Monthly Archives: December 2011

Control Frauds Continue to Maim and Kill

By William K Black

The financial scandal and the Great Recession that it causedhave understandably captured the bulk of our attention, but we must not losesight of the fact that “control frauds” continue to maim and kill enormousnumbers of people and damage the environment and society throughout theworld.  Several examples of these fraudshave led to recent press reports.  Iwrite to point out that control fraud is the common feature of thesescandals.  I address four recentmanifestations of control fraud:  theFrench manufacturer of defective silicone breast implants, the death of manyFillipinoes in floods made lethal by illegal deforestation, the deaths anddevastation caused by illegal seizure and exploitation of mines in the Congo,and the scrap metal dealers who put the profit in the theft of metals in theUK.  This first column explains theFrench breast implant fraud.

Varietiesof Control Fraud

Control frauds occur when the persons controlling aseemingly legitimate entity use it as a “weapon” to defraud.  Such frauds occur in the private, NGO, andpublic sector.  I write primarily aboutaccounting control frauds because accounting is the “weapon of choice” forfinancial control frauds.  (Liar’s loanswere the best ammunition, and subprime liar’s loans were the equivalent ofteflon-coated bullets designed to pierce protective armor.)  Shareholders and creditors are the primaryintended victims of accounting control fraud, which creates record, but fakeprofits.  Other forms of control fraudcreate real profits.  Anti-purchasercontrol frauds target the customer and involve deception as to the qualityand/or quantity of the product. Anti-public control frauds target the public.  Illegal logging, the illegal seizure andexploitation of mines, and purchasing goods one knows are likely to be stolenare examples of frauds designed to harm primarily the public. 

TheFrench Manufacturer of Defective Breast Implants

Poly Implant Prothese (PIP) was a French manufacturer ofsaline and silicone breast implants.  TheFDA found severe problems with PIP’s production of saline implants a decade agoand alerted PIP and its French regulatory counterpart to the problems in 2000.  The FDA described the saline implants as“adulterated” due to eleven flaws in its manufacturing processes.     

Learning about Jean-Claude Mas, PIP’s CEO, should serve as anecessary caution.  Far too many peoplecannot believe that people who run corporations can be “real” criminals.  CEOs can be despicable, and their approach totheir customers can be loathsome.  MasCEO knowingly put the health of hundreds of thousands of women at risk.

“Haddad[Mas’ lawyer] said that Mas freely admits using unapproved silicone gel, butremains adamant it is safe.

“PIP knew it wasn’t in compliance, but it wasn’t a toxic product,” the lawyersaid, adding it “had not been proven” the implants were any more likely toleak.

“The fact that it’s an irritant (when ruptured) is the same for all siliconegels….”

PIPused two types of silicone in its implants, Haddad said. One of them was anapproved gel made by American firm Nusil, but it also used an “identical”homemade gel that was five times cheaper.

According to PIP’s 2010 bankruptcy filing, it had exported 84 percent of itsannual production of 100,000 implants.”

But the substitute gel was not “identical” and whilemedical-grade silicone is an “irritant” when an implant ruptures thenon-medical gel posed a substantially greater risk.  PIP’s production quality problems continued,so PIP’s poor quality implants were also more likely to leak.  Indeed, PIP began putting the unlawfulsilicone in its products in 2001, shortly after it received the FDA warningabout its unsafe production methods (see here).

TheoclassicalEconomists Assume that Greater Consumer Choice is Unambiguously Good

Why would PIP continue to purchase some medical-gradesilicone at five times the price?  

“The tycoon at the heart of the breast implantsscandal that has affected hundreds of thousands of women has admitted hiscompany deliberately used inferior silicone gel.

The owner of bankrupt company Poly Implant Prothese(PIP) Jean-Claude Mas revealed that PIP sold protheses with industrial-gradesilicone that had not been approved by health authorities to be sold atdiscounted prices.

But wealthier clients were sold implants withhigh-quality gel, The Times newspaper reported.
Mr Mas, 72, explained through his lawyer, YvesHaddad, that the reason behind the product was that his company had an’economic objective’ and that his management aimed to get ‘the best cost’.

He also admitted that the industrial-grade siliconeimplants, which could cause health problems if they burst or leak, ‘did notformally receive approval’ and regulations were violated.
France’s medical safety regulators AFSSAPS werenever asked to inspect or approve the products.

Mr. Mas said there was a basic and a high-endversion of the implant, but that the cheaper version – which was ‘five timescheaper’ – was just as effective as the costlier version.”

PIP did not inform its poorer customers that it was illegally selling theminserts made with cheaper, unapproved industrial-grade silicone (see here).

PIP also did not inform its customers that “the casingaround the filling was also faulty and prone to rupture or leakage’” (see here).

Interpol’sImplicit View of the Seriousness of various Crimes

There were a flurry of press reports that Interpol had issued an arrestrequest for Mas, but it turned out that Interpol’s action was unrelated to Mas’placing the health of hundreds of thousands of women at risk through fraud. (see here)

“International police agency Interpol has beenissued a “red notice” for Mas, however it’s for an unrelated case — he wasarrested in June 2010 for drunk driving, but left the country and did not showup for a scheduled court date.”

That Interpol incident illustrates brilliantly thedifference in societal reactions to different varieties of crimes, but it alsooffers some hope.  Drunk driving is aserious crime that often maims and kills. An individual impaired driver of a car can put dozens of lives atrisk.  A fraudulent CEO running a medicalequipment company can put hundreds of thousands of lives at risk.  Only a few decades ago it was rare for lawenforcement to take drunk driving seriously, particularly if the driver waselite.  A social movement, MothersAgainst Drunk Driving (MADD), worked for many years to get society and lawenforcement to think of drunk driving as grave crime.  We need a similar social movement to getsociety and law enforcement to see control fraud as a grave crime worthy of anInterpol “red notice.”   


What separates the most destructive fraudulent CEOs fromtheir lesser counterparts is audacity. The French (naturally) have a saying that captures the conceptperfectly.  “L’audace, encore l’audace,toujours l’audace” (audacity, more audacity, always audacity).  Mas is off the scale when it comes toaudacity.  Mas exemplifies the Spanishmeaning of his name (“more”).  No soonerhad he (for the second time) been found to have endangered his customers, thanhe was planning to go back into the business of producing and selling breastimplants. (see here)

“The French head of the company at the centre of theinternational breast implant scare was employed by a second firm making [breastimplants] set up by two of his children.
The plan described Mas, 72, as a “creativegenius” and says its collaborators have “30 years of experience inthe field of quality, research and development, production andcommercialisation of breast implants”.
It stated its aim was to produce 400 silicone gelimplants every day at the former PIP production site in the south-east ofFrance, to be sold to “the European, South American and Chinesemarket”.”

It takes a special kind of depravity to describe oneself asa “creative genius” after a life of defrauding one’s customers through meansthat put their health at undue risk.  Iwrote an earlier column discussing what ring of hell Dante would make thefrauds that drove the financial crisis reside in if he were able to write amodern Divine Comedy.  After a career of preying on women, Masshould pray fervently that there is no physical or spiritual hell.  

President Obama Negotiates our Formal Surrender to Crony Capitalism – and the Nation Yawns

By William K. Black

On December 13, 2011, the Wall Street Journal published an article entitled “Banks in Pushfor Pact.” It was an obscure article buried in the real estatesection.  The article contained thisclause:  “Under the proposal, banks wouldbe released from legal claims tied to servicing delinquent mortgages as well ascertain mortgage-origination practices….” Opponents of this proposed amnesty for mortgage-origination fraud havecharged repeatedly that the federal government and Tom Miller, the AttorneyGeneral of Iowa, who is leading the settlement negotiations, support theamnesty.  Previously, Miller’s keylieutenant, but not the Obama administration, angrily denounced thecharge. 

TheFour Levels of Control Fraud Involving Mortgages

Home lenders, particularly those making liar’s loans,typically committed endemic “accounting control fraud” on multiple levels.  Control fraud occurs when the personscontrolling a seemingly legitimate entity use it as a “weapon” to defraud.  Accounting is the “weapon of choice” forfinancial control frauds.  Mortgagefrauds can be grouped into four levels, each of them exceptionallywidespread:  loan origination fraud bythe lenders and their agents, the fraudulent sale of fraudulent mortgages, thefraudulent pooling and sale of collateralized debt obligations (CDOs) in whichthe underlying was largely fraudulent mortgages, and foreclosure fraud. 

LoanOrigination Fraud

The classic economics article describing such frauds isGeorge Akerlof and Paul Romer’s “Looting: the Economic Underworld of Bankruptcyfor Profit” (1993).  The recipe” foraccounting control fraud by a lender (or purchaser) has four ingredients.

  1. Extreme growth by making (or purchasing)
  2. Loans of extremely poor quality at a premium yield
  3. While employing extreme leverage, and
  4. Providing grossly inadequate allowances for loan and lease losses (ALLL)
Origination fraud involved a series of mutually supportivefrauds: inflating the borrower’s income, inflating the appraised value of thehome, providing grossly inadequate allowances for loan and lease losses (ALLL),and failing to recognize losses on fraudulent loans held in portfolio.  It was also common for federally insuredlenders to file false reports with and make false statements to theregulators.  Lenders that made liar’sloans were “accounting control frauds.” Their CEOs cause them to create perverse incentives to suborn thesupposedly independent experts to provide opinions that inflate values andunderstate risk in order to aid and abet the underlying accounting fraud.  These perverse incentives create a“Gresham’s” dynamic in which bad ethics drives good ethics out of themarketplace.  The result is “echo” fraudepidemics.  Each of these fraudsconstitutes a federal felony.  Most ofthe frauds I have described are also felonies under state law.  Collectively, there were millions oforigination frauds with a total dollar amount of fraudulent originations wellin excess of $1 trillion.

TheFraudulent Sale of Fraudulent Loans

The second level of fraud is the fraudulent sale by thelenders of the fraudulent loans.   Thisform of fraud required endemic false “reps and warranties.”  Roughly 90 percent of liar’s loans were sold,so this second level of fraud also constitutes millions of federal and statefelonies and roughly $1 trillion in fraudulent sales.

TheFrauds involved in Pooling Fraudulent Loans to Create and Sell Fraudulent CDOs

The third level of fraud is the sale of collateralized debtobligations (CDOs) “backed” by fraudulent liar’s loans through falsedisclosures.  This level of fraudconstitutes tens of thousands of federal felonies and roughly $1 trillion infraudulent sales.


The fourth level of fraud is foreclosure fraud.  The best known of these frauds involved thecommission of hundreds of thousands of felonies through the filing of falseaffidavits to secure foreclosures (inaptly called “robo signing”).

MassiveForeclosure Fraud Generated the Global Settlement Discussions

It was this last level of fraud that prompted the settlementdiscussions.  What one must keepconstantly in mind when dealing with lenders that are control frauds is thatthey and their senior officers will be represented by the best criminal defenselawyers.  America still does many thingssuperbly, and we do lawyers really well. The fraudulent officers who control banks engaged in control fraud willspend bank funds like water for their defense lawyers.  The old joke is that when one is dealt lemonsone should make lemonade.  In law school,however, we consider that the “C minus” answer. When dealt lemons; the best lawyers seek to make Dom Perignon. 

Consider the setting – you represent a systemicallydangerous institution (SDI) that was the beneficiary of a federal bailout.  Your client has made hundreds of thousands offraudulent liar’s loans and fraudulently sold the great bulk of them.  If your client is held responsible for thesefrauds it will have to reveal that it is massively insolvent and facereceivership.  Your client is also one ofthe largest mortgage loan servicers in the world.  A small law firm representing a borrower hastaken the deposition of one of your client’s key employees who signed theaffidavits necessary to support roughly ten thousand foreclosures a month – andadmitted that the key statements she has made in each of those affidavits isfalse.  The somnolent federal governmenthad finally been forced to admit that the banks have engaged in endemic foreclosurefraud.  The states are alsoinvolved.  This would be a nightmarescenario for any normal client.  For anSDI, however, it was an opportunity. 

L’audace,encore l’audace, toujours l’audace!
(Audacity,more audacity, always audacity: the white collar defense lawyer’s creed)

One of the secrets to being an extraordinarily effectiveelite criminal is also true of their lawyers – audacity.  Elite white-collar criminals can frequently getaway with grotesque criminal conduct if they use their exceptional advantagesprovided by wealth, privilege, and seeming legitimacy.   Even within the ranks of elite white-collarcriminals, however, the CEOs who control SDIs – particularly during a financialcrisis that they caused – are unique in their power to commit crimes withimpunity.  They hold the national, evenglobal, economy hostage.  TreasurySecretary Geithner has made this strategy simple by displaying the “StockholmSyndrome.”  He has fallen in love withthe criminals that are holding our economy hostage.  Geithner claims that the fraudulent SDIs areso fragile that they would collapse if they were even investigated seriouslyfor fraud.  He conveniently ignores thefact that the primary reason for the SDIs’ fragility is that their CEOs lootedthe banks.  

They can also use “their” bank to buy the modern equivalentof indulgences for even the most destructive frauds.  There are two non-exclusive means of buyingindulgences.  The most obvious means ispolitical contributions.  The financeindustry is the leading funder of both political parties. The less obvious means of buying immunity arises from thedysfunctional nature of DOJ policies for (not) prosecuting major firms forserious felonies and the ability of the CEO to use corporate funds to purchasepersonal immunity from criminal prosecutions. Five facts about the criminal defense of large firms must be keptprominently in mind when considering the defense of banksters.  First, the CEO will gladly trade off billionsof dollars in payments by the bank and its liability insurers in order tosecure immunity from criminal charges against the CEO and the senior officerswho could implicate the CEO.  

Second, the Department of Justice (DOJ) has essentiallyceased to prosecute large firms for serious felonies.  DOJ was so traumatized by the consequences ofprosecuting Arthur Andersen that it has decided to allow large firms to enterinto “deferred prosecution” agreements (in which prosecution is, in reality,perpetually deferred).  Arthur Andersenhad entered into two deferred prosecution agreements, and DOJ offered it athird, when AA refused the agreement and went to trial.  

Third, while I have referred to the firm as the “client” andthe firm and its insurers typically pay for the attorney fees and fines, it isthe CEO that can hire and fire outside counsel. Outside counsel, therefore, are chosen by fraudulent CEOs because theyare willing to aid and abet the CEO in looting the real client (the firm).  This is a classic example of the fraudulentbank CEO deliberately creating a Gresham’s dynamic in which the least ethicalmembers of the “independent” profession drive the most ethical out of lucrativerepresentations.  In criminology jargon,control frauds are criminogenic. Fraudulent CEOs use their ability to make compensation for officers,employees, and independent professionals perverse in order to createenvironments that cause widespread frauds that aid and abet the lender’s fraudscheme.  To put it in plainer, biblicalEnglish:  fraud begets fraud.

Fourth, the settlement payments are typically deductiblefrom taxes.  This means that thedefendant’s actual burden of paying the fine is much smaller than the announcedamount of the fine.

Fifth, defense counsel typically promise to pay some portionof the fines to the victims of the fraud. This is a brilliant tactic.  Itmakes the government attorneys feel good about the settlement and it allowsthem to bash opponents of the settlement as blocking relief for the victims.  The tactic, of course, is cynical and dishonest.  The weak settlement is what prevents a fargreater recovery for the victims of the fraud. The government does not have to wait for a settlement to aid the victimsof foreclosure fraud.   
Settlement discussions by counsel for control frauds withthe government and shareholders are all about exceptionally able and zealouslegal representation of the CEO at the expense of the client, its shareholders,and the public.  Only vigorous regulatorsand prosecutors can protect the firm, shareholders, and public from looting bythese CEOs and the allies they generate.    

TheProposed Deal: The $1 Trillion Lagniappe

The obvious deal that criminal defense counsel for banksalways seek is to trade a showy amount of fines for de facto or even formal immunity for the CEO and other seniorofficers who led the frauds and became wealthy through the frauds.  Here, the defense counsel were far moreaudacious – they are demanding immunity not only from prosecution, but even frominvestigation, and they are demanding immunity for crimes they committed thathave never been investigated by the state and local prosecutors.  The foreclosure fraud cases, while enormous,are by far the least of the banksters’ worries. The potential loss exposure from the foreclosure fraud is measured inthe tens of billions of dollars.  Thepotential loss exposure from fraudulent home loan originations is in thetrillions of dollars – and a trillion is a thousand billion.  The banks’ CEOs are demanding, for a puny $25billion, a release from liability for foreclosure fraud.  That is obscene on multiple levels.  Even President Obama concedes that the bankstreat such fines as a mere “cost of doing business” (by which he means the“small tax on the wealth obtained by elites through doing fraudulentbusiness”).  The senior officers involvedin the fraud should be imprisoned. Giving them immunity, allowing them to keep their bonuses “earned”through fraud, and keeping them in leadership roles are all despicable actsthat should be anathema to every prosecutor. 

But what came next went beyond scandal as usual.  The banks then demanded a lagniappe – a little something extra,for free, in a New Orleans restaurant – they wanted immunity for loanorigination fraud.  The slight differenceis that this lagniappe is worthtrillions of dollars to the frauds.  Itsickens me to inform the reader that the Obama administration is eager toprovide the frauds with this lagniappe.  The Department of Housing and UrbanDevelopment (HUD), led by Secretary Shaun Donovan, is actively pushing thisscandalous deal, with strong support in the background from Treasury SecretaryGeithner.  The silence of AttorneyGeneral Holder, and President Obama, on this travesty is exceptional.

Worse, the banks are seeking immunity even frominvestigation of the over trillion dollars in mortgage origination fraud – andthe Obama and Bush administrations’ supposed “investigations” of mortgageorigination fraud by the large lenders that made the mass of liar’s loans areall unworthy of the word “investigations.” It would take roughly 100 investigators, working for years, to do aserious investigation of any of the largest liar’s loan lenders.  There has never been, remotely, such aninvestigation by the federal government of the any large liar’s loan lender.  The Obama administration is reported tosupport the fraudulent financial CEOs’ dearest dream – de facto immunity even from investigation of over a trilliondollars in fraudulent liar’s loans origination.  

The Republican Party and its candidates for the Party’spresidential nomination are not criticizing Obama’s proposed formal surrenderto crony capitalism.  They only wish theywere in complete power and could cash in even more heavily on the tidal bore ofcampaign contributions flowing out of the finance industry.   

Miller,and everyone involved, knows there was endemic origination fraud

Miller no longer denies that he has joined theadministration in favoring the banks’ most cherished dream – amnesty fororiginating a trillion dollars in fraudulent home loans.   Indeed, the settlement is designed toprevent even investigations of themortgage origination fraud.

I confess that I am so naïve that I would have believed itimpossible that any federal or state governmental entity would enter into suchan abject surrender to crony capitalism. Once I learned that they were seriously contemplating such a travesty Icould not believe that Miller would support it. I believed his lieutenant’s (Mr. Madigan’s) denunciation of criticism ofthe proposed amnesty.  (I have reviewedMadigan’s comments in preparing this piece and I see that they were artfullycrafted to be disingenuous.)
The testimony of Thomas J. Miller, Attorney General of Iowa, at a 2007Federal Reserve Board hearing shows that he knows that the lenders engaged inmassive origination fraud.

Over the lastseveral years, the subprime market has created a race to the bottom in whichunethical actors have been handsomely rewarded for their misdeeds and ethicalactors have lost market share…. The market incentives rewarded irresponsiblelending and made it more difficult for responsible lenders to compete. Strongregulations will create an even playing field in which ethical actors are nolonger punished.
Despite thewell documented performance struggles of 2006 vintage loans, originatorscontinued to use products with the same characteristics in 2007.
[M]anyoriginators … invent … non-existent occupations or income sources, or simplyinflat[e] income totals to support loan applications. A review of 100 statedincome loans by one lender found that a shocking 90% of the applicationsoverstated income by 5% or more and almost 60% overstated income by more than50%. Importantly, our investigations have found that most stated income fraudoccurs at the suggestion and direction of the loan originator, not theconsumer.

