide it. I thank Chris Desan, David Fox, and other participants of a recent seminar at Cambridge University for the discussion I draw upon here.

NPR’s Robert Siegel Interviews William K. Black on the Investigation of S&P

Listen to William Black explain how investigations into the recent financial crisis differ from inquiries into previous disasters. Also, you’ll find Professor Black’s review of Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance below the fold.

Guaranteed to Loot: The Perverse Incentives of Systemically Dangerous Institutions’ CEOs
A Book Review for Fidedoglake by William K. Black of:
Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance
Viral V. Acharya
Matthew Richardson
Stijn Van Nieuwerburgh
Lawrence J. White
(Princeton: 2011)
The Authors’ Revolutionary Indictment of Systemically Dangerous Institutions (SDIs)
Overview of the Authors’ Logic

Fannie and Freddie, like all U.S. systemically dangerous institutions (SDIs) were privately-owned and their liabilities were not guaranteed by the Treasury. Nevertheless, all SDIs have an implicit Treasury guarantee of their debts because any SDI failure could cause a global systemic crisis. The SDIs obtain the implicit guarantee by implicitly hold our economy hostage. The perverse incentives arising from this guarantee are the authors’ core concept.

The authors are finance professors at NYU’s Stern School. Their logic makes this a revolutionary book. The book is a case study of the perverse behavior of the managers controlling two SDIs, but the authors generalize the perverse incentives as controlling all SDIs.

The authors’ findings support James Galbraith’s thesis in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. Our financial leaders are the SDIs’ CEOs who make “free” markets impossible. The authors found that SDIs cause “a highly distorted market with two types of institutions – LCFI King Kongs and GSE Godzillas – both implicitly backed by the government….” (p. 55). (LCFI: “large complex financial institutions” – the authors’ polite euphemism for SDIs.) Their conclusion that “there was nothing free about these [housing finance] markets” applies to all the SDIs (p. 21).

“[T]he failure of the LCFIs and the GSEs is quite similar – a highly leveraged bet on the mortgage markets by firms that were implicitly backed by the government with artificially low funding rates only to differing degrees” (p. 49).

They adopt the CBO’s simile: living with Fannie and Freddie is like sharing a canoe with a bear.
“Because the GSEs are currently under the conservatorship of the government, it would be crazy not to kill off the “bear” and move forward with a model that did not again create a too-big-to-fail – and, more likely, a too-big-to-reform – monster” (p. 74).

The authors’ revolutionary logic is that it would “be crazy not to kill off the bear[s]” – the SDIs are inherently “monster[s]” that hold our economy hostage and block real markets and real democracy.
The authors argue that it is impossible even for massive SDIs to compete with the largest SDIs. Their simile is that the largest SDIs’ advantages are so great that it is “like bringing a gun to a knife fight” (p. 22).

In 1993, George Akerlof and Paul Romer authored Looting: the Economic Underworld of Bankruptcy for Profit. Akerlof & Romer explained how financial CEOs used accounting fraud to make record reported profits a “sure thing” (p. 5). The record, albeit fictional, reported profits were certain to make the CEO wealthy, while the bank was guaranteed to fail.

The authors confirmed Akerlof & Romer’s thesis. The CEOs’ perverse incentive creates three concurrent guarantees: the bank will report high (albeit fictional) short-term profits, the controlling officers will extract large increases in wealth, and the bank will suffer large losses. The bank fails, but the controlling officers walks away rich. “Control frauds” represent the ultimate form of “rent-seeking.” The SEC charged Fannie’s controlling officers with accounting and securities fraud to inflate its reported income so that they could extract greater bonuses.

The Authors Related Tenets: “Tail Risk” and the “Race to the Bottom”

The authors do not explain their concept of an extreme tail gamble, but they say that Fannie and Freddie’s tail gamble was purchasing nonprime loans. Those purchases were not honest “bets” and they were not subject to loss only in “rare” circumstances. Pervasively fraudulent “liar’s” loans sank the SDIs, hyper-inflated the bubble, and caused the great recession. Liar’s loans were certain to default catastrophically as soon as the housing bubble stalled. The housing bubble was certain to stall.

I believe that the authors’ logic chain is as follows:

1. SDI executives caused “their” banks to make investments that had a negative expected value, but a high nominal yield

2. In violation of generally accepted accounting principles (GAAP), the SDIs did not provide remotely adequate allowances for those future losses (ALLL)

3. This created a “sure thing” – SDIs were guaranteed to report high (fictional) short-term

4. This guaranteed fictional income led to the guaranteed massive executive bonuses

5. The officers controlling the SDIs used professional compensation (e.g., of auditors, appraisers, and rating agencies) to create a “race to the bottom” that led to widespread “echo” fraud epidemics among appraisers and credit rating agencies

6. The SDIs did the same thing to produce echo epidemics by loan officers and brokers

7. The accounting control frauds created a “race to the bottom” that drove the officers controlling other SDIs to mimic their frauds

8. This hyper-inflated the housing bubble

9. The hyper-inflation of the bubble allowed the SDIs to hide losses The SDIs’ creditors did not provide (expensive) market discipline because of the implicit government guarantee protected them from loss

10. The SDIs’ regulators did not act as the regulatory “cops on the beat” to break this private sector “race to the bottom” because the SDIs’ used their political power and ideological “capture” to create a regulatory “race to the bottom” (p. 191, n. 3)

11. SDIs following this fraud strategy were guaranteed to suffer massive loan losses and fail

12. These fraud epidemics and SDI failures triggered the Great Recession

The Authors’ Proposed Reforms are Criminogenic

Any analysis that ignores control fraud is certain to distract us from the reforms essential to prevent our recurrent, intensifying financial crises. Ignoring fraud led the authors to propose reforms that are criminogenic.

The authors’ suggestion that the Treasury charge the SDIs a fee equivalent to the value of their implicit Treasury subsidy would encourage accounting control fraud. Frauds use deceit to hide the risks the lender or purchaser is taking. The result would be an intensified Gresham’s dynamic because the accounting frauds would have an even greater advantage (due to the grossly inadequate charge for their implicit Treasury subsidy) over their honest competitors. Under the authors’ own logic and simile we must kill all of the bears.

The Case Against the Ratings Agencies

By Michael Hudson
(Cross-posted from

In today’s looming confrontation the ratings agencies are playing the political role of “enforcer” as the gatekeepers to credit, to put pressure on Iceland, Greece and even the United States to pursue creditor-oriented policies that lead inevitably to financial crises. These crises in turn force debtor governments to sell off their assets under distress conditions. In pursuing this guard-dog service to the world’s bankers, the ratings agencies are escalating a political strategy they have long been refined over a generation in the corrupt arena of local U.S. politics.
Why ratings agencies use public selloffs rather than sound tax policy: The Kucinich Case Study
In 1936, as part of the New Deal’s reform of America’s financial markets, regulators forbid banks and institutional money managers to buy securities deemed “speculative” by “recognized rating manuals.” Insurance companies, pension funds and mutual funds subject to public regulation are required to “take into account” the views of the credit ratings agencies, providing them with a government-sanctioned monopoly. These agencies make their money by offering their “opinions” (for which they have never been legally liable) as to the payment prospects of various grades of security, from AAA (as secure government debt, the top rating because governments always can print the money to pay) down to various depths of junk.

Moody’s, Standard and Poor’s and Fitch focus mainly on stocks and on corporate, state and local bond issues. They make money twice off the same transaction when cities and states balance their budgets by spinning off public enterprises into new corporate entities issuing new bonds and stocks. This business incentive gives the ratings agencies an antipathy to governments that finance themselves on a pay-as-you-go basis (as Adam Smith endorsed) by raising taxes on real estate and other property, income or sales taxes instead of borrowing to cover their spending. The effect of this inherent bias is not to give an opinion about what is economically best for a locality, but rather what makes the most profit for themselves.

Localities are pressured when their rising debt levels lead to a financial stringency. Banks pull back their credit lines, and urge cities and states to pay down their debts by selling off their most viable public enterprises. Offering opinions on this practice has become a big business for the ratings agencies. So it is understandable why their business model opposes policies – and political candidates – that support the idea of basing public financing on taxation rather than by borrowing. This self-interest colors their “opinions.”

If this seems too cynical an explanation for today’s ratings agencies self-serving views, there are sufficient examples going back over thirty years to illustrate their unethical behavior. The first and most notorious case occurred in Cleveland, Ohio, after Dennis Kucinich was elected mayor in 1977. The ratings agencies had been giving the city good marks despite the fact that it had been using bond funds improperly for general operating purposes to cover its budget shortfalls by borrowing, leaving Cleveland with $14.5 million owed to the banks on open short-term credit lines.

