Monthly Archives: August 2011

Paul McCulley on Bloomberg on Minsky, Liquidity Traps, Euro, and Fiscal Policy

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Why Won’t Progressives Act Like Progressives?

By Stephanie Kelton

Paul Krugman just addressed a plea from Cullen Roche, who implored him to throw his considerable weight behind a proposal for a payroll tax cut to help bolster the fledging recovery.  Krugman doesn’t really take a position for or against the proposal but instead suggests that it is DOA because the GOP doesn’t support it. Well WTF?

Is this really what it’s come to?  Experts in the field — even those with a Nobel Prize — can’t stand up for what they believe in unless they consider it politically feasible? An extension of the payroll tax cut — or, far better, a full payroll tax holiday (a 0% withholding for employers and employees) should have been a key component of the stimulus from the beginning.  But the deficit doves (the most high-profile progressives out there) never supported it.  Had they advocated such a policy, there’s a good chance the economy would be on sound footing by now.  But they did not, and impatient voters delivered the House to the GOP.  Now Social Security — along with Medicare and Medicaid — will be sacrificed at the alter of the deficit hawks.

Many of us called for a full (0% deduction) payroll tax holiday (employer AND employee) more than 2 years ago, but the beltway “progressives” all fought against it, preferring instead to accept the conservative frame that these programs face long-term solvency problems that can be “fixed” by chipping away at the very programs they claim to be defending.

I agreed (here) with Professor Krugman’s point about the politics of a payroll tax  — Republicans will do whatever they can to prevent the economy from improving before Nov. 2012. But it is the President’s job to call them out — publicly — and make them explain why they are opposed to reducing/eliminating this regressive (and anti-business) tax.

Oh, and S&P just downgraded the US.  BFD.

Michael Hudson Interviewed on Democracy Now!

Michael Hudson was interviewed recently on Democracy Now! with Amy Goodman. See below.

U.S. Subsidies to Systemically Dangerous Institutions Violate WTO Principles

By William K. Black

Greetings from Quito, Ecuador!

Introduction: The SDIs Pose Systemic Risks

This article makes the policy case that U.S. subsidies to its systemically dangerous institutions (SDIs) violate World Trade Organization (WTO) principles. The WTO describes its central mission as creating “a system of rules dedicated to open, fair and undistorted competition.”  There is a broad consensus among economists that the systemically dangerous institutions (SDIs) receive large governmental subsidies that make “open, fair, and undistorted competition” impossible.  To date, WTO is infamous for its hostility to efforts by nation states to regulate banks effectively.  At best, the result is a classic example of the catastrophic damage cause by the “intended consequences” of the SDIs’ unholy war against regulation.  

There is broad agreement among economists that the U.S. provides extremely valuable subsidies to the SDIs and that these subsidies have disastrous consequences.  Neither major Party in the U.S., however, is willing to end the SDIs or even subject them to effective regulation.  I propose that Latin America take the lead in demanding that the WTO live up to its stated mission and stop the massive governmental subsidies that the rent-seeking SDIs have extorted through their political power and their ability to hold the global economy hostage.  It would be a irony of cosmic degree if the WTO, among the SDIs’ most consistent allies were to find the SDI subsidies to violate U.S. treaty obligations.  (The same argument can be made against other nations that subsidize their SDIs, but some of the best data on the magnitude of the subsidies and the damage they cause is available now in the United States.   

The direct bailout programs to banks were enormous, but the indirect subsidies through massive purchases by the Fed of poor quality mortgage paper are far larger.  The Fed continues to hold the paper and to refuse to book losses on the bad loans.  The SDIs receive an even more opaque subsidy, however, and it too is massive.  The SDIs are able to borrow more cheaply and have greater leverage because they are perceived as “too big to fail.”  Because they pose a systemic risk of causing a global crisis SDI creditors believe that the U.S. is likely to bail them out rather than allow an SDI to collapse.  In economic essence, the SDIs hold the global economy hostage, daring the U.S. to allow them to collapse and spark a global crisis. 

Economists and bank regulators favor a thoroughly dishonest term that should be treated with derision – “systemically important” – as if the SDIs deserved a gold star for putting the global economic system under constant risk of catastrophic failure.  The U.S. does not bail out banks because they are well run institutions that provide unique benefits to the economy.  It bails out banks because they are so badly run that they have losses so large that the regulators fear could cause cascade failures at dozens of other banks.  I urge you to call authors on their use of any euphemism that fails to stress that these banks are systemically dangerous. 

The U.S. is in the process of trying to define which banks are SDIs, but there are roughly 20 U.S. financial institutions that the regulators have treated as SDIs during this crisis.  That means that the continued existence of the SDIs requires us to roll the dice twenty times every day to see whether one or more of the SDIs have reverted to form and suffered losses so great that they threaten to fail and cause a global systemic crisis.  To (cheerfully) mix my metaphors, the SDIs are ticking time bombs.

Treasury implicitly Subsidizes the SDIs

Regulators believe SDIs pose systemic risk whenever they fail.  One of the scenarios that the regulators most fear is a “cascade failure” in which the failure of the SDI causes the failure of a series of banks because the creditors of the first bank suffer losses and either fail or suddenly withdraw their loans to other banks to seek to avoid similar losses.  Regulators, therefore, typically bail out some or all of the creditors of SDIs – even uninsured creditors – in order to avoid prompting cascade failures.  Economists argue that creditors recognize this dynamic and are more willing to lend funds to SDIs than to smaller banks.  This greater willingness constitutes a valuable, implicit government guarantee to the SDIs’ creditors.

Economists Estimate that the Value of the Subsidy to the SDIs is Enormous

Economists have estimated that the value of U.S. subsidy to just two SDIs, Fannie and Freddie, was many billions of dollars.  Four Stern School finance professor at NYU (Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White) recently authored the book Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance (Princeton 2011) (“Stern 2011”) that discuses these estimates.

In a May 2001 updated study, the CBO estimated that the annual implicit subsidy had risen to $13.6 billion by the year 2000.  A few years later, Federal Reserve Board economist Wayne Passmore … estimated that the aggregate value of the subsidy ranged somewhere between $119 billion and $164 billion, of which shareholders received respectively between $50 and $97 billion (p. 29).

Economists now argue that those estimates of the value of the U.S. subsidy to only two of the 20 SDIs proved to be far too low because Fannie and Freddie changed their operations to create even greater systemic risks subsequent to these estimates in manners that greatly increased the value of the subsidy to its creditors (and, therefore, to the SDIs’ controlling managers).  From “Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009,” by Viral V. Acharya, Thomas Cooley, Matthew Richardson and Ingo Walter in Foundations and Trends in Finance Vol. 4, No. 4 (2009) 247–325 (“Acharya, et al. 2009”) we find:

Consider the investment function of the GSEs. For every $1 of mortgage-backed securities purchased with equity, there was a large amount of debt issued to purchase additional mortgage-backed securities.  Figure 2.2 shows the book and market leverage ratios of the GSEs, measured as assets divided by equity, over the period 1993–2007. The extraordinary point to note is the access to very high leverage, given that the GSEs were investing in risky, relatively illiquid mortgage-backed securities. This provides an idea of the size of the implicit government guarantee. In fact, the literature has quantified the transfer from taxpayers to the GSEs to be in the billions of dollars even before the crisis ignited (see, for example Passmore, 2005; Lucas and McDonald, 2006) (p. 270). 
These data indicate that the U.S. subsidy to the SDIs is far larger than total U.S. trade subsidies to agriculture.

While Economists often denounce the GSEs’ Subsidies, all SDIs are de facto GSEs

The Stern 2011 authors concede that the SDIs are all de facto Government Sponsored Enterprises (GSEs).  Fannie and Freddie were entirely-privately owned and managed.  It was their private managers who exploited the implicit federal subsidy.

But when one scratches below the surface, the 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).  

(“LCFI” is another euphemism for SDIs.  It refers to Large, Complex Financial Institutions.) The Stern authors argue that the massive U.S. investment banks were able to secure extraordinary leverage at extremely low interest rates because they were SDIs.

Economists Argue that the Subsidy Gives the SDIs Decisive Advantages over Competitors

The Stern authors (2011) present this simile to explain the extent of the SDIs’ competitive advantage over non-SDIs:  “Opening up mortgage markets without restraining Fannie and Freddie was like bringing a gun to a knife fight” (p. 22).  They follow this up with an even more colorful metaphor that shows that they recognize that their logic applies to all SDIs, for the refer to “LCFI King Kongs and GSE Godzillas – both implicitly backed by the government….” (p. 55).  Nobody normal – without a huge subsidy from the U.S. – can compete with either King Kong or Godzilla.  

