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Free money creation to bail out financial speculators, but not Social Security or Medicare: Only the “Crazies” Get the Bank Giveaway Right

Posted on June 16, 2011 | 13 comments

By Michael Hudson

Financial crashes were well understood for a hundred years after they became a normal financial phenomenon in the mid-19th century. Much like the buildup of plaque deposits in human veins and arteries, an accumulation of debt gained momentum exponentially until the economy crashed, wiping out bad debts – along with savings on the other side of the balance sheet. Physical property remained intact, although much was transferred from debtors to creditors. But clearing away the debt overhead from the economy’s circulatory system freed it to resume its upswing. That was the positive role of crashes: They minimized the cost of debt service, bringing prices and income back in line with actual “real” costs of production. Debt claims were replaced by equity ownership. Housing prices were lower – and more affordable, being brought back in line with their actual rental value. Goods and services no longer had to incorporate the debt charges that the financial upswing had built into the system.

Financial crashes came suddenly. They often were triggered by a crop failure causing farmers to default, or “the autumnal drain” drew down bank liquidity when funds were needed to move the crops. Crashes often also revealed large financial fraud and “excesses.”

This was not really a “cycle.” It was a scallop-shaped a ratchet pattern: an ascending curve, ending in a vertical plunge. But popular terminology called it a cycle because the pattern was similar again and again, every eleven years or so. When loans by banks and debt claims by other creditors could not be paid, they were wiped out in a convulsion of bankruptcy.

Gradually, as the financial system became more “elastic,” each business recovery started from a larger debt overhead relative to output. The United States emerged from World War II relatively debt free. Downturns occurred, crashes wiped out debts and savings, but each recovery since 1945 has taken place with a higher debt overhead. Bank loans and bonds have replaced stocks, as more stocks have been retired in leveraged buyouts (LBOs) and buyback plans (to keep stock prices high and thus give more munificent rewards to managers via the stock options they give themselves) than are being issued to raise new equity capital.

But after the stock market’s dot.com crash of 2000 and the Federal Reserve flooding the U.S. economy with credit after 9/11, 2001, there was so much “free spending money” that many economists believed that the era of scientific money management had arrived and the financial cycle had ended. Growth could occur smoothly – with no over-optimism as to debt, no inability to pay, no proliferation of over-valuation or fraud. This was the era in which Alan Greenspan was applauded as Maestro for ostensibly creating a risk-free environment by removing government regulators from the financial oversight agencies.

What has made the post-2008 crash most remarkable is not merely the delusion that the way to get rich is by debt leverage (unless you are a banker, that is). Most unique is the crash’s aftermath. This time around the bad debts have not been wiped off the books. There have indeed been the usual bankruptcies – but the bad lenders and speculators are being saved from loss by the government intervening to issue Treasury bonds to pay them off out of future tax revenues or new money creation. The Obama Administration’s Wall Street managers have kept the debt overhead in place – toxic mortgage debt, junk bonds, and most seriously, the novel web of collateralized debt obligations (CDO), credit default swaps (almost monopolized by A.I.G.) and kindred financial derivatives of a basically mathematical character that have developed in the 1990s and early 2000s.

These computerized casino cross-bets among the world’s leading financial institutions are the largest problem. Instead of this network of reciprocal claims being let go, they have been taken onto the government’s own balance sheet. This has occurred not only in the United States but even more disastrously in Ireland, shifting the obligation to pay – on what were basically gambles rather than loans – from the financial institutions that had lost on these bets (or simply held fraudulently inflated loans) onto the government (“taxpayers”). The government took over the mortgage lending guarantors Fannie Mae and Freddie Mac (privatizing the profits, “socializing” the losses) for $5.3 trillion – almost as much as the entire national debt. The Treasury lent $700 billion under the Troubled Asset Relief Plan (TARP) to Wall Street’s largest banks and brokerage houses. The latter re-incorporated themselves as “banks” to get Federal Reserve handouts and access to the Fed’s $2 trillion in “cash for trash” swaps crediting Wall Street with Fed deposits for otherwise “illiquid” loans and securities (the euphemism for toxic, fraudulent or otherwise insolvent and unmarketable debt instruments) – at “cost” based on full mark-to-model fictitious valuations.

Altogether, the post-2008 crash saw some $13 trillion in such obligations transferred onto the government’s balance sheet from high finance, euphemized as “the private sector” as if it were the core economy itself, rather than its calcifying shell. Instead of losing on their bad bets, bad loans, toxic mortgages and outright fraudulent claims, the financial institutions cleaned up, at public expense. They collected enough to create a new century’s power elite to lord it over “taxpayers” in industry, agriculture and commerce who will be charged to pay off this debt.

If there was a silver lining to all this, it has been to demonstrate that if the Treasury and Federal Reserve can create $13 trillion of public obligations – money – electronically on computer keyboards, there really is no Social Security problem at all, no Medicare shortfall, no inability of the American government to rebuild the nation’s infrastructure. The bailout of Wall Street showed how central banks can create money, as Modern Money Theory (MMT) explains. But rather than explaining how this phenomenon worked, the bailout was rammed through Congress under emergency conditions. Bankers threatened economic Armageddon if the government did not create the credit to save them from taking losses.

Even more remarkable is the attempt to convince the population that new money and debt creation to bail out Wall Street – and vest a new century of financial billionaires at public subsidy – cannot be mobilized just as readily to save labor and industry in the “real” economy. The Republicans and Obama administration appointees held over from the Bush and Clinton administration have joined to conjure up scare stories that Social Security and Medicare debts cannot be paid, although the government can quickly and with little debate take responsibility for paying trillions of dollars of bipartisan Finance-Care for the rich and their heirs.

The result is a financial schizophrenia extending across the political spectrum from the Tea Party to Tim Geithner at the Treasury and Ben Bernanke at the Fed. It seems bizarre that the most reasonable understanding of why the 2008 bank crisis did not require a vast public subsidy for Wall Street occurred at Monday’s Republican presidential debate on June 13, by none other than Congressional Tea Party leader Michele Bachmann – who had boasted in a Wall Street Journal interview two days earlier, on Saturday, that she

voted against the Troubled Asset Relief Program (TARP) “both times.” … She complains that no one bothered to ask about the constitutionality of these extraordinary interventions into the financial markets. “During a recent hearing I asked Secretary [Timothy] Geithner three times where the constitution authorized the Treasury’s actions [just [giving] the Treasury a $700 billion blank check], and his response was, ‘Well, Congress passed the law.’ …With TARP, the government blew through the Constitutional stop sign and decided ‘Whatever it takes, that’s what we’re going to do.’”

Clarifying her position regarding her willingness to see the banks fail, she explained:

I would have. People think when you have a, quote, ‘bank failure,’ that that is the end of the bank. And it isn’t necessarily. A normal way that the American free market system has worked is that we have a process of unwinding. It’s called bankruptcy. It doesn’t mean, necessarily, that the industry is eclipsed or that it’s gone. Often times, the phoenix rises out of the ashes. [1]

There were easily enough sound loans and assets in the banks to cover deposits insured by the FDIC – but not enough to pay their counterparties in the “casino capitalist” category of their transactions. This super-computerized financial horseracing is what the bailout was about, not bread-and-butter retail and business banking or insurance.

It all seems reminiscent of the 1968 presidential campaign. The economic discussion back then between Democrat Hubert Humphrey and Republican Richard Nixon was so tepid that it prompted journalist Eric Hoffer to ask why only a southern cracker, third-party candidate Alabama Governor George Wallace, was talking about the real issues. We seem to be in a similar state in preparation for the 2012 campaign, with junk economics on both sides.