Cleveland had a potential cash cow in Municipal Light, which its Progressive Era mayor Tom Johnson had created in 1907 as one of America’s first publicly owned power utilities. It provided the electricity to light Cleveland’s streets and other public uses, as well as providing power to private users. Meanwhile, banks and their leading local clients were heavily invested in Muni Light’s privately owned competitor, the Cleveland Electric Illuminating Company. Members of the Cleveland Trust sat on CEI’s board and wielded a strong influence on the city council to try and take it over. In a series of moves that city officials, the U.S. Senate and regulatory agencies found to be improper (popular usage would say criminal),[1] CEI caused a series of disruptions in service and worked with the banks and ratings agencies to try and force the city to sell it the utility. Banks for their part had their eye on financing a public buyout – and hoped to pressure the city into selling, threatening to pull the plug on its credit lines if it did not surrender Muni Light.
It was to block this privatization that Mr. Kucinich ran for mayor. To free the city from being liable to financial pressure from its vested interests – above all from the banks and private utilities – he sought to put the city’s finances on a sound footing by raising taxes. This threatened to slow borrowing from the banks (thereby shrinking the business of ratings agencies as well), while freeing Cleveland from the pressures that have risen across the United States for cities to start selling off their public enterprises, especially since the 1980s as tax-cutting politicians have left them deeper in debt.

The banks and ratings agencies told Mayor Kucinich that they would back his political career and even hinted financing a run for the governorship if he played ball with them and agreed to sell the electric utility. When he balked, the banks said that they could not renew credit lines to a city that was so reluctant to balance its books by privatizing its most profitable enterprises. This threat was like a credit-card company suddenly demanding payment of the full balance from a customer, saying that if it were not paid, the sheriff would come in and seize property to sell off (usually on credit extended to customers of the bankers).
The ratings agencies chimed in and threatened to downgrade Cleveland’s credit rating if the city did not privatize its utility. The financial tactic was to offer the carrot of corrupting the mayor politically, while using the threat of forcing the city into financial crisis and raising its interest rates. If the economy did not pay higher utility charges as a result of privatization, it would have to pay higher interest.
But standing on principle, the mayor refused to sell the utility, and voters elected to keep Muni light public by a 2-to-1 margin in a referendum. They proceeded to pay down the city’s debt by raising its income-tax rate in order to avoid paying higher rates for privatized electricity. Their choice was thoroughly in line with Book V of Adam Smith’s Wealth of Nations provides a perspective on how borrowing ends up with a proliferation of taxes to pay the interest. This makes the private sector pay higher prices for its basic needs that Cleveland Mayor Tom Johnson and other Progressive Era leaders a century ago sought to socialize in order to lower the cost of living and doing business in the United States.

The bankers’ alliance with the Cleveland’s wealthy would-be power monopoly led it to be the first U.S. city to default since the Great Depression as the state of Ohio forced it into fiscal receivership in 1979. The banks used the crisis to make an easy gain in buying up bond anticipation notes that were sold under distress conditions exacerbated by the ratings agencies. The banks helped fund Mayor Kucinich’s opponent in the 1979 mayoral race.

But in saving Muni Light he had saved voters hundreds of millions of dollars that the privatizers would have built into their electric rates to cover higher interest charges and financial fees, dividends to stockholders, and exorbitant salaries and stock options. In due course voters came to recognize Mr. Kucinich’s achievement have sent him to Congress since 1997. As for Mini Light’s privately owned rival, the Cleveland Electric Illuminating Company, it achieved notoriety for being primarily responsible for the northeastern United States power blackout in 2003 that left 50 million people without electricity.

The moral is that the ratings agencies’ criterion was simply what was best for the banks, not for the debtor economy issuing the bonds. They were eager to upgrade Cleveland’s credit ratings for doing something injurious – first, borrowing from the banks rather than covering their budget by raising property and income taxes; and second, raising the cost of doing business by selling Muni Light. They threatened to downgrade the city for acting to protect its economic interest and trying to keep its cost of living and doing business low.
The tactics by banks and credit rating agencies have been successful most easily in cities and states that have fallen deeply into debt dependency. The aim is to carve up national assets, by doing to Washington what they sought to do in Cleveland and other cities over the past generation. Similar pressure is being exerted on the international level on Greece and other countries. Ratings agencies act as political “enforcers” to knee-cap economies that refrain from privatization sell-offs to solve debt problems recognized by the markets before the ratings agencies acknowledge the bad financial mode that they endorse for self-serving business reasons.
Why ratings agencies oppose public checks against financial fraud

The danger posed by ratings agencies in pressing the global economy to a race into debt and privatization recently became even more blatant in their drive to give more leeway to abusive financial behavior by banks and underwriters. Former Congressional staffer Matt Stoller cites an example provided by Josh Rosner and Gretchen Morgenson in Reckless Endangerment regarding their support of creditor rights to engage in predatory lending and outright fraud.[2] On January 12, 2003, the state of Georgia passed strong anti-fraud laws drafted by consumer advocates. Four days later, Standard & Poor announced that if Georgia passed anti-fraud penalties for corrupt mortgage brokers and lenders, packaging including such debts could not be given AAA ratings.

Because of the state’s new Fair Lending Act, S&P said that it would no longer allow mortgage loans originated in Georgia to be placed in mortgage securities that it rated. Moody’s and Fitch soon followed with similar warnings.

 It was a critical blow. S&P’s move meant Georgia lenders would have no access to the securitization money machine; they would either have to keep the loans they made on their own books, or sell them one by one to other institutions. In turn, they made it clear to the public that there would be fewer mortgages funded, dashing “the dream” of homeownership.
The message was that only bank loans free of legal threat against dishonest behavior were deemed legally risk-free for buyers of securities backed by predatory or fraudulent mortgages. The risk in question was that state agencies would reduce or even nullify payments being extracted by crooked real estate brokers, appraisers and bankers. As Rosner and Morgenson summarize:

Standard & Poor’s said it was taking action because the new law created liability for any institution that participated in a securitization containing a loan that might be considered predatory. If a Wall Street firm purchased loans that ran afoul of the law and placed them in a mortgage pool, the firm could be liable under the law. Ditto for investors who bought into the pools. “Transaction parties in securitizations, including depositors, issuers and servicers, might all be subject to penalties for violations under the Georgia Fair Lending Act,” S&P’s press release explained.
The ratings agencies’ logic is that bondholders will not be able to collect if public entities prosecute financial fraud involved in packaging deceptive mortgage packages and bonds. It is a basic principle of law that receivers or other buyers of stolen property must forfeit it, and the asset returned to the victim. So prosecuting fraud is a threat to the buyer – much as an art collector who bought a stolen painting must give it back, regardless of how much money has been paid to the fence or intermediate art dealer. The ratings agencies do not want this principle to be followed in the financial markets.

We have fallen into quite a muddle when ratings agencies take the position that packaged mortgages can receive AAA ratings only from states that do not protect consumers and debtors against mortgage fraud and predatory finance. The logic is that giving courts the right to prosecute fraud threatens the viability of creditor claims endorses a race to the bottom. If honesty and viable credit were the objective of ratings agencies, they would give AAA ratings only to states whose courts deterred lenders from engaging in the kind of fraud that has ended up destroying the securitized mortgage binge since September 2008. But protecting the interests of savers or bank customers – and hence even the viability of securitized mortgage packages – is not the task with which ratings agencies are charged.

Masquerading as objective think tanks and research organizations, the ratings agencies act as lobbyists for banks and underwriters by endorsing a race to the bottom – into debt, privatization sell-offs and an erosion of consumer rights and control over fraud. “S&P was aggressively killing mortgage servicing regulation and rules to prevent fraudulent or predatory mortgage lending,” Stoller concludes. “Naomi Klein wrote about S&P and Moody’s being used by Canadian bankers in the early 1990s to threaten a downgrade of that country unless unemployment insurance and health care were slashed.”

The basic conundrum is that anything that interferes with the arbitrary creditor power to make money by trickery, exploitation and outright fraud threatens the collectability of claims. The banks and ratings agencies have wielded this power with such intransigence that they have corrupted the financial system into junk mortgage lending, junk bonds to finance corporate raiders, and computerized gambles in “casino capitalism.” What then is the logic in giving these agencies a public monopoly to impose their “opinions” on behalf of their paying clients, blackballing policies that the financial sector opposes – rulings that institutional investors are legally obliged to obey?
Threats to downgrade the U.S. and other national economies to force pro-financial policies

At the point where claims for payment prove self-destructive, creditors move to their fallback position. Plan B is to foreclose, taking possession of the property of debtors. In the case of public debt, governments are told to privatize the public domain – with banks creating the credit for their customers to buy these assets, typically under fire-sale distress conditions that leave room for capital gains and other financial rake-offs. In cases where foreclosure and forced sell-offs are not able to make creditors whole (as when the economy breaks down), Plan C is for governments simply to bail out the banks, taking bad bank debts and other obligations onto the public balance sheet for taxpayers to make good on.