The Stern scholars’ recent book quotes with approval from Alan Greenspan’s May 19, 2005 speech denouncing the destruction of competition caused by the Treasury subsidy to U.S. SDIs (pp. 29-30).

[I]nvestors worldwide have concluded that our government will not allow GSEs to default….  Investors have provided Fannie and Freddie with a powerful vehicle for achieving profits are virtually guaranteed through the rapid growth of their balance sheets, and the resultant scale has given them an advantage that their potential private-sector competitors cannot meet.  As a result, their annual return on equity, which has often exceeded 30 percent, is far in excess of the average annual return of approximately 15 percent that has been earned by other large financial competitors holding substantially similar assets.  Virtually none of the GSE excess return reflects higher yields on assets; it is almost wholly attributable to subsidized borrowing costs….  The Federal Reserve Board has been unable to find any credible purpose for the huge balance sheets built by Fannie and Freddie other than the creation of profit though the exploitation of the market-granted subsidy.

I was an expert witness for the regulatory agency (then, OFHEO) in its administrative enforcement action against the top leaders of Fannie during this era.  Greenspan’s analysis is wrong because he ignores accounting control fraud.  As the SEC staff investigation found, and the SEC explicitly charged in its suit, Fannie’s controlling officers created its extreme (fictional) returns by engaging in accounting fraud for the purpose of maximizing their incomes, which grew massive if they reported extraordinary profits.  Note also that Greenspan’s statement that “virtually none” of Fannie and Freddie’s fraudulently reported income was due to purchasing higher yield mortgage paper was incorrect (indeed, the Stern authors stress this point repeatedly).  Fannie and Freddie were far smaller players in liar’s loans in 2005, but they were far from trivial players.  Greenspan is internally inconsistent in claiming (1) that no private entity could compete effectively with Fannie and Freddie and (2) that Fannie and Freddie had “virtually no[]” nonprime loans.  In 2005, Fannie and Freddie had lost substantial market share precisely because other SDIs were aggressively purchasing and securitizing nonprime loans.

When the SEC discovered Fannie and Freddie’s accounting and securities frauds, OFHEO substantially limited the growth of Fannie and Freddie’s portfolio (not securitization).  Unfortunately, OFHEO did not order an end to Fannie and Freddie’s criminongenic compensation systems.  With portfolio growth limited, but massive bonuses still available for reporting high returns, the obvious alternative fraud strategy was to purchase dramatically more nonprime loans at premium yields to hold in portfolio. 
These corrections of Greenspan’s analytical errors, however, simply add to the thrust of the logic of the Stern (2011) authors’ argument.  The SDIs dominated the securitization and holding in portfolio of nonprime loans, particularly fraudulent “liar’s” loans.  The officers controlling the SDIs did so because, under the constraints of OFHEO’s restrictions on portfolio growth, this was the fraud tactic that optimized guaranteed, (fictional) reported income and their compensation.

Economists argue that SDIs remove Effective Private Market Discipline

Because SDIs’ creditors are protected from loss, and because it is expensive for creditors to provide effective private market discipline, the Stern authors state that creditors cease to provide effective market discipline.  The Stern (2011) authors found that the collapse of private market discipline with regard to the SDIs was so complete that there was a “lack of any market discipline imposed by creditors” (p. 55).

Economists argue that the Removal of Effective Discipline Maximizes Moral Hazard

The Stern (2011) authors note that SDIs inherently produce moral hazard problems even “in normal times” (p. 56).  Under the authors’ logic, the subsidy to the SDIs must remove effective private market discipline against fraudulent and abusive SDI business practices by the SDIs’ controlling officers.  This means that the U.S. Treasury subsidy that SDIs inherently receive must make the banking environment substantially more criminogenic for “accounting control fraud.” 

Economists & Criminologists Recognize that Accounting Control Frauds Drive Crises

Accounting control fraud refers to a situation in which the officials who control a seemingly legitimate entity use accounting as a “weapon” to defraud the firm’s creditors and shareholders.  Accounting control fraud epidemics drove the three recent U.S. financial crises: the savings & loan debacle, the Enron-era frauds, and the epidemic of nonprime mortgage fraud that drove the ongoing crisis.  The title of George Akerlof and Paul Romer’s famous 1993 article captures the essence of accounting control fraud – “Looting: the Economic Underworld of Bankruptcy for Profit.”  See also, Black, William K. The Best Way to Rob a Bank is to Own One (2005).    

The Stern (2011) authors use euphemisms for accounting control fraud (“tail risk”), but their logic and factual descriptions support their recognition that what they are describing is a classic accounting control fraud that followed the standard four-ingredient recipe for simultaneously maximizing (fictional) reported income, real executive compensation, and real losses.  That recipe is:

  1. Grow extremely rapidly
  2. By making (or purchasing) bad loans with premium yields, while employing
  3. Extreme leverage, and
  4. Providing grotesquely inadequate allowances for the inevitable losses.
The Stern authors describe Fannie and Freddie’s strategy as a “Ponzi scheme” (p. 5) – which is, of course, a fraud.  Akerlof & Romer made the key analytical point:

The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending:  maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.  Examinations of the operation of many such thrifts show that the own ers acted as if future losses were somebody else’s problem.  They were right (1993: 4).
Note the business practices that Akerlof & Romer aptly said an honest lender would never engage in – the precise practices that characterized nonprime lenders and investors in this crisis.
Economists Argue that Subsidizing SDIs make Free Markets Impossible

The destruction of competition and the creation of a perfect environment for accounting control fraud inherent with SDI subsidies mean that free markets are impossible.  The Stern (2011) authors are blunt on this point:  “there was nothing free about these markets” (p. 21).  SDIs create extreme market concentration and enormous income inequality. 

Akerlof & Romer and financial regulators and criminologists’ discovery of the recipe that the controlling officers use to maximize reported (albeit fictional) reported income concur that the optimal strategy is to make or purchase loans with a negative expected value.  This makes “markets” profoundly inefficient.  Accounting control frauds are engines of mass financial destruction that destroy wealth at a prodigious rate.  Accounting control frauds also cluster in the most criminogenic industries, regions, and products.  This, and each of the ingredients of the fraud recipe, makes them the ideal weapon for hyper-inflating financial bubbles.  Financial bubbles are damaging as they grow because they systematically misallocate assets and capital, but they can be catastrophic when they collapse if they have been allowed to hyper-inflate.

Accounting Control Frauds Spawn “Echo” Epidemics

George Akerlof’s seminal 1970 article on “lemon” markets presents several examples of anti-customer control frauds in which the seller deceives the buyer about the quality of the good.  He added the powerful insight that these frauds could produce a “Gresham’s” dynamic because dishonest sellers would gain a competitive advantage over their honest rivals.  At the extreme, the market would become perverse and drive honest sellers out of the marketplace.  Criminologists have employed Akerlof’s insights to explain how control frauds deliberately create Gresham’s dynamics suborn “controls” (e.g., appraisers) and agents (e.g., mortgage brokers) into fraud allies in  manner that produces limited risk of detection and prosecution.  The CEO running a fraudulent nonprime lender simply creates perverse financial incentives that create intense Gresham’s dynamics.  It is insane for an honest lender to pay bonuses to loan officers and brokers based on volume with no penalty for making bad loans – but it is optimal for an accounting control fraud to do so.  In criminological jargon:  control fraud is criminogenic.  In plainer English:  fraud begets fraud.

Accounting Control Fraud Erodes Trust and Can Cause Market Collapses

Economists and scholars from multiple disciplines have increasingly begun to find how valuable trust is in many contexts.  It is essential to finance.  The defining element at law of “fraud” is “deceit.”  To commit a fraud a perpetrator gains the victim’s trust – and then betrays it.  This is why fraud is the most effective acid against trust.  Fraud by elites is the most destructive assault on trust.  Fraud can cause market collapses long before it becomes endemic because of its ability to harm trust.  Consider attending a conference or concert where everyone is given a bottle of water.  If the public health authorities announce that one bottle in a hundred is contaminated, how many of us will drink our bottle.  Markets collapsed in 2008 because bankers no longer trusted other bankers to tell the truth about the value of the assets they were selling.  That lack of trust was rational, for deceit was the norm in the sale of “liar’s” loans.

