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Happy Birthday Social Security! A Refresher Course in Macroeconomics For Laurence Kotlikoff

Posted on August 16, 2010 | 8 comments

By Yeva Nersisyan

No day goes by without some deficit hawk trying to spread fear among ordinary Americans about the looming fiscal crisis. One gets the impression that the hawks are competing with one another to see who can come up with the scariest scenario. And it seems to be working. A recent USA Today/Gallup poll found that 64% of those surveyed in the poll disapprove of president Obama’s handling of the federal budget deficit. But Obama’s discretionary stimulus has been very small relative to the magnitude of the crisis we are in, and as discussed here most of the deficit was due to automatic stabilizers. Hence Obama’s policies have little to do with the rising deficit, and public disapproval of his policy demonstrates how misinformed the public is on the issues of federal deficit and debt.

A recent piece from one Boston University Economics professor, Laurence Kotlikoff, published in Bloomberg, was too outrageous to leave uncommented. Most of the deficit hawks seem to be united around the same agenda: getting rid of the very modest safety net that the U.S. government provides to its population. After making a bold claim that the U.S. is bankrupt here is what he has to say:

What it [the U.S.] can and must do is radically simplify its tax, health-care, retirement and financial systems, each of which is a complete mess. But this is the good news. It means they can each be redesigned to achieve their legitimate purposes at much lower cost and, in the process, revitalize the economy.

The authority that he uses to support his claim that the U.S. is bankrupt is nothing other than the I.M.F (and you thought that the I.M.F is rethinking its position on economic policy!). But what exactly does he mean by “simplifying” the tax, health-care and retirement systems? The only thing that comes to mind is downsizing – cut, cut and cut. How else would you achieve the 14% permanent fiscal adjustment that he thinks is needed? According to Kotlikoff, not only will this help put the fiscal house in order but it will also “revitalize the economy”. Moreover, these programs could still be able to achieve their “legitimate purposes at much lower cost”. What could be better?

This is the most extreme deficit hawk position that one encounters. There is a legitimate concern about a double-dip recession in the U.S. Household balance sheets are no better than they were before the crisis. Household debt stands at 122% of personal disposable income. The unemployment rate is high and is expected to stay high for the foreseeable future. In this situation the U.S. consumer can by no means be expected to pull the economy out of the hole. U.S. corporations, facing uncertainty about the strength of consumer demand, aren’t hiring despite sitting on huge piles of cash. Just what exactly will fill the aggregate spending gap when the government withdraws its spending and how cutting entitlements will “revitalize the economy” is a mystery to me. And probably to Kotlikoff too, since he makes no attempt to offer explanation in this article.

According to the IMF closing the fiscal gap will require a “permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.” (“The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years.”) This is the preferred definition of the fiscal gap promulgated by infinite horizon deficit warriors like Kotlikoff. In their world, an adjustment in the government’s fiscal balance from a 9% deficit to a 5% surplus (i.e. 14% adjustment) will take place without any negative effects on the rest of the economy. In the real world, however, we cannot have an adjustment in government’s financial balance without simultaneously having an adjustment in the non-government sector’s financial balance. A 14% of GDP fiscal adjustment means that the non-government sector’s financial balance will also adjust by the same amount, only in the other direction. For example, households could adjust their budgets to run huge deficits to allow the government to tighten its fiscal stance.

So what are our options according to Kotlikoff? To achieve this fiscal adjustment we will need nothing less than doubling of all of our taxes. “Such a tax hike would leave the U.S. running a surplus equal to 5 percent of GDP this year, rather than a 9 percent deficit”. (Of course doubling taxes is not something that he seems to be in favor of. This is just used to demonstrate how enormous the “hole” is). But one year will not do it. The U.S government will need to run a 5% surplus for many years to come to pay for scheduled expenses down the road.

Since the official deficit and debt numbers don’t look scary enough Kotlikoff offers us his own calculations. You see, the federal debt held by the public stands only at 53% of GDP and is expected to climb up to only about 68% in 2011. Compared to other developed nations this is a relatively low number. One could look at Japan and say: “Well, they have managed not to go bankrupt with a 200% Debt-to-GDP ratio so why would the U.S. be in trouble with a much lower level of debt?” Kotlikoff will then tell you that the fiscal gap is “more than 15 times the official debt”, a whopping $202 trillion. When baby boomers fully retire and collect all of their oversized benefits we will have an annual bill of $4 Trillion in today’s dollars. And if after all of this you still have any doubts then Kotlikoff will point you to the direction of Greece (I won’t go into that in this blog but you can read here on why the U.S. is not like Greece). Who wouldn’t be scared?

The alarming situation we are in, according to the deficit hysteria crowd, is the result of the government running a Ponzi scheme for 6 decades as it has been taking resources from the young and giving them to the old. If their point is that we are taking real resources from the young and giving them to the old, then yes, that’s what we are doing. And that’s what every society is doing, has always done, and will always be doing unless you want to let the elderly population die of hunger. Ditto for infants—the lazy do-nothings expect us, the working age population, to take care of them! Why can’t those lazy infants and elderly people pull their own weight?

But if it is all about real resources, the debate shifts to a completely different dimension. Will we have enough resources so that baby boomers can get a decent standard of living when they retire? Will the economy be able to produce enough to sustain its non-working members—young and old? This is the real issue and it cannot be solved by cutting government spending nor by raising taxes today. Nor can it even be resolved by ramping up financial saving today—that would only lead to more dollars chasing scarce resources tomorrow.

What matters is our capacity to produce goods and services in the future. If we want to be able to produce more in the future we need to invest more in education, technologies and infrastructure today. But if Kotlikoff thinks that we are redistributing “financial resources” from the young to the old (and I suspect that’s what he believes) then this is a false concern as explained below.

