Monthly Archives: December 2011

MMP Blog #29: What about a country that adopts a foreign currency? Part Two

By L. Randall Wray

Yet another rescue plan for the EMU is making its waythrough central Europe—with the ECB acting as lender of last resort toEuro-banks. It is trying the tried-and-failed Fed method of rescue. As we nowknow the Fed lent and spent over $29 TRILLION trying to rescue (mostly) USbanks. It did not work. The biggest banks are still insolvent, and havecontinued their massive frauds trying to cover up their insolvencies. Youcannot paper-over insolvency through massive lending by the central bank. Andthe Euroland problems are compounded by the insolvencies of virtually all theirmember states.

To be sure, we also have probable insolvencies of some ofour US states—but we’ve got a sovereign government that will eventually do theright thing (as Mr. Churchill famously said, Americans get around to that,after trying everything else first). But the Euro states do not have anysovereign backing them up. And note that the ECB remains unwilling to do thejob. A disastrous financial collapse and possible Great Depression 2.0 remainsthe most likely scenario.

How Did Euroland Get Into Such A Mess? PartOne: Private Debt

We all knowthe favourite story told: profligate-spending Mediterranean governments blew uptheir budgets, causing the crisis. If only they had followed the example ofGermany—as they were supposed to do once they joined the Euro—the EMU wouldhave worked just fine.

While thestory of fiscal excess is a stretch even in the case of the Greeks, it doesn’teasily apply to Ireland and Iceland—or even to Spain—all of which had lowbudget deficits (or even surpluses) until the crisis hit. In truth, there weretwo problems.

First, likemost Western countries, private sector debts blew up in many Euroland countriesafter the financial system was de-regulated and de-supervised. To label this asovereign debt problem is quite misleading. The dynamics are surely complex butit is clear that there is something that is driving debt growth in thedeveloped world that cannot be reduced to runaway government budget deficits.Nor does it make sense to point fingers at Mediterraneans since it is (largely)the English-speaking world of the US, UK, Canada and Australia that has seensome of the biggest increases of household debt—the total US debt ratio reached500%, of which household debt alone is 100%, and financial institution debt isanother 125% of GDP.

Take a lookat this graph, which shows the debt-to-GDP ratios for the private andgovernment sectors:
Clearly, upto 2007 the really big debt ratios were in the private sector. The story isvery similar to that of the US. But note that the problem tends to be worse in those countries with smallergovernment debts—there is an inverse relation between private debt ratios andgovernment debt ratios. Now why is that?

And as weknow from previous MMP sections, the sectoral balance identity shows thedomestic private balance equals the sum of the domestic government balance lessthe external balance. To put it succinctly, if a nation (say, the US) runs acurrent account deficit, then its domestic private balance (households plusfirms) equals its government balance less that current account deficit. To makethis concrete, when the US runs a current account deficit of 5% of GDP and abudget deficit of 10% of GDP its domestic sector has a surplus of 5%; or if itscurrent account deficit is 8% of GDP and its budget deficit is 3% then theprivate sector must have a deficit of 5%–running up its debt.

{An aside: Abig reason why much of the developed world has had a growth of its outstandingprivate and public sector debts relative to GDP is because we have witnessedthe rise of BRIC (and others—especially in Asia) current account surpluses—matchedby current account deficits in the developed Western nations taken as a whole.Hence, developed country budget deficits have widened even as their privatesector debts have grown. By itself, this is neither good nor bad. But overtime, the debt ratios and hence debt service commitments of Western domesticprivate sectors got too large. This was a major contributing factor to the GFC.}

Our Austerianssee the solution in belt-tightening, especially by Western governments. Butthat tends to slow growth, increase unemployment, and hence increase the burdenof private sector debt. The idea is that this will reduce government debt anddeficit ratios but in practice that does not work due to impacts on thedomestic private sector. Tightening the fiscal stance can occur in conjunctionwith reduction of private sector debts and deficits only if somehow thisreduces current account deficits. Yet many nations around the world rely oncurrent account surpluses to fuel domestic growth and to keep domesticgovernment and private sector balance sheets strong. They therefor react tofiscal tightening by trading partners—either by depreciating their exchangerates or by lowering their costs. In the end, this sets off a sort of modernMercantilist dynamic that leads to race to the bottom policies that few Westernnations can win.

Germany,however has specialized in such dynamics and has played its cards well. It hasheld the line on nominal wages while greatly increasing productivity. As aresult, in spite of reasonably high living standards it has become a low costproducer in Europe. Given productivity advantages it can go toe-to-toe againstnon-Euro countries in spite of what looks like an overvalued currency. ForGermany however, the euro is significantly undervalued—even though most euronations find it overvalued. The result is that Germany has operated with acurrent account surplus that allowed its domestic private sector and governmentto run deficits that were relatively small. Germany’s overall debt ratio is at200% of GDP, approximately 50% of GDP lower than the Euro zone average.

Notsurprisingly, the sectoral balances identity hit the periphery nationsparticularly hard as they suffer from what is for them an overvalued euro, and lowerproductivity than Germany enjoys. With current accounts biased toward deficitsit is not a surprise to find that the Mediterraneans have bigger government andprivate sector debt loads.

Now, if Europe’s center understood balance sheets, it wouldbe obvious that Germany’s relatively “better” balances rely on the periphery’srelatively “worse” balances. If each had separate currencies, the solutionwould be to adjust exchange rates so that our debtors would have depreciationand Germany would have an appreciating currency. Since within the euro this isnot possible, the only price adjustment that can work would be either risingwages and prices in Germany or falling wages and prices on the periphery. But ECB,Bundesbank and EU policy more generally will not allow significant wage andprice inflation in the center. Hence the only solution is persistent deflationarypressures on the periphery. Those dynamics lead to slow growth and hencecompound the debt burden problems.

How Did Euroland Get Into Such A Mess? PartTwo: Government Debt

To be sure, the private debt problem—related to the internalEuropean dynamics of a strong mercantilist Germany in the center—would be veryhard to resolve. But Euroland has an even more fatal problem: the Euro, itself.So let us turn to that second problem.

The fundamentalfault with the set-up of the EMU was the separation of nations from theircurrencies. It was a system designed to fail. It would be like a USA with noWashington—with each state fully responsible not only for state spending, butalso for social security, health care, natural disasters, and bail-outs offinancial institutions within its borders.  In the US, all of those responsibilities fall under thepurview of the issuers of the national currency—the Fed and the Treasury. Intruth, the Fed must play a subsidiary role because like the ECB it isprohibited from directly buying Treasury debt. It can only lend to financialinstitutions, and purchase government debt in the open market. It can help tostabilize the financial system, but can only lend, not spend, dollars intoexistence. The Treasury spends them into existence. When Congress is notpreoccupied with Kindergarten-level spats over debt ceilings that arrangement worksalmost tolerably well—a hurricane in the Gulf leads to Treasury spending torelieve the pain. A national economic disaster generates a Federal budgetdeficit of 5 or 10 percent of GDP to relieve pain.

That cannothappen in Euroland, where the Euro Parliament’s budget is less than one percentof GDP. The first serious Euro-wide financial crisis would expose the flaws.And it did.