Meanwhile, the economy is still suffering from the Obama administration’s failure to alleviate the debt overhead by seriously making banks write down junk mortgages to reflect actual market values and the capacity to pay. Foreclosures are still throwing homes onto the market, pushing real estate further into negative equity territory while wealth concentrates at the top of the economic pyramid. No wonder Republicans are able to shed crocodile tears for debtors and attack President Obama for representing Wall Street (as if this is not equally true of the Republicans). He is simply continuing the Bush Administration’s policies, not leading the change he had promised. So he has left the path open for Congresswoman Bachmann to highlight her opposition to the Bush-McCain-Obama-Paulson-Geithner giveaways.

The missed opportunity

When Lehman Brothers filed for bankruptcy on September 15, 2008, the presidential campaign between Barack Obama and John McCain was peaking toward Election Day on November 4. Voters told pollsters that the economy was their main issue – their debts, soaring housing costs (“wealth creation” to real estate speculators and the banks getting rich off mortgage lending), stagnant wage levels and worsening workplace conditions. And in the wake of Lehman the main issue under popular debate was how much Wall Street’s crash would hurt the “real” economy. If large banks went under, would depositors still be safely insured? What about the course of normal business and employment?

Credit is seen as necessary; but what of credit derivatives, the financial sector’s arcane “small print”? How intrinsic are financial gambles on collateralized debt obligations (CDOs, “weapons of mass financial destruction” in Warren Buffett’s terminology) – not retail banking or even business banking and insurance, but financial bets on the economy’s zigzagging measures. Without casino capitalism, could industrial capitalism survive? Or had the superstructure become rotten and best left to “free markets” to wipe out in mutually offsetting bankruptcy claims?

Mr. Obama ran as the “candidate of change” from the Bush Administration’s war in Iraq and Afghanistan, its deregulatory excesses and giveaways to the pharmaceuticals industry and other monopolies and their Wall Street backers. Today it is clear that his promises for change were no more than campaign rhetoric, not intended to limit a continuation of the policies that most voters hoped to see changed. There even has been continuity of Bush Administration officials committed to promoting financial policies to keep the debts in place, enable banks to “earn their way out of debt” at the expense of consumers and businesses – and some $13 trillion in government bailouts and subsidy.

History is being written to depict the policy of saving the bankers rather than the economy as having been necessary – as if there were no alternative, that the vast giveaways to Wall Street were simply “pragmatic.” Financial beneficiaries claim that matters would be even worse today without these giveaways. It is as if we not only need the banks, we need to save them (and their stockholders) from losses, enabling them to pay and retain their immensely rich talent at the top with even bigger salaries, bonuses and stock options.

It is all junk economics – well-subsidized illogic, quite popular among fundraisers.

From the outset in 2009, the Obama Plan has been to re-inflate the Bubble Economy by providing yet more credit (that is, debt) to bid housing and commercial real estate prices back up to pre-crash levels, not to bring debts down to the economy’s ability to pay. The result is debt deflation for the economy at large and rising unemployment – but enrichment of the wealthiest 1% of the population as economies have become even more financialized.

This smooth continuum from the Bush to the Obama Administration masks the fact that there was a choice, and even a clear disagreement at the time within Congress, if not between the two presidential candidates, who seemed to speak as Siamese Twins as far as their policies to save Wall Street (from losses, not from actually dying) were concerned. Wall Street saw an opportunity to be grabbed, and its spokesmen panicked policy-makers into imagining that there was no alternative. And as President Obama’s chief of staff Emanuel Rahm noted, this crisis is too important an opportunity to let it go to waste. For Washington’s Wall Street constituency, the bold aim was to get the government to save them from having to take a loss on loans gone bad – loans that had made them rich already by collecting fees and interest, and by placing bets as to which way real estate prices, interest rates and exchange rates would move.

After September 2008 they were to get rich on a bailout – euphemized as “saving the economy,” if one believes that Wall Street is the economy’s core, not its wrapping or supposed facilitator, not to say a vampire squid. The largest and most urgent problem was not the inability of poor homebuyers to cope with the interest-rate jumps called for in the small print of their adjustable rate mortgages. The immediate defaulters were at the top of the economic pyramid. Citibank, AIG and other “too big to fail” institutions were unable to pay the winners on the speculative gambles and guarantees they had been writing – as if the economy had become risk-free, not overburdened with debt beyond its ability to pay.

Making the government to absorb their losses – instead of recovering the enormous salaries and bonuses their managers had paid themselves for selling these bad bets – required a cover story to make it appear that the economy could not be saved without the Treasury and Federal Reserve underwriting these losing gambles. Like the sheriff in the movie Blazing Saddles threatening to shoot himself if he weren’t freed, the financial sector warned that its losses would destroy the retail banking and insurance systems, not just the upper reaches of computerized derivatives gambling.

How America’s Bailouts Endowed a Financial Elite to rule the 21st Century

The bailout of casino capitalists vested a new ruling class with $13 trillion of public IOUs (including the $5.3 trillion rescue of Fannie Mae and Freddie Mac) added to the national debt. The recipients have paid out much of this gift in salaries and bonuses, and to “make themselves whole” on their bad risks in default to pay off. An alternative would have been to prosecute them and recover what they had paid themselves as commissions for loading the economy with debt.

Although there were two sides within Congress in September 2008, there was no disagreement between the two presidential candidates. John McCain ran back to Washington on the fateful Friday of their September 26debate to insist that he was suspending his campaign in order to devote all his efforts to persuading Congress to approve the $700 billion bank bailout – and would not debate Mr. Obama until that was settled. But he capitulated and went to the debate. On September 29 the House of Representatives rejected the giveaway, headed by Republicans in opposition.

So Mr. McCain did not even get brownie points for being able to sway politicians on the side of his Wall Street campaign contributors. Until this time he had campaigned as a “maverick.” But his capitulation to high finance reminded voters of his notorious role in the Keating Five, standing up for bank crooks. His standing in the polls plummeted, and the Senate capitulated to a redrafted TARP bill on October 1. President Bush signed it into law two days later, on October 3, euphemized as the Emergency Economic Stabilization Act.

Fast-forward to today. What does it signify when a right-wing cracker makes a more realistic diagnosis of bad bank lending better than Treasury Secretary Geithner, Fed Chairman Bernanke or other Bush-era financial experts retained by the Obama team? Without the bailout the gambling arm of Wall Street would have collapsed, but the “real” economy’s everyday banking and insurance operations could have continued. The bottom 99 percent of the U.S. economy would have recovered with only a speed bump to clean out the congestion at the top, and the government would have ended up in control of the biggest and most reckless banks and AIG – as it did in any case.

The government could have used its equity ownership and control of the banks to write down mortgages to reflect market conditions. It could have left families owning their homes at the same cost they would have had to pay in rent – the economic definition of equilibrium in property prices. The government-owned “too big to fail” banks could have told to refrain from gambling on derivatives, from lending for currency and commodity speculation, and from making takeover loans and other predatory financial practices. Public ownership would have run the banks like savings banks or post office banks rather than gambling schemes fueling the international carry trade (computer-driven interest rate and currency arbitrage) that has no linkage to the production-and-consumption economy.

The government could have used its equity ownership and control of the banks to provide credit and credit card services as the “public option.” Credit is a form of infrastructure, and such public investment is what enabled the United States to undersell foreign economies in the 19th and 20th centuries despite its high wage levels and social spending programs. As Simon Patten, the first economics professor at the nation’s first business school (the Wharton School) explained, public infrastructure investment is a “fourth factor of production.” It takes its return not in the form of profits, but in the degree to which it lowers the economy’s cost of doing business and living. Public investment does not need to generate profits or pay high salaries, bonuses and stock options, or operate via offshore banking centers.

But this is not the agenda that the Bush-Obama administrations a chose. Only Wall Street had a plan in place to unwrap when the crisis opportunity erupted. The plan was predatory, not productive, not lowering the economy’s debt overhead or cost of living and doing business to make it more competitive. So the great opportunity to serve the public interest by taking over banks gone broke was missed. Stockholders were bailed out, counterparties were saved from loss, and managers today are paying themselves bonuses as usual. The “crisis” was turned into an opportunity to panic politicians into helping their Wall Street patrons.