First of all, as discussed in many posts on this blog, the government is the monopoly issuer of the country’s currency and hence it cannot go bankrupt. It doesn’t need tax or bond revenues to spend; it simply spends by crediting bank accounts which ultimately amounts to creating new currency (cash or deposits in commercial banks). It then sells government securities to drain any excess reserves that the banking system might receive as a result of government spending. This is done to help the Fed hit its interest rate target. And even if the government wanted to, it couldn’t spend your tax money. Why? Because just as government spending creates new money, taxing destroys money. Government cannot spend that which doesn’t exist.

Both government bonds and currency are liabilities of the Federal government (Treasury and Fed), its IOUs. There is only one difference between the two – bonds pay higher interest than reserves. The government pays interest on bonds to offer an interest earning alternative to reserves. To get us to accept the currency, it imposes taxes on us. If currency is government’s IOU why would government need to borrow its own IOUs in order to spend? Furthermore, there is no balance sheet operation that allows one to borrow one’s own IOUs. When the government sells bonds, it simply exchanges one type of IOU for the other – this is not borrowing. When you deliver government’s IOUs to it to pay your taxes, it simply extinguishes your tax liability, just like you deliver bank deposits (bank IOUs) to a bank to discharge your obligations (bank loans) to it. If you could issue IOUs that were as acceptable as government IOUs, i.e. if everything was for sale in your IOUs, what kind of crazy idea would it be for you to borrow them back in order to spend?

The second problem with Kotlikoff’s argument is his presumption that government can somehow run fiscal surpluses for years on end. As explained in many posts on this blog government’s fiscal surplus means that the non-government sector is running a deficit. In other words, the government is injecting less income into the private sector (through its spending) then it is draining out of it (through taxation). Assuming a 4% of GDP trade deficit (although it could shrink if the government cuts spending), the negative adjustment in private sector (firms and households) balances desired by Kotlikoff will be in the amount of 9% of GDP (5% government surplus + 4% current account deficit/foreign sector surplus). The private sector will be dissaving at a rate of 9% of GDP per year. Can this go on forever or for many years as the IMF says it should?

In Kotlikoff’s world, where this somehow will have only positive effects, it can. But in the real world this is operationally impossible. For one thing, the private sector cannot indefinitely run a deficit without facing solvency problems – it is a user of the currency not the issuer. More importantly, a persistent federal budget surplus is impossible for a sovereign currency issuer like the US because the funds used to pay taxes ultimately come from government spending. If it continuously withdraws more funds from the economy then it’s injecting into the economy then at some point the private sector’s previously accumulated hoards of government IOUs will be depleted. People will simply be unable to pay their taxes.

Deficit hawks such as Dr. Kotlikoff simply shift the public debate from pressing issues such as high unemployment to false concerns about fiscal solvency and debt sustainability. They devise numbers which are meaningless for a nation operating with a sovereign currency, and use these to misinform and scare ordinary people. They are the reason why the very people who benefit from successful government programs (such as Social Security) undermine their own economic well-being by electing deficit hawks to Congress.

The academic experts calling for deficit reduction are irresponsible to say the least. They feel they can say anything without being held accountable for the impact of their ideas on the lives of people. We should devise some standard of accountability for professional economists, maybe similar to what we have for doctors. This would definitely throw some water on the deficit hysteria fire.

8 Comments

Posted in Social Security, The Federal Government Deficit, Uncategorized

Tagged Social Security, The Federal Government Deficit

Investment Banking by Blood Sucking Vampire Squids

Posted on August 10, 2010 | 13 comments

By L. Randall Wray

While investment banking today is often compared to a casino, that is not really fair. A casino is heavily regulated and while probabilities favor the house, gamblers can win abut 48% of the time. Casinos are regulated—by the state and presumably by the mob. Top executives who steal funds end up wearing very heavy shoes at the bottom of the ocean.

By contrast, the investment bank always wins, and its customers always lose. Investment banks are “self-regulated” (meaning, of course, they do whatever they want—sort of like leaving your 15 year old at home alone all summer with the admonition to “behave yourself” and keys to the liquor cabinet and the Porsche). Top management rakes off all the funds it wants with impunity. And then the CEOs go run the Treasury to bailout the investment banks should anything go wrong.

This summer I was lunching with a trader who works for one of these investment banks (hint: there are not many left, and he was not with Goldman). Speaking of Goldman he said “those guys are good”. Indeed they are so good, he said, “I don’t know why anyone would do business with them.”

He explained: When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Note that this is also true of hedge funds and the half dozen biggest banks that are bank holding companies providing a full range of financial “services”.

In the latest revelations, JPMorgan Chase suckered the Denver public school system into an exotic $750 million transaction that has gone horribly bad. In the spring of 2008, struggling with an underfunded pension system and the need to refinance some loans, it issued floating rate debt with a complicated derivative. Effectively, when rates rose, that derivative locked the school system into a high fixed rate. Morgan had put a huge “greenmail” clause into the deal—the school district is locked into a 30 year contract with a termination fee of $81 million. That, of course, is on top of the high fees Morgan had charged up-front because of the complexity of the deal.

To add insult to injury, the whole fiasco began because the pension fund was short $400 million, and subsequent losses due to bad performance of its portfolio since 2008 wiped out almost $800 million—so even with the financing arranged by Morgan the pension fund is back in the hole where it began but the school district is levered with costly debt that it cannot afford but probably cannot afford to refinance on better terms because of the termination penalties. This experience is repeated all across America—the Service Employees International Union estimates that over the past two years state and local governments have paid $28 billion in termination fees to get out of bad deals sold to them by Wall Street. (See Morgenson www.nytimes.com/2010/08/06/business/06denver.html)

Repeat that story thousands of times. Only the names of the cities and counties need to be changed. Analysts say that deals like that pushed onto Denver would never be accepted by for-profit firms. Investment banks preserve such shenanigans to screw the public. Michael Bennet, who was the head of the school district pushing for the deal had worked for the Anschutz Investment Company—so he knew what he was doing. He was rewarded for his efforts—he is now a US senator from Colorado.