Member states became much like US states, but with two keydifferences. First, while US states can and do rely on fiscal transfers fromWashington—which controls a budget equal to more than a fifth of US GDP—EMUmember states got an underfunded European Parliament with a total budget ofless than 1% of Europe’s GDP. (To make it even worse, the Parliament’s fundingcomes from the member states!)

This meant that member states were responsible for dealingnot only with the routine expenditures on social welfare (health care,retirement, poverty relief) but also had to rise to the challenge of economicand financial crises.

The second difference is that Maastricht criteria were fartoo lax—permitting outrageously high budget deficits and government debtratios.  Most of the critics hadalways (wrongly) argued that the Maastricht criteria were too tight—prohibitingmember states from adding enough aggregate demand to keep their economieshumming along at full employment. It is true that government spending was chronicallytoo low across Europe as evidenced by chronically high unemployment and rottengrowth in most places. But since these states were essentially spending and borrowinga foreign currency—the Euro—the Maastricht criteria permitted deficits anddebts that were inappropriate.

Let us take a look at US states. All but two have balancedbudget requirements—written into state constitutions—and all of them aredisciplined by markets to submit balanced budgets. When a state finishes theyear with a deficit, it faces a credit downgrade by our good friends the creditratings agencies. (Yes, the same folks who thought that bundles of trashmortgages ought to be rated AAA—but that is not the topic today.) That wouldcause interest rates paid by states on their bonds to rise, raising budgetdeficits and fueling a vicious cycle of downgrades, rate hikes and burgeoningdeficits. So a mixture of austerity, default on debt, and Federal governmentfiscal transfers keeps US state budget deficits low.

(Yes, I know that right now many states are facingArmageddon—especially California—as the global crisis has crashed revenues andcaused deficits to explode. This is not an exception but rather demonstrates myargument.)

The following table shows the debt ratios of a selection ofUS states. Note that none of them even reaches 20% of GDP, less than a third ofthe Maastricht criteria.
Alaska
15.7
Montana
12.2
Connecticut
12.1
New Hampshire
13.0
Hawaii
12.2
New York
10.5
Maine
11.0
Rhode Island
16.9
Massachusetts
16.5
Vermont
12.6
By contrast, Euro states had much higher debt ratios—withonly Ireland coming close to the low ratios we find among US states (the redline is drawn at the Maastricht criterion of 60%).












To be clear, none of these debt ratios would be too high fora sovereign government that issues its own currency. Remember that Japan’sgovernment debt ratio is 200%–and its interest rate has been close to zero fortwo decades. But they are too high for nonsovereign nations that use a foreigncurrency.


Those who follow Modern Money Theory believed that market“discipline” would eventually impose debt and deficit limits far belowMaastricht criteria—to ratios closer to those imposed on US states. And with nofiscal authority in the center to match the US Treasury, the first seriouseconomic or financial crisis would expose the flaws of the design of the euro. Becausethe crisis would cause member state deficits and debts to grow. At the sametime markets would begin to realize that these member states are much like USstates but without the backstop of a European Treasury.
And that is precisely what has happened.

To be sure markets have not reacted simultaneously againstall member states. If you think about it, this makes sense. There is a desireto hold euro-denominated debt—the euro is a strong currency and much of theworld wants to buy European exports. So markets run out of Greece and Irelandand now Italy but need to get into other euro debt. Since Germany is thestrongest member and by far the biggest exporter, it benefits the most from arun against the periphery.

Yet as Germany is a net exporter with a relatively smallbudget deficit, it is hard to get German debt. The biggest issuer of debt wasItaly, and there was a strong belief in markets that because Italy’s debt is solarge, it is like a Bank of America—too big to fail. And ditto for France andSpain. So spreads widened for Greece and Ireland and Portugal, but have onlyrecently increased for Spain and Italy.

But after the agreement to accept a “voluntary” haircut of50% on Greek debt, no prudent investor can any longer pretend that Italy, Spainor even France and Germany is a safe bet. Faith based investing in Euro debt isover. And note that if the stronger nations really do bail-out a Spain or anItaly, our friendly credit rating agencies will quickly downgrade the strongnations (they are now threatening France) for contributing funds to rescuetheir neighbors. Even Germany will not be safe if it participates in a bailoutof Italy by committing funds.

There is thus a damned-if-you-do and damned-if-you-don’tdilemma. A bail-out by member states threatens the EMU by burdening andeventually bringing down the strong states; and allowing too-big-to-fail Italyto default would prove to markets that no member state is safe.

And this is why it does not matter how much the ECB lends toEurobanks—the banks would be crazy to buy up government debt. And it is hard tobelieve that any US money managers can make a case that it is still prudent toinvest in euro debt.

Many critics of the EMU have long blamed the ECB forsluggish growth, especially on the periphery. The argument is that it keptinterest rates too high for full employment to be achieved. I have alwaysthought that was wrong—not because I do not agree that lower interest rates aredesirable, but because even with the best-run central bank, the real problem inthe set-up was fiscal policy constraints. Indeed, several years ago, Claudio Sardoniand I demonstrated that the ECB’s policy was not significantly tighter than theFed’s—but US economic performance was consistently better. The difference wasfiscal policy—with Washington commanding a budget that was more than 20% ofGDP, and usually running a budget deficit of several percent of GDP. By contrast,the EU Parliament’s budget could never run deficits like that. Individualnations tried to fill the gap with deficits by their own governments, thesecreated the problems we see today—as the chickens came home to roost, so tospeak.

Is There Any Solution?

Once the EMU weakness is understood, it is not hard to seethe solutions. These include ramping up fiscal policy space of the EUparliament—say, increasing its budget to 15% of GDP with a capacity to issuedebt. Whether the spending decisions should be centralized is a politicalmatter—funds could simply be transferred to individual states on a per capitabasis.

It can also be done by the ECB: change the rules so that theECB can buy, say, an amount equal to 6% of Euroland GDP each year in the formof government debt issued by EMU members. As buyer it can set the interestrate—might be best to mandate that at the ECB’s overnight interest rate targetor some mark-up above that. Again, the allocation would be on a percapita basisacross the members. Note that this is similar to the blue bond, red bondproposal discussed above. Individual members could continue to also issue bondsto markets, so they could exceed the debt issue that is bought by the ECB—muchas US states do issue bonds.

One can conceive of variations on this theme, such ascreation of some EMU-wide funding authority backed by the ECB that issues debtto buy government debt from individual nations—again, along the lines of theblue bond proposal. What is essential, however, is that the backing comes fromthe center—the ECB or the EU stands behind the debt.

No amount of faith in the European integration is going tohide the flaws any longer. A comprehensive rescue by the ECB—which must standready to buy ALL member state debt at a price to ensure debt service costsbelow 3%–plus the creation of a central fiscal mechanism of a size appropriateto the needs of the European Union is the only way out. If these actions arenot taken—and soon—the only option left is to dissolve the Union.



So, finally, returning to the “one nation-one currency” rule would alloweach nation to recapture domestic policy space by returning to its owncurrency. There was never a strong argument for adopting the Euro, and theweaknesses have been exposed. Currency union without fiscal union was amistake.