Miller, T.  2007.  “Comments to the Federal Reserve Board ofGovernors on Adopting Regulations to Prohibit Unfair and Deceptive Acts andPractices under the Home Ownership and Equity Protection Act (HOEPA).” (August14).  Miller was correct.  We know that it was overwhelmingly lenders andtheir agents that put the lies in “liar’s” loans.  We know that 90 percent of liar’s loans werefraudulent.  We know that the industrymassively increased the number of liar’s loans after warnings that the loanswere endemically fraudulent.  The growthrate of liar’s loans was so rapid (over 500% from 2003-2006) that thesefraudulent loans caused the housing bubble to hyper-inflate.  We know that no government entity ever causedany entity to make or purchase (and that includes Fannie and Freddie) liar’sloans.  Indeed, the government repeatedlywarned of the dangers of liar’s loans. We know that by 2006 roughly one-third of all home loans made that yearwere liar’s loans – which means there were millionsof fraudulent loans made annually and, collectively, trillions of dollars in fraudulently originated home loans.

Whatmust be done

Our economy and our democracy cannot succeed under cronycapitalism.  Please join me in writing toCongress, the administration, your state attorney general, the media, and anycourt that must approve this proposed settlement.  It is a disgrace.  President Obama is, of course, correct thatsome actions can be illegal but exceptionally unethical and damaging.  He is about to take precisely such an actionin derogation of his oath of office to defend and protect the constitution ofthe United States of America.  Thefraudulent CEOs of the banks that became wealthy by causing the financialcrisis and the Great Recession are treating us as fools who will give trilliondollar plus gifts to the least deserving, most arrogant, and least ethicalelites.  Have we fallen so low as apeople that we will allow this to happen? 

Please join me in supporting the Attorney Generals of NewYork, Delaware, and California who have opposed this settlement.  

As for President Obama, I hope that he will make this NewYear’s resolution:  “I resolve to honormy oath of office and faithfully execute the laws of the United States anddefend its constitution, which is premised on justice and the rule of law.  No person, no matter how elite, is above thatlaw.  I have today asked Messrs.Bernanke, Geithner, and Donovan for their resignations because oftheir support for bailing out the elite banks and granting de facto amnesty to fraudulent financial CEOs.  I, and my new Attorney General and newSecretary of the Treasury, have mutually resolved to make the vigorousprosecution of the elite financial frauds that drove the ongoing crisis ourmission. ”


Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy – Part Six

By Dan Kervick

I will conclude by proposing six social tasks for the risinggeneration – six challenging tasks whose successful pursuit will help usachieve a more just, equal and democratic society.   It is my view that the resulting society willnot only be fairer and more decent.   It will also be more economically productive,and will better promote human happiness and flourishing by more effectively distributingthe goods and services we produce.    Most of us will be happier in such a societyas well, because the practices of democratic equality do a better job satisfyingthe human desires for cooperation, solidarity, trust, stability and fellowshipthat are the foundation of the social life for which human beings are naturallyframed.

Extreme laissez faire capitalism of the kind extolled offand on over the past two centuries, and increasingly preached by economists,financiers and conservative thinkers over the past four decades, is a perversedistortion of human nature, foisted upon us by cold and demented thinkers captivatedby inhuman notions of efficiency and domination.   In theend, it is a system that reduces each human being to an object whose value isnothing beyond what it is worth in the market.    We need to restore a social balance, inwhich private property, entrepreneurialism and commercial activity do notdominate our lives and set all the rules for our existence, but function withina democratic social order framed by a politically coherent and effectivecommitment to the public good.  In ademocratic social order there exists an activist public sector controlling asubstantial store of social goods, and channeling democratic energies andintelligence into the ambitious perfection of such goods.

The six proposed tasks are not intended to be in any way exhaustive.  They all pertain to the economic sphere oflife alone.  But the realization of agenuinely democratic society will require efforts that transcend the economicsphere.   We need to rejuvenate thedemocratic spirit in America, educate ourselves and our fellow citizens on theunfulfilled potentialities of democratic existence, recapture the salvageableinstitutions of our threatened but still existing democracy, and further expandthe institutions and habits of democratic practice.   Thereis much to be done, but the prospect of doing it is exciting. 

Task One: Full Employment

The first task is to employ all of our people and endunemployment as we know it.   We mustcommit our societies to the goal of full employment, and build an economicorder in which a job is always provided by either a public or private sector enterprisefor everyone willing and able to work.  We must be willing to invest continually in human development in order toprovide everyone with the skills and knowledge they need to contributemeaningful work to our productive activities, and participate meaningfully asfellow citizens in our democratic society.

Unemployment should not be regarded as some sort of inescapablecurse visited upon us by the mysterious providence of the invisible hand andthe hard tutelage of the business cycle.  It is not an essential economic medicine or purgative that we arerequired to swallow for the sake of our long-term economic health.   It is asocial choice that we have made.  And it is a bad social choice.  Yes,private sector enterprises rise and fall, and their employment needs areconstantly shifting.   But we have itwithin our power to organize the public sector to absorb workers who have beenreleased from their private sector employment, and employ them immediately inuseful public enterprises.  Then asprivate sector activity picks up and generates a demand for more workers, wecan release public sector workers back into the private sector economy.    Human needs and desires always far exceedour capacity to satisfy those needs and desires, and that means that there isalways plenty of work to be done. 

The system of persistent unemployment we have now is a badsocial choice, but it is the social choice many plutocratic power-brokers prefer.   So long as mercenary private wealth ispermitted to call the shots in our economy, many of those at the top will findit preferable to dispose of unwanted human beings and their labor byjettisoning surplus workers from the active economy from time to time, just to putthem on a low cost dole.   Thealternative – in which a democratic government is permitted to exercise its organizationalpower and pool social resources in order to employ the unemployed – is a threatto the power and wealth of plutocrats.   By preserving a permanent pool of unemployedworkers, the plutocracy ensures a permanent buyers’ market for labor, keepingwages down and worker bargaining power at a minimum.   This allows the owners of private sectorenterprises, working together with their most well-paid executive employees, tosteer a greater portion of the revenues of the enterprise into the hands of theowners and top executives.    A fullemployment economy, on the other hand, would restore bargaining power to workers,and permit those workers to retain a greater share of the firm’s revenues aswages.

The plutocracy also wishes to preserve the myth that ifthere is work that could be done, but that some private sector firm is notperforming already, then it must be unprofitable work that is just not worthdoing.  But that’s an error.  For one thing an immense amount of the goodsin this world are owned by the public at large or by nobody at all.  Private capital will be invested only when itcan bring about improvements in someone’s private property, the property ofthose who are investing their own capital or investing capital they haveborrowed from others.   This usuallygenerates a surplus that can then be sold on the market.  That’s the only way the investor can profitfrom those improvements and productive processes, and that means that privatecapital has no interest in investing in those things from which no privateindividual or firm profits.   But thepublic owns or draws value from a great many goods that lie outside this sphereof profitable private investment.  It canadd substantial, usable value to the world by organizing public investment inthese goods.

Look around and ask whether or not there is valuable work tobe done.  Of course there is.  There is always far more work to be done thanthere are people to do it.  Human beingsare mortal and limited, and when we succeed in achieving something new, thatonly frees us up to move on to something else that we were not able even tobegin to address before.   When we failto employ ourselves in doing that work because of our ideological commitmentsto an existing system of private enterprise, we stupidly deprive ourselves ofthe productive efforts of many unemployed people who are willing to work.   The existence of needless mass unemployment withinthe present system only shows that the existing system is incomplete and inefficient,and that it is not the full answer to the satisfaction of human needs.

Adam Smith, a much more moderate and reasonable man than issometimes painted by the crazed disciples of laissez faire who have adoptedSmith as their patron, also recognized that the system of private enterprise isnot sufficient to satisfy all social needs. He recognized the need for public employment, because he recognized thatthere are ends we can pursue that, “though they may be in the highest degreeadvantageous to a great society, are, however, of such a nature that the profitcould never repay the expense to any individual or small number of individuals.”

We always possess the capacity to do what we need to do inorder to employ the unemployed.   Themonetary system should never stand in our way. Since the public’s money is only a tool, and since these monetary toolscan be produced and wielded by a democratic society in whatever quantities areneeded to pursue public purposes, it is absurd to argue one cannot afford togenerate real value in the world because of a lack of money.   As wecreate additional real value in the world, we can concurrently create theadditional money we need to measure that additional value, to efficientlymanage the entry of that added value into the existing economy, and to paythose who produced the additional value.  Since the process adds new goods and services to the economy, ratherthan simply creating more money to chase existing goods and services, theadditional money we bring into existence in this way does not exert significantinflationary pressures and destabilize prices.

Unemployment has tremendous social and individualcosts.  It leads to the loss of skillsand capacity over time as a changing economy moves further and further ahead ofthe workers who have been jettisoned from it. These abandoned workers are then increasingly transformed into a burdenon others.  Unemployment also leads topsychological depression, shame and humiliation, and creates invidious social castedistinctions between the employed and the unemployed.     Our current social practice of deferringall employment decisions to private sector entities, and permitting massiveunemployment for long periods of time, is not just unnecessary.  It is cruel, barbaric and stupid.

It is notable that during the current economic crisis, thenational government in the United States decided early on to turn itsattentions away from employment and toward the plutocratic agenda of public debtreduction.  The government was willing totolerate official unemployment standing between 9% and 10%.  That, of course, is only the misleading official number.  That this national policy direction of forcedand recession-intensifying austerity was partly set by a Democratic administration, which rammed a deficit and debt reductionagenda down the throat of the national debate by appointing a “DeficitReduction Commission” headed by committed conservative deficit hawks from bothparties, is an indication of just how deeply both major national parties are nowembroiled in the game of protecting the interests of the wealthy and neglectingthe interests of tens of millions of desperate Americans.

So the young Americans who take on this first task ofemploying all of our people can expect to face a broad and bipartisan front ofresistance from politicians in the employ of private corporations and financialinterests.  There are, to be sure, goodpeople in government as well.  But theyare in the minority, and will need the kind of support that only a massmovement can provide.

Task Two: Public Investment in Our Future

The second task is actually an extension of the first task,and further develops the insight from Adam Smith quoted from the previoussection.  The private sector does a goodjob with the day-to-day management of, and innovation in, productive processesthat make new goods and useful technologies and services available tomarkets.    Entrepreneurs who want to develop these newproducts, or make old products in a better and more efficient way,  can very often work out the means of creatinga viable and sustainable business operation around their production, and can thusattract the private sector financing they need to build those businesses andmarket the products.    We all benefit from much of thisentrepreneurial creativity and industriousness.    But we need to recognize that many of the largerscale investments a society needs to carry out in order to sustain progress andbuild prosperity do not just happen by themselves through the hubbub of entrepreneurialinnovation.  They often possess a scale, scopeand degree of organizational thoughtfulness and planning that cannot or shouldnot be carried out by private sector business enterprise.

Even if some of these major national-scale infrastructureprojects can be carried out byprivate sector corporations commanding massive supplies of private capital, itmight not always be a wise social decision to allow those corporations toassume those responsibilities.   Note that what Smith said is that some highlyadvantageous social ends cannot be carried out in a way that brings profit tosome small number ofindividuals.    But of course, if we allow largeoligopolistic private corporations to acquire ownership and control ofeverything that is important to us, then those corporations might be able toprofit by investing in the satisfaction of large social needs.    Yet any enterprise with the power andcapital and political muscle to build, say, an entire national infrastructurefor electric car use, or a national electrical grid or a system of mass educationmaintaining national standards, will possess too much power to place in corporatehands.    Allowing such vast quantities of economicpower to flow into oligopolistic or monopolistic corporations is likely tobestow on those corporations the power to dominate politically the democraticcommunities they have been chartered to serve.

Note that there is an inherent tension between the corporateform of organization and the organization of a democratic society.   Corporate decision-making structures are indeedthe very antithesis of democracy:  They arehierarchical, secretive, and profoundly undemocratic command systems.   It isarguable that we need to permit such institutions to exist on smallerscales.   Or perhaps we don’t.    Butin any case, if hierarchical corporations as we know them must exist, limitingthe degree and scope of corporate power is in itself an essential publicpurpose for a democracy.

Vigilant preservation of those limits requires thatdemocratic communities at the national, state and local level deliberate in anopen and rational way on the future shape of their communities and on their desiredway of life.  They should atempt toachieve a broad consensus on those desired forms of life, and then retainsufficient control over real decision-making power so that they can carry outthe plans that will determine the long-term shape of their community’s future.   Democraticcommunities must also seek to retain ownership of substantial amounts of publicland and infrastructure within their communities.  In the end, the world is governed by thosewho own it.   Building a decent and justfuture requires substantial public command of resources and a commitment todemocratically organized public investment of those resources.

But it is not enough to invest in physical infrastructurealone.  We also need to invest in ourpeople.   We are still making do with an antiquatededucation system in which we devote a great many resources to educating ouryouth, but then leave our citizens on their own for the rest of their lives to providefor any desirable remaining education.  We should consider the possibility that such a system is no longerviable in an era in which technological and intellectual changes are constantand rapid, and in which fewer people are employed in types of work that do notrequire the continual improvement of knowledge and knowledge-based skills.   Weshould consider moving to a system in which people are given periodic paidfurloughs from work, say every five years, to return to school for six monthsfor additional publicly-delivered education. There is no reason at all that a public education needs to bepigeonholed as a purely K-12 system.   21stcentury people require educational services spread across the lifespan.

We need to reaffirm community responsibility for most formsof education.    Although some forms ofeducation might be of benefit only to the individual who receives theeducation, most forms of education benefit all of us directly or indirectly.    A prosperous and enlightened democratic communitywill develop the talents and unexpressed capacities of its citizens, and distributethese human development costs widely.    And the more equal our society becomes, themore those human development costs pay off for all of us.   In a society organized to preserve broadsocial and economic equality, the benefits of higher education aren’t allpoured into generating extravagant incomes for the privileged class of highearners who happen to have received that education, and who profit from itindividually, but are directed back into the community as the educatedcontribute the value of their enhanced skills and knowledge to generallybeneficial production and activity.

These enhanced education programs can be integrated with thefull employment commitments discussed in the first task.   For all of our people – at certain stages oftheir lives, at least – we should regard teaching or learning, or both, as thatperson’s job.   There are many usefulthings we can pay the unemployed to do, but among those things are the jobs ofteaching others the things that these unemployed people already know, and of learningsomething from someone else so that new knowledge can be brought back into theworld of productive activity to create value that couldn’t have been createdbefore.    Those people for whom theprivate sector is not providing employment represent a large treasure trove ofunutilized skill and knowledge.   We needto create the institutional frameworks in which those skills can passed ontoothers, while new skills are acquired at the same time, and in which thesecitizen educators and learners are then able to draw an income to support theirparticipation in this vital area of public investment.

In thinking about the needs for public investment in ourphysical infrastructure and our people, we should never allow ourselves to be overwhelmedand dazzled by the complex instrumentalities of money and monetary tools.  The only thing that ever stands between ourdesires for the world we want and the realization of that world is theexistence of real resources.   If theresources exist, we can always create whatever additional monetary tools andfinancial instruments are needed to command those resources and organize theirallocation.   We can adjust our monetarypolicies to give democratic communities the monetary powers they need to betterdirect their communities’ resources into the channels in which they desire themto flow.   And besides additionalmonetary policy tools, there remain the traditional tools of taxation.   Private sector systems for distributingincome are sometimes wasteful and crude in the aggregate, and do not adequatelyreflect social needs and values that are not manifested in the marketplace bypurely self-seeking customers.   Toadvance such values, the public sometimes needs to take surplus savings thatexist in wasteful and unnecessary abundance on the monetary scorecards of themost fortunate individuals, and direct those savings toward publicpurposes.   Critics sometimes claimredistributive taxation of this kind is a mere zero-sum shift of productive economicactivity in one sector of the economy to productive activity in anothersector.  But that is not true.  In some cases it is a positive net shift ofidle low-productivity savings into highly productive activity.

Task Three:  PublicStewardship of the Financial Sector

The third task is to reassert public authority over thefinancial sector of our economy.   The late economist Hyman Minksy persuasively arguedthat financial instability is not just an anomalous blip of temporary dysfunctionin generally stable and self-regulating financial markets.   Rather, Minsky said, a tendency toward financialinstability is inherent in the normal functioning of a capitalist economy.   Periods of financial stability, in fact, lieat the roots of instability.   Robustsystems of finance naturally evolve into systems characterized by higher andhigher degrees of risky, speculative lending, and ultimately higher degrees ofwhat Minsky called “Ponzi lending”.  Stability is itself destabilizing. Preventing instability therefore calls for regulation, since a systemthat is inherently prone to instability does not regulate itself.

Few people these days are in need of further convincing thatfinancial professionals are not always the sober and steady managers of moneyand investment funds that their defenders sometimes like to present themselvesas being, or that they effectively regulate themselves through the disciplineof market forces.   The US financialsector blew up a bubble of overleveraged and toxic debt based on liar loans andrunaway home prices leading up to the crash of 2007 and 2008, a bubble inflatedby a combination irrational exuberance, irresponsible management and outrightfraud.    The banks and shadow banks crashedour economy into the ground.

Human beings come in many varieties.   But there will probably always be among usthose who seek to steal, defraud, scam, swindle, manipulate, chisel, plunderand exploit.  The quantitative mazes andfine print of financial transactions and contracts provide fertile ground forsuch activity.  The financial world isfull of very clever people who devise increasingly clever ways of insertingtaps into our society’s massive flows of money and siphoning off some of theflow for themselves.   It is essentiallymoney for nothing, but it can generate huge short-term rewards for some of thelucky investors, and huge compensation packages and bonus for the cleverengineers of the leaky ductwork of money streams.   Sometimes the complex movements of money andvalue are so mathematically complicated that even relatively sophisticatedpeople who have had millions and billions stolen from them can’t even say forsure if they have been robbed, or if they just made bad decisions in purchasinglegitimate services.  To imagine thatthese dens of greedy money pillagers can be self-regulating if left to theirown devices, and that market competition generates all the information that isnecessary to enable investors and savers to make prudent decisions with thefunds for which they are responsible, is naïve in the extreme.   And ina modern economy, we are all entangled in the maze of money.  Even the most frugal, modest and cautiouspeople are dependent on the behavior of the guild of financial engineers.    So in the end, not only do the schemers andscammers exploit individuals.  Theirdestabilizing pyramids of monetary liabilities collapse and destroy wholeeconomies.

The University of Missouri, Kansas City economist andregulator William K. Black has commented on the “three dees”  – deregulation, desupervision, and de factodecriminalization – that helped bring our financial system to the ground:

Deregulation occurswhen one reduces, removes, or blocks rules or laws or authorizes entities toengage in new, unregulated activities. Desupervision occurs when the rulesremain in place but they are not enforced or are enforced more ineffectively.De facto decriminalization means that enforcement of the criminal laws becomesuncommon in the relevant industries. These three regulatory concepts are ofteninterrelated. The three “des” can produce intensely criminogenic environmentsthat produce epidemics of accounting control fraud. In finance, the centraltask of financial regulators is to serve as the regulatory “cops on the beat.”When firms gain a competitive advantage by committing fraud, “private marketdiscipline” becomes perverse and creates a “Gresham’s” dynamic that can causeunethical firms and officials to drive their honest competitors out of themarketplace. The combination of the three “des” was so criminogenic that itgenerated an unprecedented level of accounting control fraud, which in turnproduced unprecedented levels of “echo” fraud epidemics. The combination drovethe crisis in the U.S. and several other nations.
I will leave it to people like Black and other experiencedfinancial sector sleuths and regulators to recommend the specific regulatorypolicies that are needed to bend the financial sector back toward the publicpurposes it is supposed to serve, and to make sure large and risky financialventures are not allowed to escape the regulatory watchdogs – perhaps by movinginto the “shadow banking” sector.   But Ido want to suggest one specific item.  We should take a close look at creating public options for banking:not-for-profit, public savings and lending institutions that provide low-cost,low-risk alternatives to private sector banks, and that can be used whenappropriate to administer and subsidize programs of local public investmentthrough the targeted issuance of low interest loans – and perhaps sometimeseven negative interest loans.

Task Four: Reorganize Monetary Policy

The topic of banking naturally leads us into the fourthtask: the reorganization of monetary policy. Under our present system, a quasi-independent and weakly accountable centralbank is supposed to be responsible for all aspects of monetary policy, whileCongress and the Executive Branch handle the fiscal policy operations of taxingand spending.  The system has been withus so long that it is difficult for many people to conceive of alternatives.   Butsuch alternatives can and should be considered.