Magnetar, a hedge fund, actually sought the very worst tranches of mortgage-backed securities, almost single-handedly propping up the market for toxic waste that it could put into CDOs sold on to “investors” (I use that term loosely because these were suckers to the “nth” degree). It then bought credit default insurance (from, of course, AIG) to bet on failure. By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find. In other words, the financial institution bets against households, firms, and governments—and loads the dice against them—with the bank winning when its customers fail.

In a case recently prosecuted by the SEC, Goldman created synthetic CDOs that placed bets on toxic waste MBSs. Goldman agreed to pay a fine of $550 million, without admitting guilt, although it did admit to a “mistake”. The deal was proposed by John Paulson, who approached Goldman to create toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find clients willing to buy junk CDOs. According to the SEC, Goldman let Paulson suggest particularly risky securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman’s Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—an extraordinarily high percent of CDOs that are designed to fail will fail.

Previously, Goldman helped Greece to hide its government debt, then bet against the debt—another fairly certain bet since debt ratings would likely fall if the hidden debt was discovered. Goldman took on US states as clients (including California and New Jersey and 9 other states), earning fees for placing their debts, and then encouraged other clients to bet against state debt—using its knowledge of the precariousness of state finances to market the instruments that facilitated the shorts.

To be fair, Goldman is not alone — all of this appears to be common business procedure.

There is a theory that an invisible hand will guide unfettered markets to perform the public interest. In truth, unregulated Wall Street bets against the public and operates to ensure the public loses. Investment banks are now all corporations (and all have bank charters). Corporations and banks are chartered to further the public purpose. Why do we allow them the screw the public?

13 Comments

Posted in L. Randall Wray, Regulation, Uncategorized

Tagged Financial crisis, Financial innovation, Financial system, L. Randall Wray, regulation, The Financial Bailout

MEMO TO DODD: ELIZABETH WARREN IS WORTH THE FIGHT

Posted on August 8, 2010 | 10 comments

By L. Randall Wray

Outgoing Senator Dodd just weighed in on the possibility that Elizabeth Warren might get the top spot heading the new Bureau of Consumer Financial Protection at the Federal Reserve:

“What you don’t need to have is an eight-month battle for who the director or the head or chairperson of this new consumer financial protection bureau will be,” Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee, said in an interview on Bloomberg Television’s “Conversations with Judy Woodruff,” to be broadcast today.

Let us get this straight. Dodd has been a shill for Wall Street for years. He has never seen a fight against Wall Street worth fighting. He is retiring. Why would anyone care what he thinks about Warren?

Let us get this straight. Warren created the proposal to create a consumer financial protection act and agency to enforce it. She has been the driving force behind it. No one is better qualified to lead it. Any other appointment would confirm that the Obama administration is not serious about reform.

Dodd is pushing Sheila Bair, head of the FDIC. She is a fine person. She says she does not want the job. I haven’t met her, but she is no Elizabeth Warren.

We know that Dodd does not take consumer protection seriously. He has been in the back pocket of rapacious lenders so long that his views have no credibility. He is the problem, not the solution. That is why he is leaving “public service”. He knows he has no chance to win an election in the aftermath of a crisis he helped to create.

Warren, by contrast, has been a tireless defender of consumers. She knows all the “tricks and traps” that credit card issuers put into the complex contracts that—literally—no law school grad could wade through. She forcefully argues that it makes no sense that we protect consumers from faulty toasters but let Wall Street steal their home and their life savings. She knows that Wall Street bought and paid for the 2005 Bankruptcy “Reform” Act written by the credit industry to screw the last dime out of overburdened homeowners—exactly on the cusp of the collapse. She knows that states (with the help of the Supreme Court) have raised the maximum permitted interest rate from a “measly” 36% in 1965 to a median of 398% in 2007. Yes, read that again—it is not a mistake, it is a disgrace.

Warren knows that financial products are only subject to contract law—based on the notion that both parties are fully informed. And are “equals” in the contract. Yep, right—you, dear reader, are equal to the team of vampire blood sucking squids at Goldman Sachs dead set on taking away your home. What, you do not have a good corporate lawyer looking over your mortgage contract? Sucker!

Other consumer products are subject to tort law—you can sue manufacturers for injury. Imagine if you bought a lawn tractor, with 37 pages of disclaimers, and buried deep inside in incomprehensible language the contract said that due to shoddy manufacturing practices, the blade is liable to occasionally fly off and take off your leg, but if it does that, we are not liable. That is exactly what your credit card contract says.
It ain’t right. Warren knows that. She wants to protect consumers of financial products—which, arguably are far more important today than are toasters that occasionally short and burn your toast.

If you are not convinced that she is the right person for the job, please read her excellent essay: “Redesigning regulation: a case study from the consumer market”, in Government and Markets, toward a new theory of regulation, edited by Edward Balleisen and David Moss, Cambridge University Press, 2010, based on a paper she gave back in 2008.

10 Comments

Posted in L. Randall Wray, Policy and Reform, Uncategorized

Tagged L. Randall Wray, Policy and Reform

More Reasons to Doubt Rogoff and Reinhart

Posted on August 4, 2010 | 8 comments

By Yeva Nersisyan

With unemployment expected to remain high in the U.S. and Europe and the possibility of a double-dip recession growing stronger, some sensible voices are calling for another round of fiscal stimulus. And then there are others who not only argue that we don’t need more stimulus, but make a case for starting to cut spending today, notwithstanding a very fragile “recovery.” Ken Rogoff (see here), who has become the de-facto authority on the issue of sovereign deficits and debt (together with his co-author, Carmen Reinhart), in a recent FT article is trying to make the case for the redundancy of further economic stimulus. Subpar economic performance and unemployment are the usual companions of post-financial crisis recovery, he argues, hence there is no need for a “panicked fiscal response” (even Secretary Geithner has cited their research to demonstrate that the current slow pace of recovery is normal). Rogoff goes on to argue that the long-term effects of government debt accumulation on growth shouldn’t be ignored. The theoretical and empirical bases for his arguments are found in his recent book with Reinhart, This Time is Different, as well as an NBER paper, “Growth in Time of Debt”. This paper, similar to the book, has been very popular, especially among those needing empirical justification for their anti-fiscal policy stance. While the RR book focuses on the short-run, immediate impacts of sovereign debt (i.e. financial and economic crises), the focus of the paper is the impact of sovereign debt on long-term growth. In this blog I want to give a quick, critical evaluation of the paper (a longer version can be found here).