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

By Dan Kervick

A new year is upon us.  And even before its first hour has been rung in, 2012 is already takingshape before us as a pivotal year in global politics.  We canall feel the awakening under way.   Arevived longing for equality, shared prosperity and democratic solidarity isinspiring a vibrant new politics around the world.   Thisnew activist spirit is quickened by the keen apprehension of young people onevery continent that something is very, very wrong with the present economicand political order.   The risinggeneration, heirs to sick and damaged societies that have been unbalanced bydecades of plutocratic rule and antisocial cupidity, have now begun to rouse themselves- and in the process they have rallied the moral outrage of their fellowcitizens.

In the face of so much hope and energy, cynicism fallsincreasingly mute. The young occupiersof the public squares are giving new heart to all of those older, beleaguered reformerswho worried that they might never see real change in their countries duringtheir own lifetimes. Young people almost everywhere – from the defiantstreet vendor Mohamed Boazizi in Tunisia to the indignados in Spain to the participants in the Occupy movementacross the United States and elsewhere – are rejecting the destruction wrought ontheir societies by a debased system of economic predation, environmental recklessness,elite privilege, corporate fraud and sheer inhuman greed.   The youthful protestors are determined to restoredemocratic society and human decency, and redeem the dimming promise of their commonfuture, and they have set their sights on the global dictatorship of big money.  The 1%, once complacent in their impregnablefortresses of cash, can be heard to speak in worried tones of late.  They lean pensively from their tower windows,no longer quite so comfortably aloof, and hear the rebel footfalls down on thestreets in the dark.

The task the new activists have set themselves isformidable, because the economic disorders in need of repair are so numerous.  The maladies here in the United States areparticularly acute: Real unemployment iswell up into the double digits – despite standard government habits of cookingthe official unemployment books by not counting various classes of peoplewithout jobs. Unemployment rates amongthe young are especially appalling.  Income disparities and polarization arestaggering:  For example, CEO pay in theUS is now many hundreds of times higher than average worker pay, and the shareof national income going to workers is now at its lowest level since thecountry began measuring that share almost 60 years ago.  The share of income going toward corporateprofits, on the other hand, is at the highest level since 1950, and yet many ofthese profits have been harvested by firing workers and cutting costs, not fromnew production.  And by some recent measures, the proportion ofAmericans who count as either “poor” or “lower income” is close to 50%.  As always, political power follows wealth,and that ineluctable social fact poses a large part of the challenge forreform.  The greater the gap between therich and the not-rich, the greater the capacity of the rich to buy the kinds ofpolitical influence they need to prevent change.

So the problems are not small, and they will not be easy toaddress and fix.  We therefore need tobattle for social and economic changes along many fronts.  But as the new generation of activists pointour societies toward these necessary reforms, so many of which pertain to theoppressive and unjust power derived from the control of concentrated money, theywould be well advised to focus significant attention on the monetary system itself.  The monetary systems that currently exist aredeeply flawed:  they are antiquated; theyare socially inefficient; they are undemocratic; they lack openness andaccountability; and they privilege elite financial interests over the interestsof ordinary citizens and the public interest.  Citizens in every country must begin to work together to reassert publiccontrol over their monetary systems, and assure that those systems are subjectto democratic governance.  And they mustresist calls to expand the rule of private sector wealth over our monetarysystems, and to reduce the public’s control over money even further below thelevel at which it currently stands.  Thepublic’s money must remain in public hands, so it can be mobilized for publicpurposes.

The aim of this essay is to assist the bourgeoning newmovement for a more just and democratic world by contributing some ideas towarddemocratic reform of our monetary systems. These ideas do not primarily take the form of detailed policyinitiatives or specific legislative proposals, although some specificsuggestions along these lines are offered at the end of the essay.   Instead, the focus is on providing a generalframework for understanding the role of money and monetary institutions in themodern world – a framework that helps to clarify what money is, and also pointsclearly toward what money could be.  Themonetary system we actually have is an instrument of the plutocratic order ofneoliberal money manager capitalism.  Buta monetary system fit for a democratic society lies within our grasp.

Few of the ideas in this essay are original.  A good part of my thinking on the subject ofmoney and monetary theory has been inspired by the work of a school of contemporarypost-Keynesian economists and independent writers and researchers whose viewsoften go under the name “Modern Monetary Theory” – or “MMT” for short.    Some prominent thinkers in this field areL. Randall Wray, Scott Fullwiler, Stephanie Kelton, Warren Mosler, Marshall Auerback and William Mitchell.  And like many of these thinkers, my thinking has also been stronglyinfluenced by the 20th-century economists Hyman Minsky and Abba Lerner.   But I hasten to add that there are severalplaces in what follows in which I defend or suggest views that either divergefrom, or go beyond the views that have been defended by the aforementionedauthors.
1.     The Public’s Money

I have claimed that the public’s money must remain in publichands.  But what do I mean when I call amonetary system – such as the US dollar system – “the public’s money”?
I don’t mean that each and every dollar literally belongs tothe public as public property.   TheUnited States government is ultimately responsible for the oversight of themonetary system and the ongoing creation of new dollars.  But as dollars are created they are exchangedfor goods and services, and thereby become the property of the individuals whoproduce those goods and services.

Nor do I mean that each and every dollar that is created comesinto existence as a direct consequence of some act of public or governmentalchoice.  Clearly this is not thecase.  The main force driving the creation of dollarsis the banking system.  Banks bring newdollars into existence by making loans that support the economic activity ofbusinesses and individuals in the real economy. These loans expand the total sum of bank deposits, and bank deposits areproperly regarded as one form of money.   Money in a more restricted sense – physical currency and bank reserves –primarily comes into existence only after the fact in conformity with centralbank policies that accommodate the desires of ordinary banks and their customersto expand bank deposits.

But the dollar is the public’s money because the dollarsystem is the monetary system that US citizens, by right, control.   Constitutionally,the people of the United States are sovereign over their government, and the powerover the US money supply is vested in Congress, the political branch closest tothe people.  The bureaucratic engine ofdollar control – the Federal Reserve System – was created by an act of Congressand possesses all of its monetary powers by delegation of Congressionalauthority.    Congress and the Fed set the rules for thebanking system, and thus govern the processes through which new dollars arecreated and existing dollars are destroyed.  The US government can thus be viewed as a monopoly producer of thedollar, even though it has delegated operational responsibility for thosemonopoly powers to the Fed.   And privatesector banking plays the large role it does only because some of thegovernment’s monopoly power has been chartered out to the banks, presumably tofulfill a public purpose.

And yet, there is good reason to believe that the public’s monetarysystem is broken, and that the public purposes for which it is supposed toexist are being thwarted.  As we can now clearly see, banks and otherfinancial institutions blew up a vast speculative bubble of financial products leadingup to the crash in 2008, a bubble filled with airy, foolish and fraudulentpromises leveraged and re-packaged many times over.   The Fed did nothing to prevent thisinternational-scale Ponzi scheme from unfolding, and we are all now dealingwith the financial carnage that resulted.  And, as I will argue, the powerful monetary tools that could now bedeployed to restore full employment and prosperity are locked up in an outdatedand elitist system designed more to protect the reckless financial institutionsthat caused the disaster than to serve the public that is paying the price ofthe disaster.  This deeply undemocraticmonetary system is still directly supervised by the Fed.