One can only wonder what it means when the only common sense being heard about the separation of bank functions should come from a far-out extremist in the current debate. The social democratic tradition had been erased from the curriculum as it had in political memory.

Tom Fahey: Would you say the bailout program was a success? …

Bachmann: John, I was in the middle of this debate. I was behind closed doors with Secretary Paulson when he came and made the extraordinary, never-before-made request to Congress: Give us a $700 billion blank check with no strings attached.

And I fought behind closed doors against my own party on TARP. It was a wrong vote then. It’s continued to be a wrong vote since then. Sometimes that’s what you have to do. You have to take principle over your party. [2]

Proclaiming herself a libertarian, Ms. Bachmann opposes raising the federal debt ceiling, Pres. Obama’s Medicare reform and other federal initiatives. So her opposition to the Wall Street bailout turns out to lack an understanding of how governments and their central banks can create money with a stroke of the computer pen, so to speak. But at least she was clear that wiping out bank counterparty gambles made by high rollers at the financial race track could have been wiped out (or left to settle among themselves in Wall Street’s version of mafia-style kneecapping) without destroying the banking system’s key economic functions.

The moral

Contrasting Ms. Bachmann’s remarks to the panicky claims by Mr. Geithner and Hank Paulson in September 2008 confirm a basic axiom of today’s junk economics: When an economic error becomes so widespread that it is adopted as official government policy, there is always a special interest at work to promote it.

In the case of bailing out Wall Street – and thereby the wealthiest 1% of Americans – while saying there is no money for Social Security, Medicare or long-term public social spending and infrastructure investment, the beneficiaries are obvious. So are the losers. High finance means low wages, low employment, low industry and a shrinking economy under conditions where policy planning is centralized in hands of Wall Street and its political nominees rather than in more objective administrators.

[1] Stephen Moore, “On the Beach, I Bring von Mises”: Interview with Michele Bachman, Wall Street Journal, June 11, 2011.

[2] CNN Republican Presidential Debate, Transcript, June 13, 2011, http://www.malagent.com/archives/1738

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MMP BLOG # 2 RESPONSES

Posted on June 15, 2011 | 26 comments

A perceptive reader wrote: “I think MMT needs someone to do whatever it is that Charles Darwin did.”

Well, Darwin wrote “On the Origin of Species”. A great book. Not something your average homeless Burger King taxi driving immigrant is reading. Yes, someone needs to teach evolution to the taxi drivers. Heck, I wish someone would teach evolution to my local Kansas School Board officials—who reject it as “just a theory” and obviously a poor competitor to the story of creation that is by contrast infallibly true.

But we need the “Origin of Species” first, before those teachers and popularizers and monkey trial lawyers (who, of course, LOST their case) can win in the court of public opinion.

The MMP is responding to a request for a coherent, from the ground up, exposition. I have asked several times for patience. Both by those who’d rather just take to the streets now, and from those who want everything explained all at once in an elevator pitch. If at the end of the year you want your money back, tuition refunds will be provided. If you do not need a Primer, go ahead and start the organizing. If you are not interested in MMT, look elsewhere. But if you want a clear and coherent Primer that begins at the beginning, you’ve found the right URL.

On to substantive comments.

Accounting Identities. I knew we would have our skeptics. There are two types of complaints.

First there are those who are skeptical of identities altogether. To them it looks like we put two rabbits into the hat and then pulled out two and expect applause. Or, it is like saying 2+3=5 and in base 10 math it cannot be anything different. Surely we rigged the results?

Well, in some sense, yes we did. We first rule out black helicopters that drop bags of cash into backyards in the dark of night. We also rule out expenditures by some that go “nowhere”—that is, expenditures that are not received by anyone. Finally, we rule out expenditures that are not in some manner “paid for”. If our whole economy consists of you and me (I get to be Robinson Crusoe, you get to be Friday—or vice versa), then if I spend, you get income. If you spend, I get income. I can consume or save, and you can consume or save. We denominate our spending and income and saving and surpluses and deficits in “dollars” and record transactions by scratch marks on the big rock by the pond. We’ve discovered double entry bookkeeping and use it because it is a handy way of keeping track. (We trust each other, but we’ve got bad memories. I accept your IOUs denominated in dollars, and you accept mine.) Ok, so that is the set up—the rabbits and the hat. Nothing up our sleeves.

You hire me to collect coconuts from your trees, I hire you to catch fish in my pond. You own the coconuts, I own the fish—due to our property rights in our respective resources; as workers we only have a right to our wages. (Ain’t capitalism grand?) We each work 5 hours at a buck an hour. We record these on our balance sheets on the big rock: on your balance sheet, your financial asset is my IOU; my financial asset is your IOU. At the end of the first day we each had income of $5 (recorded on our asset side) and we each issued an IOU to pay wages of $5 (recorded on our liability side). (On my balance sheet I hold your $5 IOU as my asset; and I have issued my IOU to you in the amount of $5, which I record on my liability side. And vice versa.)

Now I want to buy coconuts from you and you want to buy fish from me. I “pay for” the coconuts by delivering back to you your IOUs and/or I issue an IOU. You “pay for” fish by delivering back to me my IOUs or by issuing an IOU. Let us say I consume $5 worth of coconuts (I return all $5 of your IOUs—crossing off the entry on the Big Rock) and you consume $4 worth of fish (returning to me $4 of my IOUs and retaining $1 of my IOU) because you are more frugal.

At the end of the day, I’ve got $5 worth of coconuts but have had to issue a an IOU of $1 (I used all of my income, the $5 earned wages, and you’ve still got $1 of my IOU since you did not spend all your wages); you’ve got $4 of fish plus $1 left of your income (equals your financial saving). My deficit spending has been $1 and your surplus (or saving) has been $1. They are equal (not magically—we put the rabbits in the hat), and indeed your saving accumulation takes the form of a money claim on me (my debt). When we net out all the money claims, what we are left with is the real stuff (coconuts and fish).

To be sure, we have left out of this analysis much of what is interesting about the economy—no banks, no government, no “green paper” currency, and so on. All we did was to play a little game of IOU and UOMe. But we did demonstrate the simple sectoral balance conclusion: the financial deficit of one sector (me) equals the surplus of the other (you). And that once we net out the financials, we are left with the real stuff (fish and coconuts). No magic involved.

And, yes, we can all of us accumulate in real (nonfinancial) terms. For example, we can all grow our own crops in our backyards, accumulating corn that is not offset by a financial liability. For most of the time humans have been around (after Darwinian evolution) we managed without money. Still, we fed, clothed, cared for, and fought with, our fellow humans. For the most part, the “Modern Money Primer” will be concerned with “money”—that is, the financial accounting part, and it is here where every deficit is offset by an equal surplus (somewhere) and every debt is held by someone as financial wealth—so the net is zero. In terms of our Lake Wobegone analogy, we can all accumulate in real terms (we all have IQs above zero) but our finances net to zero (our IQs average to—well—average).

Second, some readers have preferred to come up with alternative identities. Yes, you can do that. We can choose to divide up into alternative sectors: rather than going with private domestic + government + foreign, we could divide into sectors according to hair color: blonde + black + red + blue + brown + silver etc…. For our purposes (to come in subsequent blogs) our division is more useful. It is not unusual to separate off the foreign sector on the basis that it (mostly) uses a different currency (actually, multiple currencies), so we are going across exchange rates. It is also not that unusual to separate government from private, and is particularly useful in discussion of “sovereign currency”—which after all is the main purpose of this Primer. For convenience we add state and local government to the federal government even though only the federal government is the issuer of the sovereign currency. What is, admittedly, unusual is to add the households and firms together (as well as not-for-profits). This is in part due to data limitations—some data are collected this way.