Standard and Poor’s threat to downgrade of U.S. Treasury bonds from AAA to AA+ would exacerbate the problem if it actually discouraged purchasers from buying these bonds. But on the Monday on August 8, following their Friday evening downgrade, Treasury borrowing rates fell, with short-term T-bills actually in negative territory. That meant that investors had to lose a small margin simply to keep their money safe. So S&P’s opinions are as ineffectual as being a useful guide to markets as they are as a guide to promote good economic policy.

But S&P’s intent was not really to affect the marketability of Treasury bonds. It was a political stunt to promote the idea that the solution to today’s budget deficit is to pursue economic austerity. The message is that President Obama should roll back Social Security and Medicare entitlements so as to free more money for more subsidies, bailouts and tax cuts for the top of the steepening wealth pyramid. Neoliberal Harvard economics professor Robert Barro made this point explicitly in a Wall Street Journal op-ed. Calling the S&P downgrade a “wake-up call” to deal with the budget deficit, he outlined the financial sector’s preferred solution: a vicious class war against labor to reduce living standards and further polarize the U.S. economy between creditors and debtors by shifting taxes off financial speculation and property onto employees and consumers.

 First, make structural reforms to the main entitlement programs, starting with increases in ages of eligibility and a shift to an economically appropriate indexing formula. Second, lower the structure of marginal tax rates in the individual income tax. Third, in the spirit of Reagan’s 1986 tax reform, pay for the rate cuts by gradually phasing out the main tax-expenditure items, including preferences for home-mortgage interest, state and local income taxes, and employee fringe benefits—not to mention eliminating ethanol subsidies. Fourth, permanently eliminate corporate and estate taxes, levies that are inefficient and raise little money. Fifth, introduce a broad-based expenditure tax, such as a value-added tax (VAT), with a rate around 10%.[3]
Bank lobbyist Anders Aslund of the Peterson Institute of International Finance jumped onto the bandwagon by applauding Latvia’s economic disaster (a 20 percent plunge in GDP, 30 percent reduction of public-sector salaries and accelerating emigration as a success story for other European countries to follow. As they say, one can’t make this up.

As the main advocate and ultimate beneficiary of privatization, the financial sector directs debtor economies to sell off their public property and cut social services – while increasing taxes on employees. Populations living in such economies call them hell and seek to emigrate to find work or simply to flee their debts. What else should someone call surging poverty, death rates and alcoholism while a few grow rich? The ratings agencies today are like the IMF in the 1970s and ‘80s. Countries that do not agree sell off their public domain (and give tax deductibility to the interest payments of buyers-on-credit, providing multinationals with income-tax exemption on their takings from the monopolies being privatized) are treated as outlaws and isolated Cuba- or Iran-style.

Such austerity plans are a failed economic model, but the financial sector has managed to gain even as economies are carved up. Their “Plan B” is foreclosure, extending to the national scale. By the 1980s, creditor-planned economies in Third World debtor countries had reached the limit of their credit-worthiness. Under World Bank coordination, a vast market in national infrastructure spending for creditor-nation bank debt, bonds and exports. The projects being financed on credit were mainly to facilitate exports and provide electric power for foreign investments. After Mexico announced its insolvency in 1982 when it no longer could afford to service foreign-currency debt, where were creditors to turn?

Their solution was to use the debt crisis as a lever to start financing these same infrastructure projects all over again, now that most were largely paid for. This time, what was being financed was not new construction, but private-sector buyouts of property that had been financed by the World Bank and its allied consortia of international bankers. There is talk of the U.S. Government selling off its national parks and other real estate, national highways and infrastructure, perhaps the oil reserve, postal service and so forth.

S&P’s “opinion” was treated seriously enough by John Kerry, the 2004 Democratic Presidential nominee, as a warning that America should “get its house in order.” Despite the fact that on page 4 of its 8-page explanation of why it downgraded Treasury bonds, S&P’s stated: “We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act,” was one of the three senators appointed to the commission under the debt-ceiling agreement. He chimed in to endorse the S&P action as a helpful nudge for the country to deal with its “entitlements” program – as if Social Security and FICA withholding were a kind of welfare, not actual savings put in by labor, to be wiped out as the government empties its coffers to bail out Wall Street’s high rollers.

No less a financial publication than the Wall Street Journal has come to the conclusion that “in a perfect world, S&P wouldn’t exist. And neither would its rivals Moody’s Investors Service and Fitch Ratings Ltd. At least not in their current roles as global judges and juries of corporate and government bonds.”[4] As its financial editor Francesco Guerrera wrote quite eloquently in the aftermath of S&P’s bold threat to downgrade the U.S. Treasury’s credit rating: “The historic decision taken by S&P on Aug. 5 is the culmination of 75 years of policy mistakes that ended up delegating a key regulatory function to three for-profit entities.”

The behavior of leading banks and ratings agencies Cleveland and other similar cases – of promising to give good ratings to states, counties and cities that agree to pay off short-term bank debt by selling off their crown jewels – is not ostensibly criminal under the law (except when their hit men actually succeed in assassination). But the ratings agencies have made an compact with crooks to endorse only public borrowers that agree to pursue such policies and not to prosecute financial fraud.

To acquiescence in such economically destructive financial behavior is the opposite of fiscal responsibility. Cutting federal taxes and Social Security payments to obtain a more positive S&P “opinion” would give banks an ability to “pull the plug” and force privatization and anti-labor austerity plans by refraining from rolling over the U.S. debt – and cutting taxes Tea-Party style rather than funding spending by taxation on a pay-as-you-go-basis.

The present meltdown of the euro provides an object lesson for why policy-making never should be left to central bankers, because their mentality is pro-creditor. Otherwise they would not have the political reliability demanded by the financial sector that has captured the central bank, Treasury and regulatory agencies to gain veto power over who is appointed. Given their preference for debt deflation of the “real” economy – while trying to inflate asset prices by promoting the banks’ product (debt creation) – central bank and Treasury solutions tend to aggravate economic downturns. This is self-destructive because today’s major problem blocking recovery is over-indebtedness.

[1] See, as well as The financial ploy included hiring a Mafia hit man to shoot Mr. Kucinich at a parade – which he fortunately did not attend. For Mr. Kucinich’s own narrative of these events, see “Kucinich and Muny Light – Battle with the Banks,”, December 15, 2008, also available at
[3] Robert Barro, “How to Get That AAA Rating Back,” Wall Street Journal, August 8, 2011.
[4] Francesco Guerrera, “Here’s How to Rejigger the U.S. Credit-Rating System,” Wall Street Journal, August 16, 2011.


By Marshall Auerback

Forget about the S&P downgrade, which has had ZERO impact on the global equity markets. The downgrade was supposed to mean that it would be more likely that the US government would not be able to pay its debt than previously assumed. IF the markets took this warning seriously, then they would have attached a higher risk premium to US government bonds. Of course, the opposite occurred. US bonds soared in price. In other words, investors, both here and abroad, voted with money as loudly as possible that they view the US government debt as a very safe haven in a time of financial turmoil

So if it wasn’t the S&P downgrade which caused this downward cascade in the global equity markets, then what was it? By far, the most important factor currently driving the market’s bear trends is Europe or, more specifically, the future of the euro and the European Monetary Union. Systemic risk has migrated across the Atlantic to the euro zone.

 And after yesterday’s joke of a summit between German Chancellor Merkel and French President Nicolas Sarkozy, it appears yet again that Europe’s policy makers have comprehensively blown it. Their persistent reluctance to get ahead of the looming systemic ticking bomb at the heart of the euro project has reached the point where it is likely to doom the euro’s existence. Their repeated “rescue plans” (and equally fatuous statements about new committees and “euro solidarity) can no longer mask the central problem, which is that countries with very different economies are yoked to the same currency in the absence of a fiscal transfer union which would otherwise facilitate growth, not ongoing economic depression and political turmoil.

Rather than attempting to stave off a double-dip recession by easing fiscal and monetary policy, the European Central Bank (ECB) has gone careening off in the opposite direction. The euro project is consequently being turned into a Hooverian instrument of economic torture from sado-monetarists, such as Jean-Claude Trichet, who see each bailout as a way for irresponsible nations to offload their liabilities onto their fitter neighbors, rather than considering the flawed institutional structures which created the need for these stop-gap measures in the first place. Interest rates have been raised, and member states have been forced into self-defeating austerity programmes which, by destroying growth, have made underlying debt dynamics even worse. It is hard to imagine a more tragic and self-defeating type of policy mix. It is 1937 writ large.

How long will voters in rich countries stand for this? Perhaps not much longer as the Germans in particular appear to have no stomach to withstand the costs required to save the currency union. So what is this problem at the heart of the euro project?

 Let’s go back to first principles: it is important to recognize the difference between sovereign and non-sovereign currencies. A government with a non-sovereign currency, issuing debts either in foreign currency or in domestic currency pegged to foreign currency (or to a precious metal, such as gold), faces solvency risk. However, a government that spends by using its own floating and non-convertible currency cannot be forced into default, unless they willingly choose to do so (such as the US Congress almost prepared to contemplate during its recent debt ceiling negotiations). It is why a country like Japan can run government debt-to-GDP ratios that are more than twice as high as the “high debt” PIIGS, while enjoying extremely low interest rates on sovereign debt. A nation operating with its own currency can always spend by crediting bank accounts, and that includes spending on interest. Thus, there is no default risk in terms of a capacity to pay (as opposed to political WILLINGNESS to pay).