Vigorous Regulation Can Block SDIs from Causing Crises – but SDIs Destroy Regulation

The Stern (2011) authors stress that the SDIs inherently create a regulatory “race to the bottom” (p. 41).  More broadly, they understand that economic domination of this degree not only destroys free markets but free democracies.  The SDIs will use political contributions and lobbying power to try to emasculate regulation and criminal justice systems because they recognize that only these public sector bodies can possibly restrain or remove the SDIs.  The good news is that economists broadly agree that the SDIs confer no real economic advantages.  They are too large to be efficient.  Their domination is due solely to their receipt of huge governmental subsidies.  That means that shrinking the SDIs in size would simultaneously increase bank efficiency and market efficiency while dramatically reducing fraud and systemic risk and restoring more functional and democratic government.

The revolutionary nature of their logic is all the greater because their logic suffers from a devastating blind spot.  Once that blind spot is removed their logic invites the reader to look behind the edifices and see that the modern “free market” economy is a Potemkin prank.  The authors provide a superb example of why James Galbraith’s titled his most recent book The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too.  The irony of modern “capitalism” is that its leaders are the CEOs running the SDIs and, as the authors demonstrate, SDIs inherently make it impossible for markets to be “free”, efficient, or sound.  The SDI CEOs that dominate our economy and government are implacable foes of real markets.  Their bleating about the wonders of the markets is a cynical sham designed to block effective regulation.  They oppose effective regulation precisely because it would create more competitive markets.  They hate free markets.  They want rigged markets that ensure they will destroy any honest competitor. 

The SDIs’ CEOs are not risk-takers.  They seek a sure thing.  Risk-taking is supposed to be the essence of capitalism.  The Stern authors’ case study provides yet another example supporting Robert Prasch’s insights about risk.  His classic 2004 article is entitled “Shifting risk: the divorce of risk from reward in American capitalism.”  In 1993, George Akerlof and Paul Romer authored the most important economics paper on financial crises, entitled Looting: the Economic Underworld of Bankruptcy for Profit.  Akerlof & Romer explained the ultimate separation of risk and reward – what criminologists now term “accounting control fraud.”  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 and his confederates wealthy through modern executive compensation.  The bank was guaranteed to fail.  The only question was how soon it would fail. 

SDIs are Expert at Evading Rules with Impunity

The Stern (2011) authors explain that the SDIs first corrupted the Basel II rules on bank capital requirements (the regulators made them partners in creating the rules) and then used Special Investment Vehicles (SIVs) to evade even the weakened capital requirements.  The authors aruge that the SIVs, corrupt credit rating agencies, weakened capital requirements, and the death of private market discipline led to obscene levels of leverage.  Leverage, of course, is debt and debt means creditors.  Prior to the crisis, Judge Easterbrook & Professor Fischel claimed that extreme leverage guaranteed that accounting control fraud could not occur.  SDIs can afford to hire armies of professionals whose task is to create opaqueness and complexity for the express purpose of defeating even vigorous regulators.  The SDIs are “too big to regulate.” 

The SIVs raise a broader point that I will only mention due to the length of this paper.  The entire shadow banking system is another area of implicit governmental subsidy and such subsidies should be prohibited under WTO rules.  The subsidies include the avoidance of taxes, another practice that is a defining element of U.S. SDIs.  Most disturbingly, the shadow banking system is the source of many efforts to manipulate commodity prices – including food – which imperils hundreds of millions of people in less developed nations.  These efforts at manipulation make markets far less efficient, so there is no excuse for the allowing these murderous manipulations to continue.  The WTO should act with no bureaucratic delays as a scourge against these subsidies to the shadow banking system.

The Bailouts of SDIs Have Increased the Subsidies

Again, due to concern for length I will simply make the observation that virtually all the U.S. efforts to bail out the SDIs (including quantitative easing) constituted increased subsidization of the SDIs.  If the U.S. will only act to make the subsidies worse, then the WTO must act, and for the WTO to act a member nation must bring a complaint against the U.S. subsidies of the SDIs.


Another good set of comments. Either my readers are getting a heck of a lot smarter, or I’m getting better at explaining MMT. As usual, let me group responses by topic.

  1. Why is gold accepted? Well, it is bright, it is shiny, and it is the “noble element” that never changes—easy to clean-up, can be smashed into impossibly thin sheets, and looks good in ears and on fingers and in teeth (at least to some people). It also benefits from an almost mystical quality—with several thousand years at the top of the totem pole of desirable prestige goods. Oh, and yes, many countries pegged their currencies to gold in not-so-recent years. Finally, its value is maintained by fairly robust manufacturing demand as well as propensity of governments to lock most of it up behind bars. Speculators bet that governments will not release the imprisoned gold, which would instantly wipe all them out. To hedge their bets, they help to put goldbugs in government. So far as I can tell, there are no rival plausible explanations for the fascination with gold.
  2. MMT explodes heads. Probably true. Not a criticism, however. Darwin exploded heads. Newton exploded heads. Why shouldn’t the occasional economist? One of my PhD students put it much better. On the last day of class he brought in a pair of those distorting glasses for each student (and professor!) and demanded each put them on. He said that this is what MMT had done for him—his whole world view had been shown to be distorted and wrong. Then we all took the glasses off, and could see the world as it exists. There you go. Downright Kuhnian.
  3. Is government benevolent, having the interests of the population in mind? Does that belief stand behind MMT? Emphatically “NO”. Have you been paying attention to the Obama administration? Have you ever heard of a maniac named Hitler? Do you really think that when Michelle Bachmann is elected to replace Obama she’s suddenly going to turn all nice and democratic? (No, I am not equating the three politicians—two of the three are irredeemably evil. The jury is still out on the third.) MMT “works” no matter how depraved or democratic the government is. That is an entirely separate question. MMT is for Austrians, too. So long as they have not been abducted and probed by aliens. Then all bets are off.
  4. Do governments have to “finance” their deficits. Well, that depends on what we mean by “finance”. Sorry, don’t mean to sound Clintonian here. Let us save that for next week.
  5. Is all money debt? YES, all money “things” are debt. Can issue of bonds affect interest rates? No, not necessarily. Depends on central bank policy—if central bank does not want interest rates to go up, it can always prevent that. Again, a topic for detailed treatment later. Is a “debt cloud constraint” good because it constrains government spending? Well, as Paul Samuelson says, it can work like that “old time religion”—it is a lie, but he claims lies are sometimes useful. I’m a professor. I cannot lie. I will not lie to you. I will tell you the truth and you can decide whether you prefer the lies. I do think government spending should be constrained. But I believe we can tell people the truth and let them choose to constrain government. I’m in a distinct minority on this issue, however. Almost all economists—including Beltway “progressives”–prefer to lie to you. You can choose what you prefer. There are plenty of beltway progressive “think tanks” that spout the lies.
  6. Some claim fiat money is accepted because it “stores value”. What value is there in a piece of paper that says “I promise to pay you 5 pounds”? Zero. Infinite regress argument—it has value only if some poor dupe thinks it does. Or, some claim fiat money is accepted because it is backed by oil. Really? How gullible can you be? Take a dollar bill down to Treasury and demand conversion to oil. Go ahead, we will wait for a report on Geithner’s response. Really. Go ahead. Report back next week.
  7. Can we drop the FICA tax and still have a viable Social Security program. Yes. Should we? Emphatic yes. Go here. There are also many posts here at NEP that make a similar argument. Tell your “progressive” friends: Don’t hang my Social Security on the hated, job killing, regressive payroll tax! My sovereign government can always make all promised payments as they come due. Period. Then hold your dim-witted Congress-people to that promise.

The Debt Ceiling Debate that Didn’t Happen

By Michael Hudson*

To begin with the most obvious question: If governments run up their debt in the process of carrying out programs that Congress already approved, why would Congress have yet another option to stop the government from following through on these authorized expenditures, by refusing to raise the debt ceiling?

The answer is obvious when one looks at why this fail-safe check was introduced in almost every country of the world. Throughout modern history, war has been the major cause of a rising national debt. Most governments operate in fiscal balance during peacetime, financing their spending and investment by levying taxes and charging user fees. War emergencies push this balance into deficit – sometimes for defensive wars, sometimes for aggression.

In Europe, parliamentary checks on government spending were designed to prevent ambitious rulers from waging war. This was Adam Smith’s great argument against public debts, and his urging that wars be financed on a pay-as-you-go basis. He wrote that if people felt the economic impact of war immediately – rather than postponing it by borrowing – they would be less likely to support military adventurism.