One reader perceptively noticed that a more common approach is to begin with the GDP identity (GDP = consumption + investment + government purchases + net exports; which equals gross national income). Without getting overly wonky, the GDP comes out of the NIPA accounts (national income and product accounts) that have some well-known disadvantages for those of us who worry about stock-flow consistency (the topic of future blogs). NIPA actually imputes some values and things don’t quite add up (a rather large and nasty “statistical discrepancy” is used to fudge to get to the identity). Just as one example: most Americans own their own homes, but certainly we all “consume” what is called “housing services”—the sheer enjoyment we get out of having some shelter over our heads in a rain storm. So statisticians “impute” (make up some economic value for that enjoyment), adding it to GDP. What we do not like about that is that no one really has to “pay for” the consumption of “housing services” for owner-occupied housing (say, you paid off your mortgage 5 years ago, but the statistician records $12,000 worth of enjoyment you consumed this year). Another area that is problematic comes in the treatment of saving. Typically, this can be done in one of two ways: either saving is simply a residual (your income less your consumption) or it is the accumulation to your wealth. In many calculations, when there is a real estate price boom, the value of the housing stock increases, which means our wealth increases, which must mean our saving increased. However, there was no income source that allowed us to save in financial terms.

Since this Primer is very concerned about “accounting for” all spending, all income, all consumption, and all saving, we do not want to include such imputations that do not have a financial flow counterpart. So, we prefer to work from the flow of funds accounts, which are stock-flow consistent (or, at least, closer to consistency). Now, in truth, NIPA data are more readily available for many countries than are flow of funds data, and so sometimes we do use the GDP equation rather than our sectoral balances equation. Here is a comparison:

Domestic Private balance + Government balance + Foreign balance = 0

(Saving – Investment) + (Taxes – Govt Purchases) + (Imports-Exports) = 0

You can see that these are reasonably close approximations. Roughly, if private saving exceeds investment, then the private sector will be running a surplus; if taxes are less than government purchases, the government is running a deficit; and if imports exceed exports the foreign sector is running a surplus. We can get even more wonky and put in government transfer payments (things like unemployment compensation that add to private sector income) and international factor payments (flows of profits earned by American firms from abroad—that reduce our foreign imbalance). But we won’t do that here. We will usually work from the sectoral balances (thus, flow of funds) rather than from the GDP identity (NIPA) but you can do the mental gymnastics if you want to do the conversion.

One commentator wondered why we would call an “imbalance” a “balance”: ie: if the private sector runs a deficit why would we refer to that as the private sector’s “balance”? Well, you have a checking account “balance” that is probably positive. If you write a check for more than your “balance” and if you have automatic overdraft coverage then you will now have a negative “balance” in your account! So, the “balance” can be either positive, zero, or negative for any sector.

A final note regarding NAFA: I would just say that NAFA is the standard term from the stock-flow consistent literature, which, if Ramanan’s correct, ironically started in the UK. See Zezza’s paper here, which, independent of MMT, uses the same terminology. Further, it’s a term completely consistent with the accounting measure desired, while there’s not necessarily any reason to name items the exact same way as one particular nation’s accounts do (“net saving” being another example).

Thanks for the comments. Keep them coming. Watch for Blog 3 next Monday.

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Ireland versus the United States: Only One of Them Has a Debt Crisis

Posted on June 15, 2011 | 22 comments

Stephanie Kelton recently sat down with Dara McHugh, Co-Ordinator of Dublin-based Smart Taxes, to discuss Ireland’s debt problems and the economic prospects for the Irish economy. The interview appears in the June-August issue of Ireland’s Village Magazine.

Dara McHugh (DM):  Can you discuss the fundamental features – and the fundamental flaws – of the design of the Euro system?
Stephanie Kelton (SK):  The Euro is premised on a philosophy that is best characterized by the slogan, “One Market, One Money.” At the core of the Euro system is the European Central Bank, an institution that was given a limited but ostensibly critical role: keep a tight lid on inflation by strictly controlling the supply of euros.  Because they could not conceive of an event that would trigger a breakdown in the payments system itself, the authors of the Maastricht Treaty did not give the ECB the statutory mandate to act as a ‘Lender of Last Resort’ in times of crisis.  And, because a group largely composed of bankers (the Delors Committee) had written the blueprint for the Euro, it contained no systematic framework for regulating and supervising Europe’s financial institutions.  Instead, the ECB was given a sole mandate: maintain price stability.  These are significant departures from the customary modus operandi for a central bank.
Because they assumed that a sharp decline in output and employment would be rectified through emigration or a depreciation of the euro, the authors of the Maastricht Treaty saw no reason to create a fiscal analogue to the ECB, an institution that would bear responsibility for promoting growth and employment in the Eurozone.  Instead, the political intention of the Treaty was to subordinate the role of fiscal policy, leaving it to the individual member nations to cope with a downturn by permitting only a modest increase in their deficits.
The problem, as everyone now observes, is that an individual member nation can find it impossible to engineer a recovery on its own. 
During a recession, the private sector retrenches, preferring to save or pay down existing debts rather than parting with cash or borrowing to finance new purchases.  Without an offsetting increase in demand – from the public or foreign sector – unemployment will rise and GDP will decline.  The Maastricht Treaty assumed that a small increase in the deficit, together with some emigration, would be sufficient to bring about a recovery.  That was wrong.
The bottom line is this: the Euro system contains a serious design flaw.  It failed to recognize that it was designing a system that would cause its members to become more like Alaska, California or Utah than Australia, Canada or the US.  That is, it was stripping them of their capacity to use their budgets to stabilise their own economies.
DM: What are the key differences between the Euro and another currency, such as the US Dollar?
SK:   The primary difference is that the Euro can only be created by the ECB – it is the ISSUER of the currency.  The governments of Ireland, Greece, Spain, Germany, etc. are the USERS of the currency.  The implications of this distinction cannot be overstated.
Members of the Eurozone are like individual states in the US.  Like California, Ireland must go out and ‘get’ the currency – either by taxing or borrowing – before it can spend.  It must pay whatever financial markets demand, and it can be priced out of the market.  It can become insolvent, and it can be forced to default on its debt. 
In contrast, the Federal Reserve is the government’s bank.  The government does not need to ‘get’ dollars before it can spend because it is the ISSUER of the currency.  It simply spends by crediting bank accounts.  It does not need to sell bonds in order to run a deficit, and it does not have to pay market rates.  It can never become insolvent, and it can never be forced to default on its obligations. 
DM:  How do these differences affect the response to the Euro-zone debt crisis?