The division between fiscal and monetary policy is actuallysomewhat artificial.  It is an analyticaldistinction useful for understanding different dimensions of macroeconomicpolicy.  But in practical terms it isdifficult to separate fiscal operations from monetary operations, and the factthat they are institutionally separated in our current governmental frameworkkeeps economic policy makers from acting in as coherent and efficient a manneras they could.   The institutionalseparation between monetary and fiscal policy also creates needless confusionin the mind of the public, and manufactures pseudo-problems from the needlesslycomplicated manner in which Treasury spending is partially funded by Fed purchasesof Treasury bonds through private intermediaries.   This puts relatively meaningless debt ongovernment books, leading to public fears of budget crises, bond vigilantes andinsolvency.   The austerity mongers, doomsayers and enemiesof progressive government then call out this debt in their endless attempts to manipulatepublic fears and crush public sector activism.    These prophets of public penury arecontributors to the plutocratic effort to subordinate democratic governments tocorporate rule.

We have already discussed how this situation can bechanged.  Fiscal policy need not rely tosuch a high degree on the issuance of debt to the private sector.  Instead, we should enact monetary reformsthat provide for the direct crediting of Treasury Department accounts by anamount to be determined each year, as economic conditions warrant anddemand.   We can expand deficits throughpurely monetary means when necessary.   Noadded debt; no additional taxes – just money directly created by the sovereignmonetary power of the United States government and the American people.   But this is not a reform the Fed can enacton its own.  Only Congress can legislatethese changes.  Activists need to takethe case for monetary reform directly to Congress.

There are certain public purposes that are always bestserved by the public sector, no matter what else is happening in the economy.   Butthere are other public needs which arise cyclically, and some which are entirelyunpredictable.  In a deep recession ordepression, government needs to expand its spending dramatically.  The most efficient and least confusing way todo this is through direct monetary operations: clean, unconfusing moneycreation without the complex dance of bond sales mediated by private sectordealers and auctions.

Elitists and ant-democratic central bank enthusiasts haveusually argued that these kinds of reforms would put too much monetary policypower directly in the hands of a democratic rabble, and that reckless populistpoliticians wielding this kind of power would inevitably destroy our economyand spawn hyperinflationary chaos by succumbing over and over to theirresistible allure of free money.  Bunk.  These pessimistic warningsare only a stale replay of similar charges that have been levied againstdemocratic government in generation after generation.    Elitists and aristocrats in every era have always said that democracies can’thandle anything important: they can’t handle civilian control of the military;they can’t handle religious and political liberty; they can’t handle theselection of leaders; they can’t handle the legislation of laws; they can’thandle the writing of a budget and the management of public finances.   They have always been wrong.   Democraticcountries around the world perform these tasks routinely, and the consequenceof the rise of democratic government over the past century, and the defeat ofaristocratic and authoritarian alternatives, has been a spectacular surge inglobal prosperity.

So now the question is the reform of monetary policy, and theelitists are wrong again.   Decisionsabout the orderly creation, destruction and employment of the public’s money areno less amenable to routine democratic debate and thoughtful legislative decisionsthan are any other economic decisions carried out by a legislature.   Despite the political ups and downs,democracies generally do a perfectly creditable job managing the publicfinances and the public treasury.  Monetarypolicy is a matter of public policy and should be debated and carried out viathe political process just like any other public policy in a democracy.   We will surely make bad decisions from timeto time, just as we do in other areas.   But over the long run, democracy will do a much better job with monetarypolicy than do secretive central bankers, who answer mainly to the plutocraticelite, and who during a crisis quickly sacrifice the public interest to thoseelite interests.

Task Five: Promote Equality
The fifth task is to take significant and deliberate stepsto promote equality of economic condition.  Economic inequality rots the foundation of a democratic society.  

For too long we have been told, or tried to tell ourselves,that democracy can coexist with profound inequalities in wealth and income, andthat we can erect a wall of institutional structure that will protectdemocratic institutions from the encroachments of plutocrats.   We have been told, or tried to tellourselves, that even in a world in which a single wealthy person can buy morethan can be purchased by a million of his poorer fellow citizens, that unpleasantfact does not keep us from adhering to a rigorous principle of one person, onevote.  We have been told, or tried totell ourselves, that even a society with gross inequalities in wealth cansustain a system of genuine equality of opportunity.

These are absurd and preposterously naïve views.  And it is a real mystery how any significantnumber of mature and worldly people could ever have been induced to believethem.

The things in the world that we call “wealth” consist of allof those things that are produced either by nature or by human effort, that canbe transferred from some persons to other persons, and that people desire topossess either individually or collectively.  Wealth consists in the objects of human desire, and the value of theseobjects is measured in the end by the degree to which people desire them.    Those who control wealth thus control theobjects of desire; and those who control the objects of desire control people, sincepeople are beings filled with desire.  Inother words, wealth equals power.

No system has ever been devised, or could be devised, inwhich a few participants in society are permitted to control most of theultimate sources of human power, in far greater amounts than other people, butin which that privileged few does not succeed in exercising the power theypossess to seek their preferred ends in the political sphere.   Those who are permitted to own the lion’sshare of wealth will always own the lion’s share of decision-making power.  Since democracy consists in the equaldistribution of decision-making power throughout the whole body of aself-governing people, no real democracy is possible in the presence of grossinequality of wealth.   Inegalitariandemocracy is a delusional doctrine; as unrealistic as the dream of a harmonioussymphony orchestra consisting of 99 dog whistles and one tuba.

Similarly, no system can be devised in which people possessanything approaching a real equality of opportunity unless that system at leaststrives to create something approaching a real equality of condition.   Opportunity in life depends on the resourceswith which one begins life.  Butinequalities of wealth and condition are passed on from one generation to thenext, in one way or another, both among individuals and withincommunities.   Unless we take steps tolimit the grossly unequal accumulation of resources throughout a lifetime, wecannot prevent gross inequalities in the resources with which people in thenext generation begin their lives.

There are many things we can do to promote a more equalsociety:  We can restore income balancethrough redistributive taxation and much higher marginal tax rates; we canprevent those inequalities from arising in the first place by enacting maximumwage laws or wage ratio laws; we can restore the bargaining power of workersthrough a national full employment program and a revitalization of organizedlabor; we can reform corporate governance so that companies are chartered to existprimarily to provide incomes for the people who work and produce in them everyday, not for the absent and invisible owners who do nothing but buy and sellpieces of those corporations; and we could reform inheritance laws to preventinequalities arising in one generation from being propagated and multiplied inthe next.

Task Six: Public Stewardship of the Environment and OurCommon Wealth

The final task is to affirm and secure public stewardship overthings of inestimable value that profit-seeking commercial enterprises arealways threatening to ravage, exploit and destroy.

We have discussed a great many things that pertain to thegoods we produce and exchange, the things of value that we make out of whatalready exists, and whose production and distribution is organized through themedium of money.  But it is important toremember that the most supremely valuable things in life were made either by noliving human being or by no humanbeing at all, living or dead.   The sublimities of the natural world; thebeloved natural human habitants in which we make our homes and feel ourselves athome; the marvelous and diverse fellow creatures with whom we share our world;the ancient and powerful seas, mountains, forests and winds; and theinnumerable products of human art, industry and intellect that have been passeddown to us from earlier generations of earnest and optimistic human beings, andthat are now the common inheritance of every one of us – these things comprisethe all-too-frequently ignored foundation of value in a meaningful humanexistence.  They usually cost us littleor nothing to acquire; but the cost of destroying them is immeasurable.

The pursuit of the good requires not just the creativeproduction of new forms of value from the resources we possess; but thepreservation of those sources of great value that already exist.   These springs of value speak to us andcomfort us in voices that transcend the capacities of our very finite andpredominantly instrumental everyday intelligence, and they are the ground thatbrings forth and nurtures all of the myriad objects of everyday use.  These fundamental goods are as irreplaceableas they are beloved.   Human commerce hascontributed greatly to the improvement of our life on Earth.  But the commercial life and its exigenciescan also reduce us to a mean, blinkered and mercenary relationship with thethings and beings that surround us. Commerce thoroughly unleashed, commerce that is not directed by wise anddeliberate stewardship and foresight, can result in the thoughtless destructionof what is great in the manic production of what is merely transientlyuseful.   The primordial goods belong toall of us, the great democratic community of humanity.   Part of the task of democratic reform, then,must be to preserve for ourselves and our fellow citizens what is sublime andgreat.  We must ensure the equal andsustained access for all human beingsto the common inheritance of allhuman beings.

Thisis the sixth and final part of the essay. Previous installments are available here: OneTwoThreeFour Five

Fannie and Freddie Fantasies

By William K. Black

(Cross-posted from Benzinga)

An important but fundamentally flawed debate about Fannie and Freddie’s role in the ongoing crisis has raged since the SEC sued the former senior managers of both entities for securities fraud.  The Wall Street Journal and Peter Wallison (in the WSJ) have claimed that the suit vindicates their positions and discredits the Federal Crisis Inquiry Commission (FCIC).  Joe Nocera, in his New York Times column, has thundered at the SEC and then Wallison,accusing him of “The Big Lie.”  Nocera’s column is also interesting because it (implicitly) argues that the thesis of Reckless Endangerment is incorrect.  His colleague Gretchen Morgenson and Joshua Rosner co-authored that book.  I write to provide yet another view, distinct from each of the sources.

There are two primary issues about Fannie and Freddie and the crisis discussed in the debate. First, why did Fannie and Freddie, relatively suddenly, change their business practices radically and begin purchasing large amounts of nonprime mortgages?  Second, what role did declining mortgage credit quality that did not descend to the level of loans that the industry described as “subprime” play in the Fannie and Freddie crisis?  The first issue is vastly more important and this article focuses on it. (The short answer to the second question is:  “The first issue, for everyone except theSEC, comes down to this question: did Fannie and Freddie’s controlling officers(eventually) cause them to buy large amounts of nonprime loans for the same reason their counterparts running Lehman, Bear Stearns and Merrill Lynch did(the higher nominal short-term yield maximized their current compensation) or because “the government” made them buy the loans?)  (Lehman, Bear Stearns, and Merrill Lynch were not subject to any governmental requirements to purchase any category of nonprime loans.)

I show that Fannie and Freddie’s controlling officers (eventually) caused them to buy huge amounts of nonprime loans for the higher short-term nominal yield (though they knew that the actual yield would be negative as soon as the housing bubble stalled).  I exploit a “natural experiment” provided by liar’s loans – loans made without prudent underwriting of the borrower’s capacity to repay the loan.  No governmental entity ever required any lender, or any purchaser of loans (and that includes Fannie and Freddie), to make liar’s loans. The mortgage industry’s anti-fraud experts, the FBI, and the banking regulators all warned about liar’s loans producing an epidemic of fraud.  If Fannie and Freddie purchased large amounts of liar’s loans, then their controlling managers did so because liar’s loans’higher short-term nominal yield maximized their near-term compensation – not because “the government” made them do so.

OFHEO, which was Fannie and Freddie’s regulator during the relevant period, had ample regulatory authority to prevent Fannie and Freddie from purchasing liar’s loans and its head, James B. Lockhart, was a George Bush appointee and one of his oldest friends (from prep school).  Lockhart had President Bush’s full support and he was in no way intimidated by Barney Frank or Chris Dodd.  Lockhart shared Bush’s anti-regulatory mindset, his inability to envision elite business leaders as felons, and his strong support for even the most perverse executive compensation systems.  Lockhart was not “captured” by Fannie and Freddie.  He was not a supporter of either entity.  He and his senior regulators that I met simply did not believe it was legitimate for the government to regulate compensation or, absent proof that the business practice had already produced large losses, Fannie and Freddie’s business strategy.

The, SEC complaint, takes the unique, naïve, and untenable position that Fannie and Freddie bought very large amounts of nonprime loans in order to increase market share.  This position is exceptionally important because it reveals the SEC’s unwillingness to take on even the most perverse executive compensation systems that are driving our recurrent, intensifying financial crises.  Suffice it to say that the documentary record at Fannie and Freddie is replete with evidence that the controlling officers drove the decision to adopt a new business plan of purchasing vast amounts of nonprime loans and that the reason for the plan was to increase short-term nominal yields. Their risk people repeatedly warned them that the new plan could be disastrous.  High short-term yield produced extraordinary near-term compensation for Fannie and Freddie’s controlling officers,so it is no surprise that the CEOs’ decided in favor of the path that made them wealthy – and produced disaster for Fannie, Freddie, and the government.

Perverse Executive Compensation Systems are Criminogenic

Each of the discussions (and that includes the SEC complaints) is faulty because it proceeds as if Fannie and Freddie suddenly began engaging in accounting and securities fraud late in the crisis.  That is objectively false.  The SEC (and eventually Fannie and Freddie’s regulator – then OFHEO, now called FHFA) documented that Fannie and Freddie had long engaged in accounting and securities fraud – no later than the beginning of the decade that would eventually produce the crisis.  The SEC detected Freddie’s and then Fannie’sfrauds in 1983.  Indeed, the SEC explicitly charged that Fannie’s senior managers caused it to commit accounting fraud for the purpose of maximizing their executive compensation.  I was an expert witness for OFHEO against Raines, et al. in the agency’s enforcement action arising from this earlier fraud.  The SEC and OFHEO’s actions led to Freddie appointing a new CEO in December 2003 (Richard Syron, the most senior defendant in the new SEC suit arising from Freddie’s operations) and Fannie appointing a new CEO in December 2004 (Mr. Mudd, Fannie’s COO during its endemic accounting fraud from 2000-20003). Mudd is the most senior defendant in the SEC suit arising from Fannie’s operations.

One of the delightful acts of unintentional self-parody arising from the crisis is that when the Business Roundtable (the 100 largest U.S. corporations), eventually decided that they needed a spokesperson to respond to the Enron-era epidemic of “accounting control fraud,” they selected Frank Raines (Fannie’s CEO).  BusinessWeek dutifully asked Raines why the fraud epidemic occurred.  Raines responded:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.”

Raines knew of what he spoke, for his predecessors and he had devised such a bonus system (tied largely to, non-GAAP, earnings per share (EPS) targets purportedly designed to be “stretch” goals).  Fannie’s compensation system produced exactly the perverse results that Raines predicted and explained to Business Week.

“By now every one of you must have 6.46 [EPS] branded in your brains.  You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46,you must be obsessed on 6.46….  Afterall, thanks to Frank, we all have a lot of money riding on it….  We must do this with a fiery determination,not on some days, not on most days but day in and day out, give it your best,not 50%, not 75%, not 100%, but 150%.”

“Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises,ESPP, but substantially over and above if we make 6.46.  So it is our moral obligation to givewell above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.”  (Mr.Rajappa, head of Fannie’s internal audit, emphasis in original.)

I call internal audit the anti-canary.  Miners took canaries into coal mines because the birds are more susceptible than humans to carbon dioxide and monoxide.  If the canary loses consciousness the humans can survive by exiting the mine. Internal audit is supposed to the least susceptible unit in a firm.  The mantra of internal audit is“independence” from the senior managers. If internal audit is suborned by executive compensation then the rot is pervasive in other units.  In considering the import of Rajappa’s speech to his internal audit troops, consider the fact that it was a written speech and that Rajappa provided the text to Raines – and got favorable suggestions to make it even stronger.  Raines knew and approved of the fact that the rot at Fannie was pervasive.

Ireland Imports U.S. Executive Compensation and Produces a Similar Crisis

A word about “stretch goals.”  Consider this exceptionally naïve passage from a Nordic banker (Nyberg) recently asked to write a report on the failed Irish banks.  He is discussing earning targets that maximized executive compensation.

“Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector.” (Nyberg 2011: 30)

The bonus targets, of course, were not “intended to be demanding through the pursuit of sound policies.”  The senior managers chose stretch goals,impossible to reach through prudent lending, because such goals were “easily achieved” by ignoring asset quality (which they proceeded to do).  As George Akerlof and Paul Romer aptly observed in their 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”), accounting control fraud is a “sure thing.”   Whether one is in Ireland or the U.S., the fraud recipe for a lender (or loan purchaser) has four ingredients.

  1. Grow like crazy
  2. By making (or buying) exceptionally bad loans at a premium yield, while
  3. Employing extreme leverage, and
  4. Providing grossly inadequate allowances for loan and lease losses (ALLL)

Indeed, Ireland provides a superb natural experiment that helps us determine why banks make or purchase exceptionally bad loans with grossly deficient underwriting and trivial ALLL.  The fraud recipe is so perverse because it is mathematically guaranteed to produce record (albeit fictional) short-term reported income, huge compensation, and catastrophic losses.  If a material number of banks (or a small number of very large banks) follows the same fraud recipe in an asset category it will hyper-inflate a bubble in that asset. Accounting control frauds often lend into teeth of a glut.

Ireland is so useful because it had no equivalent ofa Community Reinvestment Act (CRA) and no material secondary market (noe quivalent of Fannie and Freddie – hence, no requirements to purchase a subset of below median-income home mortgages). Nevertheless, its real estate bubble was roughly twice as large (in relative terms) as the U.S. bubble and it had twin bubbles in commercial and residential real estate.  Its banks exhibited a collapse of loan quality driven by perverse executive compensation.  Irish bank CEOs followed the same fraud recipe as Lehman, Merrill Lynch, Countrywide, WaMu, Fannie,Freddie and their ilk and produced the same catastrophic losses.

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

“Occasionally,management and boards clearly mandated changes to credit criteria. However, in most banks, changes just steadily evolved to enable earnings growth targets to be met by increased lending.” (Nyberg 2011: 34)
“The associated risks appeared relevant to management and boards only to the extent that growth targets were not seriously compromised.” (Nyberg 2011: 49)

That’s right; let nothing get in the way of making it simple to meet the bonus target – even though doing so will destroy the bank.

Fannie and Freddie’s CEOs Led them in Serial Accounting and Securities Fraud

Fannie and Freddie’s accounting frauds in the earlier part of the decade, however, followed a different recipe.  Their managers’ were then “skimmers” instead of “looters.”  We should not be too kind to them.  Their earlier accounting fraud recipe put Fannie and Freddie (and therefore the government) at risk of loss and their phony (“dynamic”) hedging posed a systemic risk.  Fannie and Freddie’s original fraud scheme sought to maximize the senior managers’ income by taking substantial interest rate risk.  This required Fannie and Freddie to grow their portfolios massively.

“[F]rom 1998 to 2003,Freddie Mac’s retained portfolio grew at an annual average rate of about 21 percent. Over the same period of time, Fannie Mae’s mortgage holdings increased by an annual average rate of 17 percent. By 2003, Freddie Mac’s retained portfolio ($661 billion) was about 72 percent as large as Fannie Mae’s ($920billion.)”

The Rise and Fall of Fannie Mae and Freddie Mac: Lessons Learned and Options for Reform.  Richard K. Green and Ann B. Schnare (November 19, 2009: p. 18).

Fannie and Freddie’s controlling officers made the opposite bet on the direction of interest rates.  Fannie lost its bet, so it hid it losses by calling them “hedges.”  This accounting fraud turned Fannie’s real losses into fake profits, maximizing the officers’bonuses.  This bit of accounting and securities fraud caused the SEC to required Fannie to restate its financial statements and recognize millions of dollars in losses.  Naturally, Fannie’s officers did not give back their bonuses.  Freddie won its beton interest rates and, after recognizing enough income to maximize current executive bonuses, it created “cookie jar” loss reserves so that it could draw on them if it failed to meet the targets that maximized future bonuses.  The SEC was not amused and required Freddie to restate its financial statements.

Here is the crazy thing – the SEC, OFHEO, and Department of Justice all failed to demand that Fannie and Freddie end their perverse executive compensation system that made the executives wealthy through fraud and put the entities and the government at risk.  The Bush White House took no action and made no criticism of the compensation system. The Congress (both parties) made no criticism of the compensation systems.  Remember, we had seen these perverse compensation systems blow up the S&L industry and the Enron-era accounting control frauds.

OFHEO even allowed Mr. Mudd, Fannie’s COO during the period of its extensive accounting and securities fraud, to replace Raines’ as CEO in December 2004.  None of this was due to any weakness in OFHEO’s regulatory powers.  The problem was an unwillingness to regulate.  The unwillingness was ideological.  OFHEO’s senior managers did not consider it legitimate to regulate executive compensation or to block Fannie’s choice of its new CEO.  The new SEC suit names Mudd as a defendant.