But as has been noted by many critics of the common currency project, the relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. A country like Ireland is more like New York within the EMU than a sovereign state. This means it has little domestic policy space to use monetary or fiscal policy to deal with crisis. The upshot has been that in the face of the first large negative demand shock to hit the region, the nation states have quickly found they cannot use fiscal policy in a responsible way to protect its economy from rising unemployment and collapsing income. In a normal federation, the national government can always ensure the solvency of the constituent parts via fiscal transfers. In the legal design of the EMU, there is no such role specified and attempts by the member states to cushion the demand collapse quickly raised the ire of the Euro elites with the ECB leading the charge to impose austerity on errant governments.

In the US, states have no power to create currency; in this circumstance, taxes really do ‘finance’ state spending and states really do have to borrow (sell bonds to the markets) in order to spend in excess of tax receipts. Purchasers of state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of the debt ceiling negotiations makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate. Functionally, each nation state operates the way individual American states do, but with ONLY individual state treasuries.

The euro dilemma, then, is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced during the time that they operated currency pegs. Given the institutional constraints, deficit spending in effect requires borrowing in a “foreign currency”, according to the dictates of private markets and the nation states are externally constrained. That’s why Ireland and Latvia are in a mess and suffer from solvency issues. It’s also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan, which explains why the latter has been able to borrow money at around 1% for the past two decades, despite a public debt to GDP ratio about twice the US or the euro zone.

At this juncture, however, there isn’t enough time to create a “United States of Europe”, which is why the ECB has resumed its bond buying operations to put a floor on the bonds and alleviate concerns about the solvency issues of the individual nation states. The ECB has received a lot of criticism for this. In one sense, the criticisms are legitimate: The ECB is in effect playing a “fiscal role” for which they are ill-suited. They buy time by buying the bonds. But the bond buying attacks the symptoms, rather than the underlying problems. And it’s fundamentally undemocratic: In taking up this role – by way of the ad hoc bailouts and secondary bond market purchases the ECB has become a sort of fiscal tsar unanswerable to any national electorate.

The hope is that by backstopping the bonds, the ECB can persuade the markets that countries like Italy and Greece are not insolvent and that the markets will resume funding them. Clearly, with credit spreads blowing out again, this has proved to be a fatuous hope because the scale of the purchases have not been large enough to be credible, especially now that the contagion is spreading into core countries such as France. Europeans still have to get the institutional arrangements right and the ECB, as the sole issuer of euros, is the only instrument that today can play this role, albeit imperfectly, but there is a better way.

Immediate relief can be provided by the ECB, which should be directed to create and distribute several trillion euros across all euro zone nations on a per capita basis. This would not constitute a “bailout” as such as Germany (with the largest per capita economy) would be the largest recipient. Each individual eurozone nation would be allowed to use this emergency relief as it sees fit. Greece might choose to purchase some of its outstanding public debt; others might choose fiscal stimulus packages. While this might sound much like the current bail-out, in which the ECB buys government bonds in the secondary markets from banks (assuming the risk of a default by Greece, for example), the emergency package outlined here (first proposed by Warren Mosler) would be under the discretion of the individual nations.

Hence, the ECB would finance current government operations if national governments chose that course of action. And if they found that a country was abusing the privilege (for example, Greece being deficient in tax collection), it could withhold the payments until compliance was achieved. In effect, the sanction would be more credible as it would constitute the ECB withholding carrots, rather than beating up fiscally stressed countries with a stick and seeking compliance with a country already in dire economic straits. More significantly, the revenue sharing proposal would address the contagion impact, as the ECB could continue the distributions to other countries, even as it punished the “recalcitrant problem children”.

We emphasise that this does not address the problem of deficient aggregate demand, but does address the solvency issue, which is the main systemic threat to the euro zone right now (indeed, to the entire global economy). By persuading the markets that most of the euro zone is creditworthy, the risk of the markets shutting these countries down diminishes considerably. As these countries fund themselves on credible terms in the private markets, they can begin to grow again.

Of course, putting the problem in this context and putting out a figure that has a trillion euro handle on it, makes it harder to believe that it will be politically palatable to the ECB or its stronger creditor nations such as Germany. Which is why we think that our earlier suggestion might be the more likely endgame:

“The likely result of a German exit would be a huge surge in the value of the newly reconstituted DM. In effect, then, everybody devalues against the economic powerhouse which is Germany and the onus for fiscal reflation is now placed on the most recalcitrant member of the European Union. Germany will likely have to bail out its banks, but this is more politically palatable than, say, bailing out the Greek banks (at least from the perspective of the German populace).”

The question remains: do the Germans ultimately quit the euro to save Germany or do they take the view that their fate is too intertwined with the common currency and that departure imposes an even greater economic and political cost.

 If the latter, the Germans have to be made to understand that core problem at the heart of the euro zone is NOT a problem of “Mediterranean profligacy”. Many people, particularly in Germany, express the view that the Italian, Greek or Portuguese governments (and by association their people) are to blame for this crisis – accessing cheap loans from Northern European banks, not paying enough taxes, not working hard enough, etc (this also seems to be a common view amongst readers of this blog).

One thing is clear from the remarks that continue to emanate from Europe’s main policy makers. They do not understand basic accounting identities. They fail to see any kind of relationship between their own export model and their trading partners.

For example, it is ironic (and more than a touch hypocritical) that Germany chastises its neighbors, like Greece, or its trading partners like the U.S., for their “profligacy”, but relies on these countries “living beyond their means” to produce a trade surplus that allows its own government to run smaller budget deficits.

It’s even more extreme within the euro zone in the context of the global economy. The European Monetary Union bloc as a whole runs an approximately balanced current account with the rest of the world. Hence, within Euroland it is a zero-sum game: one nation’s current account surplus is offset by a deficit run by a neighbor. And given triple constraints — an inability to devalue the euro, a global downturn, and the most dominant partner within the bloc, Germany, committed to running its own trade surpluses — it seems quite unlikely that poor, suffering nations like Greece or Ireland could move toward a current account surplus and thereby help to reduce its own government “profligacy”.

 What about the issue of laziness, corruption, poor tax collection, all of the charges usually hurled against the so-called “PIIGS” countries? To this we would simply ask, even if the “Club Med” countries are lazy and don’t pay taxes, why did this crisis come now? As Bill Mitchell has noted these countries didn’t just become “lazy” when they joined the EMU. Why didn’t, say, the Italian government face insolvency prior to joining the EMU? The point is that it might be sensible if the Italian government could get the high income earners to pay more tax and it might be sensible to raise productivity but, as Mitchell has argued, none of these things are intrinsic to their crisis.

No, the problem is the Euro and it is a shared problem across the Euro zone. And this is what is beginning to dawn on the markets, as the contagion spreads from the periphery into the core.

Consider the chart constructed by the economist, Rebecca Braeu, of Standish Management:


The red line refers to Germany’s leading economic indicators – order books, exports, etc., and point to dramatically slower growth in the months ahead. Germany is in effect also a passenger on the Titanic, as Italian Finance Minister Guilio Tremonti recently noted. It might be in the first-class cabin, rather than steerage (or Irish stowaways, as the Germans no doubt view the former “Celtic Tiger”), but when the boat hits the iceberg, all passengers are affected.

Until now, the Eurocrats have either remained in denial about the mounting stress fractures within the system, or forced weaker countries to impose even greater fiscal austerity on their suffering populations, which has exacerbated the problems further. And there has been a complete lack of consistency of principle. When larger countries such as Germany and France routinely violated spending limits a few years ago, this was conveniently ignored (or papered over), in contrast to the vituperative criticism now being hurled at the Mediterranean profligates. The EU’s repeated tendency to make ad hoc improvisations of EMU’s treaty provisions, rather than engaging in the hard job of reforming its flawed arrangements, are a function of a silly ideology which is neither grounded in political reality, nor economic logic. As a result, a political firestorm, which completely undermines the euro’s credibility, is potentially in the offing.

And to judge from the flaccid statement that accompanied the conclusion of the Merkel-Sarkozy summit yesterday, it appears that even at this late stage, policy makers don’t get it, or just cannot summon up the political will for the huge conceptual leap forward required to save the euro. The Germans are paralysed politically and things are moving too fast for their policy makers to respond quickly. And their political leadership has neither leveled with the electorate in regard to the magnitude of the problem, nor the costs associated with ongoing punishments of the profligates. Whenever a German political leader opens his/her mouth it is to announce bad news, like the recent statement by German Finance Minister Wolfgang Schauble that the German government was opposed to any increase in the EFSF’s resources, or the creation of a euro bond, even though such a move is essential for the medium-term stabilisation of financial markets!