SK:  The US has a monetary system that remains “wedded” to its fiscal system. The Euro system created a “divorce” between the fiscal and monetary institutions within each member nation. Because of this, members of the Eurozone cannot sustain the kind of deficits that can be run in the US.  When rising interest rates and declining tax revenues force countries like Ireland and Greece into a substantial deficit position, they respond the same way Illinois and Georgia do – with massive spending cuts and tax increases to try to reduce the deficit.
DM:  What is your opinion about the current response adopted by the peripheral economies and supported by the ECB?
SK:  It is difficult to blame the peripheral economies for their response to the crisis (save Ireland’s bone-headed decision to add to its debt problems by bailing out foreign creditors).  They are doing what they believe they must in order to avoid default and live up to the promises they made when they adopted the Euro. 
As it stands, Greece, Ireland and Portugal have no choice but to try to meet the terms of the EU/IMF bailouts by driving through massive austerity programs.  It is a policy response that could only have been engineered by a group of economists who lack even a basic understanding of first principles, and it is already yielding disastrous and perverse effects across the periphery.
Indeed, the European Commission has just reported that Greece’s deficit has failed to come down as expected.  Any decent economist understands why.  Pay cuts, layoffs, tax increases and the like will only reduce private sector incomes, dragging sales and tax revenues down along the way.  Unfortunately, the EC has insisted that the government must push through even deeper cuts in order to satisfy the EU-IMF inspection team.  This is the definition of economic malpractice.
DM:  Do you see any better solutions to the debt crisis?
SK: First, let us be clear.  What is currently in place is not a “solution.”  The EU/IMF extortion program will not resolve the debt crisis – it will only prolong the ultimate demise of the Euro project. 
In order to preserve the “Union,” the ECB must recognize that the member governments are neither responsible for the debt crisis nor capable of resolving it.  The ECB must recognize the design flaw in the Euro system and, like Toyota, inform its users that it will take corrective measures to fix it.  My good friend Warren Mosler – an expert in financial markets – has pointed out that it took 10 years for most analysts to discover the flaw in the Euro system but that it would take the ECB only 10 minutes to correct it.
The fundamental problem is that member nations have no safe funding mechanism under the existing system.  To fix the problem, the ECB should create the euros that its member governments, as USERS of the currency, cannot.  It would do this simply by crediting bank accounts, just like the Federal Reserve does when it transfers money to cash-strapped states in the wake of a national disaster.  The funds could go directly into the member governments’ accounts, or they could be routed through the European Parliament, which could distribute them on a per-capita basis to all seventeen members of the Eurozone.  Because these are transfer payments – not loans – the ECB would not seek repayment.   A back-of-the-envelope calculation suggests that an annual distribution of about 10 percent of Euroland GDP would be sufficient to eliminate the funding risk, reduce borrowing costs, permit the repayment of debt and help to restore growth.
If the ECB refuses to create a safe funding mechanism for its member nations, then there may be no alternative but to abandon the euro and return to the more conventional “One Nation, One Money” arrangement.
DM:  Why is currency sovereignty so important?
SK:  Because without it you are merely the USER of the currency, no different from an individual state in the US.  You have no independent monetary policy and very little control over your budget.  You are at the mercy of financial markets, and your only hope is that some other source of demand will emerge and drag you out of the trenches. 

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The False Dichotomy between Banking Honesty and a Sound Financial System

Posted on June 13, 2011 | 4 comments

By William K. Black

(Cross-posted with Benzinga.com)

It’s exceptionally hard to kill bad ideas. The most spectacularly bad idea in economics and finance is that regulating business honesty is bad for business. The idea is exceptionally criminogenic. The idea ebbs briefly after each epidemic of control fraud it unleashes leads to crisis and scandal, but it quickly returns and intensifies. The bad idea has grown for three decades, which is why we have suffered recurrent, intensifying financial crises. Both major parties’ dominant economic policy makers embrace this bad idea.

Nothing is better for honest firms than effective police, prosecutors, and regulatory “cops on the beat.” These things make possible “free markets.” Fraud cripples markets. Criminologists know this. The best economists have known this for over 40 years. But really bright people explained why 285 years ago.

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

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

As I’ve written, these words should be inscribed on the walls of every relevant regulatory agency.

George Akerlof echoed Swift’s words in a formal economics argument in his seminal 1970 article “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.”

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

This is the article that led to the award of the Nobel Prize in Economics in 2001 to Akerlof. Akerlof went on to explain that fraud could lead to a “Gresham’s” dynamics in which bad ethics drove good ethics out of the marketplace.

The bad idea that rules designed to reduce business dishonesty harms business is premised on a false claim that markets automatically exclude fraud. Alan Greenspan is the most famous anti-regulatory who once held this view. He has, subsequently, admitted his shock at the financial fraud that defined the current crisis. He admits that his belief that markets automatically self-corrected by excluding fraud proved false. Frank Easterbrook and Daniel Fischel (1991) are the most famous proponents of the view that markets automatically exclude fraud: “a rule against fraud is not an essential or … an important ingredient of securities markets.” A generation of American law students has been taught to believe this theoclassical dogma. Easterbrook & Fischel did not alert their readers that Fischel had, in his consulting work on behalf of three of the leading control frauds of the 1980s, applied these dogmas to make a series of predictions. Those predictions proved embarrassingly false because Fischel did not understand accounting control fraud. He ended up praising the worst frauds and claiming that regulators were incapable of providing any useful information because the markets price already incorporates all useful information (he adopted a perfect markets hypothesis).

This false dichotomy between regulatory efforts against dishonest firms and improved market performance has particular importance given the ongoing attacks on Elizabeth Warren and the new Consumer Financial Protection Bureau (CFPB). The situation can be summarized briefly. Fraudulent loans hurt everybody who is honest and many of those who are somewhat dishonest. That’s what criminologists, the best economists, and effective regulators (plus geniuses like Swift) have long understood. I’m writing to a financially literate audience, so I do not need to explain that making fraudulent liar’s loans was never “profitable.” The reported “profits” were fictional and depended on either (i) making a fraudulent sale to another party or (ii) not creating a remotely adequate allowance for loan and lease losses (ALLL).

The incidence of fraud on liar’s loans was so extreme, the number of liar’s loans made in 2004-2007 was so large that it hyper-inflated and extend the bubble, the role of fraudulent loans in causing the collapse of the CDO market was so great, and Lehman’s liar’s loans were so suicidal that reducing fraud should have been a top national priority. The fraudulent lenders and the loan brokers they incentivized to engage in endemic fraud put the lies in the typical liar’s loan – in the loan application and the appraisal. That meant that millions of working class people were induced by the lenders’ and their agents’ frauds to purchase a home at a greatly inflated price that they could not afford. The result was the greatest loss of working class wealth in modern U.S. history. Another result was that the lenders were made deeply insolvent. We achieved the precise opposite of what market transactions are supposed to produce – Pareto anti-optimality. Both of the parties to the lending transaction were made worse off. Many fraudulent agents gained. Markets became spectacularly inefficient and even failed. Much of the world fell into the Great Recession.

Private market discipline didn’t simply fail, it became doubly perverse. First, the commercial and investment banks that were supposed to deny credit to and refuse to purchase loans from fraudulent and imprudent firms actually funded the massive growth of the worst lenders notorious for making endemically fraudulent liar’s loans. Second, when private market discipline did finally occur it proved disastrous. Private market discipline arose when Lehman collapsed, but it did not function in accordance with finance theory. Theory says that private discipline is greatly superior to governmental action because it is so much more flexible and rational. It is supposed to distinguish between strong and weak credits and it is supposed to be so flexible that markets remain stable. The reality was far messier, with little differentiation based on credit quality among a broad group of potentially impaired credits and credit restrictions so severe that hundreds of markets ceased functioning.

The Great Recession caused losses estimated at $10 trillion. Fraud epidemics can cause staggering losses. What does this have to do with Elizabeth Warren and the FCPA? Elizabeth Warren was one of the experts who warned about the bubble and nonprime loans. Had the FCPA existed under her direction the U.S. would have suffered far fewer losses and could have avoided the Great Recession. Reducing mortgage fraud is unambiguously good for the world. Protecting consumers from mortgage fraud by banning liar’s loans would have led to a massive reduction in mortgage fraud.

Why then are the Republicans promising to block any appointment to head such a vital agency? We know it is not because of their stated reasons (hyper-technical diversions about commission v. director leadership) because the Republicans have typically favored directorship leadership in the past for other financial regulators (e.g., the Office of Thrift Supervision). We know it has everything to do with blocking Warren’s appointment. Senator McConnell says: “We’re pretty unenthusiastic about the possibility of Elizabeth Warren.” Why? Because he fears that under her leadership the CFPB “could be a serious threat to our financial system.”

Why can’t we appoint one leader with a track record of success? We’ve appointed many regulatory leaders with track records of failure. We’ve appointed many anti-regulatory leaders because they doing so created self-fulfilling prophecies of regulatory failure. The results have been disastrous. Why not try a novel approach? Let’s appoint people because they are brilliant, honest, committed to helping the public, and get the big issues right. Warren could have saved both banks and borrowers from hundreds of billions of dollars of losses had she led a CFPB in 2002-2008. We know that fraud causes recurrent, intensifying “serious threat[s] to our financial system.” Honesty poses no threat to our financial system. McConnell is posing a severe threat to our financial system by blocking Warren’s appointment.