This obviously was not the Tea Party position, or that of the Republicans. What is so remarkable about the August 2 debt ceiling crisis in the United States is its seeming dissociation with war spending. To be sure, over a third ($350 billion) of the $917 billion cutback in current spending is assigned to the Pentagon. But that simply slows the remarkable escalation rate that has taken place from Iraq to Afghanistan to Libya.

What is even more remarkable is that last month, Democrat Dennis Kucinich and Republican Ron Paul sought to make President Obama obey the conditions of the War Powers Act and get Congressional approval for his war in Libya, as required when warfare goes on for more than three months. This attempt to apply the rule of law to the Imperial Presidency was unsuccessful. Mr. Obama clamed that bombing a country was not war. It was only war if a country’s soldiers were being killed. Bombing of Libya was done from the air, at long distance, and perhaps also by drones. So is a bloodless war really a war – bloodless on the aggressor’s side, that is?

Here was precisely the situation for which the debt ceiling rule was introduced in 1917. President Wilson had taken the United States into the Great War, breaking his election campaign promise not to do so. Isolationists in the United States sought to limit America’s commitment, by imposing Congressional oversight and approval of raising the debt ceiling. This safeguard obviously was intended to be used against unscheduled spending that occurred without Congressional approval.

The present rise in U.S. Treasury debt results from two forms of warfare. First is the overtly military Oil War in the Near East, from Iraq to Afghanistan (Pipelinistan) to oil-rich Libya. These adventures will end up costing between $3 and $5 trillion. Second and even more expensive is the more covert yet more costly economic war of Wall Street against the rest of the economy, demanding that losses by banks and financial institutions be passed onto the government balance sheet (“taxpayers”). The bailouts and “free lunch” for Wall Street – by no coincidence, Congress’s number one political campaign contributor – cost $13 trillion.

It seems remarkable that Mr. Obama’s major focus on the debt ceiling is to warn that Social Security funding must be cut back, along with that of Medicare and other social programs. He went to far as to say that despite the fact that FICA wage set-asides have been invested in Treasury securities for over half a century, the government might not send out checks this week.

A radical double standard is at work for democracies. Wall Street investors certainly had no such worry. In fact, interest rates on long-term Treasury bonds actually have gone down over the past month, and especially over the last week. So institutional debt holders obviously expected to get paid. Only the Social Security savers were to be stiffed – or was Mr. Obama simply trying to threaten them, so as to depict himself as a hero coming in to save their Social Security by negotiating a Grand Bargain?

Wall Street had it right. There was no real crisis. Authorization to raise the public debt ceiling is not a proper occasion to discuss long-term tax policy. Since 1962 – just as the Vietnam War was starting to escalate – it has been raised 74 times. This averages out to about once every eight months. It is like going to a Notary Public – just to make sure that the President is not doing something wrong. Mr. Obama could have asked for a limited vote just on this, without riders. Never before have riders such as this been attached. And even more remarkably, there was no attempt to impose a rider restricting the Obama Administration from spending any more funds on Libya, without getting an official Congressional declaration of war.
Mr. Obama could have invoked the 14th Amendment to pay. He could have taken the proposal made by Scott Fullwiler and other UMKC economists for the Treasury to issue a few $1 trillion coins and pay the Fed for Treasury securities, to retire. But Mr. Obama steered right into the debate, turning it into a discussion of how to cut back Social Security and Medicare in the emerging U.S. class war, rather than over extending the Oil War to North Africa.

The first great victory for the financial sector in America’s domestic class war was the Bush “temporary” tax cuts on the wealthy. This aggression was not undone in order to restore budget balance. No temporary tax cuts were revoked, no loopholes closed. The burden of balancing the budget was pushed even further onto the Democratic Party’s own base: urban labor, racial and ethnic minorities, the Eastern and Western seaboards. Yet the Democrats split 95/95 on the vote to raise the debt ceiling by slashing social spending on their major voting constituency.

Voting constituency, but not campaign contributors. That looks like the key to how the debt crisis has unfolded. Although leading Democrats such as Maxine Walters Waters, Dennis Kucinich, Henry Waxman, Barney Frank, Edolphus Towns, Charles Rangel and Jerrold Nadler opposed it (and on the Republican side, Ron Paul, Michele Bachmann and Ben Quayle), much of the principled opposition has come from traditional Republicans. Nixon Assistant Treasury Secretary Paul Craig Roberts accused the deal as being too right-wing and favoring the wealthy to a degree threatening to bring on depression.

The essence of classical free market economics was to restrict Executive power – in an epoch when war-making power was the major abuse of national interests. Just as the lower house of bicameral legislatures had taken over the power to commit nations to permanent national debt – rather than royal debts that died with the kings, as were the norm before the 16th century – so parliaments asserted their rights to block warfare.

But now that finance is the new form of warfare – domestically, not externally – where is the power to constrain Treasury and Federal Reserve power to commit taxpayers to bail out financial interests at the top of the economic pyramid? The Fed and other central banks claim that their political “independence” is a “hallmark of democracy.” It seems to be rather a transition to financial oligarchy. And now that finance has joined with the oil industry, major monopolies and privatizers of the public domain, the need for some kind of Congressional oversight is as necessary as was parliamentary power over military spending in times past.

No discussion of this basic principle was voiced in the debt-ceiling debate. Even critics who voted (ostensibly) reluctantly – so as to provide plausible deniability to what no doubt will be their later condemnations of the deal when election time comes around – acted as if they were saving the economy. The reality is that there is now little hope of rebuilding infrastructure as the president promised. Cutbacks in federal revenue sharing will hit cities and states hard, forcing them to sell off yet more land, roads and other assets in the public domain to cover their budget deficit as the U.S. economy sinks further into depression. Congress has just added fiscal deflation to debt deflation, slowing employment even further.

How indeed will they explain all this in the November 2012 elections?

* Cross-posted at Counterpunch

If You Liked Shelia Bair, You Would Have Loved Ed Gray and Tim Ryan: Part 2

By William K. Black

After I wrote part one of this column three weeks ago I did a two-part series on the Council of Economic Advisers’ (CEA) reports for 2005-2007.   I focused on the 2006 report because it had a significant discussion of the theory of financial intermediation and a paragraph on financial regulation.  As one would it expect, the CEA wrote to sing the praises of deregulation and to oppose efforts to reregulate banks.  In preparing for a book forum I am hosting in two weeks on Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance my research led me to read a scholarly article (“Manufacturing Tail Risk”) by two of the co-authors of the book.  That article discusses regulation, including savings & loan (S&L) regulation during the debacle.  Reading the article convinced me of the need to describe the non-statutory reregulation and re-supervision of the S&L industry that prevented the debacle from becoming a systemic economic crisis and led to the most effective prosecution of elite white-collar criminals in history.

A brief timeline is necessary.  The first phase of the S&L debacle became a crisis when Federal Reserve Chairman Volcker decided to break inflationary expectations by substantially increasing interest rates.  S&Ls were overwhelmingly portfolio lenders making long-term, fixed rate mortgages funded by extremely short-term deposits.  S&Ls were exposed to severe interest rate risk.  On a market value basis, the industry was insolvent by roughly $150 billion by mid-1982.  Federal Home Loan Bank Board (Bank Board) Chairman Richard Pratt (an academic expert in “modern finance” who had served as the S&L trade association’s top economist) drafted a bill (informally known then as “the Pratt bill”) modeled on Texas’ deregulation.  Deregulating at a time of mass insolvency was significantly insane, but Pratt was an anti-regulator of great fervor.  Using econometric techniques to choose Texas as the model – without recognizing that Texas S&Ls’ superior reported income was as fictional as the reported income and capital arising from merging two insolvent, unprofitable S&Ls – was insane and caused severe losses.     

Pratt also cut the number of examiners and, at the behest of the Reagan administration, ceased virtually all closures of failed S&Ls.  Instead, he merged insolvent S&Ls and used abusive accounting schemes that hid real losses and created massive amounts of fake income and “capital.”  He then, ever so modestly, claimed credit for “resolving” hundreds of S&L failures at virtually no cost to the insurance fund.  The “resolutions,” of course, were typically accounting shams that led to increased losses.  (Yes, Pratt was Secretary Geithner’s role model as a carnival barker.)