But it would be a mistake to focus too single-mindedly onthe Fed and its failures.  The keymonetary malefactors in the current crisis are a derelict and increasinglymalevolent US Congress, a Congress which appears actively hostile to the verypeople it was elected to represent, and which works daily to serve theplutocratic masters who fund Congressional campaigns and sit atop our society’sfinancial hierarchies.   It doesn’t haveto be this way.   The Fed is a creatureof the US Congress; it was created by the US Congress; and it continues to playits role in the formation of monetary policy at the pleasure of the USCongress.   Congress has all the powerand capacity it needs to seize control of our monetary system on behalf of thebroad public it represents, and to steer latent and untapped US financial powertoward full employment and broad prosperity.  But it refuses to make use of its inherent Constitutional powers toanswer these pressing national needs, and works instead to protect the vestedfinancial interests of the very few.  The Congress that currently exists has beenbought by the plutocracy.  So it will beup to the American people to lead the charge on behalf of monetary democracy.
This is Part One of asix-part series.

Government Spending with Self-Imposed Constraints: Responses to MMP #28

Comments are thankfully few and I already dealt with some ofthem. I doubt there will be many readers this week, but here we go:
Q1: Is it possible to show these transactions simply from anominal perspective?
A: Look if you buy a stick ofgum we need to show the “real”–you exchange a demand deposit forgum, your store gets the demand deposit and you get the gum. We can stick topurely “nominal” only if it is a financial transaction only. But youdo pay “money” (the gum you buy was denominated in dollars) so it is valuedin nominal terms: $1.45. If you did not think it was worth that you would notbuy it. So that is the nominal value we put on it. Kenneth Boulding had a verynice way of looking at it. You exchange your liquid savings (deposit) forilliquid assets (gum); then you dissave over time as you consume them. AsBoulding said, consumption is destruction of your assets–you chew your assetsaway. He said you get no satisfaction from consumption=destruction of assets.Tires on your car are a clearer example. You “consume” them over 5years as you wear them out. You’d rather that they do not wear out, but theywill. That is destruction of assets. It is a stock-flow consistent model.Boulding was among the most clever and greatest of economists.
AQ2 by WH: You wrote in Blog #24, referring to foreigner’saccumulation of reserves, such as China’s:
“Neither of these activities will force the hand of the issuinggovernment—there is no pressure on it to offer higher interest rates to try tofind buyers of its bonds…  Government can always “afford” larger  keystrokes, but markets cannot force thegovernment’s hand because it can simply stop selling bonds and thereby letmarkets  accumulate reservesinstead.” In world with self-imposed constraints like the US’s, it doesn’thave the option to stop selling bonds if it wants to deficit spend. However, like you mention, bonds are an interest-earning alternative toreserves.  So: 1) If bonds are an interest-earning alternative toreserves, is there an economic reason why the ultimate holder of reserves(whether it’s China or whoever China sells dollars to) would not place theirreserves into US debt and at an interest rate consistent with the future pathof FFRs?  In other words, it’s generally understood interest rates on USdebt follow the expected future path of FFRs.  Why would this change ifforeigners hold the debt (even a majority portion of the debt)? 2) Let’s assumeforeigners arbitrarily abstain from buying the debt.  Could the US and itsholding of reserves as well as credit creation abilities still fund the US debtat rates consistent with the path of expected FFRs?
A: First, sovereign governmentcan target any interest rate it wants—overnight, short-term, long-term. It canrefuse to offer long-term debt and instead stay at short end of market. Thus itcan offer Chinese 0.50% on 30 days, or 0% on overnight. Period. They’ll takethe 30 days, but if they decide not to, so what? And in any case, all themonetary ops undertaken to let the Treasury spend have nothing to do withChinese—it is the special banks in the US.
AQ3: wh10 1comment collapsed CollapseExpandIt seems if we take foreigners out of the picture, then there is a smalleramount of reser Q ves/treasury debt with which to buy/rollover into newdebt.  However, in sort of a reversal from my alien scenario, why couldn’tthe US just hold smaller but more frequent auctions to overcome any funding’ issues?
A: It is not a funding issueand yes, the US can do whatever it wants. The foreigners are never in the“funding” part—it is special domestic banks.
AQ4: Paul Krueger 1 comment collapsed CollapseExpandThanks, this is a nice exposition of the (at least partial) equivalence ofdifferent views of the process. To really prove a complete functionalequivalence it seems to me that you would need to show that the interest ratepaid on government bonds was the same in any of the cases. Is that a correctassumption or does that not matter for some reason?
Q5: wh10 1 comment collapsed CollapseExpandI believe at the end of Fullwiler’s paper, he also comments that bank primarydealers can take on the govt’s tsys in a manner similar to your case 3 (asopposed to non-bank primary dealers having to engage in repos to obtain thedeposits to purchase the tsy).  Is there a practical difference betweenthese two types of primary dealers?  Can bank primary dealers handle a greater
govt debt load or do it more easily?  What is the ratio of these bankprimary dealers to non-bank primary dealers? Secondly, Fullwiler has commentedto me that it is possible that a tsy auction could fail if the govt conducted atsy auction, say, 2-3x the size of what it normally does (or some conceivablesize).  This is because investors do have to secure financing toparticipate in the auction, and they might not be able to do it readily enoughwith such a large issuance.  Although, he says, the next time around,they’d likely have no problem getting things together.  Though thisdoesn’t present an issue to a
govt normally, I think it does underscore a real difference between a govt beingable to simply spend first whatever it pleases (e.g. if it had overdraftsfromthe Fed) and a govt needing to tax/sell debt to the private sector in order tospend.  That is, the private does have to secure financing for a govt debtauction to succeed.  So just because the final balance sheet position isthe same, the path to get there may be more obstructive in the realworld.  Usually, it is not an issue at all, but it seems it couldconceivably be.  I just think these types of qualifiers are worthmentioning when teaching MMT to others who may be skeptical about ‘govt spendsfirst,’ since it paints a more accurate picture
and clarifies why the real world doesn’t operate exactly like the general case ofa consolidated Fed/Tsy. 
Q6: ANeil Wilson 1 comment collapsed CollapseExpandS is there any benefit from all those extra transactions? Or is this, likeallegedly private pensions that ‘invest’  in Treasuries, simply a Job Guaranteescheme for financial sector workers?

LRWray Answers: 

Paul: A treasury that understands what bonds are would only sell bills and sowould have no impact on interest rates; that said, there might be an impact iftreasury tries to sell too many long term bonds into mkts. Solution: don’t selllong term bonds.

WH: Scott is the expert and I won’t disagree. And aliens might explode asupernova at some distant place in the universe precidely when the treasurytries to auction, causing a temporary hiccup. We cannot possibly deal withevery unlikely event. Treas and Fed converse every morning to go over plans.They aren’t going to try to auction of 3x what the mkt can handle. In any case,the primary dealers are “banks” so not sure what you are getting at. While thepath could be more difficult in practice it is not. Except when Congressrefuses to raise debt limit!