When orthodox economists start their empirical research regarding the long-term impact of deficits and sovereign debt, they do not ask whether deficits contribute to or inhibit long-term economic growth. They do not ask, because they already “know” the answer, as the ECB put it: “Although fiscal consolidation may imply costs in terms of lower economic growth in the short run, the longer-run beneficial effects of fiscal consolidation are undisputed.” (ECB, Monthly Bulletin, June, 2010). What they want to find is some threshold for deficit-to-GDP and debt-to-GDP ratios beyond which debt becomes detrimental to growth. With this goal in mind, Rogoff and Reinhart embark on a “scientific” journey through time and space.

Their method is actually quite simple: they construct some arbitrary ranges for debt-to-GDP ratios (0-30, 30-60, 60-90, >90) and take the average of growth rates for each range. They then take the average of these averages for a large number of countries and conclude that when the government debt-to-GDP ratio crosses the threshold of 90% (again, an arbitrary number), median growth rates fall by one percentage point and the average falls even more. This limit is the same for developed and developing countries, however, when it comes to external debt (which is defined in their book as both public and private debt issued in a foreign jurisdiction, and usually, but not always, denominated in foreign currency), the threshold is much lower, just 60% of GDP. Once a country crosses this lower external debt threshold, annual growth declines by about 2 percentage points and at very high levels, the growth rate is cut almost in half.

Interestingly, however, average growth rates don’t monotonically decline, i.e. the average rate of growth is higher when debt-to-GDP ratio is in the 60-90% range than the lower range of 30-60%. In addition, growth rates don’t slow down for all the countries in their sample. For some countries the average growth rate is higher when debt is over 90% of GDP than for lower levels of debt. Reinhart and Rogoff don’t point out this “anomaly,” nor do they offer any explanations. More importantly, since they take the average of averages of a number of countries, it is possible that countries like the U.S. may drive the results for the whole group. They single out the case of the U.S. in their paper to demonstrate their results. However, a closer look shows that they only have 5 data points for the U.S. when the debt-to-GDP ratio was over 90%. This is only 2.3% of the total of 216 observations. Moreover, 3 out of these 5 observations are for the years 1945, 1946 and 1947, the period after WWII when government debt was high due to war spending. In this period, growth slowed down significantly as the government was withdrawing war spending from the economy. In 1946 alone, GDP contracted at a pace of -10.9%. Rogoff and Reinhart fail to even mention this in their paper. Similar situations might be true for many other countries, where high levels of debt-to-GDP follow extreme economic or political events.

But what is even more important is that what they find in the data is merely a correlation. The causation then is imposed by Reinhart and Rogoff with explanations based on Barro’s Ricardian equivalence theory. “The simplest connection between public debt and growth is suggested by Robert Barro (1979). Assuming taxes ultimately need to be raised to achieve debt sustainability, the distortionary impact imply is likely to lower potential output” [sic].

There is no doubt about the correlation between high debt-to-GDP ratios and low economic growth found in the data. However, there is a more sensible explanation for this correlation. As explained in many past posts on this blog, the government budget balance automatically goes into deficit in a recession leading to an accumulation of public debt. Besides, GDP, the denominator of the ratio shrinks making the ratio even larger. It is sufficient to look at what happened during this most recent crisis to see this. The average rate of growth has been -0.23% for the recession years 2007-2009. At the same time, government debt held by the public has increased from 36% of GDP in 2006 to about 52% in 2009. So if you look at the data, the rate of growth was 2.7% in 2006 corresponding to a debt-to-GDP ratio of 36%. In 2009 growth was -2.6% with a corresponding debt-to-GDP ratio of 52%. Hence there is a correlation between slow growth and high levels of debt which is not surprising. But unless you want to argue that the current recession was caused by high levels of government debt, then it is obvious that causation runs from slow growth to high debt and not the other way around as Reinhart and Rogoff claim.

They also find that growth deteriorates significantly at external debt levels of over 60% and that most default on external debt in emerging economies since 1970s has been at 60% or lower debt-to-GDP ratios (which is the Maastricht criteria). While this might be a surprising finding for them, it should be clear why countries are not tolerant to external debt which is almost always denominated in foreign currency. When a government borrows in foreign currency, even low levels of indebtedness can be unsustainable since the government is not able to issue that foreign currency to meet its debt obligations. As countries need to earn foreign exchange from exports, a sudden reversal in export conditions can render the country unable to meet its foreign debt obligations leading to a crisis and slower growth. Sovereign governments, on the other hand, do not face any financial constraints and cannot run out of their own currency as they are the monopoly issuers of that currency. They don’t need to increase taxes in the future (a la Barro) to pay off the debt as they make interest payments on their “debt” as well as payments of principal by crediting bank accounts, meaning that operationally they are not constrained on how much they can spend. See here for more on this.

While many experts believe that there is an acute possibility of a double-dip recession in the U.S. (see here) and other developed nations, Ken Rogoff is not one of them. And even if we do face the threat, he argues, monetary policy will suffice (if anything, this crisis has demonstrated the ineffectiveness of monetary policy (interest rate management to be more precise) not to be confused with the massive lender-of-last resort operations that the Fed undertook to stabilize the financial system).

Even if there was no threat of a double-dip recession, one could rightly argue that the current high levels of unemployment and underemployment require more government spending. Rogoff’s argument, however, is that sustained high unemployment is the normal consequence of a financial crisis and hence he seems to conclude that fiscal measures to solve the unemployment problem are unnecessary. This is very bad policy advice – we know we have a problem (unemployment), we know how to solve it (public works), but we shouldn’t do so for fear of growth slowing or markets disciplining the government at some indefinite time in the future, a fear based on the wobbly research of Reinhart and Rogoff.