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The Financial Road to Serfdom: How Bankers are using the Debt Crisis to Roll Back the Progressive Era

Posted on June 13, 2011 | 8 comments

By Michael Hudson

Financial strategists do not intend to let today’s debt crisis go to waste. Foreclosure time has arrived. That means revolution – or more accurately, a counter-revolution to roll back the 20th century’s gains made by social democracy: pensions and social security, public health care and other infrastructure providing essential services at subsidized prices or for free. The basic model follows the former Soviet Union’s post-1991 neoliberal reforms: privatization of public enterprises, a high flat tax on labor but only nominal taxes on real estate and finance, and deregulation of the economy’s prices, working conditions and credit terms.

What is to be reversed is the “modern” agenda. The aim a century ago was to mobilize the Industrial Revolution’s soaring productivity and technology to raise living standards and use progressive taxation, public regulation, central banking and financial reform to distribute wealth fairly and make societies more equal. Today’s financial aim is the opposite: to concentrate wealth at the top of the economic pyramid and lower labor’s returns. High finance loves low wages.

The political lever to achieve this program is financial. The European Union (EU) constitution prevents central banks from financing government deficits, leaving this role to commercial banks, paying interest to them for creating credit that central banks readily monetize for themselves in Britain and the United States. Governments are to go into debt to bail out banks for loans gone bad – as do more and more loans as finance impoverishes the economy, stifling its ability to pay. Yet as long as we live in democracies, voters must agree to pay. Governments are sovereign and debt is ultimately a creature of the law and courts.

But first they need to understand what is happening. From the bankers’ perspective, the economic surplus is what they themselves end up with. Rising consumption standards and even public investment in infrastructure are seen as deadweight. Bankers and bondholders aim to increase the surplus not so much by tangible capital investment increasing the overall surplus, but by more predatory means, headed by rolling back labor’s gains and stiffening working conditions while gaining public subsidy. Banks “create wealth” by providing more credit (that is, debt leverage) to bid up asset prices for real estate and enterprises already in place – assets that either are being foreclosed on or sold off under debt pressure by private owners or governments. One commentator recently characterized the latter strategy of privatization as “tantamount to selling the family silver only to have to rent it back in order to eat dinner.” [1]

Fought in the name of free markets, this counter-revolution rejects the classical ideal of markets free of unearned income paid to special interests. The financial objective is to squeeze out a surplus by maximizing the margin of prices over costs. Opposing government enterprise and infrastructure as the road to serfdom, high finance is seeking to turn public infrastructure into rent-extracting tollbooths to extract economic rent (the “free lunch economy”), while replacing labor unions with non-union labor so as to work it more intensively.

This new road to neoserfdom is an asset grab. But to achieve it, the financial sector needs a political grab to replace democracy with financial technocrats. Their job is to pretend that there is no revolution at all, merely an increase in “efficiency,” “creating wealth” by debt-leveraging the economy to the point where the entire surplus is paid out as interest to the financial managers who are emerging as Western civilization’s new central planners.

Frederick Hayek’s Road to Serfdom portrayed a dystopia of public officials seeking to regulate the economy. In attacking government so one-sidedly, his ideological extremism sought to replace the checks and balances of mixed economies with a private sector “free” of regulation and consumer protection. His vision was of a post-modern economy “free” of the classical reforms to bring market prices into line with cost value. Instead of purifying industrial capitalism from the special rent extraction privileges bequeathed from the feudal epoch, Hayek’s ideology opened the way for unchecked financial power to make a travesty of “free markets.”

The European Union’s financial planners claim that Greece and other debtor countries have a problem that is easy to cure by imposing austerity. Pension savings, Social Security and medical insurance are to be downsized so as to “free” more debt service to be paid to creditors. Insisting that Greece only has a “liquidity problem,” European Central Bank (ECB) extremists deem an economy “solvent” as long as it has assets to privatize. ECB executive board member Lorenzo Bini Smaghi explained the plan in a Financial Times interview:

FT: Otmar Issing, your former colleague, says Greece is insolvent and it “will not be physically possible” for it to repay its debts. Is he right?

LBS: He is wrong because Greece is solvent if it applies the programme. They have assets that they can sell and reduce their debt and they have the instruments to change their tax and expenditure systems to reduce the debt. This is the assessment of the IMF, it is the assessment of the European Commission.

Poor developing countries have no assets, their income is low, and so they become insolvent easily. If you look at the balance sheet of Greece, it is not insolvent.

The key problem is political will on the part of the government and parliament. Privatisation proceeds of €50bn, which is being talked about – some mention more – would reduce the peak debt to GDP ratio from 160 per cent to about 140 per cent or 135 per cent and this could be reduced further. [2]

A week later Mr. Bini Smaghi insisted that the public sector “had marketable assets worth 300 billion euros and was not bankrupt. ‘Greece should be considered solvent and should be asked to service its debts,’ … signaling that the bank remained firmly opposed to any plan to allow Greece to stretch out its debt payments or oblige investors to accept less than full repayment, a so-called haircut.” [3] Speaking from Berlin, he said that Greece “was not insolvent.” It could pay off its bonds owed to German bankers ($22.7 billion), French bankers ($15 billion) and the ECB (reported to be on the hook for $190 billion) by selling off public land and ports, water and sewer rights, ownership of the telephone system and other basic infrastructure. In addition to getting paid in full and receiving high interest rates reflecting “market” expectations of non-payment, the banks would enjoy a new credit market financing privatization buy-outs.

Warning that failure to pay would create windfall gains for speculators who had bet that Greece would default, Mr. Bini Smaghi refused to acknowledge the corollary: to pay the full amount would create windfalls for those who bet that Greece would be forced to pay. He also claimed that: “Restructuring of Greek debt would … discourage Greece from modernizing its economy.” But the less debt service an economy pays, the more revenue it has to invest productively. And to “solve” the problem by throwing public assets on the market would create windfalls for distress buyers. As the Wall Street Journal put matters bluntly: “Greece is for sale – cheap – and Germany is buying. German companies are hunting for bargains in Greece as the debt-stricken government moves to sell state-owned assets to stabilize the country’s finances.” [4]

Rather than raising living standards while creating a more egalitarian and fair society, the ECB’s creditor-oriented “reforms” would roll the time clock back to oligarchy. Not the post-feudal oligarchy of landlords owning land conquered militarily, but a financial oligarchy accumulating banking claims and bonds growing inexorably and exponentially, leaving little over for the rest of the economy to invest or consume.

The distinction between illiquidity and insolvency

If a homeowner loses his job and cannot pay his mortgage, he must sell the house or see the bank foreclose. Is he insolvent, or merely “illiquid”? If he merely has a liquidity problem, a loan will help him earn the funds to pay down the debt. But if he falls into the negative equity that now plagues a quarter of U.S. real estate, taking on more loans will only deepen his net deficit. Ending this process by losing his home does not mean that he is merely illiquid. He is in distress, and is suffering from insolvency. But to the ECB this is merely a liquidity problem.

The public balance sheet includes land and infrastructure as if they are surplus assets that can be forfeited without fundamentally changing the owner’s status or social relations. In reality it is part of the means of survival in today’s world, at least survival as part of the middle class.

For starters, renegotiating his loan won’t help an insolvency situation such as the jobless homeowner above. Lending him the money to pay the bank interest (along with late fees and other financial penalties) or stretching out the loan merely will add to the debt balance, giving the foreclosing bank yet a larger claim on whatever property the debtor may have available to grab.

But the homeowner is in danger of being homeless, living on the street. At issue is whether solvency should be defined in the traditional common-sense way, in terms of the ability of income to carry one’s current obligations, or a purely balance-sheet approach taken by creditors seeking to extract payment by stripping assets. This is Greece’s position. Is it merely a liquidity problem if the government is told to sell off $50 billion in prime tourist sites, ports, water systems and other public assets in order to pay foreign creditors?