At this juncture, then, it seems more likely that the Germans will try to save themselves by pulling out of the euro zone (and then they recapitalise their own banks, as they did following German reunification). They take the Benelux countries with them (which have already closely converged with Germany’s economy) and have a “Greater DM” bloc and buy the rest of Europe on the cheap with their newly reconstituted DMs.

The Club Med, such as Greece, Italy, and Spain countries are saved because the euro plunges and they get to export their way out of this. The euro becomes a soft currency country again and these countries go back to living with higher inflation, higher exports and probably a generally more comfortable way of life.


Interestingly enough, the country which really gets screwed in this type of environment is France which is neither a true “Club Med” economy, but has yet to undertake many of the structural reforms of its German counterpart which it is seeking to emulate. Its economy is more akin to that of Italy, but should it seek to become part of the “greater DM bloc”, then its industrial base will likely face a huge competitive threat from Italy.

 In any case, there appear to be no happy outcomes here (although as my friend, Tom Ferguson always reminds me, “If you want to have a happy ending, go see a Disney film”). We appear to be entering most dangerous time for Europe since World War II.


Thanks for comments. Let me stick to the topic: MMT and alternative exchange rate regimes. At one end we have fixed exchange rates—with the currency pegged to gold or to a foreign currency. At the other we have floating rates. No one seemed to question my (obvious) claim that floating rates provide more domestic policy space, in general. Other than that, what are the advantages and disadvantages?

Well the belief is that fixed rates provide more certainty—you know what the dollar will be worth relative to the pound. That makes it easier to write (nonhedged) contracts. However, the uncertainty is shifted to the ability of government to maintain the peg. That is especially problematic in the post-Bretton Woods era in which countries that peg are essentially “going it alone”.

Many also (paradoxically) believe that fixed exchange rates reduce the chance of speculative attacks. That is counterfactual as well as counterintuitive. Remember the pound? George Soros brought it down and supposedly made a billion dollars in a day betting the UK could not defend the fix. Would you rather short a currency that is fixed, or one that floats minute by minute? In which of those two cases could you make a billion a day? Would you rather try to hit a moving target, or one that is stationary?

Now it is true that daily fluctuation of pegged rates might be nil for long periods of time, in contrast to floating rates that might vary all the time. But when pegged rates do move, they can generate currency crises because when the peg is broken, that is equivalent to a default. If I promise to you to convert my dollar IOUs to a foreign currency (or gold) at a fixed rate, and then I tell you that I’ll only give you half the promised amount of foreign currency, I have just defaulted. That causes havoc in markets.

So, yes, fixed rates can in some cases provide greater certainty—until they are abandoned. To ensure the fixed rate will be maintained, the country will need access to substantial foreign currency reserves. A country like China or Taiwan today can provide a believable promise of conversion at fixed exchange rates. Most nations cannot.

How do these countries obtain the foreign exchange reserves? For the most part, they run current account surpluses (selling goods and services abroad, or earning factor incomes in foreign currency) or they borrow them. How do those reserves end up at government? Because the exporters who earn—let us say—US Dollars need to cover their own domestic expenses in the domestic currency. The central bank offers exchange services to its banks—they need domestic currency reserves. The central bank creates domestic currency reserves and buys the foreign currency reserves. The central bank then typically exchanges Dollar reserves at the Fed for Treasuries. It wants to earn interest. That is why there is a very close link between US current account deficits and foreign accumulation of Treasuries. It is not that foreigners are “lending” to the US government so that it can deficit spend. Rather, the US current account allows foreigners to earn Dollars, and they want to earn interest on safe Treasuries.

What about the IMF articles mentioned that require a country to accept its own currency in exchange for Special Drawing Rights or the seller’s own currency? Does that mean that all signatories have abandoned their floating rate currency? Have they lost domestic policy space? Are they then open to speculative attacks, as if they were on a fixed exchange rate system?

First it is important to note that this is a self-imposed constraint. Governments have adopted a wide variety of these. The US government for example has a self-imposed debt limit. We just went through a huge debate about raising it. Clearly, markets did not force that on the US. Similarly, the IMF Articles of Agreement were adopted—not forced by any kind of market forces or logic.

And in practice, they have no material impact on domestic policy space. Let us say the Chinese decide to submit Dollars to the US to demand payment in RMB. Has the US pegged to RMB? No. It will provide RMB at the current exchange rate. Will this pose an affordability problem? No. Assume the US runs out of RMB. It then goes to foreign exchange markets and uses Dollars to buy RMB at the current exchange rate. Will it run out of Dollars? No. It creates as many Dollars as necessary to buy as many RMBs as it needs.  It can meet all demands as they come due.

Now, the great fear is that this will cause the Dollar to depreciate (the RMB to appreciate). So here’s the fear of our deficit hysterians: China might submit $2 trillion in US currency (reserves and Treasuries), demanding RMB, causing the Dollar to collapse. Really? That is what China wants? What happens to Chinese sales to the US? What happens to the value of Dollar assets held by China? Do you really believe China would do this?

China wants to sell some of its output to the US; if the Dollar collapses, it says “bye bye” to sales. It already holds substantial Dollar reserves. If the Dollar collapses, it is stuck holding an asset that falls in value. Now, in truth, no central bank needs to worry about that. So what if it holds worthless assets. (Just ask the Fed—it bought up toxic waste assets that really have no value at all, in order to save the banksters on Wall Street. That is a topic for another day.) But the Chinese do seem to worry about that—indeed, that is why they keep telling the US to maintain the dollar’s value, or else! (Or else what? Well, nothing. It is a lot like holding a gun to your head and demanding ransom before you blow your brains out. Again, a topic for another time.) The point is that the hyperventilator’s scenario is just not plausible. Current external holders of the Dollar have no interest in seeing it collapse.

Further, so far as I can tell, the Articles are designed to allow countries facing their own payment problems to submit their foreign currency holdings to obtain SDRs (or to drain their own currency out of foreign exchange markets—to stabilize the value of their own currency). The purpose of the Articles is NOT to support speculative attacks—but to protect countries from speculative attacks. If China ever did attempt to crash the dollar in the manner imagined by some hysterians, I suspect the Articles would be set aside until the attack ended. In other words, the Articles were adopted to help stabilize international financial markets, not to enhance destabilizing forces.

If you think about the Bretton Woods standard, the Articles imposed discipline. The Dollar was pegged to gold, and all other nations pegged to the Dollar. The Articles forced each nation to carefully manage foreign currency reserves (meaning Dollars) to ensure they could convert on a fixed exchange rate to Dollars. If too much of a country’s domestic currency was held externally, a fear would grow that it could not maintain the peg to the Dollar; foreign holders could present the currency and demand Dollars. With the Dollar and most other important currencies floating, the Articles do not impose discipline on them. But foreign holders can use the Articles to stabilize their own currencies.

There was a question about Russia’s default that Scott Fullwiler answered (directing readers to Warren Mosler’s piece). But then the question was “why” did Russia choose to default. As best I can determine (and I am no expert although I happened to be in the room when Warren was on the phone during the crisis) it was a political decision. We cannot completely ignore politics. Yes, Congress could have decided not to raise the debt limit. We appeared to be quite close. There was no good economic reason to do it—but politics can lead to some crazy results.

We will deal later with the question asking why money MUST be an IOU.

If you liked Sheila Bair you would have loved Ed Gray and Tim Ryan – Part 3

By William K. Black

(Cross-posted with

This is the third part in a series discussing financial regulation. Sheila Bair, FDIC Chair, has justly reserved praise for her service. Her willingness to support meaningful regulation distressed the Obama administration (and would have enraged the Bush administration). Without in any way diminishing her accomplishments it is important to understand that regulation has become so pathetic that Bair’s actions seem to be the zenith of regulatory vigor. We live in a time when even progressives have given up on regulation. Effective financial regulation is not only possible but essential if we are to avoid suffering recurrent, intensifying financial crises. We need to insist that regardless of the party in power the financial regulatory professionals are supported in accomplishing their prime mission – serving as the regulatory “cops on the beat.” Only regulatory cops on the beat can break the “Gresham’s dynamic” that accounting control fraud causes that can produce fraud epidemics, hyper-inflate bubbles, and cause financial crises. This installment shows how vigorous and effective regulation can be.

My first two installments explained how Federal Home Loan Bank Board Chairman Ed Gray reregulated the S&L industry over near total opposition and saved the nation $1 trillion by preventing a financial crisis. Gray realized that the central problem had become frauds led by CEOs (what we now call “control fraud”). He made the agency’s two top priorities the closure of the control frauds and their prosecution. Under Gray, the agency created a formal criminal referral process and hired top supervisors with a reputation for courage, competence, and vigor to attaining those priorities.