To summarize, the Rogoff and Reinhart research is not a scientific quest but merely a journey with a set destination. It is not based on any sensible theory, and the statistical analysis is of questionable quality as well. Government deficits and debt largely mirror what goes on in the private sector. There are no magic numbers for deficit and debt ratios applicable to all countries and all times. Devising such ratios is a useless exercise.

Even in better times, the U.S. economy is operating with considerably high levels of unemployment and underemployment (see here), underscoring the necessity of government intervention in the economy. In a recession as the private sector cuts back its spending and tries to de-leverage, the role of government, as the only entity in the economy that can run persistent deficits without facing solvency issues, becomes especially important. Regardless of whether there is a threat of a double dip recession, the government should act to solve the unemployment problem through direct job creation TODAY. High levels of unemployment are not compatible with a democratic society.

8 Comments

Posted in The Federal Government Deficit, The National Debt, Uncategorized, Unemployment

Tagged Fiscal Policy, The Federal Government Deficit, The National Debt, unemployment

The CBO’s Misplaced Fear of a Looming Fiscal Crisis

Posted on July 29, 2010 | 14 comments

By Eric Tymoigne

The Congressional Budget Office (CBO) has just released an 8-page brief titled “Federal Debt and the Risk of a Fiscal Crisis.” In it you will find all the traditional arguments regarding government deficits and debt: “unsustainability,” “crowding out”, bond rates rising to “unaffordable” levels because of fears that the Treasury would default or “monetize the debt,” the need to raise taxes to pay for interest servicing and government spending, the need “to restore investor’s confidence” by cutting government spending and raising taxes. This gives us an opportunity to go over those issues one more time.

“growing budget deficits will cause debt to rise to unsupportable levels”

A government with a sovereign currency (i.e. one that creates its own currency by fiat, only issues securities denominated in its own currency and does not promise to convert its currency into a foreign currency under any condition) does not face any liquidity or solvency constraints. All spending and debt servicing is done by crediting the accounts of the bond holders (be they foreign or domestic) and a monetarily-sovereign government can do that at will by simply pushing a computer button to mark up the size of the bond holder’s account (see Bernanke attesting to this here).

In the US, financial market participants (forget about the hopelessly misguided international “credit ratings”) recognize this implicitly by not rating Treasuries and related government-entities bonds like Fannie and Freddie. They know that the US government will always pay because it faces no operational constraint when it comes to making payments denominated in a sovereign currency. It can, quite literally, afford to buy anything for sale in its own unit of account.

This, of course, as many of us have already stated, does not mean that the government should spend without restraint. It only means that it is incorrect to state that government will “run of out money” or “burden our grandchildren” with debt (which, after all, allows us to earn interest on a very safe security), arguments that are commonly used by those who wish to reduce government services. These arguments are not wholly without merit. That is, there may well be things that the government is currently doing that the private economy could or should be doing. But that is not the case being made by the CBO, the pundits or the politicians. They are focused on questions of “affordability” and “sustainability,” which have no place in the debate over the proper size and role for government (a debate we would prefer to have). So let us get to that debate by recognizing that there is no operational constraint – ever – for a monetarily sovereign government. Any financial commitments, be they for Social Security, Medicare, the war effort, etc., that come due today and into the infinite future can be made on time and in full. Of course, this means that there is no need for a lock box, a trust fund or any of other accounting gimmick, to help the government make payments in the future. We can simply recognize that every government payment is made through the general budget. Once this is understood, issues like Social Security, Medicare and other important problems can be analyzed properly: it is not a financial problem; it is a productivity/growth problem. Such an understanding would lead to very different policies than the one currently proposed by the CBO (see Randy’s post here).

“A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers.”

First, this sentence seems to imply that government activities are unproductive (given that, following their logic, Treasury issuances “finance” government spending), which is simply wrong, just look around you in the street and your eyes will cross dozens of essential government services.

Second, the internal logic gets confusing for two reasons. One, if people are so afraid of a growing fiscal crisis, why would they buy more treasuries with their precious savings? Why not use their savings to buy bonds to fund “productive capital goods”? Using the CBO’s own logic, higher rates on government bonds would not help given that a “fiscal crisis” is expected and given that participants are supposed to allocate funds efficiently toward the most productive economic activity (and so not the government according to them). Second, we are told that “it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.” I will get back to what the government can do in that case, but you cannot get it both ways; either financial market participants buy more government securities or they don’t.

Third, this argument drives home the crowding-out effect. I am not going to go back to the old debates between Keynes and others on this, but the bottom line is that promoting thriftiness (increasing the propensity to save out of monetary income) depresses economic activity (because monetary profits and incomes go down) and so decreases willingness to invest (i.e. to increase production capacities). In addition, by spending, the government releases funds in the private sector that can be used to fund private economic activity; there is a crowding-in, not a crowding-out. This is not theory, this is what happens in practice, higher government spending injects reserves and cash in the system, which immediately places downward pressure on short-term rates unless the Fed compensates for it by selling securities and draining reserves (which is what the Fed does on a daily basis).

“if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output.”

No, as noted many times here, all spending and servicing is done by crediting creditor’s account not by taxing (or issuing bonds). Taxes are not a funding source for monetarily-sovereign governments, they serve to reduce the purchasing power of the private sector so that more real resources can be allocated to the government without leading to inflation (again all this does not mean that the government should raise taxes and takeover the entire economy; it is just a plain statement of the effects of taxation). All interest payments on domestically-denominated government securities (we are talking about a monetarily-sovereign government) can be paid, and have been met, at all times, whatever the amount, whatever their size in the government budget.

“a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.”