At issue is language regarding the legal rights of creditors vis-à-vis debtors. The United States has long had a body of law regarding this issue. A few years ago, for instance, the real estate speculator Sam Zell bought the Chicago Tribune in a debt-leveraged buyout. The newspaper soon went broke, wiping out the employees’ stock ownership plan (ESOP). They sued under the fraudulent conveyance law, which says that if a creditor makes a loan without knowing how the debtor can pay in the normal course of business, the loan is assumed to have been made with the intent of foreclosing on property, and is deemed fraudulent.

This law dates from colonial times, when British speculators eyed rich New York farmland. Their ploy was to extend loans to farmers, and then call in the loans when the farmer’s ability to pay was low, before the crop was harvested. This was indeed a liquidity problem – which financial opportunists turned into an asset grab. Some lenders, to be sure, created a genuine insolvency problem by making loans beyond the ability of the farmers to pay, and then would foreclose on their land. The colonies nullified such loans. Fraudulent conveyance laws have been kept on the books since the United States won its independence from Britain.

Creditors today are using debt leverage to force Greece to sell off its public domain – having extended credit beyond its ability to pay. So the question now being raised is whether the nation should be deemed “solvent” if the only way to carry its public debt (that is, roll it over by replacing bad old loans with newer and more inexorable obligations) is to forfeit its land and basic infrastructure. This would fundamentally alter the relationship between public and private sectors, replacing its mixed economy with a centrally planned one – planned by financial predators with little care that the economy is polarizing between rich and poor, creditors and debtors.

The financial road to serfdom

Financial lobbyists are turning the English language – and economic terminology throughout the world – into a battlefield. Creditors are to be permitted to take the assets of insolvent debtors – from homeowners and companies to entire nations – as if this were a normal working of “the market” and foreclosure was simply a way to restore “liquidity.” As for “solvency,” the ECB would strip Greece clean of its public sector’s assets. Bank officials have spoken of throwing potentially 150 billion euros of property onto the market.

Most people would think of this as a solvency problem. Solvency means the ability to maintain the kind of society one has, with existing public/private checks and balances and living standards. It is incompatible with scaling down pensions, Social Security and medical insurance to save bondholders and bankers from taking a loss. The latter policy is nothing less than a political revolution.

The asset stripping that Europe’s bankers are demanding of Greece looks like a dress rehearsal to prevent the “I won’t pay” movement from spreading to “Indignant Citizens” movements against financial austerity in Spain, Portugal and Italy. Bankers are trying to block governments from writing down debts, stretching out loans and reducing interest rates.

When a nation is directed to replace its mixed economy by transferring ownership of public infrastructure and enterprises to a financial class (mainly foreign), this is not merely “restoring solvency” by using long-term assets to pay short-term debts to maintain its balance-sheet net worth. It is a radical transformation to a centrally planned economy, shifting control out of the hands of elected representatives to those of financial managers whose time frame is short-term and extractive, not long-term and protective of social equity and basic needs.

Creditors are demanding a political transformation to replace democratic lawmakers with technocrats appointed by foreign bankers. When the economic surplus is pledged to bankers rather than invested at home, we are not merely dealing with “insolvency” but with an aggressive attack. Finance becomes a continuation of war, by economic means that are to be politicized. Acting on behalf of the commercial banks (from which most of its directors are drawn, and to which they intend to “descend from heaven” to take their rewards after serving their financial class), the European Central Bank insists on a political revolution to replace democratic government by a technocratic elite – not of industrial engineers, but of “financial engineers,” a polite name for asset stripping financial warriors. If Greece does not comply, they threaten to wreak domestic financial havoc by “pulling the plug” on Greek banks. This “carrot and stick” approach threatens that if Greece does not sign on, the ECB and IMF will withhold loans needed to keep its banking system solvent. The “carrot” was provided on May 31 they agreed to provide $86 billion in euros if Greece “puts off for the time being a restructuring, hard or soft,” of its public debt. [5]

It is a travesty to present this revolution simply as a financial exercise in solving the “liquidity problem” as if it were compatible with Europe’s past four centuries of political and classical economic reforms. This is why the Syntagma Square protest in front of Parliament has been growing each week, peaking at over 70,000 last Sunday, June 5.

Some protestors drew a parallel with the Wisconsin politicians who left the state to prevent a quorum from voting on the anti-labor program that Governor Walker tried to ram through. The next day, on June 6, thirty backbenchers of Prime Minister George Papandreou’s ruling Panhellenic Socialist party (Pasok) were joined by some of his own cabinet ministers threatening “to resign their parliamentary seats rather than vote through measures to cut thousands of public sector jobs, increase taxes again and dispose of €50bn of state assets, according to party insiders. ‘The biggest issue for the party is stringent cuts in the public sector … these go to the heart of Pasok’s model of social protection by providing jobs in state entities for its supporters,’ said a senior Socialist official.” [6]

Seeing the popular reluctance to commit financial suicide, Conservative Opposition leader Antonis Samaras also opposed paying the European bankers, “demanding a renegotiation of the package agreed last week with the ‘troika’ of the EU, IMF and the European Central Bank.” It was obvious that no party could gain popular support for the ECB’s demand that Greece relinquish popular rule and “appoint experienced technocrats to half a dozen essential ministries to implement the EU-IMF programme.” [7]

ECB President Trichet depicts himself as following Erasmus in bringing Europe beyond its “strict concept of nationhood.” This is to be done by replacing elected officials with a bureaucracy of cosmopolitan banker-friendly planners. The debt problem calls for new “monetary policy measures – we call them ‘non standard’ decisions, strictly separated from the ‘standard’ decisions, and aimed at restoring a better transmission of our monetary policy in these abnormal market conditions.” The task at hand is to make these conditions a new normalcy – and re-defining solvency to reflect a nation’s ability to pay debts by selling the public domain.

The ECB and EU claim that Greece is “solvent” as long as it has assets to sell off. But if populations in today’s mixed economies think of solvency as existing under existing public/private proportions, they will resist the financial sector’s attempt to proceed with buyouts and foreclosures until it possesses all the assets in the world, all the hitherto public and corporate assets and those of individuals and partnerships.

To minimize opposition to this dynamic the financial sector’s pet economists understate the debt burden, pretending that it can be paid without disrupting economic life and, in the Greek case for example, by using “mark to model” junk accounting and derivative swaps to simply conceal its magnitude. Dominique Strauss-Kahn at the IMF claims that the post-2008 debt crisis is merely a short-term “liquidity problem” and one of lack of “confidence,” not insolvency reflecting an underlying inability to pay. Banks promise that everything will be all right when the economy “returns to normal” – as if it can “borrow its way out of debt,” Bernanke-style.

This is what today’s financial warfare is about. At issue is the financial sector’s relationship to the “real” economy. From the latter’s perspective the proper role of credit – that is, debt – is to fund productive capital investment and spending, because it is out of the economic surplus that debts are paid. This requires a financial regulatory system and tax system to maximize growth. But that is precisely the fiscal policy that today’s financial sector is fighting against. It demands preferential tax-deductibility for interest to encourage debt financing rather than equity. It has disabled truth-in-lending laws and regulations to keeping interest rates and fees in line with costs of production. And it blocks governments from having central banks to freely finance their own operations and provide economies with money. And to cap matters it now demands that democratic society yield to centralized authoritarian financial rule.

Finance and democracy: from mutual reinforcement to antagonism

The relationship between banking and democracy has taken many twists over the centuries. Earlier this year, democratic opposition to the ECB and IMF attempt to impose austerity and privatization selloffs succeeded when Iceland’s President Grímsson insisted on a national referendum on the Icesave debt payment that Althing leaders had negotiated with Britain and the Netherlands (if one can characterize abject capitulation as a real negotiation). To their credit, a heavy 3-to-2 majority of Icelanders voted “No,” saving their economy from being driven into the debt peonage.