And that leads to Neil: NO, obviously all the intermediate transactions justintroduce the possibility that something could possibly go wrong. You can be amuch better boxer if you do not tie your hands behind your back and your shoestogether. These constraints arise because Congress doesn’t understand monetaryoperations.

Solvency Starts with the ECB

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President Obama’s view of fraud “from 40,000 feet” (without an oxygen mask)

By William K. Black
(Cross-posted from Benzinga)


Sixty Minutes’ December 11, 2011interview of President Obama included the following gem:

KROFT: One of the things that surprised me the mostabout this poll is that 42%, when asked who your policies favor the most, 42%said Wall Street. Only 35% said average Americans. My suspicion is some of thatmay have to do with the fact that there’s not been any prosecutions, criminalprosecutions, of people on Wall Street. And that the civil charges that havebeen brought have often resulted in what many people think have been slap onthe wrists, fines. “Cost of doing business,” I think you called it inthe Kansas speech. Are you disappointed by that?

PRESIDENT OBAMA: Well, I think you’re absolutelyright in your interpretation. And, you know, I can’t, as President of theUnited States, comment on the decisions about particular prosecutions. That’sthe job of the Justice Department. And we keep those things separate, so that there’sno political influence on decisions made by professional prosecutors. I cantell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.

That’s exactly why we had to change the laws. Andthat’s why we put in place the toughest financial reform package since F.D.R.and the Great Depression. And that law is not yet fully implemented, butalready what we’re doing is we’ve said to banks, “You know what? You can’ttake wild risks with other people’s money. You can’t expect a taxpayer bailout.

Hallucinations occur at high altitude when you become oxygen deprived.  Let’s review the bidding on theBush/Obama record in prosecuting the elite control frauds that drove theongoing crisis.  There are noconvictions of the Wall Street elites that made, purchased, packaged, and soldmillions of fraudulent liar’s loans. There are no federal prosecutions of the major banks that committed over100,000 fraudulent foreclosures. There are a few settlements that sound like large dollar amounts, butare merely what even Obama concedes to be the (deeply inadequate) “cost ofdoing (fraudulent) business.” Fraud pays – it pays enormously and our elites now commit it withimpunity as a means of becoming wealthy. We have just witnessed the travesty of Wachovia admitting to criminalconduct in their (grotesquely weak) settlement with the Department of Justice(which has a policy of no longer prosecuting large corporations that commitcrimes) – and having the SEC refuse to require Wachovia to make similaradmissions in its settlement.  Allthis, the President implicitly or even explicitly concedes.



But the President asserts:  “Ican tell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.”  Kroft, sadly, didnot follow up on this incredible and, if true, extraordinarily importantassertion.  Obama’s statementsabout fraud and ethics are inaccurate on multiple levels. 
Obama’s factual assertions about the failure to prosecute fraud areunresponsive to the question, false, and logically inconsistent.  Note the artful manner in which Obamaevaded answering Kroft’s question. Kroft asks why there are no prosecutions of the Wall Street frauds thatdrove the crisis.  Obama answersthat “some” unethical Wall Street actions were not illegal.  Obama’s answer implicitly admitted thatmost Wall Street actions that causedthe crisis were criminal.  Hesimply argues that some highlyunethical behavior by Wall Street that was not illegal contributed to thatcrisis.  As David Cay Johnstonemphasized in his column about Obama’s response to Kroft’s question, Obama’s answeris a non-answer.  Why has he failedto prosecute any of the criminal conduct by Wall Street that drove thefinancial crisis?  The (alleged)fact that “some” destructive Wall Street conduct was highly unethical, but notillegal, obviously provides no basis for not prosecuting what Obama concedeswas primarily criminal conduct.   


Obama claims that the purported legality of Wall Street’s (unspecified)“least ethical behavior” is “exactly why we had to change the laws.”  He then describes the two specificchanges in the Dodd-Frank law that he asserts make illegal that “least ethical behavior” for the firsttime.  Obama claims that Dodd-Frankmakes it illegal to “take wild riskswith other people’s money” and for bankers to “expect a taxpayer bailout.”  Obama is a lawyer and former lawprofessor, so these are matters as to which he is capable of precision.   Dodd-Frank does not make it illegal for bankers to take “wildrisks.”  Banks inherently takerisks “with other people’s money” so that bit of rhetoric issuperfluous. 
Dodd-Frank does not make it illegal for a banker to “expect a taxpayerbailout.”  Dodd-Frank does not makeit illegal (and could not constitutionally do so) for bankers to lobby for abailout.  We have all seen thesuccess of such lobbying with the Bush and Obama administrations.  Both administrations have refused toorder an end to the “systemically dangerous institutions” (SDIs) (inaccuratelyreferred to as “too big to fail”). Both administrations asserted that when the next SDI failed it was likelyto cause a global systemic crisis. (It is a matter of “when”, not “if” they will fail, or more precisely,when we will admit that they failed.) 


The SDIs are also too big to manage – they are inefficiently large.  We can increase efficiency,dramatically reduce global systemic risk, and reduce the SDI’s exceptionalpolitical dominance by ordering them to shrink over the next five years to apoint that they no longer pose a systemic risk.  Instead, the Obama administration continues the Bushpractice of referring to the SDIs as “systemically important” (as if theydeserved a gold star for putting the world’s economy at risk).  The Bush and Obama administrations haveallowed, even encouraged, the SDIs to grow larger.  That policy is insane. It poses a clear and present danger to the U.S. and global economy andto our democracy.  The SDIs will be“bailed out” when they fail. Indeed, they are being bailed out continuously by policies the Fed andTreasury follow that are designed to provide massive governmental subsidiesprimarily for the benefit of the zombie SDIs that have already failed in realeconomic terms, e.g., Bank of America and Citi.

“Wild risks” are not remotely Wall Street’s “least ethicalbehavior.”  It is impossible, givenObama’s generalities and Kroft’s failure to probe to know what “wild risks”Obama is talking about, but none of the (supposed) risky loans banks made evenapproach lenders’ “least ethical behavior.”  The riskiest loans that banks made were liar’s loans toborrowers with bad credit histories. Credit Suisse reported in early 2007 that, by 2006, 49 percent of loansthat lenders called “subprime” (because they were made to borrowers with known,serious credit defects) were also liar’s loans (loans made without prudentunderwriting).  I agree with Obamathat making a subprime liar’s loan is exceptionally “damaging.”  Such loans damaged the lender, theborrower, the purchaser of such loans, and the purchaser of the collateralizeddebt obligations (CDOs) that were backed by subprime liar’s loans.  (Of course, “backed” deserves to be inquotation marks.)  Such loans wouldbe dumb, but they wouldn’t be among the banks’ “least ethical” actions if theloans were lawful.  Indeed, ifmaking subprime liar’s loans were merely risky, one could argue morepersuasively that the banks were acting altruistically when they made suchloans. 