If the US Treasury cannot issue bonds at the rate it likes there is a very simple solution: do not issue them. This does not alter in any way its spending capacity given that the US federal government is a monetarily-sovereign government so bond issuances are not a source of funds for the government. Think of the Federal Reserve: does it need to borrow its own Federal Reserve notes to be able to spend? No, all spending is done by issuing more notes (or, more accurately, crediting more accounts) and if the Fed ever decided borrow its own notes by issuing Fed bonds to holders of Federal Reserve notes (a pretty weird idea), a failure of the auction would not alter its spending power. The Treasury uses the Fed as an accountant (or fiscal agent) for its own economic operations; the “independence” of the Fed in making monetary policy does not alter this fact.

“It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis.”

It is always possible that anything can happen, but what is the record? The record is that there is no relationship between the fiscal position of the US government and T-bond rates. Massive deficits in WWII went pari passu with record low interest rates on the whole Treasury yield curve. With the help of the central bank, the government made a point of keeping long-term rates on treasuries at about 2% for the entire war and beyond, despite massive deficits. There is a repetition of this story playing out right now, and Japan has been doing the same for more than a decade. Despite its mounting government debt, the yield on 10-year government bonds is not more than 2% as of July 2010. In the end, market rates tend to follow whatever the central bank does in terms of short-term rates, not what the fiscal position of the government is.

As we already stated on this blog before, a simple observation of how government finance operates shows that government spending injects reserves into the banking system (pressing down short-term interest rate), while the payment of taxes reduces/destroys reserves (pushing short-term rates up). The Fed has institutions that allow it to coordinate on a daily basis with the Treasury (they call each other every day) to make sure that all these government operations do not push the interest rate outside the Fed’s target range.

“If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.”

That’s a repeat of the first question but with a bit of elaboration. The US government cannot default on its securities for financial reasons, it is perfectly solvent and liquid. (Sovereign governments can, as we have conceded on this blog, refuse to pay – e.g. Japan after the war – but that is because it was unwilling to repay, not because it was unable to pay.) Thus, despite Reinhart and Rogoff’s warnings, the credit history of the US government (and any monetarily-sovereign government) remains perfect. No government with a non-convertible, sovereign currency has ever bounced a check trying to make payment in its own unit of account.

The US government always pays by crediting the account of someone (i.e. “monetary creation”). If the creditor is a bank, this leads to higher reserves, if it is a non-bank institution it leads also to an increase in the money supply. It has been like this from day one of Treasury activities. It is not a choice the government can make (between increasing the money supply, taxing or issuing bonds); any spending must lead to a monetary creation; there is no alternative. Again taxes and bonds are not funding sources for the US federal government; however they have important functions. Taxes help to keep inflation in check (in addition to maintaining demand for the government’s monetary instruments). Bond sales allow the government to deficit spend without creating excessive volatility in the federal funds market. If financial market participants want more bonds, the Treasury issues more to keep bond rates high enough for its tastes; if financial market participants do not want more treasury bonds, the government does not issue to avoid raising rates. The US Treasury (and any monetarily sovereign government as long as they understand it) has total control over the rate it pays on its debts; whether the government understands this or not is another question. A monetarily sovereign government does not have to pay “market rates” in order to convince markets to hold its bonds. Indeed, it does not even have to issue securities if it does not want to. In the US, it is usually the financial institutions that beg the Treasury to issue more securities.

The recent episode of the “Supplementary Financing Program” is a very good illustration of that point. Financial market participants were crying for more Treasuries and the Fed could not keep pace. As a consequence the Treasury agreed to issue more Treasuries than expected to meet the demand and help the Fed drain reserves and thereby hit their interest rate target. According to the Federal Reserve Bank of New York (DOMESTIC OPEN MARKET OPERATIONS DURING 2008, page 28): “To help manage the balance sheet impact of the Federal Reserve’s liquidity initiatives, the Treasury announced the establishment of a temporary Supplementary Financing Program (SFP) on September 17. The program consists of a series of Treasury bills issued by Treasury, the proceeds of which are deposited in an account at the Federal Reserve, draining reserve balances from the banking sector.”

Now look how this was deformed by the Treasury (quite a few journalists and bloggers followed): “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.” No, Mr. Treasury, this was not done for funding purpose; it was done to drain reserves from the banking system. The Fed does not need any cash from the Treasury. The Fed is the monopoly supplier of cash.

A final point regarding inflation. Inflation is a potential issue, as we have always maintained. But, there is no automatic causation from the money supply to inflation (a point Paul Krugman appears to have forgotten). Inflationary pressures depend on the state of the economy (supply and demand-side factors). Most importantly, perhaps, it depends on people’s desire to hoard vs. spend cash. Even the massive deficits during WWII, when resources were fully employed, did not lead to a spiraling out of control of inflation. Finally, it is quite possible that causation actually runs the other way around – i.e. from inflation to the money supply – given the endogeneity of the money supply, but that’s a story for another day…

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Posted in Eric Tymoigne, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, Uncategorized, Unemployment

Tagged Eric Tymoigne, Financial crisis, Fiscal Policy, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, unemployment

RAB Capital’s Marshall Auerback on the CBO’s Report

Posted on July 28, 2010 | 1 comment

Watch the latest video at video.foxbusiness.com

1 Comment

Posted in Marshall Auerback, Uncategorized

Tagged Marshall Auerback

Towards a Libertarian/Austrian Modern Money Theory

Posted on July 27, 2010 | 31 comments

By L. Randall Wray

For reasons that I cannot fathom, the most vehement critics of Modern Money Theory (MMT) are the wingnut libertarians and Austrians (and, please, I use the term wingnut with some affection for our fellow fringe travellers). Any time there is an MMT post on this blog, or over at New Deal, Naked Capitalism, or the Huff, the comments are dominated by conspiracy theorists, haters of government, goldbugs, and victims of alien probings who are certain that MMT-ers are united in their effort to ramp up government until it consumes the entire economy. So let us try to mend fences.