The Reagan administration’s cynical secret deal with Speaker of the House Jim Wright to not reappoint Gray as Chairman when his term ended on June 30, 1987 led to the appointment of M. Danny Wall (Senator Garn’s top aide). Wall had, as Garn’s aide, advised Gray to give in to Wright’s “request” that we fire our most prestigious and important supervisor, Joe Selby. Gray had personally recruited Selby to supervise Texas S&Ls, the largest hunting ground of the control frauds. Wall immediately sought to reverse many of Gray’s policies. He publicly took “credit” for forcing Selby to resign. He removed our (the Federal Home Loan Bank of San Francisco’s (FHLBSF) jurisdiction over Lincoln Savings because we continued to insist that it should be taken over. Wall was terrified by Charles Keating’s political power, which included the five U.S. Senators that became known as the “Keating Five” after they unsuccessfully sought to intimate us at the April 9, 1987 meeting, and Wright. Wall’s staff refused to forward our referrals to the enforcement agencies against the largest S&L in the nation. He stated that, “by definition,” we did not place Texas S&Ls in receivership, and he took credit for reducing the number of enforcement actions. Wall’s self-description was that he was a “child of the Senate” and his actions demonstrated the accuracy of his admission.

Enforcement had long been the Bank Board’s weakest link. I referred to it as “the land of the invertebrates.” Left to its own devices, it had always been a serious barrier to regulatory effectiveness. How bad was it – the lawyers representing fraudulent S&Ls actively sought to get our enforcement lawyers in the room when discussing supervisory problems. Our enforcement director was so clueless that she thought this was a good thing.

When the first President Bush took office he faced a dilemma in determining the regulatory response to the S&L debacle. As Reagan’s Vice President, Bush Chaired the administration’s financial deregulation task force. He was, therefore, as culpable as anyone in the nation for the deregulation and desupervision that made the S&L industry a criminogenic environment. We now know from document obtained through discovery from Lincoln Savings that Keating’s lobbyists viewed VP Bush’s offices as containing strong supporters of Keating and Gray’s fiercest critics. Bush also owed Wall a large political debt. Wall’s nickname on the Hill was “M. Danny Isuzu.” (Isuzu was running commercials then featuring a car salesman who was an obvious, inveterate liar.) The central lie that Wall was spreading in 1988 in the run-up to the election was that there was no S&L crisis and no need for federal funds. This lie was of significant benefit to Bush’s candidacy.

Bush also knew, however, that Wall was a disaster. Bush’s response to the dilemma was politically astute. He immediately ordered that the Bank Board would no longer run any receiverships but would instead appoint the FDIC as its receiver for any new failed S&Ls. He framed the FIRREA bill that terminated FSLIC and transferred the S&L insurance function to the FDIC. Both of these actions enraged Wall. The FIRREA bill, however, did something extraordinary for Wall. It appointed him as head of the successor agency (the Office of Thrift Supervision (OTS)) without the advice and consent of the Senate. Bush was warned in advance that this act could be held to be unconstitutional. The Senate Banking Committee was delighted not to hold hearings. Its chairman and ranking Democrat were members of the Keating Five and the ranking Republican, Garn, was co-sponsor of the Garn-St Germain Act of 1982 (the key deregulation bill) and Wall’s great patron. Senate confirmation hearings would have been intensely embarrassing to the new Bush administration, Wall, and the Senate Banking committee’s most powerful members.

FIRREA became law, Wall was appointed head of OTS by statute without the Senate’s advice and consent, and a federal court declared Wall’s appointment unconstitutional. The key development, however, was that Henry B. Gonzalez became Chairman of the House Financial Services Committee and began holding hearings on Wall’s regulatory failures at Lincoln Savings. Gonzalez’ actions were brave. Four of the five members of the Keating Five were Democrats. Many of Gonzalez’ Democratic senior colleagues were enraged that Gonzalez would hold hearings that were certain to embarrass the Keating Five.

Gonzalez’ series of hearings led to our powerful testimony explaining in detail Wall’s refusal to take action against Keating. Wall used the enforcement director as his attack dog to respond by attacking the FHLBSF and Gray – and to claim that Keating was the victim. Bush eventually responded by indicating that he no longer had confidence in Wall and Wall was forced to resign. His resignation was reported on December 5, 1989. Bush nominated Timothy Ryan to head the OTS and gave him a simple mandate – find the most prominent S&L frauds and take them down in the most public fashion to show that there was a new sheriff in town.

Our testimony also led to the resignation of the agency’s top supervisor, Mr. Dochow, who returned to a relatively low level supervisory position in our most obscure office – Seattle. Dochow was notorious because of his support for Wall’s cowardly caving in to Keating’s political pressure.

Ryan came into office shortly after we had provided a graphic example of how effective regulation could be. Pinnacle West, MeraBank’s holding company, had signed a net worth maintenance agreement as a condition of acquiring MeraBank. MeraBank was deeply insolvent, which meant that Pinnacle West was on the hook for many hundreds of millions of dollars. Pinnacle West’s lawyers came up with a clever means of evading the net worth maintenance agreement. They would dividend to their shareholders Pinnacle West’s ownership of MeraBank. The net worth maintenance agreement only obligated entities that “controlled” MeraBank to maintain MeraBank’s net worth, and because Pinnacle West’s shareholders were diverse there would be no one remaining (after the dividend) who owned a controlling interest in MeraBank.

There were only three problems to the clever scheme. First, there was a mechanical problem. As part of the deal in which Pinnacle West acquired 100% of MeraBank, the parties agreed that MeraBank would issue a single share certificate representing that 100% ownership to Pinnacle West. Pinnacle West’s lawyers thought they had a straight forward answer to the mechanical problem – MeraBank would issue hundreds of thousands of individual share certificates to Pinnacle West and Pinnacle West would dividend them to its shareholders.

That lawyerly solution to the mechanical problem, however, ran into the second and third problems. The second problem was the FHLBSF. After he removed the FHLBSF’s jurisdiction over Lincoln Savings, Wall’s effort to cover up its insolvency and frauds were blown up by courageous examiners from the California Department of Savings and Loan and several other Federal Home Loan Banks (special kudos to the FHLB Chicago staff). Wall realized that he was faced with a disaster on multiple dimensions and that he had to stop his jihad against the FHLBSF. That meant that he could no longer block us from taking vigorous regulatory actions, e.g., against Pinnacle West.

The third problem was that it would be a naked violation of their fiduciary duties for MeraBank’s board of directors to vote to issue additional shares. Pinnacle West’s primary asset was the net worth maintenance agreement. Voting to effectively remove that agreement would violate the duty of care. If the MeraBank directors who were also Pinnacle West officers voted to effectively destroy the net worth maintenance agreement that would violate the duty of loyalty (because of their crippling conflict of interest) and the duty of care. The FHLBSF’s senior staff flew to Arizona to address the MeraBank board of directors meeting to make this explicit to each director. In the trade in the U.S., this is known as a “come to Jesus” meeting. The MeraBank directors promptly decided that there was no way to issue the additional share certificates.

The FHLBSF then took the lead in negotiating an agreement that released Pinnacle West from its net worth maintenance agreement – in return for a $450 million payment. (Note: the enforceability of net worth maintenance agreements had never been litigated and our commercial ability to recover even if we were successful in establishing that enforceability was unclear. Pinnacle West, on a stand-alone basis, was insolvent. The net asset value of the holding company was tied up in its Arizona public utility and it was unlikely that the Arizona Public Utility Commission would approve a massive increase in electrical rates in order to provide funds to Pinnacle West so that Pinnacle West could pay the federal insurance fund a billion dollars. In sum, there were good litigation reasons for us to settle instead of suing.) Pinnacle agreed to the $450 million deal and OTS approved the settlement on December 7, 1989 (Pearl Harbor’s anniversary and the same day that President Bush announced his acceptance of Wall’s resignation.

The Pinnacle West deal confirmed Ryan’s view that OTS could accomplish great things if it were vigorous. He recruited Harris Weinstein, an accomplished, senior litigation partner at one of the nation’s most prestigious firms as his Chief Counsel. Among their first acts were to make clear that they supported fully the FHLBSF’s vigorous approach to regulation. (Most FHLB’s shared that same approach, but openly embracing us signaled that Wall’s jihad against the FHLBSF was over. Weinstein proved adept as a manger. He did not fire or criticize the enforcement director. He simply removed her monopoly over enforcement. OTS established three regional enforcement bodies headed by its most vigorous personnel and parallel enforcement bodies in Washington. The supervisors were permitted to use whichever enforcers they found most effective. The former litigation director left the agency for private practice.

The OTS took actions against the most elite control frauds on four fronts: regulation, civil actions, administrative enforcement actions, and support for criminal prosecutions. It closed the remaining frauds, virtually all of which had collapsed due to Gray’s rule restricting growth. (For a Ponzi scheme, growth is life.) More impressively, the West Region of OTS (staffed by supervisory personnel from the FHLBSF), killed through normal supervision the growing practice in Orange County, California of making “liar’s” loans and imprudent subprime loans. Michael Patriarca, personally recruited by Gray to crack down on the Western frauds, led the West Region’s crackdown. The effort was so successful that the leading nonprime S&L lender, Roland Arnall, gave up his federal charter (and federal deposit insurance) in order to escape our jurisdiction. Arnall created Ameriquest, a mortgage banker, to take advantage of a regulatory “black hole.” Arnall’s leading competitors also came from the S&L industry, e.g., the Jedinaks, who we “removed and prohibited” from the federally-insured financial industry through an enforcement action.