What Obama missed, and Kroft failed to call him on, is that “wildrisk” by banks are typically frauds. I have explained these matters at length in previous posts, so I willprovide the ultra short version here. Honest home lenders do not make liar’s loans.  In particular, honest lenders do not make subprime liar’sloans.  Honest home lenders do notmake such loans because they create intense “adverse selection” and create a“negative expected value” (in plain English, they will lose money).  No government (here or abroad),required any lender or other entity (i.e., Fannie and Freddie) to make oracquire liar’s loans.  In fact, thegovernment repeatedly criticized liar’s loans.  The FBI warned of an “epidemic” of mortgage fraud inSeptember 2004.  The mortgagelending industry’s own anti-fraud body (MARI) warned every member of theMortgage Bankers Association (MBA) in writing in the 2006 that “stated income”loans were “an open invitation to fraudsters,” had a fraud incidence of 90percent, and deserved the term the industry used behind closed doors todescribe them – “liar’s” loans. Despite these warnings, lenders massively increased the number of liar’sloans they made. 

Home lenders made subprime liar’s loans because they were“accounting control frauds.”  Subprimeliar’s loans were ideal “ammunition” for accounting fraud.  They reduced the paper trailestablishing that the lender knew the loan was fraudulent and they optimizedthe four-ingredient “recipe” for a lender engaged in accounting controlfraud.  (Grow rapidly by making badloans at a premium yield, while employing extreme leverage and providing onlygrossly inadequate allowances for loan and lease losses (ALLL)).  The CEOs of lenders that made subprimeliar’s loans as part of this recipe were not taking risks in the conventionalmanner we discuss in finance (uncertainty).  As George Akerlof and Paul Romer explained in their famous1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”),accounting control fraud is a “sure thing.”  The lender is guaranteed to report record (albeit fictional)profits in the near term, which makes the CEO wealthy when he uses modernexecutive compensation to loot the lender.  Unfortunately, the same recipe that creates extremefictional income produces massive real losses.

Making liar’s home loans inherently requires lenders tocreate perverse incentives for widespread mortgage fraud.  It was lenders and their agents thatoverwhelmingly put the lies in liar’s loans.  The CEOs of the lenders who made subprime liar’s loanscompounded their initial mortgage origination fraud by making fraudulent repsand warranties to sell the endemically fraudulent mortgages.  The growth in liar’s loans (roughlyhalf of them were also subprime loans) was so extreme – over 500% from 2003 to2006 – that it caused the bubble to hyper-inflate).  Making fraudulent loans that placed millions of workingclass borrowers in loans that they frequently could not afford to repay andwere deeply underwater caused them a massive loss of wealth and wasdistressingly unethical.  Theofficers controlling the lenders that made fraudulent liar’s loans were evenmore unethical because they caused this devastation in order to become exceptionallywealthy.  The most morally depravedof the CEOs running accounting control frauds sought out the least financiallysophisticated borrowers, often minorities, as their victims.    

Obama has unintentionallyproved the accuracy of the plurality of survey responders who concluded that heserves Wall Street’s interests at the expense of the public.  He cynically evaded responding to theprimary reason why the public “gets it” – the abject failure of his administrationto prosecute the elite financial frauds that drove the financial crisis and theGreat Recession.  Obama offered thepathetic (and factually inaccurate) non-excuse that “some” unethical conductmight be legal.  It is time forObama (and Attorney General Holder) to “man up.”  If they refuse to do so and are going to continue to be lapdogs for the elite financial frauds they should at least change the name of theJustice Department. 


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

MMP Blog #28: Government Spending with Self-Imposed Constraints

By L. Randall Wray

               
In the Primer we discussed the general case of governmentspending, taxing, and bond sales. To briefly summarize, we saw that when agovernment spends, there is a simultaneous credit to someone’s bank deposit andto the bank’s reserve deposit at the central bank; taxes are simply the reverseof that operation: a debit to a bank account and to bank reserves. Bond salesare accomplished by debiting a bank’s reserves. For the purposes of thesimplest explication, it is convenient to consolidate the treasury and centralbank accounts into a “government account”.
To be sure, the real world is more complicated: there is acentral bank and a treasury, and there are specific operational proceduresadopted. In addition there are constraints imposed on those operations. Twocommon and important constraints are a) the treasury keeps a deposit account atthe central bank, and must draw upon that in order to spend, and b) the centralbank is prohibited from buying bonds directly from the treasury and fromlending to the treasury (which would directly increase the treasury’s depositat the central bank). The US is an example of a country that has both of theseconstraints. In this blog we will go through the complex operating proceduresused by the Fed and US Treasury. Scott Fullwiler is perhaps the mostknowledgeable economist on these matters, and this discussion draws veryheavily on his paper. Readers who want even more detail should go to his paper,which uses a stock-flow consistent approach to explicitly show results.
First, however, let us do the simple case, beginning with aconsolidated government (central bank plus treasury) and look at theconsequences of its spending. Then we will look at the real world example ofthe US today. Readers have asked for some balance sheet examples, so I am usingsome simple T-accounts here. It might take some readers a bit of patience towork through this if they have not seen T-accounts before. (Note: these arepartial balance sheets—I am only entering the minimum number of entries to showwhat is going on.)
Let us assume government buys a bomb and imposes a taxliability. This is shown as Case 1a:
The government gets the bomb, the private seller gets ademand deposit. Note that the tax liability reduces the seller’s net worth and increasesthe government’s (after all, that is the purpose of taxes—to move resources tothe government). The private bank gets a reserve deposit at the government.
Now the tax is paid by debiting the taxpayer’s deposit andthe bank’s reserves:

 And so the final position is:
The implication of “balanced budget” spending and taxing bythe government is to move the bomb to the government sector—reducing theprivate sector’s net worth. Government uses the monetary system to accomplishthe “public purpose”: to get resources such as bombs.
Now let us see what happens when government deficit spends.(Don’t get confused—we are not arguing that taxes are not needed; remember“taxes drive money” so there is a tax system in place but government decidesthat this week it will buy a bomb without imposing an additional tax).

Here, the bomb is moved to the government, but the deficitspending allows net financial assets to be created in the private sector (theseller has a demand deposit equal to the government’s financialliability—reserves). However, the bank is holding more reserves than desired.It would like to earn more interest, so government responds by selling a bond(remember: bonds are sold as part of monetary policy, to allow the governmentto hit its overnight interest rate target):

And the end result is:

The net financial asset remains, but in the form of atreasury rather than reserves. Compared with Case 1a, the private sector ismuch happier! It’s total wealth is not changed, but the wealth was convertedfrom a real asset (bomb) to a financial asset (claim on government).

Ah, but that was too easy. Government decides to tie itshands behind its back by requiring it sell the bond before it deficit spends.Here’s the first balance sheet, with the bank buying the bond and crediting thegovernment’s deposit account:

Now government writes a check on its deposit account, to buythe bomb:

The bank debits the government’s deposit and credits theseller’s. The final position is as follows:

Note it is exactly the same as case 1b: selling the bondbefore deficit spending has no impact on the result, so long as the privatebank is able to buy the bond and the government can write a check on itsdeposit account.

That, too, is too simple. Let’s tie the government’s shoestogether: it can only write checks on its account at the central bank. So inthe first step it sells a bond to get a deposit at a private bank.

Next it will move the deposit to the central bank, so thatit can write a check.