Pratt’s 1982 deregulation bill became the Garn-St Germain Act of 1982.  It immediately prompted a competition in regulatory laxity.  California and Texas “won” the race to the bottom – and those two states caused roughly 60% of total losses in the debacle.

Pratt declared victory and resigned in early 1983.  He went to Merrill Lynch to sell MBS to S&Ls. Edwin Gray had been a Bank Board Member with Pratt.  Gray was a personal friend of the President and Mrs. Reagan.  He has said that the S&L trade association chose him to be its top regulator because he was a strong supporter of financial deregulation and because they believed he would be friendly to the S&L  industry (in which he had worked). 

Gray became Chairman of the agency in April 1983.  Initially, he largely continued Pratt’s deregulatory approach.  Within months, however, he became convinced that the industry was headed towards catastrophe even though the industry reported that it was experiencing a robust recovery.     

Gray deserves particular credit for his accurate analysis because it is easy to “fight the last war” (interest rate risk) and miss the development of the new war (accounting control fraud).  For a conservative, free market, ultra-loyal Reagan supporter, officer from the S&L industry to be willing to believe that hundreds of S&L CEOs could be felons also showed remarkable openness to unpleasant facts.
My prior column explained that Pratt, Texas, and California had (unintentionally) optimized the S&L industry as a criminogenic environment for accounting control fraud by deregulating, desupervising, leaving insolvent S&Ls open, ignoring extreme conflicts of interest among S&L acquirers and founders, approving federal deposit insurance for newly created (de novo) S&Ls in Texas, California, and Florida despite the total inability and unwillingness of these states to regulate, and debasing the accounting, concentration, and capital rules.  Criminal referrals (and prosecutions) were virtually non-existent under Pratt.  The Bank Board had  no system for ensuring that criminal referrals were made, for monitoring the progress of the FBI in pursuing the referrals, or for training agency, FBI, and Department of Justice staff in how to detect, investigate, and prosecute elite frauds.

The Bank Board did not have remotely adequate numbers of examiners and too many of its senior supervisors were unwilling to take vigorous action against major S&Ls.  Texas and Louisiana were totally out of control.  By 1983, there were hundreds of frauds growing at an average annual rate of 50 percent.  Had Pratt’s anti-regulatory policies continued even a few more years that level of obscene growth would have soon led the frauds to dominate the entire industry and to hyper-inflate multiple regional real estate bubbles. 

Gray went to an emergency footing.  He refused to grant federal deposit insurance to any California, Texas, or Florida de novos unless those states provided adequate examiners and supervisors.  He doubled the number of examiners and supervisors within 18 months.  He reassigned hundreds of examiners from outside Texas on temporary duty to examine Texas S&Ls.  He fired the President of the Federal Home Loan Bank of Dallas.  He ordered supervisory agents to certify that any violations of law or unsafe conditions or practices found by the examiners had either been fixed or that the supervisor had referred the matter to enforcement to force the S&L to fix the problem.

Gray personally recruited senior banking regulators with reputations for competence, integrity, and vigor and put them in charge of every region with severe problems.  He picked the two regulators he found most impressive, Joe Selby and Mike Patriarca, to be the top regulators for the regions responsible for regulating Texas and California S&Ls.  

Gray, over the opposition of his fellow Bank Board members, adopted a series of rules and orders in 1983-1986 that targeted the accounting control frauds.  The rule restricting growth doomed the accounting control frauds.  Gray also prioritized for closure the worst frauds identified by the examiners and the agency began to place S&Ls in conservatorship even  when they were reporting profitability and adequate capital. 

Gray also requested Congress to provide additional funds and statutory powers to the agency to fight the frauds.  Congress refused to meet any of Gray’s requests while he was in office.  Instead, a majority of the members of the House, at the behest of Charles Keating’s Lincoln S&L (the most notorious S&L fraud) co-sponsored a resolution calling on the agency to cease reregulation.  Congress passed the Competitive Equality in Banking Act (CEBA) in 1987.  They passed CEBA after Gray’s term ended. 
The White House reached a secret deal with Speaker Wright not to reappoint Gray in the Spring of 1987.  Speaker Wright was a Texan and his closest business associates (who employed the Speaker’s spouse) owed substantial sums to failed S&Ls.  The receivers we appointed for failed S&Ls would typically sue to recover these debts.  Speaker Wright put held the bill that eventually became CEBA hostage in order to extort the Bank Board to give special regulatory favors to Texas S&Ls controlled by contributors to the Democratic Party.   Gray spent virtually all the cash in the FSLIC insurance fund to close failed S&Ls.  We spent the fund down to $500 million – which was insuring a deeply insolvent industry with over a trillion dollars in liabilities.  CEBA was a Rube Goldberg financing scheme to allow the agency to borrow additional funds so that it could continue to close the frauds.  The financing scheme was necessary because the administration refused to admit that the industry and the insurance fund were massively insolvent.   Getting the additional funds was our ultimate agency priority, and Speaker Wright knew that by holding the bill hostage he could exert maximum leverage to try to kill Gray’s reregulation.  Speaker Wright became so brazen  in his extortion that he asked Gray to force Selby out as the top regulator in Texas on the purported grounds that Selby was a homosexual who Wright claimed was sending all the legal business of the regional agency to “homosexual law firms.”  M. Danny Wall, then the top aide to Senate Banking Chairman Jake Garn, urged Gray to accede to Wrights’s reprehensible demands to get rid of Selby.

The CEBA bill had two components, which generated two Faustian bargains.  As proposed, the bill would have allowed the agency to raise an additional $15 billion through the convoluted financing mechanism and it would have given the Bank Board additional supervision and enforcement powers.  The S&L trade association’s top priority was minimizing the funding to the insurance fund because it indirectly came from the industry.  Political scientists had called the S&L trade association the third most powerful lobby in America.  Americans liked S&Ls and the trade association had a large group of S&L CEOs – each of them an important contributor to members of Congress with whom they were on a first name basis – pledged to be in DC walking the Hill offices within 48 hours of receiving the trade association’s call to arms.  Their trade association was a force of nature, but they S&L control frauds had even closer ties with a subset of Congressional leaders.  They induced Speaker Wright to hold the bill hostage in the House and Senator Cranston to place a secret “hold” on the bill in the Senate.   The fraudulent S&Ls wanted to delay and reduce the funding provided to the agency to close the frauds, but they had a more audacious approach to the portion of the draft bill that would grant the agency additional supervisory and enforcement powers.  They decided to pervert that portion of the bill to accomplish the opposite – to use it to gut the agency’s power to supervise and enforce.  The first Faustian bargain was the agreement of the trade association and the frauds to combine their lobbying efforts against the bill in order to reduce the funding dramatically and mandate regulatory “forbearance.”

The second, inconsistent, Faustian bargain was between the administration and Speaker Wright.  (They despised each other because of their conflicts over U.S. support for the Contras’ war against the Nicaraguan government.)  Wright and the frauds were happy to the full $15 billion in funding passed as long as it was used to bail out rather than close the insolvent S&Ls.  The administration had always opposed Gray’s reregulation.  It only cared about the dollar amount of the funding.  Speaker Wright agreed to stop holding CEBA hostage and to support the $15 billion in financing in return for the administration’s agreement not to oppose mandatory regulatory forbearance and not to reappoint Gray for another term.  The administration’s sole S&L priority at all times during the debacle was covering up the scale of the crisis and it welcomed the opportunity to halt and reverse Gray’s reregulation.  The administration had no intention of reappointing Gray to another term as Chairman of the Bank Board and Speaker Wright had no intention of really supporting $15 billion in funding for the agency to close down hundreds of Texas S&Ls.  The Speaker spoke in favor of the bill while his Whip told the Democrats to ignore his words and crush the funding amount, which they (and many Republicans) proceeded to do with gusto.   

CEBA provided the agency with some additional funds, but it sought to mandate “regulatory forbearance” provisions drafted by counsel for the leading frauds for the purpose of eviscerating Gray’s re-regulatory efforts.  (“Reregulation” was the label the Reagan administration ascribed to us.  It was their vilest curse and they bestowed on Gray the special disdain and rage reserved for true believers who become apostate.)  We were able to work with Representatives Henry B. Gonzalez, Jim Leach, Tom Carper (now a U.S. Senator), and Buddy Roemer helped us insert subtle changes in the CEBA drafts that removed most of the harm that the “regulatory forbearance” were intended to cause.  Senator Gramm was also helpful to us in this effort.  Senator Gramm’s actions are instructive of an important fact of human life, people are not always consistent.  Senator Gramm also asked the President to appoint an attorney to the Bank Board who created the de facto trade association of the worst Texas control frauds.  The worst two S&L frauds in the nation Vernon Savings (referred to by its regulators as “Vermin” – 96% of its loans defaulted) and Charles Keating’s Lincoln Savings exerted the most successful lobbying power.  Speaker Wright intervened on behalf of Lincoln Savings and Vernon Savings.  Senator Cranston put the secret freeze on the CEBA bill in Senate as a favor to Charles Keating.      