Ryan and Weinstein were exceptionally effective in prompting effective enforcement actions. In interpreting the magnitude of the increase in enforcement actions in 1990 over 1989 one must recall that the administration did not select Ryan until March 1990. Ryan then had to go through a bitterly contested Senate investigation and vote to secure appointment. Ryan’s selection of Weinstein became public on May 9, 1990. It, of course, took Weinstein months to create the parallel enforcement structure that I described and staff it.

In 1989, the agency issued 34 cease and desist (C&D) orders. In 1990, agency issued 63 C&Ds. In 1989, the agency issued 47 removal and prohibition (R&P) orders, in 1990 it issued 78. In 1990, the agency used its new grant of enforcement powers (via FIRREA) to issue 26 civil money penalties (CMPs). In 1989, the agency entered into 260 formal agreements, in 1990 that number rose to 347. The cliché “hit the ground running” applies to Ryan and Weinstein. In 1991, the agency completed 868 enforcement actions and in 1992 it completed 667 actions. Ryan announced his intent to resign on November 9, 1992.

In addition to the dramatic increase in the number of enforcement actions one must take into account that the actions brought under Ryan and Weinstein were far more major than the actions brought under Wall. Ryan and Weinstein went after the most elite, politically connected frauds to demonstrate that no one was above the law. The classic proof was the agency’s enforcement action against President Bush’s son, Neil. The enforcement action antagonized the Bush family. William Seidman’s (then, FDIC chair), book about his governmental service recounts how a senior White House staffer got the bright idea of convincing the FDIC to take over the case from the OTS so that the FDIC could kill the action. He called the FDIC’s general counsel to propose the idea. The general counsel, being a bear of very little brain, went to Seidman with the proposal. Seidman told him the idea was insane and not to get involved with it. The general counsel, being a bear with very little brain and soul, called the OTS to pitch the idea. Ryan made sure that the OTS filed an ethics complaint. The OTS went ahead and issued the enforcement order. (In truth, the order was a slap on the wrist – but royalty doesn’t think it should be slapped by peons.) From that day on, Ryan’s chances for advancement under President Bush were dead.

“But Mr. Ryan said that there were occasions when his decisions bore personal, as well as political, repercussions. He said some former political associates, whom he would not identify, had stopped talking to him after the Office of Thrift Supervision had decided to censure Neil Bush, the President’s son, for his role as a director of the Silverado Banking, Savings and Loan Association of Denver, one of the largest failures on record.

“Because of Neil Bush, I was persona non grata,” Mr. Ryan said. “At first I think it was because they did not want to influence me, and afterward I don’t know why they did not talk to me.””

Regulator Of S.& L.’s Resigns
Published: November 09, 1992

The amazing aspect of the Bush administration’s response to the OTS enforcement action against Neil Bush is that it never became a scandal. In the current era, it would lead to an immediate demand for impeachment.

Weinstein made most of the legal community enraged when he brought an enforcement action against one of Keating’s primary law firms and “froze” its assets. “Froze” is an inaccurate description, but the one the bar used. Weinstein also moved to invoke the “fraud crime” exception to the ability to withhold the production of documents on the grounds of attorney client privilege. The law firm settled and its insurer made a major payout.

The agency’s and the Resolution Trust Corporation’s (RTC’s) civil suits were equally vigorous and effective. They produced billions of dollars in recoveries, often from what were then known as the “Big 8” audit firms. The lawsuits, of course, enraged the auditors.

On the criminal prosecution front, Ryan and Weinstein returned to Gray’s policy of making the support of criminal investigations and prosecutions a top agency priority. The agency met with the Department of Justice (DOJ) to create a formal prioritization of these cases – the “Top 100.” The dirty 100 were overwhelmingly S&Ls, as opposed to individuals, so this prioritization led to the prosecution of over 500 of the most elite and destructive criminals. The agency made well over 10,000 criminal referrals. Our criminal referral specialists liaised constantly with the FBI to get feedback on how to prepare the most useful referrals and trained our staff to produce superb referrals. (In modern management jargon, we really engaged in “continuous improvement.” Our criminal referrals were often 20 to 30 pages in length with two to three hundred pages of attachments. The referrals provided the detailed road map explaining the fraud and providing the key documents. The agency “detailed” a significant number of examiners to the FBI to serve as internal experts during the investigations (for the lawyers: this allowed them access to “6 (e)” grand jury materials). (The FHLBSF had pioneered an even more selfless approach – it paid the salary of an AUSA in Los Angeles dedicated to prosecuting S&L frauds. He did not, of course, answer to the FHLBSF.) Agency officials trained agency personnel, FBI agents, and AUSAs on detecting, investigating, and prosecuting elite financial frauds. We also served as free expert witnesses for the AUSAs in cases that came to trial. The results were spectacular. The conviction rate in S&L cases designated as “major” by DOJ was roughly 90 percent – against many of the top criminal defense lawyers in the world. We secured over 1000 felony convictions in “major” cases, and by prioritizing the “Top 100” we ensured that we acted against each of the worst frauds.

In 1993, the new Clinton administration moved DOJ resources to refocus on health care fraud. That may have been a correct prioritization of DOJ resources given out success against the worst S&L frauds, but it does mean that our 1000 convictions represents only a portion of fraud identified in our criminal referrals.

By the time Ryan and Weinstein left governmental service the S&L industry was cleansed of major frauds. The “liar’s” loans lenders had been driven out of the industry. The OTS criminal referral process was superb.

In the current crisis, President Bush (the Second) appointed “Chainsaw” Gilleran as OTS director – providing the crisis’ iconic image. Gilleran is holding a chain saw and standing next to the nation’s three leading bank lobbyists and the FDIC’s Vice-Chair, who are holding pruning shears. They are poised and posed over a pile of regulations. To make the imagery clear, the regulations are tied up in elaborate red tape. The image makes clear Gilleran’s and the FDIC’s intention to slash through all regulation. (Mission Accomplished!) Naturally, the anti-regulators were so proud of this image that they featured it the FDIC’s 2003 annual report.

The OTS leaders decided that the key to destroying regulation was to bring back to power the nation’s most notorious professional regulator – Dochow (of Keating infamy). Dochow rode Washington Mutual (WaMu) (based in Seattle) back to power. WaMu was a great “success” because it engaged in a variant of the accounting control fraud that made Keating infamous, but Dochow was not one to learn from his mistakes. The OTS leadership then used Dochow to convince Countrywide to convert its charter and become an S&L in order to avoid a potential enforcement by the somnolent Office of the Comptroller of the Currency (OCC). Dochow finally had to be asked to leave when he was caught agreeing to allow IndyMac (which, like WaMu, specialized in making “liar’s” loans) to backdate documents to inflate its financial “strength.”

So, how many criminal referrals did OTS make in current crisis? Zero – during what the FBI aptly described in September 2004 as an “epidemic” of mortgage fraud that the FBI aptly predicted would cause a financial “crisis” if it were not contained. Gray, Patriarca, Ryan, and Weinstein were all available to the second President Bush (and Obama) to use their expertise, integrity, and vigor to clean up the Stygian stables of the fraudulent and systemically dangerous institutions (SDIs) that drove this crisis. They are all available now, as are many of the people that helped these leaders clean up the industry. Patriarca and Ryan are young enough to serve as full time regulatory leaders. To my knowledge, the Bush II and Obama administrations have not drawn on the expertise of any of these leaders or their principal lieutenants who led the successful struggle against prior epidemics of accounting control fraud to implement an effective response to this crisis.

What would it take for the Geithners and Holders of the world to admit that allowing control fraud to occur with impunity is insane and that they should learn from people with a track record of success, integrity, and courage? Geithner, like “M.Danny Isuzu Wall,” is still pretending that he “resolved” the crisis at virtually no cost and kvetching that the world doesn’t applaud his genius. Like the Wizard of Oz, he demands that we: “ignore the man behind the screen,” i.e., the man holding the liar’s loans at Fannie and Freddie that will cause hundreds of billions of dollars of losses, the man at the Fed with hundreds of billions of dollars of losses on fraudulent mortgage paper pledged to Fed (which the Fed will eventually dump on Fannie and Freddie – which is to say, the Treasury), and the men holding the hundreds of billions of dollars of unrecognized losses among the SDIs. Geithner’s con has only fooled one person. Unfortunately, the man that fell for the Geithner con is President Obama, he of the infamous “man crush” for the admitted tax evader he appointed to be in charge of our nation’s tax collection.