OFHEO had its maximum leverage over Fannie and Freddie when the SEC discovered their accounting and securities frauds and its own examinations confirmed those frauds in the middle of the critical decade.  OFHEO used its leverage to fight the last war – ensuring that Fannie and Freddie did not take excessive interest rate risk.  It sharply limited the amount that Fannie and Freddie could grow their portfolios and cracked down on hedging abuses.  Unfortunately, the first of these actions, while completely appropriate, helps explain the new accounting and securities fraud that are (or should be in a better complaint and prosecution) the subject of the new SEC action.

Fannie and Freddie’s New Controlling Insiders become Looters

By December 2004, the SEC and OFHEO had forced out Fannie and Freddie’s controlling managers who led the accounting control frauds in the first part of the decade, but they left in place Fannie and Freddie’s exceptionally perverse executive compensation systems that promised that the new senior officers could attain vast wealth if they could cause Fannie and Freddie to report high, short-term profits. Their old scam, interest rate risk plus hedge/cookie jar accounting fraud could no longer be used when Fannie and Freddie’s new controlling officers took power.  There was only one alternative means of creating (fictional) outsized reported profits.  They could not grow their portfolio significantly, but OFHEO failed to require them to divest those portfolios –and those portfolios were massive because of the earlier fraud scheme.

In 2005, Fannie and Freddie’s new controlling officers led them into an orgy of purchasing nonprime loans (liar’s loans, subprime loans, and subprime liar’s loans) – the loans sure to generate the largest short-term nominal yield.  This had the intended effect on the controlling officers’ executive compensation. Fannie and Freddie’s controlling officers increasingly moved prime loans out of portfolio by securitizing and selling them.  Their portfolios increasingly became littered with nonprime loans.  Fannie and Freddie’s controlling officers followed the classic recipe for looters using accounting control fraud.  The difference between Fannie and Freddie and some of its counterparts is that Fannie and Freddie’s risk and (some) underwriting officers mounted considerably greater opposition to the fraud recipe than many other accounting control frauds.  This explains why Fannie and Freddie’s losses (relative to the amount of nonprime loans they purchased) were smaller than many of their counterparts.

It is only by taking into account Fannie and Freddie’s earlier accounting fraud and the SEC and OFHEO’s reactions to those frauds that one can understand why Fannie and Freddie made radical changes in their purchase of nonprime loans in 2005. It is only by taking into account the (moderately) superior professional culture of its risk professionals that one can understand why their losses were not far worse (given the enormous amounts of nonprime loans they purchased from 2005-2007).  Wallison implicitly assumes that if Fannie and Freddie had not purchased these nonprime loans their competitors would not have done so.  That assumption is extraordinary and requires heavy proof.  Wallison provides none.  It was Fannie and Freddie’s competitors who purchased the same nonprime loans so eagerly in 1998-2004 that they eviscerated Fannie and Freddie’s once dominant market share in the secondary market for mortgage loans.  Fannie and Freddie’s combined share of the secondary market fell from well over 90% in 1990 to under one-half by 2004.  Indeed, many of Fannie and Freddie’s losses come from investing in or guaranteeing the financial derivatives issued by its competitors where the underlying asset was nonprime assets, particularly liar’s loans and subprime liar’s loans.

“Private label securities accounted for 56 percent of Fannie Mae’s total mortgage-related security purchases from 2004 through 2006, and 54 percent for Freddie Mac. (See Exhibit 4.) Most of these purchases involved securities backed by subprime or Alt-A mortgages. (See Exhibit 9.) In 2006, the GSEs’ purchases of such securities represented 9.8 percent of the total volume of subprime and Alt-A originations made within the year.” (Green & Shnare 2009: 23)

“Alt-A” is one of the many euphemisms for liar’s loans.  The term is a double lie.  It purports that the loans are prime quality (“A” grade) and it purports that the loans are underwritten through “alternative” means.  In reality, the capacity of the borrower to repay the loan was not underwritten.  Typically, the lenders and their agents fraudulently inflated the borrower’s income. 

Fannieand Freddie were Late to Purchasing Huge Amounts of Nonprime Paper

Fannie (which predated Freddie), created the concept and standard of the “prime” home loan decades ago when it was an independent government agency before it was privatized. When it was a government agency, it was the principal source of desirable market discipline ensuring high mortgage quality.  Nonprime home loans include three primary categories – liar’s loans (loans made without prudent underwriting of the borrower’s capacity to repay the loan), subprime (loans made to borrowers with known, serious credit defects), and subprime liar’s loans (combining both problems).  One of the easy tests of competence is to find whether a writer knows so little that he believes that subprime and liar’s loans are dichotomous. Credit Suisse reports that, by 2006, 49% of the loans called “subprime” were also liar’s loans.

Prior to 2005, nonprime loans were sold overwhelmingly to large investment banks. These banks were not subject to any governmental requirements to purchase such loans.  The investment banks purchased the nonprime loans because doing so maximized their controlling officers’ compensation.  Fannie and Freddie lost enormous market share because of this competition. 

Wallison’s Thesis has been Repeatedly Falsified

The indisputable fact that it was the non-regulated sector (mortgage banks, mortgage brokers, investment banks, and non-bank affiliates that led the epidemic making and purchasing fraudulent nonprime loans has not prevented multiple, major analytical failures about the role that Fannie and Freddie played in the crisis. The historical quibble is that Fannie and Freddie reduced their loan purchase standards well before 2005. That is true, but it does not explain why Fannie and Freddie suffered huge losses on nonprime loans.  Fannie and Freddie’s definition of “prime” created an exceptionally safe standard in which credit losses were minimal.  It was possible to reduce that standard without creating a criminogenic environment and the data review by FCIC demonstrates that the loans that Wallison has lumped together (relying on Pinto’s work) and labeled “subprime” are extremely disparate.

Fannie’s original definition of “prime” was equivalent to an A+.  The loans that themortgage industry called “subprime” were a C-. Liar’s loans were a D-.  Subprime liar’s loans were an F.  There is a large range in credit quality between the original definition of prime and loans the industry called “subprime.”  FCIC showed that the loans that Pinto (but not the industry) classified as “subprime” had dramatically lower default rates than the loans that the industry classified as subprime.  As Charles Calomiris, one of Fannie and Freddie’s most virulent critics has emphasized, the proof as to who is correct in this argument about categorization rests on the performance of the loans.  The loans at Fannie and Freddie that Pinto (but not the industry) termed subprime performed far better than the loans the industry termed subprime.

Nocera’s December 23, 2011 column calls Pinto and Wallison’s work a “big lie” because it categorizes loans that Fannie and Freddie would not have considered “prime” (circa 1982) as “subprime” even when these loans were not considered “subprime” by the industry (circa 2006).

This is unduly harsh.  Pinto and Wallison (and Joshua Rosner and Gretchen Morgenson) are correct that the credit quality of some loans considered prime deteriorated for over a decade.  The real problem is the authors’ lack of consistency.  At root, their point is that differences matter.  Specifically, they argue that making nonprime loans is far riskier than making prime loans.  The same logic, however, requires them to evaluate whether differences matter withinthe vast category that they created and labeled as “subprime.”  They failed to conduct this evaluation.  The FCIC conducted one aspect of the evaluation and found that the differences within the Pinto/Wallison category had enormous consequences for relative performance.  The bulk of Fannie and Freddie’s loans that fall within Pinto/Wallison’s unique and far broader categorization of “subprime” loans perform far better (have much lower default rates) than the narrower, commonly used categorization of subprime.

Second, all the authors advancing this meme failed to evaluate the difference between liar’s loans and non-liar’s loans for the purpose of their real thesis – “the government” caused the crisis by forcing Fannie and Freddie to purchase bad loans. This argument has many factual weaknesses, but one fatal weakness is the fact that there was never any governmental requirement for Fannie and Freddie to purchase liar’s loans.  This provides a natural experiment that allows us to test, and reject, the thesis that Fannie and Freddie purchased bad loans because of governmental mandates.  The CEOs of Fannie and Freddie caused them to buy vast amounts of liar’s loans because the higher nominal yield maximized near-term executive compensation.  The CEOs of Fannie and Freddie acted like the CEOs of Bear Stearns, Lehman, and Merrill Lynch and they did so for the same reasons and with the same fatal consequences.  Akerlof and Romer captured the dynamic in the title of their article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  The firm fails, but the CEO walks away wealthy because accounting control fraud is a “sure thing.”

Remember, the FBI has already warned (in September2004) and the mortgage industry’s own anti-fraud unit (MARI) has warned in early 2006, respectively, that an “epidemic” of mortgage fraud will produce a financial “crisis” if it is not stopped and that liar’s loans are 90% fraudulent.  No honest, financially sophisticated entity would make or purchase liar’s loans (or CDOs backed by liar’s loans) knowing these facts.  Yet, several of the leading investment banks, hundreds of mortgage bankers, WaMu, Countrywide, IndyMac, and Fannie and Freddie rushed to make or purchase endemically fraudulent mortgage paper. This would be irrational for any honest CEO, but it would be optimal for a CEO directing an accounting control fraud.  Fannie and Freddie’s losses on liar’s loans paper are extreme – and note that the authors of the study make the common error of assuming that liar’s loans and subprime loans are dichotomous.  If one examined separately the losses on Fannie and Freddie’s subprime liar’s loans (and CDOs where such loans were the bulk of the underlying) the losses would be catastrophic.

“In 2008, for example,Alt-A mortgages represented just 9.7 percent of Fannie Mae’s book, but accounted for almost 40 percent of the company’s credit losses. The experience at Freddie Mac tells a similar story: the serious delinquency rate on FreddieMac’s Alt-A book (which is 8 percent of the portfolio) is more than three times higher than the total portfolio’s rate.” (Green & Schnare 2009: 24).

Sadly, the SEC fails to exploit this natural experiment involving liar’s loans. Indeed, the SEC complaint appears to have been drafted by someone so poorly informed that he believes that liar’s loans and subprime loans are dichotomous categories.  Nocera is also critical of the SEC complaint, but his criticism arises from his erroneous belief that the complaint rests on Pinto and Wallison’s unique categorization of “subprime” loans.  Nocera is guilty of what he accuses Pinto and Wallison of doing, writing “I still maintain that the S.E.C.’s charges are weak, and that the agency brought the case in part for political reasons: how better to curry favor with House Republicans than to go after former Fannie and Freddie executives?” This is a strong charge requiring at least some proof, but Nocera provides no support.

Nocera (and Wallison) miss entirely the key aspect of the SEC complaint that refutes Wallison’s thesis that Fannie and Freddie bought bad loans because “the government” made them buy bad loans.  Wallison’s facially implausible claim is that Fannie and Freddie were weak political actors forced by crazed Democrats to purchase suicidal loans in order to subsidize poorer minorities that support Democrats.  Fannie and Freddie were exceptionally powerful political entities with strong support from both parties, e.g., Newt Gingrich, but ignore this aspect of unreality solely for the purpose of testing the internal logic of Wallison’s hypothesis.  Wallison’s claim is that Fannie and Freddie were so weak politically that they were forced to take on suicidal loans in order to curry political favor with the Democrats.  If that were true, then Fannie and Freddie should have consistently been leading the purchase of subprime loans from 1993 on (which was when HOEPA became law).  In reality, Fannie and Freddie lost tremendous market share because they (generally) refused to purchase loans the industry categorized as subprime until roughly 2005.  Their rivals, the investment banks (who were not subject to any affordable housing mandates), rushed to purchase massive amounts of these subprime loans.  That is the conventional (compelling) reason to reject Wallison’s thesis.  I have added another reason – Fannie and Freddie would never have purchased liar’s loans under Wallison’s thesis because “the government” never compelled them to purchase liar’s loans and doing so would be suicidal.

The SEC complaint adds an additional reason why Wallison’s thesis fails.  Under Wallison’s thesis Fannie and Freddie should have been exaggerating the amount of subprime loans they were making in order to curry favor with the despicable Democrats.  But the SEC complaint (and Wallison and Pinto’s own work) prove that Fannie and Freddie did the opposite.  Fannie and Freddie’s controlling managers consistently cooked their financial statements and financial disclosures to make it appear that Fannie and Freddie purchased vastly fewer subprime loans than they actually purchased.  (They did the samething with their liar’s loans – for the same reasons.)  Nocera (incorrectly) assumes that the SEC complaint relies on Pinto/Wallison’s unique, ultra-broad categorization of “subprime” loans, but Fannie and Freddie’s documents show that they understated both the number of liar’s loans and subprime loans they purchased (as categorized by conventional industry norms). This makes perfect sense for managers running an accounting control fraud, but it makes no sense under Wallison’s thesis.

We need to be blunt about the source of Wallison’s thesis.  Wallison is one of the leading architects of the global financial crisis in his capacity as AEI’s long-time co-director of their financial deregulation program.  He pushed the criminogenic three “de’s”:  deregulation, desupervision, and de facto decriminalization.  He criticized Fannie and Freddie for notmaking greater amounts of nonprime loans. He is desperately seeking to escape accountability for his major role in creating a global crisis.  He is an ideologue who would have been fired by AEI had he supported financial re-regulation.  His thesis that the crisis was really caused by the government forcing the politically powerless Fannie and Freddie to make suicidal loans is a desperate effort to save himself and his ideology.

Wallison’s thesis cannot survive the laughtest.  It requires that, for over a decade in which the Republicans had control over the Congress and/or the White House Fannie and Freddie’s CEOs knew they were purchasing loans that would eventually prove catastrophic for Fannie and Freddie, the lenders (loan sales to Fannie and Freddie are made with recourse back to the seller), and for the (poorer minorities) purchasing the homes. No one at Fannie and Freddie leaks this to the Republican Congress or the Bush White House even though such leaks would have (under Wallison’s thesis) provided the mother of all Democrat-bashing congressional hearings.  No one at OFHEO, including Bush’s old friend, and strong Republican, James Lockhart (the guy running OFHEO), informs Bush that Fannie and Freddie are headed for catastrophe because the Democrats have forced them to purchase suicidal loans to poorer minorities (i.e., the base of the Democratic Party).

The thesis also requires that, knowing of the coming catastrophe, Fannie and Freddie’s controlling officers, for over 15 years, decided to provide only trivial accounting allowances for the inevitable catastrophic losses – even though GAAP would mandate that they provide massive allowances in such circumstances and even though the controlling officers’ failure to do so could be prosecuted as securities fraud.  The failure to provide massive allowances makes no sense under the Wallison thesis, but it is the standard “fourth ingredient” for an accounting control fraud. Had Fannie and Freddie’s controlling officers appropriate allowances for losses their financial reports would have shown the truth – that the actual long-term yield on liar’s loans was negative.  Fannie and Freddie would have reported substantial losses from 2005 on had they established the allowances required by GAAP, which would have eliminated their bonuses.

Wallison is the Problem and Placing him on FCIC was Scandalous

The Wall Street Journal editorial on the SEC complaints against Fannie and Freddie claims that FCIC should be embarrassed that it ignored the key role that Fannie and Freddie played in the crisis.  Wallison has a new piece in The Atlantic in which he claims “the government” caused the crisis.

If one had to pick one person in the private sector most responsible for causing the global financial crisis it would be Wallison.  As I explained, he is the person, who with the aid of industry funding, who has pushed the longest and the hardest for the three “de’s.”  It was the three “de’s” combined with modern executive and professional compensation that created the intensely criminogenic environments that have caused our recurrent, intensifying crises.  He complained during the build-up to the crisis that Fannie and Freddie weren’t purchasing more affordable housing loans.  He now claims that it was Fannie and Freddie’s purchase of affordable housing loans that caused the crisis.  He ignores the massive accounting control fraud epidemics and resulting crises that his policies generate.  Upon reading that Fannie and Freddie’s controlling officers purchased the loans as part of a fraud, he asserts that the suit (which refutes his claims) proves his claims.

Placing Wallison on FCIC was like placing the Don’s consigliere on a panel that is supposed to investigate the mafia.  What was Wallison going to say as a FCIC member? “Mea Culpa, I’ve been wrong for a quarter-century about everything important and I have come to admit that deregulation, desupervision, and de factodecriminalization are disastrous.” There was a reason no other Republican appointee to FCIC was willing to sign on to Wallison’s dissent.  His dissent is a screed that is devoted to protecting his theoclassical economic ideology.  FCIC did not ignore Pinto’s work, it refuted its analytics. Wallison’s real complaint is that FCIC took Pinto’s work seriously enough to do the analytical work that Pinto and Wallison should have done to determine whether Pinto’s unique categorization of “subprime” produced a category of loans with similar (terrible) performance results.  What Wallison cannot forgive the FCIC staff and other commissioners for is that they did treat his claims seriously despite his obvious self-interest and the logical inconsistency of his claims.  It was taking his claims seriously and evaluating his data that he failed to evaluate that put the final nail in the coffin of his claims.  Wallison and Pinto have had a year to point out any data errors in FCIC’s demonstration that the loans Pinto categorized as “subprime” had greatly superior loan performance compared to loans the industry categorized as “subprime.”

There is no point criticizing the Wall Street Journal’s editorial staff.  They know that FCIC concluded that Fannie and Freddie played a major role in the crisis.  FCIC was correct that Fannie and Freddie were late to the party in terms of purchasing the loans and CDOs that eventually caused the catastrophic losses.  The question was why Fannie and Freddie suddenly began to buy enormous amounts of largely fraudulent nonprime paper in 2005. They did so, as the repeated investigations have found, for the same reason that Fannie and Freddie engaged in accounting control fraud earlier in the decade – it makes the controlling officers wealthy.  It is a “sure thing.”  What I have added is the relevant time line explaining the role that Fannie and Freddie’s earlier accounting control frauds, and the modest sanctions levied by the SEC and OFHEO, played in explaining why they went so heavily into fraudulent nonprime paper around 2005.

Wallison has been conspicuously silent in demanding that elite CEO frauds that drove this crisis be prosecuted.  I ask him, and I ask reporters who discuss any story with him, whether he will now demand that we end the de facto decriminalization of the fraudulent CEOs who drive our financial crises and become wealthy through their frauds.  Does Wallison believe that Fannie and Freddie’s controlling officers would be a good place to begin prosecuting?

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

Did OFHEO Fix Fannie and Freddie’s Compensation Systems after discovering their Frauds?

By William K. Black

I have been chastised by a friend and former colleague forwriting:

“Here is the crazy thing – theSEC, OFHEO, and Department of Justice all failed to demand that Fannie andFreddie end their perverse executive compensation system that made theexecutives wealthy through fraud and put the entities and the government atrisk.”

My friend notes that Fannie, under pressure from OFHEO andwith its prior approval, changed its compensation system after the initialaccounting fraud.  

My sentence would beclearer if it was revised to read as follows:

“Here is the crazy thing – theSEC, OFHEO, and the Department of Justice all failed to prevent Fannie andFreddie from using perverse executive compensation systems that made theexecutives wealthy through fraud and put the entities and the government atrisk.”

The new compensation systems at Fannie and Freddie remainedexceptionally perverse after the changes. Their CEOs continued to cause them to engage in systematic accountingfraud by not providing remotely adequate loss reserves and allowances for loanlosses despite purchasing massive amounts of fraudulent liar’s loans andfraudulent subprime liar’s loans.  The samescam that made the officers rich was certain to destroy Fannie and Freddie.

I have alsoexamined a number of statements by both of OFHEO’s leaders during the relevantperiod, concerning compensation and the initial Fannie accounting fraud.  James Lockhart issued a hard hitting releaseon May 23, 2006 accompanying OFHEO’s report on its investigation of Fannie entitled:  “FANNIE MAE FAÇADE: Fannie MaeCriticized for Earnings Manipulation.” The release begins with this passage that directly ties the accountingfraud to the controlling officers’ desire to trigger bonuses.  

“The report details an arrogant andunethical corporate culture where Fannie Mae employees manipulated accountingand earnings to trigger bonuses for senior executives from 1998 to 2004. Thereport also prescribes corrective actions to ensure the safety and soundness ofthe company.”

Note that the release emphasizes that the OFHEO report “prescribescorrective actions.”  The purpose of therelease, of course, is to emphasize the most important aspects of the lengthyOFHEO report.  The release makes it clearthat executive compensation drove the fraud.

 “The combination of earnings manipulation,mismanagement and unconstrained growth resulted in an estimated $10.6 billionof losses, well over a billion dollars in expenses to fix the problems, andill-gotten bonuses in the hundreds of millions of dollars.”    