We have assumed the bank had no extra reserves to be debitedwhen the Treasury moved its deposit, hence, the central bank had to lendreserves to the private bank (temporarily, as we will see). Now the treasuryhas its deposit at the central bank, on which it can write a check to buy thebomb.

When the treasury spends, the private bank receives a creditof reserves, allowing it to retire its short term borrowing from the centralbank (looking to the private bank’s balance sheet, we could show a credit ofreserves to its asset side, and then that is debited simultaneously with itsborrowed reserves; I left out the intermediate step to keep the balance sheetsimpler). The private bank credits the bomb seller’s account. The finalposition is as follows:

What do you know, it is exactly the same as Case 2 and Case1b! Even if the government ties its hands behind its back and its shoestogether, it makes no difference.

OK, admittedly these are still overly simple thoughtexperiments. Let’s see how it is really done in the US—where the Treasuryreally does hold accounts in both private banks and the Fed, but can writechecks only on its account at the Fed. Further, the Fed is prohibited frombuying Treasuries directly from the Treasury (and is not supposed to allowoverdrafts on the Treasury’s account). The deposits in private banks come(mostly) from tax receipts, but Treasury cannot write checks on those deposits.So the Treasury needs to move those deposits from private banks and/or sellbonds to obtain deposits when tax receipts are too low. So let us go throughthe actual steps taken. Warning: it gets wonky.
*The following discussion is adapted from Treasury Debt Operations—An Analysis IntegratingSocial Fabric Matrix and Social Accounting Matrix Methodologies, by ScottT. Fullwiler, September 2010 (edited April 2011),http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1874795
The Federal Reserve Act now specifies that the Fed can onlypurchase Treasury debt in “the open market,” though this has not always beenthe case.  This necessitates that theTreasury have a positive balance in its account at the Fed (which, as set inthe Federal Reserve Act, is the fiscal agent for the Treasury and holds theTreasury’s balances as a liability on its balance sheet).  Therefore, prior to spending, the Treasurymust replenish its own account at the Fed either via balances collected fromtax (and other) revenues or debt issuance to “the open market”. 
Given that the Treasury’s deposit account is a liability forthe Fed, flows to/from this account affect the quantity of reserve balances.For example, Treasury spending will increase bank reserve balances while taxreceipts will lower reserve balances. Normally, increases or decreases to bankingsystem reserves impact overnight interest rates. Consequently, the Treasury’sdebt operations are inseparable from the Fed’s monetary policy operationsrelated to setting and maintaining its target rate.  Flows to/from the Treasury’s account must beoffset by other changes to the Fed’s balance sheet if they are not consistentwith the quantity of reserve balances required for the Fed to achieve itstarget rate on a given day.  As such, theTreasury uses transfers to and from thousands of private bank deposit (bothdemand and time) accounts—usually called tax and loan accounts—for thispurpose.  Prior to fall 2008, theTreasury would attempt to maintain its end-of-day account balance at the Fed at$5 around billion on most days, achieving this through “calls” from tax andloan accounts to its account at the Fed (if the latter’s balance were below $5billion) or “adds” to the tax and loan accounts from the account at the Fed (ifthe latter were above $5 billion). (The global financial crisis and the Fed’sresponse, especially “quantitative easing” has led to some rather abnormalsituations that we will mostly ignore here.)
In other words, timelinessin the Treasury’s debt operations requires consistency with both the Treasury’smanagement of its own spending/revenue time sequences and the time sequencesrelated to the Fed’s management of its interest rate target.  As such, under normal, “pre-global financialcrisis” conditions for the Fed’s operations in which its target rate was setabove the rate paid on banks’ reserve balances (which had been set at zeroprior to October 2008, but is now set above zero as the Fed pays interest onreserves), there were six financial transactions required for the Treasury toengage in deficit spending.  Since it isclear that current conditions for the Fed’s operations (in which the targetrate is set equal to the remuneration rate) are intended to be temporary and atsome point there is presumably a desire (by Fed policy makers) to return to themore “normal” “pre-crisis” conditions, these six transactions are the base caseanalyzed here (though the “post-crisis” operating procedures do notsignificantly impact conclusions reached). 
The six transactions for Treasury debt operations for thepurpose of deficit spending in the base case conditions are the following:

  1. The Fed undertakes repurchase agreement operations with primary dealers (in which the Fed purchases Treasury securities from primary dealers with a promise to buy them back on a specific date) to ensure sufficient reserve balances are circulating for settlement of the Treasury’s auction (which will debit reserve balances in bank accounts as the Treasury’s account is credited) while also achieving the Fed’s target rate.  It is well-known that settlement of Treasury auctions are “high payment flow days” that necessitate a larger quantity of reserve balances circulating than other days, and the Fed accommodates the demand.
  2. The Treasury’s auction settles as Treasury securities are exchanged for reserve balances, so bank reserve accounts are debited to credit the Treasury’s account, and dealer accounts at banks are debited. 
  3. The Treasury adds balances credited to its account from the auction settlement to tax and loan accounts.  This credits the reserve accounts of the banks holding the credited tax and loan accounts.
  4. (Transactions D and E are interchangeable; that is, in practice, transaction E might occur before transaction D.)  The Fed’s repurchase agreement is reversed, as the second leg of the repurchase agreement occurs in which a primary dealer purchases Treasury securities back from the Fed.  Transactions in A above are reversed.
  5. Prior to spending, the Treasury calls in balances from its tax and loan accounts at banks.  This reverses the transactions in C.
  6. The Treasury deficit spends by debiting its account at the Fed, resulting in a credit to bank reserve accounts at the Fed and the bank accounts of spending recipients.
Again, it is important to recall that all of thetransactions listed above settle via Fedwire (T2).  Also, the analysis is much the same in thecase of a deficit created by a tax cut instead of an increase in spending.  That is, with a tax cut the Treasury’sspending is greater than revenues just as it is with pro-active deficitspending.

Note, also that the end result is exactly as stated aboveusing the example of a consolidated government (treasury and central bank):government deficit spending leads to a credit to someone’s bank account and acredit of reserves to a bank which are then exchanged for a treasury toextinguish the excess reserves. However, with the procedures actually adopted,the transactions are more complex and the sequencing is different. But thefinal balance sheet position is the same: the government has the bomb, and theprivate sector has a treasury.

Watch William K. Black’s Latest Appearance on The Dylan Ratigan Show

Dante’s Divine Comedy: Banksters Edition

By William K. Black
(Cross-posted from Benzinga)

Sixty Minutes’ December 11, 2011 interview of President Obama included a claim by Obama that, unfortunately, did not lead the interviewer to ask the obvious, essential follow-up questions.

“I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn’t illegal.”

Obama did not explain what Wall Street behavior he found least ethical or what unethical Wall Street actions he believed was not illegal. It would have done the world (and Obama) a great service had he been asked these questions. He would not have given a coherent answer because his thinking on these issues has never been coherent. If he had to explain his position he, and the public, would recognize it was indefensible. I offer the following scale of unethical banker behavior related to fraudulent mortgages and mortgage paper (principally collateralized debt obligations (CDOs)) that is illegal and deserved punishment. I write to prompt the rigorous analytical discussion that is essential to expose and end Obama and Bush’s “Presidential Amnesty for Contributors” (PAC) doctrine. The financial industry is the leading campaign contributor to both parties and those contributions come overwhelmingly from the wealthiest officers – the one-tenth of one percent that thrives by being parasites on the 99 percent.