Gray’s reregulation saved the nation a trillion dollars and prevented an economic crisis.  He acted despite the combined opposition of a majority of the House, the Reagan administration, the OMB (which threatened to file a criminal referral against Chairman Gray on the specious grounds that he violated the anti-Deficiency Act by closing too many insolvent S&Ls, the “Keating Five,” the industry’s trade association, the great bulk of the business media, most of the state S&L regulatory heads, his fellow Bank Board members, and important segments of the Bank Board’s professional staff.  The Reagan administration appointed Danny Wall as Gray’s replacement and Wall publicly took “credit” for forcing Selby to resign.  This followed the administration’s 2006 effort to appoint two members of the Bank Board chosen by Charles Keating, the worst S&L fraud.  The Bank Board had three members, so this would have given Keating control of the agency and added massively to the losses.  Keating succeeded in getting the administration to appoint one of his choices to the agency and he proceeded to serve as Keating’s “mole” at the agency until I blew the whistle on him.  He resigned as part of a deal with a Justice Department to end its investigation. 

Several of us were sued by Lincoln Savings in our personal capacities for $400 million.  Keating hired investigators twice that we learned of to investigate me.  Keating was able to induce William Weld, one of the most senior Justice Department officials to order a criminal investigation of the agency at the same time that the DOJ initially declined to investigate our criminal referrals (which eventually led to convictions). 

Wall removed our (the Federal Home Loan Bank of San Francisco’s) jurisdiction over Lincoln Savings because we persisted in recommending that the agency take it over.  This had never happened before in regulatory history and it sent shock waves through the financial regulatory community.  Wall tried to engineer a sham examination of Lincoln Savings, but there was a revolt by many field regulators and the California Department of Savings and Loan.  Wall’s removal of our jurisdiction, the sweetheart deal he cut with Keating, and the $3.4 billion in fraud losses at Lincoln Savings led to his resignation in disgrace after our (the field regulators’) Congressional testimony. 

The story of why the S&L debacle did not lead to a general financial crisis is a story of an agency head and staff identifying the coming crisis through an “autopsy” process of reviewing every failure and looking for patterns.  The agency head then rose above his long-held anti-regulatory perspective and abandoned business as usual in favor of an emergency response along over a dozen dimensions.  The agency’s analytics proved superb and its remedies proved effective.  The head of the agency recruited strong, competent leaders with great integrity.  Many of those regulatory leaders paid a high personal price for their successful work in preventing the debacle from becoming a systemic economic crisis.  Gray’s regulators were sometimes crushed during Wall’s tenure but their blood was always on the front of their shirts as they interposed themselves between the frauds and their political patrons and the American people.

None of this history comes through in the recent article that (correctly) observes that the S&L debacle has important lessons for understanding the causes and appropriate responses to the ongoing crisis.  The full citation to the published article (available free on line through the author’s web page) is: Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009.  By Viral V. Acharya, Thomas Cooley, Matthew Richardson and Ingo Walter Foundations and Trends in Finance Vol. 4, No. 4 (2009) 247–325 
The authors incorrectly state that deregulation began at the federal level instead of the reality that the federal deregulation was modeled on Texas’ earlier deregulation.  The authors do not distinguish between the Bank Board Chairmen.  The article talks about the large number of newly chartered S&Ls but misses the fact that Gray denied hundreds of them deposit insurance and they never opened.  They do note correctly that the industry fought bitterly to prevent the recapitalization of the FSLIC insurance fund and they seem to understand that the agency’s goal was to use the proceeds to close hundreds of failed S&Ls.  The authors’ imply that S&Ls took steps that caused most of their losses primarily late in process after they became “zombies” (the walking dead) and their managers developed perverse incentives to make honest gambles for resurrection.  This is contrary to the facts.  First, the agency developed and used techniques to place insolvent S&Ls in receivership that required relatively litter upfront cash.  Second, the agency restricted growth, so the ability of zombies to increase their risk exposure was limited by regulation.  Third, the agency adopted a far more stringent examination and supervision regime beginning in 1983, so over time (during Gray’s tenure) even most fraudulent S&L were increasingly constrained rather than becoming “banks gone wild.”  Fourth, the agency often prioritized the fastest growing insolvent S&Ls for enforcement and receiverships.  Fifth, the incentive for S&Ls to engage in fraud generally had nothing to do with the S&Ls being zombies.  The opposite was true – it was the healthiest S&Ls, the de novos, that were far more likely to engage in accounting control fraud than traditional S&Ls that had been insolvent on a market value basis for several years.  Traditional S&Ls were all insolvent in early 1982, but only a small percentage of them became “high flier” frauds.  The percentage of frauds among Texas and California chartered de novos was far higher because the new S&Ls were typically created and operated by real estate developers with intense conflicts of interest.
The reregulation of the industry by the regulators began in 1983.  The statutory reregulation of the S&L industry began only six years late in 1989.  Absent the regulatory actions there would have been a systemic crisis, but the authors of the article draw the opposite conclusion.  They do so contrary to the facts and without citation. 

There are several lessons from the S&L mess.  [R]egulators can easily be captured by the industry they regulate. This was clearly the case with the FHLBB.
It would be difficult to find an regulatory agency that was more clearly not captured by the industry than the S&L regulators under Gray and Ryan.  The reason Keating and the other S&L control frauds had to go to such extraordinary lengths to try to crush the agency was that the agency was the industry’s most bitter and successful opponent.  Superficially, one might think that the agency was captured by the industry under Chairman Pratt or Wall’s terms of office, but that too would be incorrect.  One trait that all four of the heads of the federal S&L regulatory agency and the head of the S&L industry’s trade association during the S&L debacle shared was a mutual loathing.  Yes, the industry supported financial deregulation, as did Pratt, but his worship of deregulation was due to his ideological and policy views.  Pratt refused to grant the industry its dearest dream – the ability to create massive fictional accounting income and capital without merging with another S&L.  When an administration appoints anti-regulatory leaders as its top financial regulators there is normally no need for the industry to “capture” the regulator.  Gray is the exception that proves the rule.
The third portion of this column will describes the essential role that Office of Thrift Supervision (OTS) Director Tim Ryan, and his chief counsel, Harris Weinstein, played in the successful enforcement, civil action, and prosecution of the elite criminals that drove the second phase of the S&L debacle.

Coin Seignorage and Inflation

By Scott Fullwiler
Solving the debt-ceiling issue via proof platinum coin seigniorage—an idea that began and was nurtured within the MMT ranks, mostly by Joe Firestone and Beowulf (see Joe’s post here and the numerous links therein)—has gone viral in the blogs and news sources as a viable option to end the debt ceiling crisis.  The one thing that naysayers, and even some supporters, instinctively claim, however, is that coin seigniorage would be inflationary or even hyperinflationary. But this is not true!
Let’s begin by noting the most basic point in the proposal (see link above for more details)—a platinum coin or coins would be minted and deposited in the US Mint’s Public Enterprise Fund (PEF) at the Fed, where it would be credited for its (their) full legal tender face value by the Fed. The Treasury would then “sweep” the profits (the difference between the cost to the Mint of producing the coin (s) and face value of the coin(s)) into the Treasury general Account (TGA) at the Federal Reserve.  The face value of the coin(s) can be whatever the Mint chooses to stamp on it (them); there is no requirement that the coin(s) weight be related to the face value.  So, the coin(s) could be $1 trillion or more, or less if preferred.  This is all perfectly legal, as, again, several blogs and news articles have explained.  It’s highly unlikely that one would have to worry about the coin(s) being stolen—they would be nothing more than a collector’s item as the extraordinarily high dollar value could never actually be cashed anywhere (who’s going to give you change for $1 trillion?).
So, why won’t coin seigniorage, using very large face value coins, be inflationary?  Here are the reasons:
The coin(s) would never circulate among the public.  It (they) would always remain on the asset side of the Fed’s balance sheet, and would always rest in a vault at the Fed.  Since the platinum coin(s) never circulate(s), minting and depositing the coins at the Fed cannot possibly be inflationary.
Depositing the coin into the Treasury’s account at the Fed will provide the Treasury with an account balance nearly equal to the stamped value of the coin(s), but this is not inflationary, either, for the following reasons.
Coin Seigniorage and Government Spending