First, on one level, MMT is a description of the way a sovereign currency works. Love it or hate it, our sovereign government spends by crediting bank accounts. Over the past 20 years, MMT has investigated, analyzed, and documented the sordid operational details. We can lecture for hours on the balance sheet manipulations involving the Treasury, the Fed, the primary security dealers, the special depositories, and the regular private banks every time the Treasury buys a notepad from OfficeMax. We did the work, so you do not have to do it. And believe me, you do not want to do it. You can skip directly to the conclusion: “Yes, government spends by crediting bank accounts, taxes by debiting them, and sells bonds to provide an interest-earning substitute to low-earning reserves. Q.E.D.”

A few libertarians and Austrians now get this, although instead of thanking us for a job well done, they immediately attack us for explaining how things work. Now, why would they do that? Because they fear that if we tell policymakers and the general public how things work, democratic processes will inevitably blow up the government’s budget as everyone demands that wine flow freely through the nation’s drinking fountains whilst workers retire from government jobs at age 28 on generous pensions provided at the public trough. And off we go to Zimbabwe land, with hyperinflation that destroys the currency and sucks the precious body fluids from our economy.

Ok, understood. We fear inflation, too. That has always been our message, too. Indeed, “price stability” has always been one of the two key missions of UMKC’s Center for Full Employment and Price Stability (http://www.cfeps.org/). Maybe you do not like our proposed methods of battling inflation. Fine. Show us yours. I realize that many libertarians and Austrians believe that the only foolproof method for avoiding inflation is to go back to gold. Again, fine. But don’t criticize our labor “buffer stock” scheme for its political infeasibility! Going back to the gold standard is less likely than alien abduction. (Oh, sorry, no offence intended.) Anyway, we (also) do not want black helicopters flying around dropping bags of cash; and we (also) oppose government “pump-priming” demand stimulus—the libertarians and Austrians and even Milton Friedman are correct in their argument that this would generate inflation.

So it is true that there is a second level to MMT: we use our understanding of the way money works to bring rational analysis to government policy-making. Since involuntary default is, literally, impossible for a sovereign government, we quickly move beyond fears about government deficits and debt ratios and all the other nonsense that currently grips Washington. Can we “afford” full employment? Yes. Can we “afford” Social Security? Yes. Can we “afford” to put wine in all the drinking fountains? Yes. The problem IS NOT, CANNOT BE about affordability. It is about resources. Unemployment is easy: by definition, someone who is unemployed is available to hire. So government can put them to work. Social Security is a little more difficult: can we move enough resources to the aged (plus their dependents, and people with disabilities) so that they can enjoy a comfortable, American-style, life? On all reasonable projections of demographics and US ability to produce, the answer is yes. The projections could turn out to be wrong. But if they do, affordability still will not be the problem—it will be a resource problem. Finally, wine in drinking fountains? There probably is not enough fine wine, but we could probably fill all the drinking fountains with cheap French wine. Again, it is a resource problem and if we convert the American prairies to wine production we could probably even resolve that one.

Perhaps the most important policy pushed by most MMT-ers is the Job Guarantee/Employer of Last Resort proposal. This provides a federal-government funded job to anyone who wants to work, at a uniform, basic compensation (wages plus benefits). Our libertarian/Austrian fellow travelers seem to hate this program, again for unfathomable reasons. I suspect that they have misinterpreted this to be some kind of Big Government/Big Brother program based on a weird combination of force plus welfare. The claim is simultaneously that it “forces” everyone to work, and that it also pays everyone for not working. Actually, it is a purely voluntary program, only for those who want to work. Those who will not work cannot participate. Libertarians and Austrians ought to love it. It is not Big Brother. It is not even Big Government. The jobs do not have to be provided by government at all. No one has to take a job. It is consistent with, I think, the most cherished norms of freedom-loving libertarians and Austrians.

So to sum up:

1. MMT is consistent with any size of government. It can be a small libertarian government if you like. But it issues a sovereign floating currency. It supports the currency by imposing a tax payable in that currency.

2. Job Guarantee/Employer of Last Resort is also consistent with any size of government. If you want a big private sector and small government sector, keep taxes and government spending low. That frees up resources to be used by the big private sector. But you will need the JG/ELR to take up the labor resources the private sector cannot fully employ.

3. JG/ELR can be as decentralized as you want. I think there are massive incentive problems if you have federal government pay wages of for-profit firms. So I would have federal government pay the wages in the program but have the jobs actually created and managed by: not-for-profits, local government, maybe state government, maybe only as a final last resort the federal government. Argentina experimented with cooperatives and they looked to me to be highly successful.

4. The problem with a monetary economy (you can call it capitalism if you like) is that from inception imposition of taxes creates unemployment (those looking for money to pay taxes). We scale this up to our modern almost fully monetized economy (you need money just to eat, watch TV, play on cell phones, etc) and we get everyone looking for money (and not just to pay taxes). It is sheer folly to then force the private sector to solve the unemployment problem created by the government’s tax. The private sector alone will never (never has) provide full employment. ELR/JG is a logical and empirical necessity to support the private sector. It is a complement not a substitute for private sector employment.

5. How can the belief that all ought to work, and contribute to society, rather than lay about and collect welfare be called socialism?

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Posted in L. Randall Wray, Uncategorized

Tagged Fiscal Policy, L. Randall Wray

May the Biggest Loser Win: Euroland’s Race to the Bottom

Posted on July 26, 2010 | 3 comments

By L. Randall Wray

As part of the EU/IMF plan to resolve Greece’s debt crisis and to make its economy more competitive, the government announced a couple of weeks ago plans to revamp labor relations laws and social security entitlements. The minimum monthly wage for new entrants into the labor market will be decreased from 700 euros to 560 euros, and workers will be required to have 40 years of employment to receive a full pension (which has also been subject to significant reductions). And companies would face far fewer restrictions with regard to layoffs and layofff compensations–which have been cut in half. The strategy is obvious: Greece wants to win the race to the bottom in the Eurozone, that is, to win competitive advantage by having the region’s lowest and meanest living standards. That, of course, will now be an even tougher race to win, with the recent entry of Estonia into the Eurozone.