“By deliberately andintentionally manipulating accounting to hit earnings targets, seniormanagement maximized the bonuses and other executive compensation theyreceived, at the expense of shareholders. Earnings management made asignificant contribution to the compensation of Fannie Mae Chairman and CEOFranklin Raines, which totaled over $90 million from 1998 through 2003. Of thattotal, over $52 million was directly tied to achieving earnings per sharetargets.”

When it comes to the steps that Lockhart consideredcritical, however, executive compensation was not specifically mentioned.

The report ends with recommendations fromOFHEO’s staff to [Lockhart], which he has accepted. Some of the keyrecommendations include:

Fannie Mae must meet all of its commitments forremediation and do so with an emphasis on implementation – with dates certain –of plans already presented to OFHEO.

Fannie Mae must review OFHEO’s report todetermine additional steps to take to improve its controls, accounting systems,risk management practices and systems, external relations program, dataquality, and corporate culture. Emphasis must be placed on implementation ofthose plans.

Fannie Mae must strengthen its Board ofDirectors procedures to enhance Board oversight of Fannie Mae’s management.

Fannie Mae must undertake a review ofindividuals currently with the Enterprise that are mentioned in OFHEO’s report.

Due to Fannie Mae’s current operational andinternal control deficiencies and other risks, the Enterprise’s growth shouldbe limited.

OFHEO should continue to support legislation toprovide the powers essential to meeting its mission of assuring safe and soundoperations at the Enterprises.

Similarly, on June 6, 2006, Lockhart testified before theHouse on Fannie’s fraud.  He explainedhow Fannie’s executive compensation system created the perverse incentives thatdrove the massive accounting fraud.  Heended by listing how OFHEO responded to the frauds by ordering changes atFannie.  None of these changes discussedexecutive compensation.  The failure ofthis excerpt to discuss executive compensation is particularly striking.

“Fannie Mae must takeadditional steps to improve its internal controls, accounting systems,operational and other risk management practices and systems, data quality, andjournal entries. Emphasis must be placed on implementation with dates certain.”

Executive compensation, the most critical problem at Fannieand Freddie, the problem that drove their accounting control frauds, receivedminimal attention from OFHEO’s head. Fannie and Freddie’s CEOs proceeded to become wealthy through bonuses“earned” through business strategies that were sure to destroy Fannie andFreddie.  OFHEO took no effective actionto remove these perverse incentives.

Armando Falcon, Lockhart’s predecessor as head of OFHEO,achieved the remarkable – his revulsion for Fannie’s controlling officersexceeded Lockhart’s.  “While all of thispolitical power satisfied the egos of Fannie and Freddie executives, itultimately served one primary purpose: the speedy accumulation of personalwealth by any means.”  Testimony ofArmando Falcon, submitted to the Financial Crisis Inquiry Commission (April 9,2010).  His testimony details howFannie’s controlling officers used accounting fraud to attain massive bonuses.

TheTerrible Cost of Failing to Understand Accounting Control Fraud

The sad irony is that immediately after Falcon explained theperverse incentives arising from Fannie’s compensation system he went on to beonly half right in his analysis of Fannie and Freddie’s eventual failure.  The half he got wrong stemmed from hisfailure to understand the interplay of accounting control fraud and perverseexecutive compensation. 

“Your letter also asked me about the impact of the affordablehousing goals on the enterprises’ financial problems. In my opinion, the goalswere not the cause of the enterprises demise. The firms would not engage in anyactivity, goal fulfilling or otherwise, unless there was a profit to be made.Fannie and Freddie invested in subprime and Alt A mortgages in order toincrease profits and regain market share. Any impact on meeting affordablehousing goals was a byproduct of the activity.”

In addition, OFHEOmade it very clear to both enterprises that safety and soundness was always ahigher priority than the affordable housing goals. They should not take onexcessive risk in order to meet any one of the goals.”

Falcon almost gets this right, but his failureto understand the most destructive financial fraud mechanism leads him to misswhat happened at Fannie and Freddie even with the benefit of hindsight.  His analytical failures exemplify OFHEO’scentral analytical failure.  He iscorrect that only the exceptionally naïve could believe that Fannie andFreddie’s controlling officers based their business decisions on meeting theaffordable housing goals.  He isgrotesquely incorrect in assuming that their controlling officers only engagedin an activity if “there was a profit to be made.”  His error is bizarre given the fact that hehad explained that Fannie’s controlling officers engaged in activity thatcaused large losses and then used accounting fraud to transmute real lossesinto fictional gains in order to maximize their bonuses. 

Falcon is correct that Fannie’s controllingofficers had “one primary purpose” at all times – “thespeedy accumulation of personal wealth by any means.”  What he fails to understand is thataccounting control fraud is a “sure thing” and that the formula for maximizingfictional income (and real bonuses) maximizes real losses.  Fannie and Freddie’s controlling officers“one primary purpose” was making themselves wealthy.  Accounting fraud was their “weapon of choice”to produce great wealth very quickly. Purchasing large amounts of “liar’s” loans guaranteed that Fannie andFreddie would suffer massive losses. Purchasing large amounts of subprime liar’s loans guaranteed that theywould suffer catastrophic losses.  Liar’s(home) loans create such intense “adverse selection” that they have a sharplynegative “expected value.”  In plainEnglish, the purchaser will lose money. It’s equivalent to betting against the House, except that the odds areso bad that the expected value is more negative than playing the lottery.  Liar’s loans can only fail to produce obvioussevere losses temporarily while the bubble is expanding.  Refinancing hides the losses during the rapidexpansion phase of the bubble.  Thesaying in the trade is that “a rolling loan gathers no loss.”  Bubbles, however, are only temporary andliar’s loans will begin blowing as soon as the bubble starts inflating, whichcan be over a year prior to the bubble bursting. 

Fannie and Freddie’s CEOs chased higher nominal yields, notreal “profit” for the firms.  Theirstrategy exemplified the logic of George Akerlof and Paul Romer’s famous 1993article, captured in their title (“Looting: the Economic Underworld ofBankruptcy for Profit”).  The firm fails,but the controlling officers walk away rich because the frauds they leadproduce fictional income and real bonuses. (Akerlof and Romer’s use of the word “profit” is ironic.  It refers to gains to the controllingofficers from fraudulent business strategies that cause fatal losses to thefirm.)  Akerlof and Romer aptly termedthe accounting control fraud strategy a “sure thing.”

Fannie and Freddie’s risk officers alerted their CEOs to thefact that nonprime loans were likely to produce far greater losses, that therapid rise in home prices was temporarily suppressing default rates, and thatthe rapid rise in home prices could not continue indefinitely.  It is inconceivable that Fannie and Freddiedid not know of the FBI’s September 2004 warning that there was an “epidemic”of mortgage fraud and their prediction that the fraud epidemic would cause aneconomic “crisis” if it were not contained. Fannie and Freddie’s purchase of liar’s loans that cause severe lossesoverwhelmingly occurred after the FBI’s warning.  “The government” never required any entity tomake or purchase liar’s loans.  Most ofthe liar’s loans that caused Fannie and Freddie’s severe losses were purchasedafter MARI’s five-part warning to the mortgage industry in April 2006.  “The Mortgage Asset Research Institute’s(MARI) EIGHTH PERIODIC MORTGAGE FRAUD CASE REPORT TOthe MORTGAGE BANKERS ASSOCIATION.”  (Itis inconceivable that Fannie and Freddie’s controlling officers, or OFHEO, wereunaware of these warnings.  Louis Freeh,former head of the FBI, joined Fannie’s board of directors in mid-2007.) 

MARI paired it first two warnings:

“Stated income and reduceddocumentation loans speed up the approval process, but they are open invitationsto fraudsters. It appears that many members of the industry have littlehistorical appreciation for the havoc created by low-doc/no-doc products thatwere the rage in the early 1990s. Those loans produced hundreds of millions ofdollars in losses for their users.”

MARI’s third warning quantified the incidence of fraud insuch loans.  It paired these data withits fourth warning dealing with the revealing label the industry usedinternally for such loans.

“One of MARI’s customersrecently reviewed a sample of 100 stated income loans upon which they had IRSForms 4506. When the stated incomes were compared to the IRS figures, theresulting differences were dramatic. Ninety percent of the stated incomes wereexaggerated by 5% or more. More disturbingly, almost 60% of the stated amountswere exaggerated by more than 50%. These results suggest that the stated incomeloan deserves the nickname used by many in the industry, the “liar’s loan.””

MARI’s fifth warning reported the views of federal bankingregulators.

Federal regulators of insuredfinancial institutions have expressed safety and soundness concerns over theseloans with lower documentation requirements and other “nontraditional” loans.

To summarize, MARI warned every member of the MortgageBankers Association (MBA) in writing in early 2006 that so-called “statedincome” loans:

  1. Were “open invitations to fraudsters”
  2. Had produced hundreds of millions of dollars of losses when they became common in the early 1990s
  3. Had a fraud incidence of 90%
  4. Deserved the industry term for such loans:  “liar’s loans”
  5. Were opposed by federal banking regulators because of safety and soundness concerns
It was in this context that (1) lenders moved massively toincrease their origination of fraudulent liar’s loans and to sell such loansthrough fraudulent “reps and warranties” (2) Fannie and Freddie (and theirinvestment banker counterparts) moved massively to purchase these endemicallyfraudulent loans, and (3) OFHEO did nothing meaningful to prevent Fannie andFreddie from purchasing fatal amounts of fraudulent liar’s loans. 

Fannieand Freddie (and the FHFA) still get it wrong

Indeed, even after the second wave of accounting controlfraud caused the failure of Fannie and Freddie, OFHEO failed to end theirperverse executive compensation practices. Steve Linick, the FHFA’s Inspector General (FHFA is the successor agencyto OFHEO) reported:

“Linick said the FHFA rejected his recommendationthat it test and independently verify the annual pay packages, which are set bythe boards of Fannie and Freddie and approved by the agency in consultationwith the Treasury Department.

The FHFA “lacks key controls necessary to monitorthe enterprises’ ongoing executive compensation decisions under the approvedpackages,” the inspector general wrote. “FHFA has neither developed writtenprocedures to evaluate the enterprises’ recommended compensation levels eachyear, nor required FHFA staff to verify and test independently the means bywhich the Enterprises calculate their recommended compensation levels.”

Further, the agency “lacks independent testingand verification of the Enterprises’ submissions in support of executivecompensation packages,” the report said.”

The federal “pay czar” heavily criticized all but one of theexecutive compensation plans submitted by the bailed-out firms still subject tospecial regulation.  Executivecompensation is so typically perverse that it is one of leading causes ofcriminogenic environments for accounting control fraud.  The intellectual father of modern executivecompensation, Michael Jensen, has decried the results, which he concedesincludes rampant earnings manipulation. Fannie and Freddie are simply the most expensive failures to date causedby accounting control fraud.   

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy – Part Five

Where We Can Go from Here

I have asked the reader to follow me through a lengthyseries of reflections and thought experiments on the nature and role of moneyin modern economies.   Some might ask whythis issue is so important.  How canthese ruminations on the nature of modern monetary systems help guide ourthinking on the task of building a more fair and decent society of democratic equals?   How can they help us create a society inwhich democratic solidarity trumps self-regarding and avaricious greed, and inwhich broad and shared prosperity replaces the concentrated economic privilegeand supremacy of the few?

It is important to keep the political problem of money inproper perspective.  No one needs to bereminded that money plays an incredibly significant role in modernsocieties.  But it is also important notto overrate the role of money.  The mostimportant reason to reflect on the nature of money is that by doing so webetter understand all those things that are notmoney, all of the sources of real and non-instrumental value in the world thatare the ultimate ends we seek and the ultimate sources of our happiness.  And as we improve our understanding of thepurposes served by money and monetary systems, our improved understanding canhelp liberate us from our dependency on monetary systems controlled by thepowerful.

Clearly money is just an instrument:  a tool that helps us to organize our economiclives.  It is used for assigningquantitative values to the real goods and services we produce.  It assists in the production, distributionand exchange of those goods and services, and in the prudent storage of valueand purchasing power over time.   Amonetary system cannot be separated from the larger economic and social orderof which it is a part.   A moredemocratic monetary system will therefore be part of a more democratic economicsystem and a more democratic society.

The cause of genuine democracy will, of course, requiresteps that go well beyond reform of the monetary system.  If we seek a more democratic society, one inwhich decision-making power over our everyday lives and common futures is moreevenly distributed among all of our people, it will be necessary for all of usto embrace the demanding responsibilities of democratic governance.   This can be hard to do in the face of somany decades of governmental failure, where government itself has sometimes seemedto have become nothing but a tool of the plutocracy.  Some of the tendency in recent history amongdissidents and reformers has been to pull away from one another other ratherthan pull together.   Some of us hopeonly to liberate ourselves from government and from one another in order to beleft alone to pursue our individual happiness on our own terms.

This thoroughly individualistic approach cannotsucceed.   The cravings for ever morepersonal freedom, and for ever more liberation from the responsibilities ofdemocratic government, will only lead to the eventual dissolution of democraticgovernment and the triumph of authoritarianism. Either we work together as equals to govern our lives and govern oursocieties, or ambitious and ruthless people commanding great stores of wealthwill take advantage of the vacuum to seize control and govern our societies forus.   The urge for freedom is natural andpraiseworthy, but the dream of a real and durable freedom that can existoutside the cooperative efforts of a democratic people practicing vigilant andindustrious democratic governance is not the dream of a free people, but thetwilight illusion of a defeated and alienated people who have given up on thekinds of freedom and well-being that can only be achieved through socialsolidarity and teamwork.   In the end, we are dependent and socialcreatures, built by nature for social and community life, and for relationshipsbased on love, fellowship and friendship.

We have been living in recent decades through an anti-socialera of greed, separation and inequality.  Those of us who have lived this way for a long time might have becomeaccustomed to the norms and practices of this era, and might even haveconvinced ourselves that these norms and practices are appropriate and healthy.   But the rising generation of young people,whose natural and healthy sociality and friendliness has not yet been toodamaged and disfigured by the ruthless demands of the system of greed know thatsomething  is wrong.  They know that our present way of economiclife is disordered and out of balance.

The anti-social era has been marked by a fatalisticpassivity in the face of unregulated commerce and market behavior.    But the forlorn era of low socialexpectations is dying; we can feel it.  People are tired of being on their own.  The defeatist dogma about social change characterizing this dying era isthat we can’t choose our society’s future, because people are too weak andstupid and selfish and limited for collective effort to succeed on a largescale.  The future can only emerge in an entirely unpredictablefashion from the crisscrossing patterns of individuals pursuing their own personalgoals without any significant degree of social cooperation orcoordination.   The result of this trendin thinking has been a withering of the social imagination and the enfeeblementof the democratic practices of our people.  

In the neoliberal world of the past few decades, politicshas become small, unambitious and managerial.  This dispirited managerial government presides over a society in whichpathologies of social living are promoted as virtues: radical individualism,greed, ambitions of supremacy, cravings for isolation, hatred of community, anda debasement of healthy human relationships into commercial and exploitativetransactions come to be seen as normal.  But the gloomy religions of self-seeking isolation are not justdebilitating; they are dispiriting.  AsDavid Graeber has written, “the last thirty years have seen the construction ofa vast bureaucratic apparatus for the creation and maintenance of hopelessness,a giant machine designed, first and foremost, to destroy any sense of possiblealternative futures.”

The fading era of market fundamentalism andhyper-individualism was trumpeted as the “end of history.”   But history is starting up again.   In theshadow of the current recession, we are beginning to recapture the optimistic sensethat the future is something we can envision and choose.  We can work to build a social consensus aboutthe future we want, make large and ambitious choices about the shape of thatfuture and then work with one another in the task of creating the future we haveenvisioned.   We need not sit back, wait,and just see what turns up.  Thepossibility of a mass democratic movement for profound social change beginswith the recognition that the machine of despair is a lie, and that success isactually possible.

It is starting.   Peopleall over the world, frustrated by the dismal and meaningless pursuit ofindividual achievement and material gain alone without larger social purpose, andfatigued by the insecurity, stresses and manic busyness that afflict the neoliberalindividual, are reaching out to re-forge the social contract, establish a newsense of justice based on teamwork and equality, and articulate visions of thehuman future that are a match for the inherent human dignity we sense inourselves and recognize in our fellows.  The world that we have passively allowed to be built around us bycommercial frenzy devoid of higher purpose is an assault on that dignity.

It is notable and inspiring that as the Occupy Wall Streetmovement took shape around the United States and other parts of the world, theparticipants in the occupations organized themselves as communities of equals,in which every voice is equally prized and harmonious consensus is avidlysought.  The hunger for democraticcommunity and self-determination is palpable. This is not the laissez faire form of self-determination, in which eachindividual strives only to determine the course of one individual life, but amore encompassing phenomenon, in which people strive to build and sustain communitiesand then work together as equals in order to make well-founded, democratic decisionsto determine the direction of the community.  It’s hard work.    But the work is inspiring and ennobling, andpeople are naturally drawn to it.

In both the United States and Europe, policy-making elites –whose allegiances are to the plutocrats who are responsible for funding andsustaining the political operations of these elites – are aggressively workingto take advantage of the stress and confusion caused by the present globaleconomic crisis to dismantle progressive social systems.  They are targeting systems of publicownership and organized social cooperation, and are working to undermine thecapacity for democratic governance.   Forthe very wealthy, democratic governments represent nothing butcompetitors.   These governments have sometimesacted in the past to diminish some of the formidable power the wealthy wouldotherwise possess over entire societies, and they sometimes even strip them ofsome of the wealth that they have earned from the sweat of others.  Plutocrats would like nothing better than toput real democracy out of business, and to leave behind nothing but a toyfacsimile of democracy – something like a high school student government thatis allowed to engage in a little democratic role-playing inside an adult socialinstitution that the students really don’t control.

So the plutocrats have put out a stark and coordinatedmessage through the media channels they control, and through the opinion-leadersthey own and influence.  It is a messagedesigned to invoke fear and panic, and to achieve democratic surrender:   The message is that we are out of money,that our governments are bankrupt, that they must opt for austerity anddownsizing and contraction, and that we must hand over even moredecision-making to bankers, bond markets and technocrats – the functionaries ofthe plutocracy.

This message is preposterous.   Societies build their futures and commonwealth out of the real resources they possess, not out of money.  Money is only a tool, and it is the simplestand most inexpensive tool we can make.  Modern democracies are very rich in human, material and technologicalresources.   We are not “out of” anythingimportant of real and fundamental value. The plutocrats might be out of ideas; and they are running out oftime.   But the democratic peoples overwhom the plutocrats are trying to reassert control are only out of patiencewith the plutocracy.
And this brings us back to the issue of monetarydemocracy.  The time has come to considersome specifics:  What role can money playin building a more democratic society? How should we organize our monetary system so that the public’s money isruled by the public and made to serve public purposes, and is not instead pervertedinto an instrument that primarily serves plutocrats in their drive to rule overthe public?   In the final installment inthis series I will propose six tasks for democratic economic reform, each ofwhich has some dependence on the democratic reform of our monetary system.

Thisis Part Five of a six-part series. Previous installments are available here: OneTwoThree, Four

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy – Part Four

By Dan Kervick

Is The United States a Monetary Sovereign?

I have set out a simplified model of a monetarily sovereigngovernment.   But near the end of theprevious section, I began to suggest that the United States government is indeeda monetary sovereign by this kind.   Thereader might now suspect that I have yielded my rational mind over to a simplisticfiction of my own creation.   And by thispoint, the reader is probably thinking that however interesting it might be toimagine this fictional entity, the so-called monetary sovereign, such fictionshave nothing to do with the complexities of the real world, because actualgovernments maintain accounts that are indeed constrained by the amount ofmoney in those accounts and by the external sources of funding to which theyhave access.   After all, can’t a governmentdefault on its debt?  What about the recentdebt ceiling debate in the US?  Whatabout what is happening in Europe with the sovereign debt crisis?   Also, if a government like the United Statesgovernment was a monetary sovereign of the kind I have described, theconsequences would seem to be enormous. Surely if a democratic government possessed this kind of power, we wouldmake much more use of it than we do.   In short, monetary sovereignty as describedseems both too simple to be real and too good to be true.

These skeptical intuitions are reasonable, so they need tobe addressed.   First, let’s consider thequestion of whether monetary sovereignty is toosimple to be real.