1.     The Treasury can never legally spend any more than what has been appropriated by Congress.  Congress still retains the “power of the purse,” actually the “power of the purse strings.”  So, the coin(s) will never add to the government’s spending beyond what has been passed by both houses and signed by the President. There will be no inflation resulting from additional spending, due to coin seigniorage itself, since there won’t be any spending on goods and services not appropriated by Congress. So, as long as Congress doesn’t appropriate spending great enough to be inflationary, there’s no inflation problem, regardless of whether we use coin seigniorage to make the debt ceiling irrelevant.
Coin Seigniorage to Retire Debt Held by the Federal Reserve

2.     The balances in the Treasury’s account could simply be used to retire the debt owed to the Fed.  As of July 28, this is $1.635 trillion.  So, the Mint stamps a coin or coins worth $1.635 trillion, the profits (the difference between the cost of minting and the face value of the coin) end up in the Treasury’s account, and the Treasury then pays down the debt held by the Fed, and then both the balance in the Treasury’s account and the Treasury securities owned by the Fed are debited.  The coin replaces the securities on the Fed’s asset side of its balance sheet.  The Treasury is now $1.635 trillion under the debt ceiling, but to spend again must receive revenue or issue more Treasury securities to the public (given that the Fed is not legally authorized to provide overdrafts to the Treasury—though some are now questioning this, it’s a separate issue and it’s not clear to me (at least yet) that it could work).  Clearly, coin seigniorage has not been inflationary to this point, as there hasn’t even been one penny of new money put into circulation.  This option is much like Ron Paul’s proposal—actually identical in terms of the effect on the debt ceiling and the Treasury—except that his proposal would destroy all of the Fed’s capital (and then some), which is a potential problem politically (not the least of which being that Paul himself has previously worried about the Fed being “bankrupt”), though not operationally, and which the Fed is therefore very unlikely to agree to.
Coin Seigniorage to Retire Debt Held by Agencies of the Federal Government

3.     In addition to retiring debt held by the Fed, a coin or coins could be minted to retire the more than $4.5 trillion held by trust funds and government agencies.  (I will here deal only with the debt held by the trust funds, as this is far and away the largest portion of the national debt held by agencies of the federal government.)  Retiring this debt also demonstrates both how silly it is to count the trust funds against the debt ceiling and how the trust funds themselves are simply accounting gimmicks that do not actually “fund” anything in an operational sense.  The trust funds are not altogether unlike if I were to promise today to pay for my daughter’s college expenses after she graduates from high school 14 years from now and having this promise show up in my credit reports as actual debt owed.  (Some will say that the “promise” to the trust funds has the force of law while mine to my daughter doesn’t; however, the government—since it makes the laws—can choose to renege on this “promise” at any time, or water it down, as the President is currently attempting to do, just as I could tell my daughter next year that I’ll only pay, say, 85% of her college expenses, not 100%.)  At any rate, since larger trust funds signal improved prospects for both Social Security and Medicare under current law, it is counterintuitive to count the improved “health” of these programs against the debt ceiling; that is, the larger the trust funds, the “healthier” the programs, the larger the debt counted against the debt ceiling.  Go figure.

At any rate, the Treasury could simply mint another $4.5 trillion coin, or just one coin for a bit over $6.1 trillion to cover debt owed to both the Fed and the trust funds.  Just as with paying off debt held by the Fed, the coin(s) would not circulate but instead would remain an asset on the Fed’s balance sheet while the Treasury’s account would be credited with the profits.  To pay off the trust funds, the Treasury would simply create a special fund or balance separate from its “general” account from which it normally spends—sort of like it did beginning in fall 2008 with the supplemental financing account—that would be balances available for the trust funds to spend from.  As such, these balances would replace the debt currently held by the trust funds and others as non-marketable bonds.  These balances would not be spent for some time given that current payroll taxes are sufficient to cover spending by Social Security and Medicare for the time being.  (Point 6 below explains what happens when the balances are eventually spent.)
The only difference between holding the trust funds as non-marketable securities and holding them as special balances in the Treasury’s account is that the latter would not earn interest.  Some might therefore be against using the coin(s) to retire these debts as a result.  However, because these debts are simply accounting gimmicks that do not really finance anything, any lost interest due to seigniorage could be more than replaced at any time the Congress wanted to by (a) simply appropriating more balances (which could be paid via coin seigniorage), (b) considering the special account at the Treasury to be a “savings” account that earns interest for the trust funds (which also could be paid via additional coin seigniorage), or (c) simply guaranteeing that the expenses would be covered by general revenues as it already does for parts of Medicare. 
As with retiring debt owned by the Fed, retiring debt owned by the trust funds would similarly not be inflationary.  The bonds as assets would simply be replaced with one or more coins that would never circulate.  Nothing about the actual spending operations or outlays for the programs would change.
So, now we’re up to more than $6 trillion of debt retired via coin seigniorage, and not a chance of inflation yet.
Coin Seigniorage to Retire Debt Held by Private Investors

4.     As with retiring debt owned by the Fed, the Treasury could mint coins, deposit the profits in its account at the Fed, and use balances thereby credited to its account to buy back bonds held by private investors.  As I previously explained, this is the operational equivalent of quantitative easing (QE).  This is not inflationary.  The purchase of Treasury securities by the Treasury would retire the securities and leave banks holding reserve balances.  But, as I explained in the previous post, “Banks can’t ‘do’ anything with all the extra reserve balances.  Loans create deposits—reserve balances don’t finance lending or add any ‘fuel’ to the economy. Banks don’t lend reserve balances except in the federal funds market, and in that case the Fed always provides sufficient quantities to keep the federal funds rate at its target—that’s what it means to set an interest rate target. Widespread belief that reserve balances add ‘fuel’ to bank lending is flawed, as I explained here over two years ago.”
One should also recognize that all the reserve balances created will necessarily earn the Fed’s target rate unless the Fed desired a 0% overnight rate (since that’s what it would get if it didn’t pay interest).  Neoclassical economists almost uniformly believe (from Krugman to Sumner to the Fed’s own economists) that interest on reserve balances makes “base money” and Treasury bills equivalent, which then makes whatever quantity of reserve balances circulates non-inflationary.  MMT’ers disagree that interest on reserve balances has this effect, but given most everyone who thinks coin seigniorage would be inflationary subscribes to the (incorrect) neoclassical understanding of the monetary system, this is a necessary point to make—anyone thinking coin seigniorage would be inflationary because it amounts to “printing money” must also disagree with (again, incorrect) standard economics descriptions of the monetary system found in any textbook to be internally consistent.
Furthermore, while non-bank sellers of the Treasury securities would now be holding deposits instead of securities, this is also not inflationary.  Again, from my previous post:
“First, sellers of bonds were always able to sell their securities for deposits with or without the Treasury’s intervention given that there are around 20 dealers posting bids at all times.  Anyone holding a Treasury Security and desiring to sell it in order to spend more out of current income can do so easily; holders of Treasury Securities are never constrained in spending by the fact that they hold the security instead of a deposit. Further, dealers finance purchases of securities from both the private sector and the Treasury by borrowing in the repo market—that is, via credit creation using securities as collateral. This means there is no ‘taking money from one person to give it to another’ zero sum game when bonds are issued (banks can similarly purchase securities by taking an overdraft in reserve accounts and clearing it at the end of the day in the federal funds market), as what in fact happens is that the existence of the security actually enables more credit creation and is known to regularly facilitate credit creation in money markets that are a multiple of face value. Removing the security from circulation eliminates the ability for it to be leveraged many times over in money markets.”
“Second, the seller of the security now holding a deposit is earning less interest and can convert the deposit to an interest earning balance. Just as one holding a Treasury can easily sell, one holding a deposit can easily find interest earning alternatives. Some make the argument that the security can decline in value and so this is not the same as holding a deposit, but this unwittingly supports my point that holders of deposits aren’t necessarily doing so to spend. Deposits don’t spend themselves, after all.”
“Third, these operations by the Treasury create no new net financial assets for the non-government sector (and can in fact reduce its net saving by reducing interest paid on the national debt as bonds are replaced by reserve balances earning 0.25%).  Any increase in aggregate spending would thereby require the private sector to spend more out of existing income, or to dis-save, as opposed to doing additional spending out of additional income. The commonly held view that ‘more money’ necessarily creates spending confuses ‘more money’ with ‘more income.’ QE—whether ‘Fed style’ or ‘Treasury style’—creates the former via an asset swap; on the other hand, a true helicopter drop would create the latter as it raises the net financial assets of the private sector. Again, ‘money’ doesn’t spend itself. By definition, spending more out of existing income is a re-leveraging of private sector balance sheets. This is highly unlikely in the current balance-sheet recession, aside from the fact that QE again does nothing to facilitate more spending or credit creation beyond what is already possible without QE. The exception is that QE may reduce interest rates, particularly if the Fed or (in this case) the Treasury sets a fixed bid and offers to purchase all bonds offered for sale at that price—though this again may not lead to more credit creation in a balance-sheet recession and has the negative effect of reducing the net interest income of the private sector. (As an aside, a key difficulty neoclassical economists are having at the moment is they do not recognize the difference between a balance-sheet recession and their own flawed understanding of Keynes’s liquidity trap.)”
It is important to remember that using coin seigniorage to retire Treasury securities held by the private sector—because it is the operational equivalent of QE—can only be as inflationary as QE is, and we already know it has not been both in the US and in Japan earlier.
And if the public or policy makers end up unwilling to accept that this would not be inflationary, the Fed could take the additional step of either selling securities from its own balance sheet or issuing its own time deposits to banks, both of which would drain the reserve balances from circulation.  The former would effectively be reversing the QE; the latter would also do this while effectively transfer debt from the Treasury’s books to the Fed’s.  A combination of the two would be possible, too, if desired.  These would not reduce the real inflationary effects of coin seigniorage, in fact, because there are none, but within the neoclassical understanding of the monetary system they would do so.  So, again, anyone believing that coin seigniorage would be inflationary if the Treasury uses it to retire debt held by private investors is reasoning in a manner that is either inconsistent with actual monetary operations or inconsistent with the neoclassical textbook understanding of monetary operations.
And now, the entire national debt has been “paid off,” without any inflationary impact whatsoever.
But we don’t need to stop there.
Coin Seigniorage to Precede All Government Spending