I have explained at length in my blogs and articles why:

  • Only fraudulent home lenders made liar’s loans 
  • Liar’s loans were endemically fraudulent 
  • Lenders and their agents put the lies in liar’s loans 
  • Appraisal fraud was endemic and led by lenders and their agents 
  • Liar’s loans could only be sold through fraudulent reps and warranties 
  • CDOs “backed” by liar’s loans were inherently fraudulent 
  • CDOs backed by liar’s loans could only be sold through fraudulent reps and warranties 
  • Liar’s loans hyper-inflated the bubble 
  • Liar’s loans became roughly one-third of mortgage originations by 2006

Each of these frauds is a conventional fraud that could be prosecuted under existing laws. Hundreds of lenders and over a hundred thousand loan brokers were “accounting control frauds” specializing largely in making fraudulent liar’s loans. My prior work explains control fraud, why accounting is the “weapon on choice” for fraudulent financial firms, and why liar’s loans were superior “ammunition” for committing massive accounting fraud. These accounting control frauds caused greater direct financial losses than any other crime epidemic in history. They also drove the financial crisis that produced the Great Recession and cost millions of Americans their jobs.


In considering my scale of unethical conduct it is important to keep in mind that it is highly likely that anyone that causes very large numbers of people to lose their homes will cause multiple suicides and indirect deaths that arise from the greater vulnerability of the homeless and the blue collar crime effects of destroying neighborhoods inherent to widespread foreclosures. I ignore for this purpose the fact that the fraudulent loans caused the bubble to hyper-inflate and drove the financial crisis that caused millions of people to lose their jobs. The financial accounting control frauds are the weapons of mass destruction of wealth, employment, and happiness. I also ignore the fact that the frauds described here made the perpetrators wealthy. My scale, therefore, systematically and dramatically understates the perpetrators’ moral turpitude. I have also excluded the massive foreclosure frauds from my scale because they did not cause the underlying crisis. When Obama reveals the bankers actions he claims to be legal but highly unethical readers should keep my conscious understatement of the moral depravity of the illegal acts by bankers that drove this crisis in mind when they compare the relative ethical failings.

As a criminologist, I do not favor sentencing criminals to the fates they richly deserve. I would never torture prisoners or place them at risk of assault, rape, or psychological trauma. I do not believe that extremely longer terms of imprisonment are desirable except in rare circumstances. As a lawyer and a criminologist I emphasize that any sentence should come only after a conviction in a trial providing due process protections or a guilty plea.My scale provides a label for the comparative moral depravity of the perpetrator, the deserved punishment (which when vicious is not the far more humane one I would actually impose), and a brief description of the specific frauds that are characteristic of this level of immorality and the number of perpetrators falling in each category. My inspiration was Dante’s circles of hell as described in his Divine Comedy.

The Scale of Ethical Depravity by the Frauds that Drove the Ongoing Crisis

Level 10: Septic tank scum

Eternal Hell: these banksters deserve a physical hell of infinite torment and duration

 Officers that directed control frauds that involved making predatory loans to more than 10,000 homeowners who lost their homes as the result of the frauds. Predatory loans in this context mean deliberately seeking out the elderly or minorities for such loans because they were easier to con into taking loans they could not repay – at a premium yield (interest rate). Dozens of CEOs fall in this category.

Level 9: Pond scum

Time in Hell:  These banksters deservea term in hell


Officers that directed control frauds that led to more than 10,000homeowners losing their homes.  Hundredsof CEOs fall in this category.


Level 8:  Generic scum


Gitmo:  Hell’s starkest suburb


Officers that directed control frauds that led to more than 1,000 homeownerslosing their homes.  Thousands of CEOsfall in this category.


Level 7:  Dante’s deserved denizens


Supermax:   No view, and no way out


The professionals that aided and abetted the overall control frauds byinflating appraisals, giving “clean” audit opinions to fraudulent financialstatements, “AAA” ratings to toxic waste, and accommodating legal opinions tothe frauds.  Thousands of professionalsfall in this category.


Level 6:  Aspiring to great wealththrough fraud 


Alcatraz:  Great view, but no way out


The senior lieutenants of the control frauds who committed the frauds thatcaused more than 10,000 homeowners to lose their homes.  Thousands of senior officers fall in thiscategory.


Level 5:  A large cog in a smallerfraud


Generic Hardcore Prison:  A life ofboredom and the almost total loss of freedom


The senior lieutenants of the control frauds who committed the frauds thatcaused more than 1,000 homeowners to lose their homes.   Thousands of senior officers fall in thiscategory.


Level 4:  The banksters who cost usour money instead of our homes – Goldman Sachs & friends


Generic Prison:  A life of boredom anda severe loss of freedom


The officers that led the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product.  Dozens of officers fall in this category.


Level 3:  The banksters’ seniorlieutenants who cost us our money instead of our homes


Prisons designed for serious, but less physically dangerous felons


The senior officers of the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product.  Scores of senior officers fall in thiscategory.


Level 2:  Banksters who defraudedother bankers (who were willing to be defrauded)


Privatized prisons:  Let them enjoythe consequences of their odes to privatization


The largest control frauds sold tens of billions of dollars of fraudulentloans to each other through fraudulent “reps and warranties.”  The kicker here, as Charles Calomiris hasemphasized, is that the control frauds on both sides of the transactions knew thatthey were engaged in a mutual fraud. Hundreds of senior officers fall in this category.


Level 1:  Small fraudulent fry


Catch and release:  Convict them andput them on probation if they cooperate with the investigations


The small fry are the loan officers, loan broker employees, and borrowerswho knowingly participated in making fraudulent mortgage loans.  Over 100,000 individuals fall in thiscategory.

We Need to End the PAC Doctrine

To date, Bush and Obama have prosecuted none of the mortgage frauds in the top nine levels. I urge reporters to ask him to explain three things about his statements to 60 Minutes.

  • Why are there no prosecutions of the felons that drove the crisis and occupy the nine worst rungs of unethical and destructive acts?
  • Explain the five unethical acts by elite financial institutions that you consider the most destructive and least ethical – but which you believe to be legal. How do you rank the degree of unethical conduct and destruction in those acts?
  • What specific statutory provisions did you propose to make those five unethical acts illegal? As enacted, which provisions of the Dodd-Frank Act made those five unethical acts illegal? Who has been prosecuted for those formerly legal but seriously unethical and destructive acts that were made illegal by the Dodd-Frank Act?

Reporters will have to be persistent in coordinating their follow-up questions to get Obama to provide direct answers to these questions.

I request that private citizens write President Obama to ask him to provide specific, written answers to these three questions. I will be proposing a series of questions that I will urge citizens to demand answers to because it is clear that the regular media will rarely ask demanding questions of elite politicians or bankers. It is up to us to hold them accountable and end the doctrine of Presidential Amnesty for Contributors.

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