I will argue that the government of a country like theUnited States is much closer to the ideal of monetary sovereignty than thetypical citizen recognizes.   To theextent the model is overly simplified, that is due entirely to choices we have made about how ourgovernment should be organized internally. The financial and monetary operations that occur in our actual governmentare not carried out by a single operational center, but rather involve severalparts of the executive branch, most prominently the Treasury department.   Congress is involved as well, as is the FederalReserve System.  These branches of thegovernment are subject to various legal restrictions and constraints.  But these are all constraints that thecountry’s legislators have chosen toimpose on the government’s financial operations.  They are to that extent voluntary and could thereforebe altered.

Congress has chosen, for example, to make the US Treasury,and even Congress itself to some extent, function as a currency user rather than a currency issuer, and has attempted to assign to theFed all primary responsibility for direct decisions over the increase anddecrease of the money supply.  Ultimatemonetary authority obviously resides in Congress, but Congress has delegatedmuch of that authority to the Fed, and has been reluctant to exercise theauthority directly by engaging in direct monetary operations on behalf of thepublic it represents. 

These restrictions have been implemented in several ways:  The Treasury Department can only spend ifthere are sufficient points on its monetary scorecard – that is, if sufficientdollars are credited to its bank accounts.   Its accounts are held at the Fed and administered by the Fed.   It isforbidden from overdrawing its accounts at the Federal Reserve, and the Fed hasno authorization to credit those accounts directly and unilaterally.   So theTreasury can’t create money itself by a direct act, in the course of itsordinary operations, nor can the Fed create it directly for the Treasury.   IfCongress has authorized some spending by the Treasury Department, the Treasurycan only carry out that spending if the combination of tax revenues and borrowedfunds currently supplying Treasury accounts constitute sufficient funds for thespending.   If tax revenues areinsufficient, then in most cases the Treasury Department will sell bonds to theprivate sector, and raise funds in that way.  However, Congress has alsoimposed a debt ceiling on Treasury borrowing, so the Treasury’s prerogative inissuing bonds is capped.

The Treasury Department does possess, through its operationof the US Mint and as a result of certain loopholes in existing authorizationsto mint coins, a potential source of direct control over monetaryoperations.   But taking advantage ofthese loopholes would be highly unusual and politically controversial.  And if Congress remained determined to keep delegatedmonetary authority with the Fed, then the loopholes would probably be closedquickly by legislation.

Also, the Treasury Department is forbidden from sellingbonds directly to the Fed.   So while the Fed is permitted to create moneyand use it for making loans to banks in the Federal Reserve System, or for thepurchase of financial assets from private sector owners of those assets, itcannot purchase bonds directly from Treasury.  And thus the Treasury cannot borrow directly from the Fed.    The two departments must instead follow amore roundabout method.   The Treasury cansell bonds to private sector dealers in an auction, as it ordinarily does.  The Fed can then, at its discretion, purchasethose bonds from the private dealers in separate auctions.   Treasury ends up with some amount ofborrowed funds, but also with a liability to pay the Fed the principle on theloan.   Any interest payments on the bondswill be returned to the Treasury, since the Fed is not permitted to collectinterest from the sale of Treasury bonds.  So the Treasury ends up in a better position than if the bonds werestill owned by the private sector dealer.  But the Treasury still owes the Fed the principle.   How these loan payments are funded is then ultimatelyup to Congress to decide.

Let’s conduct a thought experiment, and imagine how things mightwork if the Treasury could sell bondsdirectly to the Fed, and if Congress exercised more direct supervision over theFed’s purchases of Treasury dept.

Suppose the Treasury Department were permitted to issue aspecial class of bonds – call them “M-bonds”.  These bonds could not be sold to privatesector purchasers on the open market, but could only be sold to the Feddirectly.  Suppose that the bonds carriedno coupon payments and 0% interest, and matured in a year.  In other words, if the Treasury sells a $1 billionM-bond to the Fed today, then the Treasury receives $1 billion from the Fedtoday, and next year they pay the Fed exactly $1 billion, with no interestpayments in between.

Suppose also that the Fed were not permitted to refuse tobuy M-bonds.  Let’s imagine that Congresshas passed a law mandating that, if Treasury issues an M-bond and offers it forsale to the Fed, the Fed has to buy it.  But let’s also assume that Treasury is still not permitted anyoverdrafts on its account at the Fed. Congress continues to mandate that any Treasury spending must be clearedthrough its Fed account, and that the only ways of funding that account are thoughtax revenues, sales of ordinary Treasury bonds to the private sector and salesof M-bonds to the Fed.

Now, finally, let’s suppose that the Treasury Department hasa standing policy of funding $100 billion of public sector spending each yearthrough the sale of M-bonds.  It also hasa policy of issuing new M-bonds each year to meet the full costs of servicing its outstanding M-bond debt.    Inother words, it always pays the debt it owes on its M-bonds just by sellingmore M-bonds.    So, in Year One it sellsthe Fed $100 billion of M-bonds, and spends the proceeds.   In Year Two, it sells $200 billion ofM-bonds, spending $100 billion of the proceeds and using the other $100 billionto pay off the Year One debt.   In YearThree, it borrows $300 billion, spends $100 billion and uses the remaining $200billion to pay off the Year Two debt. Etc.

We can see that the portion of Federal debt attributable toM-bond issuance grows arithmetically by $100 billion each year.   So the national debt continues to rise.   But we can also see that that portion of thedebt is relatively meaningless.   And itwouldn’t matter if M-bonds were not sold at 0% interest, but carried somepositive interest rate – say 10% or more. In the latter case, the debt due to M-bonds would not rise onlyarithmetically, but would rapidly compound.   But itwould be just as meaningless, since the whole quantity of the previous year’sM-bond debt would be borrowed from the Fed each year, and then paid back thenext year with additional borrowings from the Fed.  The Fed would be required to purchase thisadditional M-bond debt each year, so the rising debt places no rising burden onthe US Treasury or the American taxpayer.

It should be clear at this point that the entire functionaleffect of all that borrowing and repayment with M-bonds could be accomplishedby the following simpler alternative operation: Congress simply mandates that each year that the Fed must directlycredit $100 billion to Treasury Department accounts at the Fed.  No bonds. No borrowing.   End of story.   While this might appear to be an entirelydifferent kind of operation, ultimately they are just too different mechanismsfor accomplishing exactly the same effect.  Thus, the rapid arithmetical rise in M-bond debt in our thoughtexperiment is not functionally equivalent to a cycle of hyperinflationaryrunaway money printing.   There is insteada fixed, modest annual amount of net money creation – $100 billion, which isjust a fraction of annual US GDP – and the ballooning debt payments are just anartifact of the convoluted M-bond method Congress has hypothetically prescribedin our thought experiment to accomplish this money creation.  The M-Bond debt owed by the government to theFed – which is itself part of the government – has a fictional quality.

It is vital to recognize, then, that the third party privatesector involvement in the current borrowing relationship between the Fed andthe Treasury is entirely voluntary on the part of the US government.  Congress could remove it at any time, simply bypassing the appropriate legislation.   

Congress could also, at any time, direct the Fed to credit TreasuryDepartment’s accounts – their monetary scorecards – by any amount Congress seesfit.  The recent debt ceiling crisis,therefore, is entirely the result of self-imposed, voluntary governmentconstraints.  The government can never runout of money unless it chooses tosubject itself to various self-imposedconstraints.

Congress has not provided itself with any institutionalizedmeans for conducting monetary operations directly, and has imposed on bothitself and the Executive Branch – the two political, elected branches of thegovernment – a system that requires both branches to act as though they are themere users of a currency that is controlled by the Fed.   Congresshas thus imposed a quotidian accounting constraint – to use a term introducedearlier – on the political branches of government.   The Fed, on the other hand, is effectively permittedto spend without a scorecard.   But its spending options are limited by law: Itcan buy government bonds and other bonds on the open market.  It can also lend funds to banks at a rate ofits own choosing.   But it can’t buy abattleship, or hire 100,000 people to spruce up the national parks or build ahighway or rail line, or simply send checks to selected American citizens.   Or at least if it tried to do these thingsit would likely be challenged legally for conducting operations that appear to exceedits intended legal powers.  Just what theactual limits of those powers are, and how much Congressional spending power hasbeen delegated to the Fed, seems to be a matter of some controversy.  But it is clear that the Constitutionalintention is that the “power of the purse” is supposed to reside with Congress.  And thus any move by the Fed to begin conducting fiscal policy byspending money on all matter of goods and services would be extremelycontroversial to say the least.

It sounds a little bit strange, of course, to say thatCongress has imposed operational constraints or restrictions on itself  in the area of monetarypolicy.   After all, apart from thosesupreme laws that are embedded in the US Constitution, Congress makes thelaws.  So in what sense can Congress beconstrained by laws of which Congress itself is the author and master?   We might think here of the ancient Greekhero Odysseus, who had himself bound to the mast of his own ship to prevent hisship’s ruin on the rocky island of the Sirens.  But the important thing to remember in this area is that while the USCongress might be bound by laws that Congress itself has created, these lawscan be changed at any time by the same Congress that enacted them.  Congress can intervene in US monetaryoperations at any time, since US monetary power is constitutionally vested inCongress.

So the parts of the government that can actually accomplish a lot with their spending – Congress andthe Executive Branch – are presently required by law to act as mere currency users that must draw on private sectorfunding sources to carry out that spending, while the part of the governmentthat is permitted to act as a currency creator – the Fed – is subject to fairlystrict limits on what it canaccomplish and whom it can affect with that spending.

The whole system seems cumbersome and byzantine when viewedin this light.   But perhaps theseself-imposed constraints have important policy justifications?   Perhaps Congress in its wisdom has seen thatmonetary power is simply too dangerous for direct democratic governance, andthat even Congress itself cannot be trusted to carry out monetary operations inconjunction with spending and taxing operations, in a democratically influencedfashion?   We will return to thisquestion later.   But for now, let’s turnto the other instinctive reaction to the model we have developed of a monetarilysovereign government: that it is too goodto be true.

If the monetary sovereign is not subject to any operationalrequirement either to tax or to borrow in order to spend, and if the monetarysovereign has the power to create money at will, then isn’t that the ultimatefree lunch?   Doesn’t that mean that agovernment of this kind can spend without limit either to purchase goods orservices for the public sector or to effect direct transfers of monetarybonanzas to private sector accounts?

We all know something is wrong with this suggestion, if weinterpret it in its most obvious sense.  And where it goes wrong is in its loose use of the word “can”.  Of course, in one sense the monetarilysovereign government can spendwithout limit.   There is no operationalconstraint on this spending.  The USCongress can authorize as muchspending as it desires, and of almost any kind. It can, if it chooses, permitthat expanded spending to go forward in the absence of any additional taxrevenues.  It could remove the debt ceiling and authorize, or even direct,unlimited borrowing by the Treasury.  Orit could direct the Fed to credit theTreasury Department account directly with some large amount of money.  It couldeven eliminate the Treasury Department’s Fed account entirely, and simplydirect the Fed to clear any check issued by the Treasury Department, and alwaysmake a payment directly to the account of whatever bank presents that Treasurycheck to the Fed.

In the purely operational sense of “can”, our government cando all of these things.   But we all knowthat under many circumstances, such actions could have very bad effects.   In addition to whatever operationalconstraints do or do not bind government actions, there are also what we havecalled policy constraints.  A policy constraint on government actions issimply a policy choice the government has made that cannot be effectivelycarried out if the government does not act within that constraint.  And if the policies are sensible ones, thepolicy constraints are sensible as well.
One such policy which most governments seek to implement isa price stability policy.  For goodreasons, governments seek to prevent prices on goods and services from risingor falling too much in a short period of time; or from rising or fallingsharply and suddenly, or in an accelerating fashion; or from behaving in anerratic and unpredictable manner.   Priceinstability of these kinds can have an inhibiting, recessionary effect oneconomic activity, as the participants in the economy struggle to predict theoutcomes of their medium-term and long-term contracts and transactions.  If a monetarily sovereign government suddenlyauthorizes the creation of excessively massive amounts of new money, and simplyspends that money into the private sector directly to make public sectorpurchases, or transfers it to individuals who in turn spend it, the effectcould be a sharp and sudden surge in the level of prices.  High inflation and shortages of goods are thelikely result.

And yet the risk of runaway inflation as a result ofgovernment money creation is frequently exaggerated.   Some commentators seem to assume that the merecreation of new money will always have a corresponding inflationary effect, nomatter how the new money is spent.   Theyare constantly warning is that “hyperinflation” is just around the corner as aresult of government money creation.   Butthis inference does not meet the test of either common sense or consideredexamination.   Adding money to theeconomy only exerts pressure on prices if that money is in the marketplace, inthe hands of customers, competing with other potential customers for goods andservices to bid up the prices of those goods and services.  If the money is inserted into the economy insuch a way that it mostly goes into savings or bank reserve buffers, it willnot contribute to price pressure.  Suchappears to be the case with recent “quantitative easing” policies pursued bythe Fed.

But even if the money does accompany hungry customersstraight into the marketplace in pursuit of goods and services, it still mightnot exert much pressure on prices.   Itreally depends on how and where the money is inserted.   Consider an economy like the one we areenduring currently, with double-digit real unemployment and substantialunderutilized human and material resources.  Many businesses are experiencing empty shelves, unused warehouse space,vacant office space, idle productive machinery and internal systems operatingwell short of their capacity.  Inresponse to a surge in demand from new customers with money to spend, suchbusinesses can ramp up production rather quickly.  They can hire workers from among the hugearmy of unemployed people hungry for jobs, put productive capacity back online, and fill up existing shelves or distribution facilities with very littleadditional cost per unit of output.  Infact, with so much underutilized capacity, the cost per unit of output sometimeseven falls with additional production, as current capacity is used moreefficiently.   So businesses would havelittle reason in these circumstances to raise prices on the basis of costpressures alone.   At the same time, anybusiness that is even tempted to raise prices in response to the new demandwould face intense pressure from their competitors, who have been starved forcustomers throughout the recession, and who will be only too happy to keepprices low and reap increased revenues from boosted sales alone, with the same unitproduction costs, and without attempting to frost the tasty new cake with anuncompetitive price increase.

So, inflation fears vented over proposals for moregovernment deficit spending assisted by sovereign monetary power are oftenoverblown.  An economy in a deeprecession like ours would likely benefit greatly from such a direct expansionof government spending.

In fact, not only is government spending in a recessionlikely to be beneficial, but the decision to throttle down government spendingand reduce deficits – that is, the decision to practice austerity – ispositively harmful in the same circumstances.  That is because, in the absence of any change in a country’s currentaccount status with respect to its trade abroad, any decrease in the governmentdeficit corresponds to an aggregate worsening of private sector balance sheetpositions.    If the government insistson pushing its own balance sheet into a position of surplus, it will likely pushthe private sector into a deeper deficit, which is precisely the wrong thing todo as the private sector struggles to deleverage, and as household and businessincomes fall.   And in the context of aglobal recession, where virtually every country would like to increase exportssignificantly but few countries can do so because there are not enough foreignbuyers for their goods, the clear present need is for expanded public sectorspending.

But suppose our government chose to expand spending bymaking use of additional borrowing from the private sector?   In that case, the additional deficitspending would drive up the national debt. Isn’t there great risk in these high debt levels?   If the government’s debt goes to 100% ormore of our entire annual national product, isn’t that dangerous?   Many pundits are warning these days aboutthe allegedly calamitous level of debt and the threat of ruin or bankruptcygovernments face as a result.

And private sector debtis certainly a big problem.   As we havediscussed, individuals, households and firms – unlike monetarily sovereigngovernments – are mere users of debt instruments and monetary instruments theydon’t control, and operate under real and inviolable budget constraints.   They can face insolvency if their debts gettoo large.  And even if they are not inimmediate danger of insolvency, high debt burdens place serious limits on theability of private sector borrowers to spend their income on satisfying otherwants and needs.

Politicians have recentlydrawn on these fears of private sector debt in the United States to elevatesimilar fears about the debts of the US government.   We hear politicians and other nationalopinion leaders warn that the government faces “bankruptcy”.  They say that it is “broke” or “out ofmoney”.    And they are exploiting thesefears to pressure Americans to reduce the size of their public sector spending,and grant even more power to the private sector firms that helped steer us intoour current crisis.   But the claimsbehind these warnings about government debt are often downright false.   At best they are often wildly overblown, andbased on significant misunderstandings about how our government’s monetary systemoperates, and how any monetarily sovereign government relates to the world ofprivate sector finance with which it interacts.    Hereare several facts to bear in my about federal government debt in the UnitedStates:

First, the US government, as a monetarily sovereign nationthat is the monopoly producer of the US dollar, can face no solvency risk otherthan a voluntary, self-imposedsolvency risk.    The US borrows in dollars, a currency that theUS government itself controls and produces. The US government therefore simply cannotgo bankrupt and fail to pay its debts unless the US Congress chooses to prohibit the TreasuryDepartment from paying those debts, by choosingto prohibit the Treasury from making use of the inherent monetary power ofthe United States.  Now this is in factwhat the US Congress threatened to do in the summer of 2011.  That is not because the government faced anexternally imposed solvency crisis.   Itis because some members of Congress chose to manufacture a crisis bythreatening a voluntary default, inorder to blackmail American citizens and other members of Congress intoreducing the size of public sector spending.

It is true that the Treasury Department is currentlyconstrained by Congress to sell its bonds to private sector lenders.  But that is again an arrangement thatCongress has chosen.  At any timeCongress could enact legislation permitting direct borrowing from the Fed –effectively creating what I called “M-bonds” – or direct the Fed to credit the TreasuryDepartment’s account by any amount Congress desires, including whatever amountmight be necessary to pay any existing debt liabilities.  So there is simply no risk of US governmentbankruptcy other than the risk that the US Congress might, somewhat recklesslyand fanatically, choose to default onUS government debt.

The only real constraint that needs to be born in mind inthe area of government borrowing is the policy constraint of pricestability.  Once economic activityreturns to full capacity, the need to preserve price stability will requirethat government debt liabilities to the private are met through processes that beginto remove compensating monetary assets from the non-governmental sector throughtaxation rather than processes that continually expand those monetary assetsthrough more central bank purchases of debt. Most of that transition will occur automatically.   As economic growth returns and incomes rise,tax revenues will automatically rise along with the incomes.

Some worry about the size of the debt we owe to foreignlenders, including foreign governments.   The Chinese government, for example, currentlypossesses over 9% of US treasury debt.  Politicians use this fact to portray the Chinese as a potentiallyoppressive creditor that could choose to “call in our loan” and drive us intoinsolvency or crisis.   These fears arealso overblown.   When the Chinese or otherspurchase US treasury debt, they purchase it with dollars – dollars they alreadypossess.  There are only so money thingsyou can do with a foreign government’s currency you possess.    One ofthose things is to buy bonds from that foreign government (or save it with afinancial institution that is itself buying government bonds).   A bond issued by the Treasury Departmentfunctions as the equivalent of an interest bearing savings account for peoplewith dollars to save.  If the dollarholding foreign nation chooses not to put their dollars in “savings” by purchasingbonds either directly or indirectly, they will have to keep their dollars in“checking” by leaving them in bank accounts earning lower interest.   Why would they do that?

Suppose the Chinese decided they no longer wanted topurchase US government debt.  What wouldthey do with their dollars?  Their onlyreal alternative would be to exchange those dollars for something else.   That is, they could buy something with thedollars in markets where the dollar is accepted – primarily America.   At that point, it is hard to imagine themedia screaming, “Crisis!  Chineseseeking to buy massive amounts of American goods!”

Under current arrangements, as we have seen, the TreasuryDepartment is constrained to sell bonds on the private market.   So the fear might be that even if the Fed isprepared to buy up as much Treasury debt as is needed in order to supportTreasury spending operations, the Fed might not get that option if skittishprivate sector borrowers refuse to buy government debt at high prices.   Again, the problem with this line ofthinking is that the entire world that does business in dollars has no otheroptions but to save its dollars in savings vehicles that are in one way oranother founded on government debt liabilities.   The Fed exercises tremendous control overinterest rates through its open market operations.   So realistically, there will always belenders ready to purchase bonds that the government issues, at the interestrates we desire, so long as the Fed stands ready to purchase as much governmentdebt as needed to set the interest rates its desires to set.   Borrowing costs for the US government remainextremely low, despite the warnings of those who fear federal government debtis too high.   Nor do people in other countries seem any lessinclined to save and do business in dollars. The dollar is currently very strong on world currency markets, despitepersistent warnings by the fear mongers that government money creation willlead to a hyperinflationary loss of value in the dollar.