5.     Coin seigniorage could be used to add balances to the Treasury’s account before it spends.  Would this be inflationary?  Only in as much as the deficit that might be incurred would be inflationary.  This is because, whether or not the Treasury spends via coin seigniorage, either the Treasury or the Fed must issue debt in order for the Fed to achieve its target rate, or the Fed must pay interest on reserve balances.  In other words, without coin seigniorage, the Treasury issues securities for every dollar of deficit incurred; with coin seigniorage, the Treasury issues securities, the Fed issues time deposits, or the Fed pays interest on reserve balances for every dollar of deficit incurred.  There is no difference, while the alternative, as above, is to allow the federal funds rate to fall to zero.  Again, then, using coin seigniorage to go beyond retiring debt and in addition (or instead) use it to finance spending does not add to inflationary pressures besides those already in place as a result of the deficit the government would have incurred anyway. 
Note what I did not say here—I did not say that coin seigniorage enables the federal government to increase spending or reduce taxes willy nilly and “just print” its way (or “mint its way,” as the case would be) to larger deficits.  Any rise in inflation would be due to Congressional appropriations relative to revenues becoming inflationary rather than the effect of the “full purse” resulting from coin seigniorage.  The inflation issue concerns whether “the purse strings” will  be monitored and managed by Congress, not whether the purse is full in the first place.
In other words, larger deficits absolutely can be inflationary, just as they can be now—indeed, there’s absolutely no difference, as above—but not because of coin seigniorage; and because of coin seigniorage, even future deficits do not need to count against the debt ceiling.
Coin Seigniorage and Entitlement Spending After Trust Funds Have Been Retired

Finally, regarding the special balances held on behalf of the trust funds in the Treasury’s account . . . what happens when those are spent?  Won’t that be inflationary?
6.     Again, there is no difference.  With a trust fund, the relevant agency presents the Treasury with a non-marketable security and is given legal authority to spend beyond revenues earned by that program; balances are withdrawn from the Treasury’s account to pay beneficiaries. 
With balances held in a special fund in the Treasury’s account, the relevant agency informs the Treasury that it desires to draw down its balances and is thereby given legal authority to spend beyond revenues earned by that program; balances are withdrawn from the Treasury’s account to pay beneficiaries.
In either case, whether or not inflation rises depends on the total deficit incurred by the program relative to the deficit incurred by the rest of the government’s spending versus its revenues—the deficit incurred by spending more on entitlements than revenues could conceivably be offset by a surplus for the rest of the government’s budget.  Whether there has been coin seigniorage to move the balances held by trust funds in non-marketable securities into a special account within the Treasury’s account at the Fed has nothing to do with the inflationary impact of future spending on entitlements.  (Note also, as in point 5, that any deficits incurred via seigniorage will still require the Treasury to issue bonds, the Fed to issue its own debt, or the Fed to pay interest on reserve balances in order to achieve a non-zero federal funds rate target.)
Coin Seigniorage and Lifting the Veil on Real-World Monetary Operations

As I wrote earlier, using coin seigniorage to finance spending lifts the veil on monetary operations to expose their true nature.  As MMT’ers have always argued:
“It then would be clear to everyone that the Treasury’s spending is not operationally constrained by revenues or its ability to sell bonds.  It would be obvious that the Treasury spends by crediting the reserve accounts of banks, who in turn credit the deposit accounts of the spending recipients. . . .  As MMT’ers have explained for years (even decades), the operational purpose of the Treasury’s sale of a bond is merely to aid the Fed’s ability to achieve its overnight target by draining reserve balances created by a deficit.”
Similarly, coin seigniorage to pay off the trust funds and “fund” future entitlement spending demonstrates that the government’s ability to finance these expenditures is never at issue. Instead, it would be clear that the fundamental purpose of taxation is to constrain aggregate spending, not to finance government spending, another fundamental tenet of MMT.
Analytical Mistakes Made by Those Claiming Coin Seigniorage Would Be Inflationary

All in all, those claiming that proof-platinum coin seigniorage would be inflationary are in fact guilty of one or more of the following:  
(a) misunderstanding the very basics of the proposal;
(b) misunderstanding how the monetary system actually works;
(c) misunderstanding the standard textbook explanation of the monetary system; and/or
(d) misunderstanding the options available to policy makers for dealing with concerns related to the standard textbook understanding of the monetary system. 
Consequently, there is simply no reason for anyone who has carefully thought through the proposal and how it would actually work to argue that coin seigniorage would be inflationary (aside from the possible temporary reactions by those in markets that might similarly have a poor understanding of both of these—which itself assumes that policy makers in conflict with their own interests do a poor job of explaining the proposal and its effects).

We need to be on guard against inflation all the time; indeed, MMT’ers have always argued that inflation is the true constraint that the government should concern itself with, not traditional notions of “sound finance” or “bankruptcy.”  Even so, we shouldn’t be paralyzed in adopting new financial arrangements for the federal government by people invoking the bogeyman hiding under the bed. That, only means that we will never cope with our financial problems and always remain in the present silly deadlocks, or worse (as in, sometimes the solutions to the deadlocks make one wonder if the deadlock was all that bad).  What I’ve shown above is that there’s no reason to believe that using proof-platinum coin seigniorage will cause either significant demand-pull or cost-push inflation, regardless of the denomination, whether it be $ 1 trillion or $60 trillion, of the coin used to fill the federal purse. So, the coin seigniorage option for coping with the debt ceiling—whether now or in the future—is both a legal option, and also one that will not have any inflationary side effects.
The amount of coin seigniorage employed is highly significant for several issues, including the following:  whether we will have any federal debt in the future as measured by the debt ceiling or the ratings agencies; whether wealthy individuals or foreign nations will continue to receive risk-free “welfare” payments in the form of interest from the federal government; whether we will perform reserve drains via debt issuance or paying interest on reserve balances; whether arguing over the national debt and deficits will have a place in our politics anymore; whether we will ever suffer the fate of Greece.  However, one issue that it is not relevant to is whether coin seigniorage itself causes inflation. It just doesn’t.
(Special thanks to Joe Firestone for helpful comments and suggestions.  For those interested, there is further discussion of the issues raised above here)