Even in the best of times, this would be a dangerous strategy. Given that all members of the Eurozone have removed trade and capital barriers and adopted a common currency, there is no possibility of gaining advantage through the normal methods of currency devaluation or by tacking tariffs onto imports. This means that trade surpluses can be achieved only by lowering costs and increasing labor productivity. Costs are cut by slashing wages and benefits; productivity is increased by working employees harder—downsizing the labor force, longer hours, shorter vacations, and postponed retirement. But every nation will adopt the same strategy. Matters are made worse by the deep global crisis. Markets for exports are depressed and tourism is down. Meanwhile, governments are cutting spending—especially in those areas that could actually help increase productivity and enhance competitiveness: public infrastructure investment and education. Lower wages and retail sales, and a smaller workforce result in collapsing government tax revenue—fueling a vicious cycle of spending cuts but falling tax revenue so that budget deficits cannot be reduced.

To be sure, Greece has had its problems. Its labor costs have grown significantly over the past decade, much faster than those of Germany and other Eurozone nations. But the notion that workers in Greece have been enjoying the fruits of an overly generous welfare state is belied by the facts. (See here) In reality, the Greeks have one of the lowest per capita incomes in Europe (€21,100), much lower than the Eurozone 12 (€27,600) or the German level (€29,400). Further, the Greek social safety nets might seem generous by US standards but are modest by European standards. On average, for 1998-2007 Greece spent only €3530 per capita on social protection benefits–slightly less than Spain’s spending and only €700 more than Portugal’s, which has one of the lowest levels in all of the Eurozone. By contrast, Germany and France spent more than double the Greek level, while the original Eurozone 12 level averaged €6251.78. Even Ireland, which has one of the most neoliberal economies in the euro area, spent more on social protection than the supposedly profligate Greeks.

Greece is also supposed to suffer from inefficiency and cronyism in its government—so its administrative costs should be higher than those of more disciplined governments such as the German and French. But this is obviously not the case as the table below demonstrates. Even spending on pensions, which is the main target of the neoliberals, is lower than in other European countries.

Table 2 shows total social spending of select Eurozone countries as a per cent of GDP. Through 2005, Greece’s spending lagged behind that of all euro countries except for Ireland, and was below the OECD average. Note also that in spite of all the commentary on early retirement in Greece, its spending on old age programs was in line with the spending in Germany and France.

Greece has one of the most unequal distributions of income in Europe, and a very high level of poverty, as the following table shows. Again, the evidence is not consistent with the picture presented in the media of an overly generous welfare state.

The proposed cuts will simply widen the gap between living standards in Greece versus those in the wealthiest Eurozone nations.

This is a race to the bottom that can only be won by the biggest loser. It is bizarre that the EU and the IMF are promoting such a contest since it is completely inconsistent with the longer-run strategy of convergence across Euroland. Indeed, it will ultimately destroy the union.

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Posted in L. Randall Wray, Policy and Reform, Uncategorized

Tagged Fiscal Policy, L. Randall Wray, Policy and Reform

Deficit Doves Meet the Deficit Owls

Posted on July 21, 2010 | 6 comments

By Stephanie Kelton

On July 19, The Daily Beast published a piece by Harold Evans, Joseph Stiglitz, Alan Blinder, Robert Reich and others, urging greater fiscal stimulus in the short-term and renewed fiscal discipline over the medium- and longer-term horizon. A number of bloggers on this site were asked to support their deficit-dove petition. We declined, and so did the three wise owls who wrote the following statement, which first appeared at New Deal 2.0.

The following is a reprint of a response by Paul Davidson, James K. Galbraith and Lord Robert Skidelsky (Deficit Owls) First published at New Deal 2.0

“We three were each asked to sign the letter organized by Sir Harold Evans and now co-signed by many of our friends, including Joseph Stiglitz, Robert Reich, Laura Tyson, Derek Shearer, Alan Blinder and Richard Parker. We support the central objective of the letter — a full employment policy now, based on sharply expanded public effort. Yet we each, separately, declined to sign it.

Our reservations centered on one sentence, namely, “We recognize the necessity of a program to cut the mid-and long-term federal deficit…” Since we do not agree with this statement, we could not sign the letter. Why do we disagree with this statement? The answer is that apart from the effects of unemployment itself the United States does not in fact face a serious deficit problem over the next generation, and for this reason there is no “necessity [for] a program to cut the mid-and long-term deficit.”

On the contrary: If unemployment can be cured, the deficits we presently face will necessarily shrink. This is the universal experience of rapid economic growth: tax revenues rise, public welfare spending falls, and the budget moves toward balance. There is indeed no other experience in modern peacetime American history, most recently in the late 1990s when the budget went into surplus as full employment was reached.

We agree that health care costs are an important issue. But health care is a burden faced by both the public and private sectors, and cost control is a job for health policy, not budget policy. Cutting the public element in health care – Medicare, especially – in response to the health care cost problem is just a way of invidiously targeting the elderly who are covered by that program. We oppose this.

The long-term deficit scare story plays into the hands of those who will argue, very soon, for cuts in Social Security as though these were necessary for economic reasons. In fact, Social Security is a highly successful program which (along with Medicare) maintains our entire elderly population out of poverty and helps to stabilize the macroeconomy. It is a transfer program and indefinitely sustainable as it is.

We call on fellow economists to reconsider their casual willingness to concede to an unfounded hysteria over supposed long-term deficits, and to concentrate instead on solving the vast problems we presently face. It would be tragic if the Evans letter and similar efforts – whose basic purpose we strongly support – led to acquiescence in Social Security and Medicare cuts that impoverish America’s elderly just a few years from now.”

James K. Galbraith is a Professor at The University of Texas at Austin and author of “The Predator State.”

Lord Robert Skidelsky is the author, most recently, of “Keynes: The Return of the Master.”Paul Davidson is the Editor of the Journal of Post Keynesian Economics and author of “The Keynes Solution.”