Some of those who spread fear about dramatic inflation orhyperinflation resulting from government money creation point to the recentrounds of “quantitative easing”, in which the Fed purchased large quantities offinancial assets on the private market.  Since the Fed effectively creates the money on the spot that it needs topurchase those assets, some fear that this massive program of purchases hasflooded the economic system with money, and the pressures from this deluge willeventually lead to a runaway rise in prices.  But it is important to recognize that when the Fed buys financialassets, that purchase amounts to a removal of money from the economy over timeas well as an insertion of money in the present.

Suppose that some private sector entity A possesses a bondissued by some other entity B, where B can be either the Treasury Department orsome private sector lender.   Supposethat the bond commits B to the payment of $10,000 to A over the next fiveyears, on some pre-determined schedule.  Now suppose that the Fed offers to purchase this bond from A for $9000,and that A decides to sell the bond because A prefers the $9000 now to thedelayed receipt of $10,000 over five years.  It is true that when the Fed makes the purchase it inserts an additional$9000 into the economy.  But rememberthat $10,000 was originally supposed to move from B to A over five years.  Now the $10,000 will flow from B to the Fedrather than to A.   In other words, theFed has poured $9000 out of its infinite money well into the private sectortoday, but over the next five years B will pour $10,000 back down into thatinfinite money well.  That amounts to anet removal of $1000 from the privatesector.  All the Fed has done with itsbond purchase is swap out one financial asset- a bond – for a different asset –some money.   It has adjusted theschedule of insertions and removals of money from the private sector withouteffecting a net increase in the amount of money inserted.

Finally, before moving on to a discussion of making the USmonetary system more democratic, it will be worthwhile saying a few words abouthow the current European monetary system falls short of the kind of monetarysovereignty – or near monetary sovereignty – I have attributed to the system inthe United States.

European governments are all part of a currency union – theEurosystem.    Each government issues itsown bonds and each operates its own central bank.   All of these transactions occur in Euros,the common currency of the Eurosystem.  But those national central banks are subject to rigorous policyconstraints set by the European Central Bank.  The individual countries themselves do not set their own monetarypolicies, and they borrow in a currency they do not themselves control.   In effect this makes each government acurrency user rather than a monetarysovereign.   If we think of governmentbonds as the equivalent of bank savings accounts, then each of the governmentsis in effect the equivalent of a savings bank that competes with the other governments in the Eurosystem to offerattractive interest rates to savers.  This gives holders of Euros tremendous bargaining power to drive up bondyields and interest on government debt, because they can always take theirmoney elsewhere to other governments if they don’t get the yields theywant.  And since the individualgovernments do not control their own monetary policies, they cannot maintainspending during periods of low revenues by selling debt directly to theirnational central bank and drawing on the money-creating power of that nationalcentral bank.  Only the European CentralBank can alter those monetary policies, but the ECB is prohibited by treatyfrom buying government debt directly.   TheECB also lacks the capacity to carry out a fiscal policy of central bankfinanced spending operations in Europe.

In effect, then, the technocratically-managed ECB runsEurope’s private banking system and the private banking system runs Europe’sgovernments.   The citizens of Europehave turned their capacity for economic self-determination over to anundemocratic, continent-wide banking conglomerate.  This is the worst kind of nightmare in thelong struggle between democracy and private wealth.  It’s not as though the Europeans havesurrendered their sovereignty to be part of a larger sovereign democraticgovernment encompassing all of Europe.  Rather, sovereign democratic governments have been transformed in thisinstance into something like mere business enterprises that are dependent onprivate wealth and financing for their operations.  These governments now govern only at thepleasure of bankers.

Thisis Part Four of a six-part series. Previous installments are available here: One, Two, Three

What if the SEC investigated Banks the way it is investigating Mutual Funds?

By William K. Black 

The Wall Street Journal ran a story today (12/27/11) entitled “SEC Ups Its Game to Identify Rogue Firms.”

“Rogue” is an interesting word with a range of definitions. When it is used as an adjective its meaning is: “a playfully mischievous person; scamp.” The trivialization of the most destructive elite frauds is one of the most common forms of what criminologists call “neutralization” of the moral content of wrong doing. Neutralization increases crime.

The actual story makes it clear that the criminals that the SEC was identifying were not “rogues.” They were the CEOs of seemingly legitimate firms. The SEC is identifying “accounting control frauds” – the frauds that cause greater financial losses than all other forms of property crime combined. The SEC is not identifying a few rotten apples, but roughly 100 hedge funds likely to have engaged in accounting fraud. The WSJ describes the SEC’s identification system:

“The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won’t say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the “aberrational performance initiative.””The SEC should be applauded for finally understanding that “if it’s too good to be true; it probably isn’t true.” Our agency put a similar system in place in 1984 to identify the S&L accounting control frauds that were driving that crisis. A quarter-century later, the SEC began to follow our well-trodden trail – but only with regard to felons inhabiting the middle of the fraud food chain (hedge funds). 

The SEC has, inevitably, discovered that accounting fraud is common among hedge funds. It is unlikely that the SEC system is really “high-tech” in information science terms. Low-tech information systems have been capable of identifying “aberrational performance” for at least thirty years. We did not have to create any pioneering software in 1984 in order to identify aberrational performance. The cost and time to create our “red flags” was trivial (a few hours of programming time by an agency staffer). (We were collecting the data and computing the necessary ratios anyway. One simply decides the level of a few key variables worthy of being flagged. There’s nothing magic about a “flag.” All it means is that suspicious levels are highlighted on the computer screen and on physical copies of the periodic reports so that they capture the reader’s attention.)

The SEC took two years to create its “aberrational performance” system and is embarrassed enough about the cost that it wants to keep it secret. The two year development process allowed the SEC to make a major advance relative to our system – they invented a title consisting of two words and eight syllables. Devising a title that recondite doubtless accounts for six months of the time it took the SEC to develop its flags.

The most interesting aspects of the WSJ story, however, are two unexamined topics that should have been central to the story. First, there is not a word in the article about criminal prosecutions for the frauds the SEC has identified. The frauds, as described in the article, are so blatant that they would make relatively simple to prosecute. There is no indication that the SEC wanted the WSJ to know that they had made well over a hundred criminal referrals against hedge fund CEOs and senior officers. There is no indication that the WSJ reporters were interested in whether the SEC had made criminal referrals against these moderately elite felons. As a result, we have no information on whether the SEC has in fact made hundreds of criminal referrals against the senior officers at the hedge funds that they have identified as having engaged in likely fraud. Indeed, we have no evidence that they have made any criminal referrals. Neither the SEC nor the WSJ reporters indicated that any prosecutions, or even Department of Justice investigations, resulted from the SEC hedge fund investigations.

Second, why isn’t the SEC’s top priority the systemically dangerous institutions (SDIs)? The SDIs are the financial institutions that are so large that the administration fears that their failure will cause a new global crisis. The SDIs pose by far the greatest risk to the economy and investors of any entity. Their frauds reached “epidemic” proportions and drove our ongoing crisis and the Great Recession. The SEC, however, applied its “aberrational performance” system to its smallest entities and is now expanding it to mutual funds. There is no indication that the SEC intends to use the system to spot fraudulent SDIs. There is no indication that the SEC has even contemplated using the system to spot fraudulent SDIs. There is no indication that the WSJ reporters asked why the SEC was failing to use its system where it was most needed.

Applying the SEC system to the SDIs would have led the SEC to develop a more sophisticated analytical approach to identifying fraud. There is no indication that the SEC has any familiarity with the criminology, economics, and regulatory literature about how to identify accounting fraud. Admittedly, the SEC (finally) has taken seriously the warning that generations of parents have impressed upon their children – “if it’s too good to be true; it probably isn’t true.” The Achilles’ heel of the SEC analytics is that it assumes fraud must be aberrational and its flags are (at least as described in the story) all tied to identifying aberrations premised on the implicit assumption that fraud cannot be endemic. The SEC official told the WSJ reporter that they looked for “outliers.” Accounting control fraud, however, can become endemic, particularly in a product line, because it produces a “Gresham’s dynamic” in which bad ethics drives good ethics out of the market. Accounting control frauds report results that are too good to be true, but they all report extraordinary results because accounting fraud is a “sure thing” (George Akerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy for Profit, 1993). Accounting control fraud was far more common among the SDIs than the SEC system has identified among hedge funds.

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy – Part Three

By Dan Kervick

Consequences of Monetary Sovereignty

Now so far, I have described the operations of the monetarysovereign as though money were the only thing in the world.   But this is clearly not thecase.   The model of themonetary sovereign I have developed is intended to be a model of agovernment.   And whilegovernments might have nearly unlimited and very easily deployed power in thecreation and destruction of money, a government also participates in theexchange of real goods and services.   And these goods and services are clearly finite.    So there is something veryspecial about money which is yet to be considered.

Let’s remember that government spending – insertions ofmoney – can come in different varieties: there are purchases, in which money is inserted into a private sector accountin exchange for some good or service delivered to the sovereign; and there arestraight transfers, in which somemoney is inserted into a private sector account without condition, with thegovernment receiving nothing in return.    Similarly,we need to recall that government receipts – removals of money –  can come also in different varieties: there are sales, in which money is removed from aprivate sector account in exchange for some good or service delivered by thegovernment to the owner of that account – as when someone buys a carton from thepostal service, for example – and there are taxes,in which some money is removed from a private sector account without condition,with the owner of that account receiving nothing in return.

In a democratic society, we should think of the owner of themonetary sovereign’s account as the entire public, representing a significantportion of the economy usually called the publicsector.   The publiccannot create valuable goods out of nothing at will, or receive the benefits ofvaluable services at will.  Thesethings come in finite amounts, and it is a very big deal to the public whetheror not it possesses some good – like a bridge, a park, or a work of publicsculpture, or a dam, or a rocket engine.    It is also a very big deal to the public whetherit is performing some service for a private sector individual or firm, orwhether that individual or firm is providing a service to the public.  So, while it might make littledifference whether we think of the monetary sovereign’s monetary possessions accordingto the infinite account model, the empty account model or the quotidien accountmodel, we have no such freedom when considering the public’s possession andexchanges of real goods, or its receipts and provisions of the benefits of realservices.   When it comes tothe exchange of real goods and services, what the public possesses matters.  As democratic citizens, decisions over the public sectorprovision or acquisition of real goods and service are among the most frequentand important decisions we have to make.

And herein lies an important difference between theproduction of money and the production of other goods.  Traditionally, the difference in costbetween producing some unit of money, and the value that can be fetched by thatmoney in the market when it is used to purchase something, is called“seignorage”.    Inearlier times, when the public’s money was fashioned from material resourceslike gold, which had to be mined from the ground, refined and shipped at a substantialcost, seignorage was still important, but less significant than today.   But in the world of modern money,when money in colossal denominations can be created at very low cost, simply bymoving a few electrons around on some hard drives by virtue of a few keystrokeson a computer keyboard, the value that is derived from seignorage is even moresignificant.

A democratic public that possesses seignorage power shouldbe very hesitant to give it up, as it would for example, by ceding monetarypower to private sector corporations with their relatively small collections ofself-seeking owners and their hierarchical, non-democratic forms of government.   If the creation of the variousforms of money were permitted to be strictly a private sector endeavor in themodern world, we might reasonably suspect it would all end up in the hands of afew financial sector oligarchs – Goldman Sachs, Barclay’s, Chase, etc. – justas these oligarchs have come to dominate other forms of financial power.   Nor should the public take acasual attitude toward free-styling monetary entrepreneurs who might seek toemploy innovative technologies to invent forms of money that have the potentialto succeed in supplanting the public’s money.  They would thereby reap seignorage profit for their ownprivate benefit, while at the same time diminishing public control over thepublic’s monetary system, and robbing a democratic public of its monetary power.    And the romantic andentrepreneurial monetary rebel of today could easily become the monopolizingmonetary kingpin of tomorrow without the restraint of democratic governance.

So let’s turn away from these anti-democratic nightmarescenarios of the public’s monetary powers falling into private hands, andreturn now to our simple model of the monetary sovereign, which we will regardas a democratic government connected to a public sector, wielding its monetaryand other powers on behalf of public purposes.

It is important to recognize that a monetary sovereign hasno operational need, strictlyspeaking, to borrow or tax in orderto spend.  By an operational need Imean something that the government must do in order to carry out someoperation, and without which that operation simply cannot occur.   Because the monetary sovereign canalways create any money it needs in order to carry out a spending operation,there is no operational need for it first to acquire that money from some othersource.   In the end, recall,the monetary sovereign is responsible for all of the money that exists in themonetary system which it governs. It is the producer of the currency in that system, not a mere user ofthe currency.  It is just flatwrong to view a monetary sovereign as an enterprise like any other enterprise –such as a household, a small business, a corporation – mere users of the monetary sovereign’s moneywhose monetary power is limited to the making of exchanges, and whose monetaryscorecard is subject to ordinary budget constraints.

So the monetary sovereign has no operational need to tax orborrow in order to spend.   However,the monetarily sovereign government may have a policy need to tax or borrow. That is, the government may have reasonable policy goals – such as themaintenance of price stability, the encouragement of private sector productionand commerce, the promotion of economic equality or other goals- that are bestcarried out with the aid of taxing or borrowing.  The economist Abba Lerner encouraged us to view allgovernment financial operations functionally– that is in terms of their effects. Whether a monetarily sovereign government should engage in some particularmonetary or financial operation depends entirely on the government’s policygoals, and the degree to which the operation helps advance those policy goals.  Lerner thus called this approach togovernment financial operations “functional finance”, and contrasted it withthe ideal of “sound finance” – an ideal based on misconstruing monetarilysovereign governments as mere currency users subject to ordinary budget constraints.

Now this idea of a monetary sovereign might seemfrightening.   Surely thediscretionary power to create and destroy the money that is in common use is anawesome and potentially threatening power indeed.   The trepidation experienced here is not at allmisplaced.   But it is alsoimportant to realize that the existence of such power, or at least thepotential existence of such power, is inherent in the very idea of governmentalsovereignty, and that much therefore depends on the specific form of governmentthat possesses this sovereign power, and the wisdom of those who determine theactions of that government.  A democratic public – in which sovereignty is distributed equally among itsentire people, which endeavors to subject itself and its own governmentaloperations to the rule of law and appropriate checks and balances, underdurable and vigilantly maintained democratic institutions – can employ itsmonetary sovereignty wisely and on behalf of enlightened public purposes andthe general good.

The idea of monetary sovereign can also inspire a differentkind of emotional reaction in people: not fear, but disapproval.   The public sector under amonetarily sovereign government, if such a thing exists, seems to receive somethingfor nothing by virtue of a seignorage power.  The employment of that power effectively delivers benefitsto the public that are not received inexchange for something else.    All the rest of us private individuals, on theother hand, are generally required to produce something of value in exchangefor the benefits we received.  This asymmetry might not seem fair or appropriate, since the monetarilysovereign government has an unfair advantage over private sector economicactors.   Various inhospitable terms might come to mind here todescribe the monetary sovereign’s advantage:  “free lunch”, “ill-gotten gains”, “theft over honest toil”, “counterfeiting”etc.

This emotional reaction can be hard for people to shake, andis even in some sense natural, but it is grounded in a profoundly wrongheaded andfalse analogy between the sovereign role of a self-governing people under ademocracy, on the one hand, and the role of private individuals, households andcompanies on the other.   First of all, The United States government and its people have made asubstantial investment – of work and sweat and tears, and even including aninvestment of many lives – in order to secure something approaching monetarysovereignty for their society.  So if they exercise this monetary sovereignty in the pursuit of publicpurposes and the general good they are hardly receiving something fornothing.   They have investeda whole lot of something in the pastin order to control a monetary system they can use to accomplish these public goals.

Second, a democratic government like the government of theUnited States is not just one enterprise among others in a competitive economicgame of rising and falling fortunes, a game in which the government musttherefore “play by the same rules” as every private sector individual,household or firm.   TheUnited States government is the instrument by which we the people are supposedto organize and direct our common efforts toward the fulfillment of our mostimportant national goals and aspirations, including such things as “promotingthe general welfare” and “establishing justice.”   It is absurd to suggest that because a corporationlike Goldman Sachs, for example, does not possess the seignorage power thatcomes from monetary sovereignty, then the American people must decline toemploy that power themselves, in the spirit of fairness to Goldman Sachs and thedesire for a level playing field.   Goldman Sachs is not entitled to a levelplaying field with the sovereign American people.   We’re the constitutionally recognized boss in oursociety.   If the people ofthe United States have been strong enough, and diligent enough, and havesacrificed enough to deny seignorage power to Goldman Sachs but preserve it forthemselves and their democratic government, then tough for Goldman Sachs.   But good for us.

Finally, it is absurd to claim, as some monetarycommentators across the generations sometimes have, that government money printingor its modern electronic equivalents represent something analogous tocounterfeiting, as though the money used by a sovereign government were theproperty and creature of some mysterious third party or extra- governmentalpower or entity that the government then fraudulently manufactures foritself.  In modern economies moneyis the creature of a government, and its creation and regulation subject to thelaws of that government.  Under ademocratic government, the power to create and regulate money belongs to thepublic.   The public, workingthrough its government, can’t be the counterfeiter of its own legally ordainedmoney.  It might make foolishdecisions from time to time in the way it deploys its money-creating power, butthese decisions do not encompass the counterfeiting of its own money.  It is impossible for the rightfulissuer of a currency to counterfeit that currency.

So the emotional aversion some feel to the exercise ofmonetary power by a democratic government is misguided.  Much political energy, however, hasgone into perpetuating these irrational reactions.   The owners and servants of concentrated privatefinancial power sometimes seek to shield the US public from a clear awarenessand understanding of its own monetary powers, and from recognizing that it candeploy its inherent monetary sovereignty for public purposes so long as itorganizes itself to lay hold of these powers and command them.   They would like the American people to believe that thepeople themselves, and their democratic government, are mere users of amysterious currency they do not control, and are thus dependent on the will ofothers in exercising whatever monetary power the people are permitted to wieldby those mysterious powers.   Theplutocrats promote these myths and taboos of monetary superstition because aninformed public with a clear-eyed appreciation of monetary matters wouldobviously work to prevent the further usurpation of their powers by plutocrats.

This is Part Three ofa six-part series.

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy – Part Two

By Dan Kervick

Reflections on Modern Money

Before considering what it would mean to make our monetarysystem more democratic, let’s begin by calling to mind a few familiar featuresof money and modern monetary systems in general, features we all intuitivelyunderstand as users of money in a modern monetary economy.

First, money obviously comes in very different forms.   Not only are there different currencysystems – the dollar system, the euro system, the renminbi system, etc. – buteven within a single system, money can take significantly different forms.   There is all of that familiarpaper and metal currency, consisting of tangible objects that can be physicallytransported from one hand to another, and that are denominated with differentface values.  But money might alsoexist simply as “points” electronically credited to someone’s digital monetaryscorecard at a bank.  These pointsare debited from and credited to various accounts, and need never be exchangedfor physical currency.   We can already see a near future inwhich the traditional material currency of metal coins and paper notes will nolonger be used.   In thinkingabout our modern monetary system, then, it is useful to think of it as anetwork of such monetary scorecards.   And we can think of the exchange of physical paper andmetal currency as just one among several ways of adding and subtracting pointsfrom the monetary scorecards of those who exchange the money.   Each individual possess such ascorecard, but so do businesses, governments and other organizations.

Conceiving of our monetary transactions in this way iscompatible with the intellectual framework developed by Hyman Minsky, who said,“A capitalist economy can be described by a set of interrelated balance sheetsand income statements.”  However, the world of balance sheets Minsky asked us to describe containsmore than just money.  Thesebalance sheets record the ownership of other financial assets – that is,promises or commitments of money rather than money itself.   And they also contain accounts ofreal assets – items of positive valueto their owners, like cars or buildings or a book collection – that are notfinancial assets.  Finally, thebalance sheets are also accounts of liabilities– things that represent negative value to their owners, such as debts thatlegally commit the owner of the debt to an outflow of wealth over time.

A second thing to note about modern monetary systems is thatthe market value of these exchangeable monetary points lies, for all of their users,purely in their exchange value.   That is, the only value that attaches tothe acquisition and possession of money comes from the knowledge that money canbe exchanged for other things.  It is true that people also seek to acquire money as a “store of value”that they save for indefinite periods and have no definite plans to spend.   But the only reason one can besuccessful in storing value when onesaves money is that other things continue to happen out in society that preservethe use of that money as a medium of exchange.   If at any time people became unwilling to accept thatform of money in exchange, the saver would no longer be storing value when theysaved their money, but valueless points on a meaningless scorecard.