One of our proudest moments at OTS (under Ryan and Weinstein) was issuing an R&P against Lee Henkel – one of the presidential appointees that ran our predecessor agency. President Reagan, at the behest of one of his leading contributors (Charles Keating), made Henkel a “recess” appointment to run the Federal Home Loan Bank Board. Henkel served as Keating’s “mole” at the agency. He resigned after I blew the whistle on him as part of a deal with the FBI to drop its criminal investigation of him. The OTS, however, made sure he would not come back to harm the public by issuing a removal and prohibition from federally insured depositories. If only Sheila Bair had possessed the nerve to remove and prohibit Geithner’s Treasury minions that he recruited from the fraudulent SDIs…. Sigh, one can dream.

By volume, Part 3 of my column has focused on enforcement, civil suits, and prosecutions. It is vital to keep in mind that these are after the fact remedies. It is vastly more important for financial regulators to understand accounting control fraud mechanisms and patterns so that they can identify and take regulatory action that will prevent the crisis. Patriarca’s actions to end liar’s loans in by Orange County S&Ls (taken while Ryan was Director) are a classic example of how successful a regulator can be when it understands the need to function as a “cop on the beat” and prevent the Gresham’s dynamics that drive fraud epidemics. The same actions show one of the important lessons of regulation. No one builds a bank vault and then puts an unguarded and unlocked hole in it, but our anti-regulators constantly seek to achieve the equivalent by creating financial regulatory systems that are designed to fail. The Fed had unique authority under HOEPA to close all of these regulatory black holes. Alan Greenspan and Ben Bernanke refused to do so. If Gray, Ryan, Patriarca, or Weinstein had been in charge there would have been no epidemic of mortgage fraud, no crisis at Fannie and Freddie, no overall financial crisis, and no Great Recession. (I’m not suggesting they had the power to end recessions and business cycles.)

We see the consequences of what happens when, during the last three administrations, we did not care to send the very best into the ranks of regulatory leadership. There were times during the Civil War in which thousands of men’s lives were thrown away because their senior officers were incompetent political hacks. Why do we routinely send incompetent political hacks and the equivalent of “flat earth” anti-regulatory ideologues to be our regulatory leaders and then blame “regulation” for the disaster? Even the Soviets figured out that one of the secrets of success was to “never reinforce failure.” We promote our failures and give them presidential medals. The high priests of theoclassical economics and their law and economics acolytes will always fail as regulators. They are trained to create and worship intensely criminogenic environments.

I do not know whether you, the reader, has focused on the politics of the leaders I have been praising. Gray and Ryan are Republicans. I worked for years with Patriarca and Weinstein and do not know their political affiliation. It never mattered to us. We despise the elite frauds and their professional and political toadies regardless of their party.

William K. Black on Speculation and the European Debt Crisis


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

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




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

Let us deal with the case of governments that do not promise to convert their currencies on demand into precious metals or anything else. When a $5 note is presented to the US Treasury, it can be used to pay taxes or it can be exchanged for five $1 notes (or for some combination of notes and coins to total $5)—but the US government will not convert it to anything else.
Further, the US government does not promise to maintain the exchange rate of US Dollars at any particular level. We can designate the US Dollar as an example of a sovereign currency that is nonconvertible, and we can say that the US operates with a floating exchange rate. Examples of such currencies include the US Dollar, the Australian Dollar, the Canadian Dollar, the UK Pound, the Japanese Yen, the Turkish Lira, the Mexican Peso, the Argentinean Peso, and so on.
In the following sections we will distinguish between these sovereign nonconvertible floating currencies and currencies that are convertible at fixed exchange rates.
The gold standard and fixed exchange rates. A century ago, many nations operated with a gold standard in which the country not only promised to redeem its currency for gold, but also promised to make this redemption at a fixed exchange rate.
An example of a fixed exchange rate is a promise to convert thirty-five US Dollars to one ounce of gold. For many years, this was indeed the official US exchange rate. Other nations also adopted fixed exchange rates, pegging the value of their currency either to gold or, after WWII, to the US Dollar.
For example, the official exchange rate for the UK Pound was $2.80 US. In other words, the government of the UK would provide $2.80 (US currency) for each UK Pound presented for conversion. With an international fixed exchange rate system, each currency will be fixed in value relative to all other currencies in the system.

In order to make good on its promises to convert its currency at fixed exchange rates, the UK had to keep a reserve of foreign currencies (and/or gold). If a lot of UK Pounds were presented for conversion, the UK’s reserves of foreign currency could be depleted rapidly.
There were a number of actions that could be taken by the UK government to avoid running out of foreign currency reserves, but none of them was very pleasant. We will save most of the details for a later discussion. The choice mostly boiled down to three types of actions: a) depreciate the Pound; b) borrow foreign currency reserves; or c) deflate the economy.
In the first case, the government changes the conversion ratio to, say, $1.40 (US currency) per UK Pound. In this manner it effectively doubles its reserve because it only has to provide half as much foreign currency in exchange for the Pound. Unfortunately, such a move by the UK government could reduce confidence in the UK government and in its currency, which could actually increase the demands for redemption of Pounds.
In the second case, the government borrows foreign currencies to meet demanded conversions. This requires willing lenders, and puts the UK into debt on which interest has to be paid. For example, it could borrow US Dollars but then it would be committed to paying interest in Dollars—a currency it cannot issue.
Finally, the government can try to deflate, or slow, the economy. There are a number of policies that can be used to slow an economy—but the idea behind them is that slower economic growth in the UK will reduce imports of goods and services relative to exports. This will allow the UK to run a surplus budget on its foreign account, accumulating foreign currency reserves.
The advantage is that the UK obtains foreign currency without going into debt. The disadvantage, however, is that domestic economic growth is lower, which usually results in lower employment and higher unemployment.
Note that a deflation of the economy can work in conjunction with a currency depreciation to create a net export surplus. This is because a currency depreciation makes domestic output cheap for foreigners (they deliver less of their own currency per UK Pound) while foreign output is more expensive for British residents (it takes more Pounds to buy something denominated in a foreign currency).
Hence, the UK might use a combination of all three policies to meet the demand for conversions while increasing its holding of Dollars and other foreign currencies.
Floating exchange rates. However, since the early 1970s, the US, as well as most developed nations, has operated on a floating exchange rate system, in which the government does not promise to convert the dollar.
Of course, it is easy to convert the US dollar or any other major currency at private banks and at kiosks in international airports. Currency exchanges do these conversions at the current exchange rate set in international markets (less fees charged for the transactions). These exchange rates change day-by-day, or even minute-by-minute, fluctuating to match demand (from those trying to obtain dollars) and supply (from those offering dollars for other currencies).
The determination of exchange rates in a floating exchange rate system is exceedingly complex. The international value of the dollar might be influenced by such factors as the demand for US assets, the US trade balance, US interest rates relative to those in the rest of the world, US inflation, and US growth relative to that in the rest of the world. So many factors are involved that no model has yet been developed that can reliably predict movements of exchange rates.
What is important for our analysis, however, is that on a floating exchange rate, a government does not need to fear that it will run out of foreign currency reserves (or gold reserves) for the simple reason that it does not convert its domestic currency to foreign currency at a fixed exchange rate. Indeed, the government does not have to promise to make any conversions at all.
In practice, governments operating with floating exchange rates do hold foreign currency reserves, and they do offer currency exchange services for the convenience of their financial institutions. However, the conversions are done at current market exchange rates, rather than to keep the exchange rate from moving.
Governments can also intervene into currency exchange markets to try to nudge the exchange rate in the desired direction. They also will use macroeconomic policy (including monetary and fiscal policy) in an attempt to affect exchange rates. Sometimes this works, and sometimes it does not.
The point is that on a floating exchange rate, attempts to influence exchange rates are discretionary.  By contrast, with a fixed exchange rate, government must use policy to try to keep the exchange rate from moving. The floating exchange rate ensures that the government has greater freedom to pursue other goals—such as maintenance of full employment, sufficient economic growth, and price stability.
As we continue this discussion in coming weeks, we will argue that a floating currency provides more policy space—the ability to use domestic fiscal and monetary policy to achieve policy goals. By contrast, a fixed exchange rate reduces policy space. That does not necessarily mean that a government with a fixed exchange rate cannot pursue domestic policy. It depends. One important factor will be whether it can accumulate sufficient foreign currency (or gold) to defend its currency.
Next week, however, we will take a brief diversion to examine so-called commodity money. The fixed exchange rate based on a gold standard has been a reality in relatively recent times. And during much of the past two millennia, governments issued coins with silver and gold content. Many equate these with “commodity money”—a monetary system supposedly based on precious metal, indeed, one in which money derives value from embodied gold or silver.
We will come to a surprising conclusion, however. Even coins made of gold and silver are really IOUs stamped on metal. They are not examples of commodity money. They are sovereign currencies.
I can already hear the teeth of our resident Austrian gold bugs rattling so hard their fillings threaten to shake loose.