Democratic action historically has been needed to enforce debt collection. Until four centuries ago royal treasuries typically were kept in the royal bedroom, and loans to rulers were in the character of personal debts. Bankers repeatedly found themselves burned, especially by Habsburg and Bourbon despots on the thrones of Spain, Austria and France. Loans to such rulers were liable to expire upon their death, unless their successors remained dependent on these same financiers rather than turning to their rivals. The numerous bankruptcies of Spain’s autocratic Habsburg ruler Charles V exhausted his credit, preventing the nation from raising funds to defeat the rebellious Low Countries to the north.

The problem facing bankers was how to make loans permanent national obligations. Solving this problem gave an advantage to parliamentary democracies. It was a major factor enabling the Low Countries to win their independence from Habsburg Spain in the 16th century. The Dutch Republic committed the entire nation to pay its public debts, binding the people themselves, through their elected representatives who earmarked taxes to their creditors. Bankers saw parliamentary democracy as a precondition for making sound loans to governments. This security for bankers could be achieved only from electorates having at least a nominal voice in government. And raising war loans was a key element in military rivalry in an epoch when the maxim for survival was “Money is the sinews of war.”

As long as governments remained despotic, they found that their ability to incur more debt was limited. At this time “the legal position of the King qua borrower was obscure, and it was still doubtful whether his creditors had any remedy against him in case of default.” [8] Earlier Dutch-English financing had not satisfied creditors on this count. When Charles I borrowed 650,000 guilders from the Dutch States-General in 1625, the two countries’ military alliance against Spain helped defer the implicit constitutional struggle over who ultimately was liable for British debts.

The key financial achievement of parliamentary government was thus to establish nations as political bodies whose debts were not merely the personal obligations of rulers, but truly public and binding regardless of who occupied the throne. This is why the first two democratic nations, the Netherlands and Britain after its 1688 dynastic linkage between Holland and Britain in the person of William I, and the emergence of Parliamentary authority over public financing. They developed the most active capital markets and became Europe’s leading military powers. “A funded debt could not be formed so long as the King and Parliament were fighting for the mastery,” concludes the financial historian Richard Ehrenberg. “It was only after the [1688] revolution that the English State became what the Dutch Republic had long been – a real corporation of individuals firmly associated together, a permanent organism.” [9]

In sum, nations emerged in their modern form by adopting the financial characteristics of democratic city states. The financial imperatives of 17th-century warfare helped make these democracies victorious, for the new national financial systems facilitated military spending on a vastly extended scale. Conversely, the more despotic Spain, Austria and France became, the greater the difficulty they found in financing their military adventures. Austria was left “without credit, and consequently without much debt” by the end of the 18th century, the least credit-worthy and worst armed country in Europe, as Sir James Steuart noted in 1767 [10]. It became fully dependent on British subsidies and loan guarantees by the time of the Napoleonic Wars.

The modern epoch of war financing therefore went hand in hand with the spread of parliamentary democracy. The situation was similar to that enjoyed by plebeian tribunes in Rome in the early centuries of its Republic. They were able to veto all military funding until the patricians made political concessions. The lesson was not lost on 18th-century Protestant parliaments. For war debts and other national obligations to become binding, the people’s elected representatives had to pledge taxes. This could be achieved only by giving the electorate a voice in government.

It thus was the desire to be repaid that turned the preference of creditors away from autocracies toward democracies. In the end it was only from democracies that they were able to collect. This of course did not necessarily reflect liberal political convictions on the part of creditors. They simply wanted to be paid.

Europe’s sovereign commercial cities developed the best credit ratings, and hence were best able to employ mercenaries. Access to credit was “their most powerful weapon in the struggle for their freedom,” notes Ehrenberg, in an age whose “growth in the use of fire arms had forced them to surround themselves with stronger fortifications.” [11] The problem was that “Anyone who gave credit to a prince knew that the repayment of the debt depended only on his debtor’s capacity and will to pay. The case was very different for the cities, who had power as overlords, but were also corporations, associations of individuals held in common bond. According to the generally accepted law each individual burgher was liable for the debts of the city both with his person and his property.”

But the tables are now turning, from Icelandic voters to the large crowds gathering in Syntagma Square and elsewhere throughout Greece to oppose the terms on which Prime Minister Papandreou has been negotiating an EU bailout loan for the government – to bail out German and French banks. Now that nations are not raising money for war but to subsidize reckless predatory bankers, Jean-Claude Trichet of the ECB recently suggested taking financial policy out of the hands of democracy.

But if a country is still not delivering, I think all would agree that the second stage has to be different. Would it go too far if we envisaged, at this second stage, giving euro area authorities a much deeper and authoritative say in the formation of the country’s economic policies if these go harmfully astray? A direct influence, well over and above the reinforced surveillance that is presently envisaged? …

At issue is sovereignty itself, when it comes to government responsibility for debts. And in this respect the war being waged against Greece by the European Central Bank (ECB) may best be seen as a dress rehearsal not only for the rest of Europe, but for what financial lobbyists would like to bring about in the United States.

[1] Yves Smith, “Wisconsin’s Walker Joins Government Asset Giveaway Club (and is Rahm Soon to Follow?)” Naked Capitalism, February 22, 2011.

[2] Ralph Atkins, “Transcript: Lorenzo Bini Smaghi,” Financial Times, May 30, 2011.

[3] Jack Ewing, “In Asset Sale, Greece to Give Up 10% Stake in Telecom Company,” The New York Times, June 7, 2011.

[4] Christopher Lawton and Laura Stevens, “Deutsche Telekom, Others Look to Grab State-Owned Assets at Fire-Sale Prices,” Wall Street Journal, June 7, 2011.

[5] Landon Thomas Jr., “New Rescue Package for Greece Takes Shape,” The New York Times, June 1, 2011.

[6] Kerin Hope, “Rift widens on Greek reform plan,” Financial Times, June 7, 2011.

[7] Ibid. See also Kerin Hope, “Thousands protest against Greek austerity,” Financial Times, June 6, 2011: “‘Thieves, thieves … Where did our money go?’ the protesters shouted, blowing whistles and waving Greek flags as riot police thickened ranks around the parliament building on Syntagma square in the centre of the capital. … Banners draped nearby read ‘Take back the new measures’ and ‘Greece is not for sale’ – a reference to the government’s plans to include state property and real estate for tourist development in the privatisation scheme.”

[8] Charles Wilson, England’s Apprenticeship: 1603-1763 (London: 1965), p. 89.

[9] Richard Ehrenberg, Capital and Finance in the Age of the Renaissance (1928), p. 354.

[10] James Steuart, Principles of Political Oeconomy (1767), p. 353.

[11] Ehrenberg, op. cit., pp. 44f., 33.

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Should European Nations Repudiate the Debt?

Posted on June 12, 2011 | 9 comments

By L. Randall Wray

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

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

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

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

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

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

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

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MMP Blog 2: THE BASICS OF MACRO ACCOUNTING

Posted on June 12, 2011 | 75 comments

By L. Randall Wray

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Control Fraud and the Irish Banking Crisis

Posted on June 11, 2011 | 3 comments

By William K. Black

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

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

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

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

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

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

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

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

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

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

Gresham’s dynamics and control fraud

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

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

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

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

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

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

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

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

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

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

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

Control fraud and bubbles

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

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

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

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

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

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

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

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

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

The Nyberg Report about Ireland

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

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

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

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

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

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

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

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

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

Nyberg on Compensation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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MMT Explained to Mums

Posted on June 11, 2011 | 41 comments

By Paolo Rossi Barnard

Intro.

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

MMT Explained to Mums

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

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

Ask yourself: What’s the government for?

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

Does the government do it?

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

Yes, easily, we’ll explain why.

So, why has the government never done it?

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

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

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

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

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

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

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

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

In conlcusion.

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

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

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

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

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How Would You Reinvent Capitalism?

Posted on June 11, 2011 | 2 comments

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

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