The fact that the value of modern money is purely based onits acceptance in exchange makes money different from all of the non-monetaryitems that we accumulate and exchange.  Non-monetary items of valuealways have a direct practical utility, for at least some significant number ofpeople, a utility that is not dependent on the prior exchange of those itemsfor something else.   Theutility might be realized in consumption, as it is with a bar of chocolate, or inthe production of some other product or service, as with a block of iron.   It is true that for some specificpeople, the entire value of some non-monetary object might derive from theprospect of exchanging that object for something else.   So, for example, I might be aphilistine art collector who buys paintings only to store value over time andperhaps exchange them later for the things I really want.   For me, paintings function as something like money.   But I can use paintings in thispurely mercenary way, as merely something to exchange for something else, onlybecause there are other people wholove paintings for their own sake.   Similarly, I might be a prisonerwho trades goods for cigarettes, even though I don’t smoke, but only becausesome other prisoners do smoke, and are willing to give something up for thecigarettes.   But money isdifferent altogether.  What makes acertain good a form of money is that its value for pretty much everyone lies entirely in the fact that others willaccept it in exchange.  There is nonon-monetary, non-instrumental foundation for the exchange value of money.   There might be a few dementedmisers with a perverse love for paper bills and metal coins themselves, and afew numismatic hobbyists who collect these bits of money as culturalcuriosities and works of art in themselves.  But the exchange value of money does not depend in anysignificant way of the existence of this relatively small number of people.

Thirdly and finally, it is clear that governments play avery important role in the regulation of contemporary monetary systems, and inthe creation and destruction of the monetary units in that system.  The monies we use have an official,legally institutionalized role in our economies, an official status that isadvertized to us by the markings and declarations on the physical currencyitself.  Almost all money in actualwidespread use is some government’s money.   The government is central in preserving the value andstability of the government’s money over time.   And we know that while we all have a great deal ofliberty to exchange the money we personally possess for other good andservices, and to exchange goods and services for money, the legal authority tocreate and destroy the official government money is tightly regulated andprotected.   It is to suchofficial, government administered monetary systems – at least when they existin democratic societies – that I refer when I describe a monetary system suchas the dollar system as “the public’s money.”

But how do those governmental monetary processeshappen?   How is the monetarysystem stabilized over time?  How is money actually created and destroyed in a modern monetary economy?    The full answer to these questions is not simple.   Governments are complex entities,consisting of many separate branches, divisions, departments and agencies, eachwith its own assigned powers and authorities, and many distinct operationalcenters have their hands on different aspects of the monetary system.   The private sector plays a key role as well.    My focus will primarily beon the processes that create and destroy money.  We can put off the precise details of government monetaryoperations for now, and start instead with a simplified model.   I will call the government in this simple model a “monetarilysovereign government”, or just a “monetary sovereign”.   

Monetary sovereigns can come in different forms, but in ademocracy the people as a whole are supposed to be the ultimate seat and sourceof the government’s sovereignty, including its sovereignty over monetaryoperations.   Think of the monetarysovereign, no matter what individual or group of individuals constitute andexercise that sovereignty, as possessing a single monetary account of its own -a single unified monetary scorecard.  Initially, the monetarysovereign’s scorecard can be thought of as very much like anyone else’smonetary scorecard.  When themonetary sovereign spends, and either buys something from someone in theprivate sector or transfers money outright to the private sector, some monetarypoints are deducted from the monetary sovereign’s scorecard and an equal numberof points are added to that private sector scorecard.   And going in the other direction, when the monetarysovereign taxes, or when someone purchases some good or service from agovernment agency, some monetary points are deducted from the private sectorscorecard and an equal number of points are added to the monetary sovereign’s scorecard.

But there are two wrinkles, two special circumstances thatmake the monetary sovereign’s scorecard very different from private sector scorecards.

First, the monetary sovereign is the seat of government, andhence the ultimate administrator of its own scorecard.   If you and I exchange money, andthe exchange takes place via our bank accounts, the banks that oversee theseaccounts administer the adjustment of the monetary points on ourscorecards.  And if two banks exchangemoney, the government, which operates a central bank that serves as a sort ofbank for bankers, administers the adjustment of monetary points between the twobank scorecards.   But when amonetary exchange takes place between the monetary sovereign and any other personor entity in the private sector, the monetary sovereign is the ultimateadministrator or arbiter of the monetary adjustment.  The monetary sovereign’s scorecard is not administered bysome third party, but by the monetary sovereign itself.

It is true that the scorecard of some agency within the government might beadministered by some other agency of the government.  In the US system, for example, the Treasury Department’smonetary transactions are administered by the Federal Reserve System, whichholds the Treasury Department’s accounts. But the Fed is ultimately part of the government, which means that theUS government as a whole is the ultimate administrator of the government’s ownaccounts.

The other way in which the monetary sovereign’s monetaryscorecard is different from a private sector scorecard is connected with thefirst difference:  A monetarilysovereign government reserves for itself the power of adding or deleting monetarypoints on its own scorecard or any other scorecard, at its own discretion, withoutany requirement that an equal number of monetary points are debited from anyother scorecard or credited to any other scorecard.  And the monetary sovereign uses its power to guarantee thatit is the sole entity in the monetarysystem that possesses such power.  The monetary sovereign, in other words, wields the exclusive power tocreate and destroy money in the monetary system it controls.   Currency users in the private sector, on the other hand, canonly exchange monetary points in waysthat make the books balance.  Tothe extent that agents other than the monetary sovereign are permitted toengage in money-creating and money-destroying operations, these operations takeplace only with the permission of the monetary sovereign, and under theguidance or supervision of the monetary sovereign.

There might appear to be one partial exception to the aboverestriction, however.   Privatesector banks are also permitted, within certain limits, to create new monetarypoints in the monetary system.  When a bank decides to give a loan to some new borrower, it creates adeposit account for that borrower and credits the loaned amount of dollars tothat account.  In effect, itcreates a new monetary scorecard for the borrower and puts some monetary pointson it.   As the economistsBasil Moore, Scott Fullwiler, Marc Lavoie and many others have emphasized, thosepoints need not come from anywhere.  They need not be the result of a transfer of points from some otheraccount to the borrower’s account. Although the bank might be subject to central bank reserve requirementsthat mandate the bank hold a certain percentage of money against its deposits,in its reserve account at the central bank, the bank typically has severalweeks to meet these requirements, and can acquire the reserves after making the initial loan, eitherfrom other banks or from the central bank itself.

So bank lending can in some sense create additionalmoney.   However, in a verystrict sense, what the bank borrower receives is not monetary points, but a promise of monetary points to bedelivered in the future.  Thatpromise is a liability of the bank – something it now owes the borrower and thatthe borrower can convert into money on demand.  If the borrower decides to withdraw the promised money inthe form of material currency, the bank must take cash from its vault and giveit to the borrower.   At thispoint, we can see an actual transfer of money from the bank to theborrower.  But the bank’s vaultcash has to be acquired from the monetary sovereign, and it has to pay for thatcash.

Now since bank deposits can be exchanged just about asfreely as money in any form, they can be legitimately defined as one form ofmoney itself.  There is perhaps nostrict line that can be drawn between liabilities for money or promises ofmoney, on the one hand, and money itself, on the other hand.   But ultimately, however we define“money”, all of these banking operations are administered and regulated by themonetary sovereign, and so the monetary sovereign’s decisions are ultimatelyresponsible for which lending operations a bank is permitted to conduct, and whetherthe bank’s lending results in a net increase in money in the monetary system.   The monetary system is under theultimate control of the monetary sovereign, even if the sovereign chooses not to be very assertive inexercising that control, and passively allows banks to create money as they seefit.

So let’s return to the operations of the monetary sovereignitself.    In order tobring the nature and ultimate capacities of monetary sovereignty into sharperrelief, let’s consider three distinct models or mental pictures of the monetarysovereign’s monetary operations.    These mental pictures are designed only toprovide a more vivid imaginative understanding of monetary sovereignty.   And initially at least, theymight appear to be dramatically different pictures.   But we will see that in the end the pictures are,somewhat surprisingly, fully equivalent in everything that is really essentialand important about the monetary sovereign’s operations.

The first picture can be called the infinite account model. Think of the monetary sovereign as possessing an account or monetaryscorecard that holds an infinite quantity of dollars.  When it spends in its unit of currency, it credits someamount of units X to some private sector account, but debits X units from itsown account.   When it taxes,it debits X units from some private sector account, but credits X units fromits own account.   But sinceit possesses infinitely many units of the currency in the first place, theseoperations have no effect on its own balances.   Currency units come in and go out, but the addition orsubtraction of a finite number of units from an infinite stock of units nevermakes any difference.  The sameinfinite number of units exists on the monetary sovereign’s scorecard at alltimes.

A second picture is the emptyaccount model.  In this case, thinkof the monetarily sovereign government as possessing an account that containsno money whatsoever.   Its scorecard always stands atzero.  When it spends, it credits Xunits to some private sector account, but makes no change at all in its ownaccount.   When it taxes, itdebits X units from some private sector account, but again makes no changes atall to its own account.  Since it never possesses any money on its books, the monetarysovereign’s basic monetary operations of taxing and spending can be viewed as simplycreating private sector monetary points out of thin air and destroying privatesector money, not transferring that money back and forth between the privatesector and the government.  On the empty account model, only private sector monetary scorecards aremarked up with monetary balances, and the monetary sovereign never possessesmoney of its own.

Finally, there is the quotidienaccount model.  The monetarilysovereign government is seen on this model as always possessing a finite amountof currency units – just like a private sector entity.  At all times, some finite number of monetaryunits are on its monetary scorecard, and the monetary sovereign running a quotidienaccount is scrupulous about balancing the books on its monetaryoperations.   When it spends,it credits X units to some private sector scorecard, but scrupulously debits X unitsfrom its own scorecard.   Whenit taxes, it debits X units from some private sector scorecard, but againcarefully credits X units to its own account.   Since it possesses only finitely many units in thefirst place, these operations do have an effect on its balances.  However, there is one added wrinkle:the monetary sovereign is, as before, legally entitled to create or destroycurrency units on its scorecard as a separate operation.   So in the end, while there arealways some finite number of units on its scorecard, the monetarily sovereign governmentultimately chooses exactly how many unitsthat is, since it can add or subtract units from its own scorecard at any time.   Even though the sovereign’sbookkeepers are scrupulously balancing the books when it comes to recordingexchanges to and from the private sector, the fact that the government can atany time credit or debit some additional amount makes the bookkeeper’s caresomewhat absurd or meaningless, at least with regard to the monetarysovereign’s own account.

Recognizing that degree of meaninglessness in the quotidien accountmodel is the key to grasping a very fundamental fact about monetary sovereignty.  When it comes to understanding the realeconomic effects of the monetarysovereign’s operations, it really makes no difference whatsoever which picture oneemploys.   The three picturesare all equivalent.   If themonetary sovereign is entitled to create or destroy currency units at will, it reallydoesn’t matter whether we imagine the sovereign as possessing infinitely many units,zero units or some finite number of units of its own choosing.   All that matters is what happensto the accounts in the non-governmental sector.    The monetary sovereign administers the monetary systemof the real economy, and that real economy consists of the sphere of goods andservices that are produced and exchanged by the world outside of thegovernment, a world in which the government’s money plays the role offacilitating exchange, accounting for value in a standard unit of measure andmaking payments.   Since thosepeople and entities in the private sector economy are not permitted to create currencyunits at will, unless such power has been delegated to them by the monetarysovereign, their spending and savings decisions are constrained at any time bythe number of units they possess at that time.   And the rate at which money is exchanged for goods andservices depends ultimately on the amount and distribution of money that existsout in the private sector.   Whatultimately matters, then, is whether some government operation has the effectof adding monetary points to some private, non-governmental sector scorecard,or deleting monetary points from some private, non-governmental sectorscorecard.   What happens tothe sovereign’s own scorecard is insignificant with regard to the creation anddestruction of value in the real economy, that is, with regard to all of thethings we really care about.

Going forward, then, it will be good to use neutral terms todescribe the effects of the fundamental monetary operations of the monetarysovereign, terms which do not depend on which of the three models we use toconceive of these operations.  We will say, then, that taxes “remove” money from the non-governmentalsector, and that government spending “inserts” money into the non-governmentalsector.  The monetary sovereign possessesthe power of a government to make these things happen, and the insertion andremoval of money from various places in the private sector can have profoundeffects.  But what happens behindthe accounting wall separating the monetary sovereign’s scorecard for all ofthe other scorecards makes no real difference to anybody.  Whether one chooses to regard theinsertion of money into the economy as a transferof money – in accordance with either the infinite account model or the quotidianaccount model – or as the creation ofmoney from nothing – in accordance with the empty account model – really makesno difference to the effects of these operations in the private sector economy.

So far, I have discussed only two main kinds of governmentmonetary operations: taxing and spending. But I have neglected to discuss borrowing, another significantgovernment financial operation. How should we understand the borrowing operations of a monetarilysovereign government?

To answer this question, we should begin by asking what wemean by “borrowing” and “lending”, in the financial senses of those words.   What does it mean to say someone has borrowed money from somebank lender?   Well it isclear that we don’t mean quite thesame thing that we mean when we talk about other non-monetary acts of borrowing and lending in the everyday world.   If my neighbor borrows mylawnmower from me, and I lend it to him, I simply hand over my lawnmower to himfor some more-or-less agreed amount of time.   He uses it for a while, and then gives it back tome.  End of story.   The value of the lawnmower hasprobably depreciated just a tiny bit as a result of the use, and my neighborhas derived some value from the lawnmower for which he did not pay me.   But if, instead of agreeing to lend him the lawnmower, I amonly willing to hand over the lawnmower for some more-or-less agreed paymentfrom my neighbor, we would probably say that my neighbor has then rented by lawnmower from me, notborrowed it.   So in essence,my act of lending constitutes a modest neighborly gift on my part.   I give the gift and my neighborreceives it.  That’s all.

But clearly, that is not at all the way we are using theterms “borrowing” and “lending” when we apply these terms in the usual way tothe borrowing and lending of money.   As we all know, abank loan is no gift!    In the case of money, we are talkingabout an exchange or trade.    When people borrow money, they acquire somemoney in exchange for a promise, a promise to pay some other amount of money inthe future – almost always a greater amount.  The promise then represents a financial asset for thelender, and a financial liability to the borrower: it represents something thelender is slated to gain and the borrower is slated to lose.   The financial instrument, thepromise, represents a cash flow.  From the point of view of the lender, it represents an inflow ofmonetary payments, generally associated with a fixed payment schedule.  From the point of view of the borroweron the other hand, the financial instrument represents an outflow of money onthe same more-or-less fixed payment schedule.   A bond – suchas the bonds sold by businesses and governments – are essentially financialinstruments formalizing promises of this kind.   In terms of a monetary scorecard, we can think of afinancial asset like a bond as something like some marks on the scorecard correspondingto a schedule of pre-determined point increases.  The lender’s scorecard contains the bond as well as anypreviously existing monetary points the lender possessed.   As any one of the various timesindicated on the schedule transpire, some marks indicating a scheduled paymentof currency units at that time are erased, and the appropriate numbers of actualcurrency units are added to the scorecard.   Gradually what begins as a mere schedule of monetarypoints to be received in the future is transformed into some quantity of actualmonetary points.

People can also sell bonds that they have already purchasedfrom some other party.  Suppose A has purchased a bond – a schedule of monetary payments – fromB.   But suppose A no longerwants to wait for the promised money to be credited to her scorecard onschedule, and prefers some money now.   Then A might be able to find somethird party C who is willing to buy the remaining schedule of payments fromA.   A receives some moneyfrom C – that is, A’s monetary scorecard is credited by some amount and C’smonetary scorecard is debited by some amount.   Now B still owes the remaining schedule of monetarypoints, but B now owes them to C.  In accordance with the remaining schedule of payments, C’s scorecardwill be marked up with additional monetary points and B’s schedule will bedebited by that amount of points concurrently.

So, borrowing and lending money in financial markets doesnot involve any kind of gift.  Itis an exchange in which each party gives something up and each party receivessomething in return.  The borrowerreceives present money and in return gives up money in the future.   The lender gives up present moneyand in return receives money in the future.  Generally, people are only willing to make such an exchangeif it is mutually beneficial.  It is important to keep the mutually beneficial nature of creditrelationships in mind.  There is anunfortunate tendency in contemporary discourse about credit to regard thelender as a person who has bestowed some favor, gift or act of grace on theborrower.   But that is notthe case.   Rather, two peoplehave made a simple mutually beneficial exchange.  One party to the exchange receives from the other some moneyin the present; the other party to the exchange receives from the other somemoney in the future.

But let’s return now to the case of a monetary sovereign,and look at these borrowing and lending processes from the perspective of amonetary sovereign’s operations, in line with any one of the three models wedescribed before.   Start with borrowing.  What are the effects of governmentborrowing from the non-government sector, at positive interest?   Well, first, the private sector lender buys a bond from the monetarysovereign.   At the time ofthe purchase, some monetary points are removed from the lender’s monetary scorecard,and a schedule of pre-determined monetary points is added to that scorecard.   Then over time, some of the marksrepresenting pre-scheduled monetary points are removed and the appropriate numberof monetary points are added.  These operations are likely to be very important to the private sectorlender.   But remember that fromthe standpoint of the monetary sovereign it makes no difference what happens tothe monetary sovereign’s own scorecard. All that is important is what happens to the private sector scorecard:some money is first subtracted from the scorecard, and then some greater amountof money is added to the scorecard over time.   And since that lender is part of the private sector, thegovernment in this case first removes money from the private sector and theninserts money into the private sector over time, on a pre-determined schedule.

Now what if, instead of borrowing from the private sector,the monetary sovereign lends to theprivate sector?  We can understandthe effects of this operation by just reversing the time order and direction ofthe previously described borrowing operation.   When the government lends to a private sector entity, somemoney is first added to that entity’s scorecard, and then some greater amountof money is subtracted from the scorecard over time.   The government in this case first inserts money intothe private sector and then removes money from the private sector over time, ona pre-determined schedule.     But remember again that from thestandpoint of the monetary sovereign it makes no difference what happens to themonetary sovereign’s own scorecard. All that is important is what happens to the private sector scorecard:some money is in this case first added to the scorecard, and then some greateramount of money is subtracted from the scorecard over time.

Now consider the monetary effects of several of thesemonetary operations together: taxing, transfer spending, borrowing andlending.   Both money andofficial promises of money represent assets to the party that hold them.  So the effect of these governmentmonetary operations is the swapping around of government-issued financial assetson private sector balance sheets.  In each case, the monetary sovereign is mainly adjusting the scheduleson which it will insert and remove money from the private sector, and theaccounts on which it will make these changes.  In some cases it adjusts a schedule of money removals andmoney insertions forward in time toward the present; in some cases it adjusts aschedule further off in time toward the future.   It is likely engaging in a large and complexcombination of such adjustment operations at any time.    All of these adjustments helpregulate the flow of additional money into and out of the private sector.

Think of it this way: The private sector can be imagined as a collection of wells, and eachwell is outfitted with a collection of nozzles to which one can attachhoses.  Each hose either drawswater out of a well and into the monetary sovereign’s well, or draws water outof the monetary sovereign’s well and into the private sector well.  Some of the hoses carry a steady flowwhenever they are hooked up.  Otherhoses are outfitted with valves that deliver their water flow in bursts, on aset time schedule.  The monetarysovereign’s various monetary operations can then be seen to consist indetaching some hoses and attaching others, sometimes swapping out one hose foranother.

But just as before, remember that it doesn’t really matterwhat happens to the monetary sovereign’s own well.  This is perhaps easiest to imagine if we think of themonetary sovereign’s well as infinitely deep – as in the infinite accountmodel.   Water flows into andout of the monetary sovereign’s well.   But these flows make no difference from the standpoint ofthe monetary sovereign itself, since the sovereign’s well is always infinitelydeep and filled with an infinite amount of water.   But the flows of water make quite a bit of differenceindeed to the owners of the many ordinary wells out in the private sector.
This is Part Two of asix-part series.  Part One is here.